Introduction to California LLCs – San Diego Corporate Law

California LLC – San Diego Corporate Law Summary

Operating a business as a California LLC combines the best parts of partnerships and corporations:

• Flexible management structure with management provided by all California LLC members (owners), one manager (who may or may not be a member, or more than one manager (who may or may not be members);

• Limiting personal liability against claims from lawsuits and creditors;

• Protection from charging orders;

• The ability to raise capital from investors by issuing membership interests or units;

• The ability to choose taxation between disregarded for tax purposes (taxation as a sole proprietorship if there is only one member), partnership taxation (if there are two or more members), taxation as a corporation, or taxation as an S Corporation;

• Passing through profits and losses to members, thus avoiding double taxation (depending upon the taxation type selected);

• Access to capital gains taxes upon disposition of appreciated assets (depending upon the taxation type selected);

• Reducing self-employment taxes for shareholders earning wages (depending upon the taxation type selected); and

• Minimal formal governance compared to California Corporations and California S-Corps.

All California limited liability company formations by San Diego Corporate Law include attorney-drafted Articles of Organization and Operating Agreement, federal EIN application, and company records book with membership certificates.

California LLC – San Diego Corporate Law Details

A Limited Liability Company (LLC) in California is a well-regarded business structure that offers key benefits for businesses of all sizes and scopes. A California LLC can be established by one or more individuals, known as members, who do not typically have personal liability for the debts, liabilities, obligations, or legal judgments against the California LLC. The streamlined structure and reduced formalities make it an appealing choice for many business owners.

A California LLC strikes a unique balance by offering the personal liability protection of a corporation together with the operational flexibility of a partnership and the ability to elect the most taxation type. A California LLC allows for the election of taxation type based on the number of owners, ranging from a disregarded entity for tax purposes to partnership taxation, right up to taxation as a corporation or S Corporation. This flexibility in tax treatment further adds to the appeal of forming an LLC in California. Moreover, a California LLC is an excellent choice of business entity for holding appreciating assets such as real estate, providing the opportunity to access capital gains taxation, further enhancing the tax efficiency of this business entity.

California Law Applicable to California LLCs

The primary California law applicable to California LLCs is the California Revised Uniform Limited Liability Company Act (abbreviated RULLCA) found in California Corporations Code §§17701.01–17713.13. The California Revised Uniform Limited Liability Company Act provides comprehensive guidelines detailing the formation, operation, and dissolution of Limited Liability Companies in California. The California Revised Uniform Limited Liability Company Act also outlines the rights and duties of members and managers, provisions for Operating Agreements, and the procedures for handling disputes.

The California Revised Uniform Limited Liability Company Act replaced the Beverly-Killea Limited Liability Company Act. This change took place on January 1, 2014. The transition was made to modernize and simplify the laws governing California LLCs, providing clearer guidelines on the formation and operation of limited liability companies in the State of California.

Restrictions on California LLC Operation and Ownership

Restrictions on California LLCs Generally

One or more individuals, partnerships, limited partnerships, trusts, estates, associations, corporations, LLCs, or other entities may form a California limited liability company. Unless otherwise specified in the Articles of Organization or Operating Agreement, any member may transfer their interest in a California LLC without the consent of other members or managers.

A California limited liability company is not allowed to engage in business for profit unless it has at least one manager. California Corporations Code § 17704.07(a). The legislation does not specify any qualifications for managers, who are not required to become a member. California Corporations Code §§ 17704.07(a), (b).

