When it comes to launching a new business in California, choosing the right legal entity is a critical decision. Each entity – be it a Sole Proprietorship, General Partnership, Corporation, S-Corp, Limited Liability Company (LLC), or Limited Partnership – carries its own set of advantages and drawbacks. This largely depends on factors such as the scope, size, and nature of your business, your financial goals, and the level of liability protection you seek. In this blog, we will shed light on the various entity choices in California, helping you make an informed decision that aligns with your business objectives.

California Sole Proprietorship

What is a California Sole Proprietorship?

A California Sole Proprietorship is the simplest form of business entity in California, where the business is owned and managed by a single individual (or a married couple who file taxes jointly). In this structure, there is no legal distinction between the owner and the business, meaning the owner is personally liable for all business debts, liabilities, and obligations. Its simplicity, ease of setup, and minimal regulatory requirements make it a popular choice for small businesses and entrepreneurs.

How is a California Sole Proprietorship Formed?

Forming a Sole Proprietorship in California is straightforward. No formal filing with the California Secretary of State is required. The individual simply starts conducting business after obtaining a local business license, filing a fictitious business name statement, and obtaining a seller’s permit (if the business needs to collect and remit California sales tax).

How is a California Sole Proprietorship Taxed?

The sole proprietor reports all business income and expenses on Schedule C of their federal tax return (Form 1040 or 1040-SR). For California state taxes, the income from the sole proprietorship is reported on the California personal income tax return (Form 540) of the sole proprietor.

The net income derived is subject to California federal income tax and self-employment tax.

When is a California Sole Proprietorship the Right Choice?

A California Sole Proprietorship is best suited for individuals starting a low-risk business where the chances of incurring business debts or being sued are minimal and the net profit is not expected to exceed $60,000 annually.

California General Partnership

What is a California General Partnership?

A California General Partnership is a business structure where two or more people agree to share in the profits and losses of a business venture. In a general partnership, partners can share equal control of the business, or divide responsibilities based on their agreement. Each partner is personally liable for business debts and obligations, including the actions of the other partners. This structure is often chosen for its simplicity and flexibility in management and profit distribution.

How is a California General Partnership Formed?

While a Certificate of General Partnership may be filed with the California Secretary of State, a California General Partnership is formed when the partners commence operations of a business venture together.

The partners are not legally required to enter into a written Partnership Agreement to outline the division of roles, responsibilities, profits, and losses, but having a written Partnership Agreement is a good idea.

Similar to a Sole Proprietorship, a General Partnership may also need a local business license, a fictitious business name statement, and a seller’s permit, but all California General Partnerships are required to obtain an EIN from the Internal Revenue Service (IRS).

How is a California General Partnership Taxed?

A California General Partnership is a “pass-through” taxation structure, where the profits or losses of the business are reported on IRS Form 1065 and California FTB Form 565, but the taxes on the business net profit is passed through to the personal tax returns of the partners.

The net income derived is subject to California and federal income tax and self-employment tax on the personal tax returns of each partner.

When is a California General Partnership the Right Choice?

A California General Partnership could be the ideal choice for business ventures where all partners wish to have an equal hand in management and accept personal liability for debts, liabilities, and obligations of the business.

This structure is especially beneficial for businesses with low risk, where partners seek simplicity in setup and operations, and the net profit is not expected to exceed $60,000 annually.

California Corporation

What is a California Corporation?

A California Corporation is a business entity separate from its owners, providing them with personal liability protection. This structure is defined by its shareholders, who own shares of stock, its board of directors who make the strategic decisions, and its officers who run the day-to-day operations of the business. In a small corporation, one person may hold all these positions, but in larger corporations, the identity of shareholders, the board of directors, and the officers may be different.

How is a California Corporation Formed?

Forming a California Corporation involves several steps. First, Articles of Incorporation must be filed with the California Secretary of State, followed by the adoption of bylaws, holding an initial meeting of the board of directors, filing a Statement of Information with the California Secretary of State, obtaining an Employer Identification Number (EIN) from the IRS, and acquire any necessary business licenses and permits, and issuing shares of stock to the shareholders in compliance with federal and California securities laws and regulations.

How is a California Corporation Taxed?

A California Corporation is subject to the corporate tax structure.

When a shareholder is also an employee of a California Corporation, the shareholder may pay themselves fair market value wages that are business expenses to the corporation but are subject to California and federal income taxes and employment taxes.

The corporation pays California and federal income tax on its net income after deducting business expenses (including wages) using the IRS Form 1120. For the state taxes, California Corporations must file California Form 100 with the California FTB and pay state corporate tax on net income derived from California.

All California Corporations are subject to an $800 annual minimum franchise tax.

Dividends paid to shareholders from the after-tax profits of the corporation are taxed again on the personal tax returns of shareholders, meaning profits are subject to double taxation; once at the corporate level, and again at the shareholder level.

When is a California Corporation the Right Choice?

A California Corporation is an advantageous choice for businesses looking for a structure that provides personal liability protection to its owners. It is essential to note that a California Corporation requires effort to maintain, including adherence to strict record-keeping and operational processes. However, a California S-Corp is usually a more tax-efficient structure to use when possible.

California S-Corp

What is a California S-Corp?

A California S-Corp is the same California Corporation discussed above with the addition of a special tax election with the Internal Revenue Service.

Permissible shareholders of a California S-Corp must be individuals, certain trusts, estates, or tax-exempt organizations, all of whom must be citizens or permanent residents of the United States. There may not be more than 100 shareholders, and the S-Corp may only have one class of stock.