Restrictions on California LLCs for the Provision of Professional Services

In California, there are restrictions on LLCs regarding the provision of professional services. California Corporations Code Section 17701.04(e). A professional service is defined as any type of professional service that may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act. California Corporations Code § 13401(a). Examples include the services of:

Certified Public Accountants (California Business and Professions Code §§ 5150-5158)

Acupuncturists (California Business and Professions Code §§ 4975-4979)

Architects (California Business and Professions Code §§ 5610-5610.7)

Audiologists (California Business and Professions Code §§ 2536-2537.5)

Chiropractors (California Business and Professions Code §§ 1050-1058)

Clinical Social Workers (California Business and Professions Code §§ 4998-4998.5)

Dentists (California Business and Professions Code §§ 1800-1808)

Dental Hygienists in Alternative Practice (California Business and Professions Code §§ 1967-1967.4)

Attorneys (California Business and Professions Code §§ 6127.5, 6160-6172)

Marriage and Family Therapists (California Business and Professions Code §§ 4987.5-4988.2)

Physicians (California Business and Professions Code §§ 2400-2417)

Midwives (California Business and Professions Code §§ 2505-2523)

Naturopathic Doctors (California Business and Professions Code §§ 3670-3675)

Nurses (California Business and Professions Code §§ 2575-2781)

Occupational Therapists (California Business and Professions Code §§ 2572)

Optometrists (California Business and Professions Code §§ 3160-3167)

Osteopaths (California Business and Professions Code §§ 2402-2417, 3600)

Pharmacists (California Business and Professions Code §§ 4150-4156)

Physical Therapists (California Business and Professions Code §§ 2690-2696)

Physician Assistants (California Business and Professions Code § 3540-3545)

Podiatrists (California Business and Professions Code §§ 2402-2417)

Professional Clinical Counselors (California Business and Professions Code §§ 4999.123-4999.129)

Psychologists (California Business and Professions Code §§ 2907-2907.5, 2995-2999)

Shorthand Court Reporters (California Business and Professions Code §§ 8040-8047)

Speech-Language Pathologists (California Business and Professions Code §§ 2537.5)

Veterinarians (California Business and Professions Code §§ 4910-4917)

Under California law, an LLC is generally not permitted to provide these professional services, and professionals who wish to form a limited liability entity may instead form a professional corporation or a registered limited liability partnership. Corporations Code § 13400 et seq., Corporations Code § 16956 et seq. (as permitted for certain professions only).

Restrictions on California LLCs Electing S Corporation Taxation

A California LLC that elects S Corporation taxation can provide significant tax benefits to the California LLC members, however, the California LLC and its members must adhere to specific limitations and obligations on its ownership to qualify for S Corporation taxation, and a failure to maintain these limitations and obligations may lead to the loss of the S Corporation tax status.

The Internal Revenue Service, in its regulations and the Internal Revenue Code, requires business entities that elect to be taxed as S corporations can only have a maximum of (100) beneficial owners. 26 USC § 1361(b)(1)(A). Each owner must be a natural person (or estate or certain trusts) but not a corporation, partnership, other LLC, or other business or artificial entity. 26 USC § 1361(b)(1)(B). Each of these owners must be a citizen of the United States or a permanent resident of the United States. 26 USC § 1361(b)(1)(C). Finally, there may only be one class of ownership, meaning all members have an equal right of management, and allocations of profits and losses, and distributions must be made based upon their percentage ownership. 26 USC § 1361(b)(1)(D).

Certain types of businesses are not eligible for S corporation taxation, such as certain financial institutions, insurance companies, and domestic international sales corporations. 26 USC §§ 1361(b)(2)(A)-(C).

California LLC Formation Process

California LLC Articles of Organization

A California LLC is formed by drafting and filing Articles of Organization with the California Secretary of State. California Corporations Code C §§ 17702(a). Articles of Organization for a California LLC must be filed on California Secretary of State Form LLC-1 (Articles of Organization of a Limited Liability Company (LLC)). California Corporations Code § 17702.01(a). Articles of Organization for a California LLC serve as the official document for the formation of a California LLC under California laws.

California Articles of Incorporation for a California LLC include the following information about the California LLC they form:

• The name of the California LLC;
• The initial street address of the principal office of the California LLC;
• The initial mailing address of the California LLC (if different than the principal office address);
• The name and address of the registered agent for the California LLC (which is the agent for service of process authorized to receive legal documents on behalf of the California LLC, whether a professional registered agent service is engaged, one of the members or managers is the registered agent, or San Diego Corporate Law provides initial registered agent services free of charge when forming California LLCs for its clients);
• The management structure of the California (whether there is one manager, more than one manager, or all members manage);
• The purpose statement of the California LLC; and
• The signature and business title of the organizer of the California LLC.

The Articles of Organization of a California LLC are filed with the office of the California Secretary of State in person, online, or by mail accompanied by the required filing fee, currently $70.00. California Government Code §12190(b). Subject to availability, the California Secretary of State will process the Articles of Organization for a California LLC within 24 hours for an additional $350.00 Class C Expedited Filing Fee when filed in person or online.

Once approved, the Articles of Organization legally recognize the California LLC as a business entity separate from its owners, providing them with limited liability protection and all the other benefits of a California LLC, however, a California LLC is formed upon filing Articles of Organization with the California Secretary of State. California Corporations Code § 17702.01(d).

California LLC Operating Agreement

An Operating Agreement for a California LLC is a legal document and/or binding contract, and as such, it may be adjusted as per the needs of the California LLC it governs, giving the members a significant degree of flexibility in terms of establishing the governance of their California LLC, especially compared to bylaws of corporations, which are more heavily proscribed by the California Corporations Code. A California Operating Agreement is internal and does not need to be filed with the California Secretary of State or any other governmental authority in the State of California.

A well-written California Operating Agreement should include provisions for:

• Outlining the ownership structure and member roles within the California LLC;
• Outlining the management structure and manager roles and responsibilities to the California LLC;
• Providing for decision-making processes, how to call and conduct meetings, and the voting rights of members and/or managers of the California LLC;
• Set forth the allocation of profits and losses and priorities thereto;
• How financial records should be established and maintained;
• Naming a tax matters member;
• Establish initial capital contributions and how additional capital contributions and capital calls may be made;
• Provisions for the addition of new members, the dissociation of existing members, and restrictions on transfer;
• Establish provisions for dispute resolution in the event of a dispute between members and/or managers;
• Under what circumstances the California LLC may be dissolved.

A California Operating Agreement is the most important document for a California LLC for many reasons, including without limitation, ensuring smooth operation while also safeguarding the rights and interests of its members. The members of a California LLC should invest time in a comprehensive and detailed California Operating Agreement that thoughtfully addresses all aspects of the business operations. Drafting and entering into a California Operating Agreement is not the time or place for organizers of a California LLC to cut corners.

Under the California Revised Uniform Limited Liability Company Act, a California Operating Agreement can take various forms, including oral, written, implied, or a combination of these forms. California Corporations Code § 17701.02(s). California law does require that an LLC have an Operating Agreement in place, though it does not need to be written. California Corporations Code § 17701.10(a). While a California Operating Agreement need not be in writing, it is strongly recommended that this agreement be well drafted and in writing. Oral agreements, while legally valid, are inherently unenforceable due to their lack of evidentiary provenance, susceptibility to memory errors, and even honest misunderstandings between members.

A written California Operating Agreement, on the other hand, provides a tangible record of the contractually agreed upon rights, responsibilities, and procedures by and between members. This serves as a point of reference in case of disputes, ensuring the preservation of the agreed-upon terms and reducing ambiguity. Moreover, a written California Operating Agreement is perceived with higher credibility in legal scenarios, providing the California LLC and its members with a more robust legal footing. The decision to document a California Operating Agreement in writing enables smooth operations, mitigates potential disputes, and ensures a more secure and efficient management of a California LLC.

Without a written California Operating Agreement, or to the extent a California Operating Agreement does not otherwise provide for a matter described in California Corporations Code § 17701.10(a), governance, management, allocations of profit and loss, membership interest percentages, and all other specific provisions of a California LLC default to the standard provisions of the California Revised Uniform Limited Liability Company Act. California Corporations Code § 17701.10(b).

California LLC Federal Employer Identification Number

A federal Employer Identification Number (EIN) is a unique nine-digit number assigned by the Internal Revenue Service to businesses for tax filing and reporting purposes. Much like a Social Security Number (SSN) for individuals, an EIN is used to identify a business entity.