How is a California S-Corp Formed?

The formation of a California S-Corp is identical to the formation of a California Corporation with the addition of filing IRS Form 2553, the Election by a Small Business Corporation, within two months and 15 days of the beginning of the tax year the election is to take effect.

How is a California S-Corp Taxed?

A California S-Corp is taxed as a pass-through entity, similar to a California General Partnership.

As with a California Corporation, when a shareholder of a California S-Corp is also an employee, they must be paid fair market value wages that are business expenses to the S-Corp but are subject to California and federal income taxes and employment taxes.

The S-Corp itself does not pay federal income tax but reports its net profit on IRS Form 1120S and California FTB Form 100S. The business income is passed through to the shareholders and reported on their personal tax returns, where they are responsible for paying California and federal income taxes on the net income of the S-Corp, which is just a single level of taxation as compared to the double taxation of California Corporations.

All California Corporations are subject to the greater of an $800 annual minimum franchise tax or 1.5% franchise tax on net income.

Net profits of a California S-Corp may be distributed to shareholders and are not subject to self-employment tax, which is a distinct advantage over California Corporations and most other pass-through entities in California.

When is a California S-Corp the Right Choice?

A California S-Corp is an excellent choice for businesses anticipating a net profit exceeding $60,000 annually and seeking to leverage the advantage of pass-through taxation and limitation of self-employment and employment taxes.

California LLC

What is a California LLC?

A California Limited Liability Company (LLC) is a business structure that offers the flexibility of a partnership with the liability protection of a corporation. Owners of an LLC, known as members, are protected from personal liability for the debts, liabilities, and obligations of the company. LLCs in California can be managed either by the members themselves or by assigned managers, and there is no restriction on the number or type of members, making it a versatile option for many businesses.

How is a California LLC Formed?

Articles of Organization must be filed with the California Secretary of State, an Operating Agreement is required (although not required to be in writing), a Statement of Information must be filed with the California Secretary of State, an Employer Identification Number must be obtained from the IRS, and all necessary business licenses and permits should be acquired.

How is a California LLC Taxed?

A California LLC has flexible taxation options. If the LLC has a single member, it may be treated as a disregarded entity for tax purposes and taxed like a sole proprietorship.

An LLC with multiple members can choose to be taxed as a General Partnership, where income and expenses are passed through the individual tax returns of each member.

Whether disregarded for tax purposes or taxed as a partnership, taxable dispositions may be treated as capital gains for income tax purposes as opposed to California Corporations and California S-Corps, where all income is deemed to be ordinary income subject to income tax.

Finally, whether a single-member LLC or LLC with multiple members, an LLC can elect to be taxed as a corporation or an S-Corporation by filing appropriate forms with the IRS, however, such election does not allow access to capital gains tax treatment.

All California Corporations are subject to an $800 annual minimum franchise tax. In addition to the franchise tax, LLCs may also be subject to the California LLC Fee if their annual gross receipts exceed $250,000. This fee ranges from $900 to $11,790, depending on total income.

When to Use a California LLC?

A California LLC is the optimal choice when businesses require liability protection coupled with the desire to access capital gains tax in situations such as holding real estate, intellectual property, and other assets capable of appreciation.

California Limited Partnership

What is a California Limited Partnership?

A California Limited Partnership is a business entity with at least one General Partner and at least one Limited Partner. The General Partner manages the business and is personally liable for business debts, liabilities, and obligations of the business, and the Limited Partners contribute capital and share in profits but take no part in running the business and incur no liability beyond the amount of their contribution. While the General Partner has unlimited liability and risks its personal assets, a limited liability entity such as a corporation, S-Corp, or LLC may be used to provide liability protection to the General Partner.

How is a California Limited Partnership Formed?

The formation of a California Limited Partnership requires the filing of a Certificate of Limited Partnership with the California Secretary of State, establishing a Limited Partnership Agreement, obtaining an Employer Identification Number (EIN) from the IRS along with local business license and permits and other requirements applicable to all businesses.

How is a California Limited Partnership Taxed?

A California Limited Partnership is taxed as a partnership, like a California General Partnership, for California and federal income tax purposes.

All California Limited Partnerships are subject to an $800 annual franchise tax, but not state franchise tax like a California Corporation, a 1.5% tax like a corporation, nor the California LLC Fee.

Like California General Partnerships and California LLCs disregarded for tax purposes or taxed as a partnership, California Limited Partnerships have access to capital gains taxation.

When is a California Limited Partnership the Right Choice?

A California Limited Partnership emerges as the optimal choice when businesses need access to capital gains taxation but anticipate gross revenue exceeding $250,000 annually. In such scenarios, limited liability companies would trigger the California LLC Fee, whereas a California Limited Partnership would not be subjected to this.

Other California Entities

While the business structures discussed above represent the most frequently chosen options in California, they are by no means the only choices available from the State of California. An experienced corporate attorney may suggest several other entity types depending on the unique circumstances and needs of your business. Therefore, it is imperative to seek professional legal guidance to ensure the chosen entity best aligns with your business objectives.

Let Us Help You Choose the Right California Entity

Navigating the complexities of entity choices can be quite challenging. To ensure that you are selecting the most advantageous entity that aligns with your business goals, it is critical to seek professional guidance. At San Diego Corporate Law, our experienced team of corporate attorneys is committed to helping you make informed decisions. Contact us today to schedule an initial consultation and let us assist you in choosing the right California business entity.