When forming a Limited Liability Company in California, obtaining an EIN from the Internal Revenue Service is a required step following the approval of the Articles of Organization by the California Secretary of State in the California LLC formation process. This number is required for several purposes such as opening a business bank account in the name of the California LLC, applying for business licenses and permits, filing a tax return for the LLC, and setting up payroll for employees (if the California LLC will have employees).

Applications for an EIN for a California LLC may be submitted to the Internal Revenue Service by mail, fax, or online on the website of the Internal Revenue Service. The Internal Revenue Service will provide an EIN for a California LLC free of charge, and San Diego Corporate Law similarly does not charge to obtain an EIN when forming a California LLC for its clients.

An EIN cannot be transferred or canceled, and certain structural or taxation changes may require a new EIN.

Unlike a Social Security Number for individuals that is used for both federal and state purposes, an EIN for a California LLC is a federal tax identification number and various California and municipal taxing authorities may require a California LLC to have other tax identification numbers associated (e.g., an EDD number from the California Employment Development Department for payroll and employment tax purposes, an account number from a sellers permit with the California Department of Tax and Fee Administration for remitting collected sales tax, etc.). However, these additional identification numbers will be applied for when and as needed and are not appropriate to apply for as a part of the formation of a California LLC.

California LLC Statement of Information

An initial Statement of Information on California Secretary of State Form LLC-12 must be filed within 90 days of filing the Articles of Organization with the California Secretary of State. California Corporations Code §17702.09(a). The filing requirements for statements of information servers to provide updated and confirmed records the California Secretary of State maintains for each California LLC (and foreign LLC), ensuring relevant and current information about the California LLC.

This document includes a wide range of essential details about the LLC, such as its name, principal business office address, mailing address, name and address of the agent for service of process, as well as the names and complete business or residential addresses of any manager or chief executive officer.

As a result of AB 3075, effective as of January 1, 2022, every Statement of Information must contain a Yes or No answer to the following question:

“Does any Manager or Member have an outstanding final judgment issued by the Division of Labor Standards Enforcement or a court of law, for which no appeal therefrom is pending, for the violation of any wage order or provision of the Labor Code?”

After filing the initial Statement of Information that a California LLC must file with the California Secretary of State within 90 days after the filing of its original Articles of Organization (or registered foreign LLC after registering for authority to transact business in California), a California LLC is required to file a Statement of Information every two years during the applicable filing period, which is the calendar month during which the original Articles of Organization were filed and the immediately preceding five calendar months. California Corporations Code §17702.09(a).

A Statement of Information may be filed online on the website of the California Secretary of State, by mail, or in person. The filing fee for the Statement of Information is currently $20. California Government Code § 12190(k). If the Statement of Information is not filed on time, the LLC may be subject to a $250 penalty.

Financial Crimes Enforcement Network Beneficial Ownership Information Reporting

Starting January 1, 2024, the Financial Crimes Enforcement Network Beneficial Ownership Information Reporting will become a required step in the formation process of most California LLCs. This new federal requirement aims to improve transparency and prevent illegal activities such as money laundering, fraud, and tax evasion.

California LLCs formed before January 1, 2024, will be required to disclose their beneficial owners on or before December 31, 2024. California LLCs formed between January 1, 2024, through December 31, 2024, will be required to disclose their beneficial owners within ninety (90) days of formation. California LLCs formed on or after January 1, 2025, will be required to disclose their beneficial owners within thirty (30) days of formation.

While this will not be an annual filing, once an initial Beneficial Ownership Information Report is filed, any changes to the reported information will require an updated filing which is required to be made within thirty (30) days of such a change.

The term “beneficial owner” is defined as any individual who owns 25% or more of the equity interests of a California LLC or has a significant responsibility to control or manage the entity, including without limitation, a California LLC member with management rights who has less than 25% membership interest in a California LLC or non-member managers of a California LLC. The information required includes the name, date of birth, address, and an identification number, such as a passport number or driver’s license number.

Non-compliance with the Financial Crimes Enforcement Network Beneficial Ownership Information Reporting requirements can result in significant penalties, including civil fines of up to $500 per day of non-compliance and potential criminal charges of up to $10,000 and 2 years of imprisonment.

Federal, State, and California Securities Filings

The formation of a California LLC may also necessitate the completion of federal, state, and California securities filings. However, the requirements of these filings are contingent upon the specific structure of the California LLC. These securities regulations aim to protect investors by ensuring they have all the information necessary to make informed investment decisions. These filings may include disclosures about the company’s financial condition, the nature of the business, and the risks involved in investing in the LLC. The most common securities exemption filings are discussed in more detail further down this page, but it is crucial to consult legal advice to understand and comply with the various securities laws that might apply to your situation. It is also worth noting that online filing services generally do not address federal, state, or California securities laws, leaving it to the members to figure out whether or not any securities filings are required when forming a California LLC.

Personal Liability for Members of an LLC in California

Understanding the implications and limitations of personal liability is important for members and prospective members involved in a California LLC, as it provides insights into the potential risks to members associated with the business.

Personal Liability Protection for Members of a California LLC

Members of a California LLC generally enjoy protection from personal liability. The primary provision of this personal liability protection is based upon a California LC being considered a separate legal entity from its members. As such, members are typically not personally responsible for the debts, liabilities, obligations, or legal judgments against a California LLC. This means that typically creditors cannot successfully pursue the personal assets of members, such as their homes, cars, or personal bank accounts, to satisfy the debt, liabilities, obligations, and legal judgments against a California LLC.

Charging Order Protection for Members of a California LLC

Charging order protection is a key benefit of forming a California LLC. Charging order protection provides a member of a California LLC with a layer of financial protection against the personal creditors of other California LLC members in a California LLC.

A charging order is a court-ordered lien placed on a membership interest in a California LLC due to personal debts, liabilities, obligations, and legal judgments against a member of a California LLC. It allows the creditor of a California LLC member to receive any distributions from the California LLC that would otherwise go to the indebted member, thereby satisfying the personal debts of the member.

However, under California law, a charging order merely grants a creditor the right to receive distributions from a California LLC; it does not permit the creditor to exercise any management or voting rights in that California LLC. This means that while a creditor can receive financial distributions, they cannot interfere with the day-to-day operation of the California LLC or force the California LLC to make distributions.

The provision for charging order protection in California can be found in the California Corporations Code §17705.03. This particular statute underscores that a charging order is the exclusive remedy by which a judgment creditor of the member or a transferee may satisfy a judgment out of the transferable interest of the member of the California LLC.

The charging order protection mechanism ensures the seamless operation of a California LLC while preventing personal creditors of members from seizing control of the California LLC.

Fiduciary Duties of Members of a California LLC

Members of a California LLC are entrusted with fiduciary duties, which are responsibilities that guide their actions and decisions within the California LLC. The two primary fiduciary duties are the duty of loyalty and the duty of care, but the duty of good faith and the duty of fair dealing also apply.

1. Duty of Loyalty. The duty of loyalty requires members to act in the best interest of the California LLC at all times. Members must not engage in self-dealing or competing with the California LLC. This includes avoiding conflicts of interest and not using the business opportunities of the California LLC for personal gain without consent from other members of the California LLC.
2. Duty of Care. The duty of care mandates that members act with the level of care that a reasonable person would exercise under similar circumstances. This means making informed decisions for the California LLC and avoiding reckless actions or negligence that could harm the California LLC.
3. Duty of Good Faith. The duty of good faith requires members to act honestly and in good faith when making decisions for the California LLC. This includes disclosing any pertinent information and not hiding or manipulating facts from the other members of the California LLC for personal gain.
4. Duty of Fair Dealing. The duty of fair dealing means that members of a California LLC must treat each other with fairness and integrity in all interactions related to the California LLC. This includes communication, business transactions, and decision-making processes.

Breaching these fiduciary duties can have serious legal consequences. If a member fails to uphold their duties, they may be held liable for any resulting damages to the California LLC or its other members.

While a California LLC provides a level of personal liability protection to its members, a California LLC does not absolve its members from their fiduciary duties to the California LLC and its other members. Members must act in the best interest of the California LLC and can be held personally liable for any breaches of these duties.

Limitations on Personal Liability Protection for Members of a California LLC

A member of a California LLC is typically not liable for the debts, liabilities, obligations, and legal judgments against a California LLC, but this protection is limited.

“The corporate veil” is a legal concept that separates the identity of a limited liability business entity, including California LLCs, from their members, thus protecting the members from being personally liable for the debts, liabilities, obligations, and legal judgments against a California LLC. This legal separation provides a layer of protection for the personal assets of members of a California LLC, meaning creditors and legal agencies typically cannot successfully pursue the personal assets of California LLC members to settle for the debts, liabilities, obligations, and legal judgments against a California LLC.

The corporate veil can be “pierced” or removed in certain situations where the California LLC is found to be an alter ego of the members of the California LLC. There are specific circumstances where this veil of protection may be pierced, and members may be held personally liable, such as:

1. When a member of a California LLC provides a personal guaranty for a debt, liability, or obligation of a California LLC, that personal guaranty is personal to the California LLC member providing it, so with respect to that debt, liability, or obligation, the corporate veil of the California LLC does not protect that member.
2. When a member of a California LLC engages in tortious conduct, that member is personally liable for their actions whether or not those actions were done on behalf of a California LLC or for the benefit of a California LLC because tortious conduct, whether via an intentional act of the member, the negligence of the member, or strict liability for the acts or omissions of the member cannot be transferred to a California LLC.
3. If a member of a California LLC receives improper distributions of the assets of a California LLC, that member is responsible for the improper distribution and they may be personally liable for returning the over-distributed assets back to the California LLC so that such over-distributed assets may be used to satisfy the debts, liabilities, obligations, and legal judgments against that California LLC.
4. If any actions are taken by members of a California LLC without proper authority or compliance with the law or governing documents, such as a member acting on behalf of the California LLC without proper authorization or in violation of California law, that member may be held personally liable for any resulting debts, liabilities, obligations, or legal judgments against a California LLC.
5. If a member of a California LLC intermingles personal and corporate matters, such as using personal financial resources to pay for California LLC expenses or using the financial resources of a California LLC to pay for personal expenses, the corporate veil may be pierced, and members of the California LLC could be held personally liable.

Members of a California LLC are advised to maintain proper records and follow all applicable laws, the provisions of their Articles of Organization and Operating Agreement, keep assets of their California LLC separate from their personal assets, and otherwise operate their California LLC as a legal entity separate from its members to best ensure their personal assets are protected.

A member who acts as a manager of a California LLC may have increased personal liability stemming from their actions as a manager.

Anonymity of Members in a Limited Liability Company in California

The names of the members of a California LLC are not a matter of public record unless the member serves as a manager of the limited liability company.

Manager-Managed California LLC Member Anonymity

In a manager-managed California LLC, the names and addresses of the managers of the California LLC are listed on each Statement of Information filed with the California Secretary of State under California Corporations Code §17702.09, but the members of a manager-managed California LLC need not be listed on a Statement of Information, and thus are not a matter of public record.

Sole-Member and Member-Managed California LLC Member Anonymity

In a sole-member California LLC or a member-managed California LLC, the name of each member is required to be listed on each Statement of Information filed with the California Secretary of State under California Corporations Code §17702.09, thus the name and address of each member will become public record.

Anonymity After Financial Crimes Enforcement Network Beneficial Ownership Information Reporting

According to the Department of Treasury, the federal agency in charge of the Financial Crimes Enforcement Network Beneficial Ownership Information Reporting requirement, the beneficial owner information will be strictly used for law enforcement and regulatory purposes and is protected by privacy laws to avoid misuse. This means that the disclosed information should not made publicly available, however, only with time and court decisions with regard to beneficial owner information requests under the Freedom of Information Act and inadvertent data leaks and data breaches will there be definitive information regarding the privacy promised for beneficial owner information.

Management of a California LLC

Management of a California limited liability company is dictated by the Operating Agreement but must be accurately indicated in its Articles of Organization. A California LLC may be managed by all members, some members, or by one or more non-members.

Management of Sole-Member California LLCs

In a sole-member California LLC, the management structure is relatively straightforward. Since there is only one member, the sole member possesses complete control over the sole-member California LLC. This means that the sole member has the authority to make all executive decisions related to the operation of the sole-member California LLC without the need for consensus or approval from other members (because there is only one member). This includes, but is not limited to, decisions concerning financial management, business strategy, human resources, and legal affairs.

Despite the ultimate authority of a sole member, a sole member may still opt to appoint one manager or more than one manager to manage the day-to-day operations of the sole-member California LLC. This can be beneficial for a sole member who prefers to focus on high-level strategic decisions or if they have other obligations that prevent them from being deeply involved in the daily management of the sole-member California LLC. However, regardless of whether one manager or more than one manager is appointed to manage a sole-member California LLC, the sole member retains ultimate decision-making authority.

Just because a sole-member California LLC has its ultimate control vested in its sole member, the sole-member California LLC must still maintain proper documentation of all decisions and actions taken to uphold the corporate veil separating the debts, liabilities, obligations, and legal judgments against the sole-member California LLC from the personal assets of the sole member. By treating the sole-member California LLC as a legal entity separate from its sole member with all actions taken in the name of the sole-member California LLC, the personal liability of the sole member may be limited, and their personal assets protected. Failure to maintain this separation could lead to the piercing of the corporate veil, making the sole member personally responsible for the debts, liabilities, obligations, and legal judgments against the sole-member California LLC, and risk the personal assets of the sole member be used to satisfy these debts, liabilities, obligations, and legal judgments.

While a sole-member California LLC offers a great deal of flexibility in terms of management, it still entails a high level of responsibility and accountability for the sole member. Proper management, documentation, and legal compliance are therefore key to the successful operation of a sole-member California LLC.

California LLCs in which All Members Manage

In a California LLC where all members manage, often referred to as member-managed LLCs, every member is actively involved in the day-to-day operations and decisions of the company. In the absence of a formal Operating Agreement indicating otherwise, the California Corporations Code defaults to the presumption that a California LLC is member-managed.

Each member has a vote in the operations of the member-managed California LLC proportional to the percentage of the membership interest held, but this may be modified in the Operating Agreement if desired. Members participate directly in making decisions on significant business affairs of a member-managed California LLC, such as negotiating contracts, hiring and firing personnel, or making financial decisions. This management structure provides each member of a member-managed California LLC with direct control over the business and its operations, fostering transparency, and encouraging active participation.

Member-managed California LLCs require a higher degree of responsibility from each member, as they are all legally considered agents of the member-managed California LLC. This means that any contractual agreement made by a member binds the entire member-managed California LLC. Therefore, a detailed Operating Agreement should be entered by all members of a member-managed California LLC and its members should communicate thoroughly to ensure that decisions align with the overall vision and goals of the member-managed California LLC and its members.

The members of a member-managed LLC should establish a detailed Operating Agreement outlining the roles, responsibilities, and decision-making processes for the member-managed California LLC and its members to put limits on decisions a member may make without input from the other members to avert potential disputes or confusion.

While all members have the authority to manage a member-managed California LLC, these members also share the legal responsibilities and potential liabilities that come along with management. Therefore, all members should be involved and informed about the business operations to protect the member-managed California LLC, the other members, and themselves.

California LLCs with One Manager

In a California LLC managed by one manager, the management structure is markedly different from both sole-member California LLCs and member-managed California LLCs. Often referred to as manager-managed California LLCs, these entities place the control of day-to-day operations and decision-making into the hands of a single designated manager. This manager may be a member of the manager-managed California LLC, but need not be a member of the manager-managed California LLC, providing flexibility in choosing the right manager to manage the operations of the manager-managed California LLC.

The manager holds the responsibility for making decisions on behalf of the manager-managed California LLC, including financial and operational decisions, hiring, negotiating contracts, and any other activities related to the regular operation of the LLC. The role of non-managing members in a manager-managed LLC is primarily passive, usually limited to voting on high-level decisions such as amending the Articles of Organization or Operating Agreement, a merger or dissolution of the manager-managed California LLC, or changing the management structure of the manager-managed California LLC.

The designation of a manager-managed structure of a California LLC is determined by its Operating Agreement but must be accurately stated in the Articles of Organization. Furthermore, the specific rights, responsibilities, and limitations of the manager should also be outlined in the Operating Agreement, providing clear guidelines on the authority and limits on the manager to mitigate potential disputes and misunderstandings.

Despite the benefits of a streamlined decision-making process, a manager-managed California LLC also carries inherent risks. The manager is legally considered as the agent of the manager-managed California LLC, meaning any contractual agreements made by the manager bind the manager-managed California LLC. Therefore, a trustworthy and competent manager should be selected to maintain communication between the manager and the members.

While the manager assumes the primary responsibility for the operation of a manager-managed California LLC, all members should remain informed and involved enough to oversee the decisions of the manager to ensure alignment with the overall vision and goals of the members of the manager-managed California LLC. Ultimately, in a manager-managed California LLC, the members entrust their investment in the hands of the manager, while the manager carries the responsibility to make decisions that are in the best interest of the manager-managed California LLC and its members.

California LLCs with More than One Manager

In a California LLC managed by more than one manager, the structure is similar to a California LLC with one manager, but there are two or more managers. This type of LLC is also referred to as a manager-managed California LLC, which can be confusing when comparing and contrasting the management of a California LLC with one manager versus more than one manager. Instead of a single manager making decisions, the manager-managed California LLC is managed by a group of two or more managers, who collectively make decisions on behalf of the manager-managed California LLC. Each manager within the manager-managed California LLC with more than one manager does not need to hold a member interest in the LLC, allowing for the inclusion of outside expertise into the management structure, however one or more (or all) of the managers may also be a member of the manager-managed California LLC with more than one manager, and there are no restrictions on the composition of the managers other than not all members can be managers unless there is one or more non-member manager (logically, this would otherwise be an all member manage California LLC).

The managers share the responsibility for decisions related to the daily operations of the manager-managed California LLC with more than one manager, including financial decision-making, negotiating contracts, hiring, and other operational activities. Decisions are typically made through a majority vote of the managers, although the specific decision-making process can be outlined in the Operating Agreement.

Non-managing members in a manager-managed California LLC with more than one manager are usually passive, with their involvement primarily limited to high-level decision-making, such as amending the Operating Agreement or Articles of Organization, merging or dissolving the manager-managed California LLC with more than one manager, or changing the management structure of the manager-managed California LLC with more than one manager.

As with a manager-managed California LLC with one manager, the designation of a multi-manager structure should be outlined in both the Operating Agreement and correctly stated in the Articles of Organization. The Operating Agreement should also establish the rights, responsibilities, and limitations of each manager, providing clear guidelines for their roles within the manager-managed California LLC with more than one manager to prevent potential disputes and misunderstandings.

While having more than one manager allows for a broader range of expertise and a balance of power within a manager-managed California LLC with more than one manager, it also carries its own set of risks. Each manager is considered an agent of the LLC, meaning any contractual agreements made by any manager binds the manager-managed California LLC with more than one manager. It is therefore crucial to have trust and open communication among the group of managers. It is also recommended that all members, even if not managers, stay informed and involved enough to oversee the decisions made by the managers. In a manager-managed California LLC with more than one manager, the management team carries the responsibility to make decisions in the best interest of all members, while the members place their investments in the hands of these managers.

Capitalization

Members of a California LLC contribute assets to a California LLC in exchange for membership interests, which are the measure of ownership of a California LLC. These contributions are referred to as capital contributions. Membership interests may be expressed either in units of membership or by percentage of ownership. A California LLC may create more than one class of membership with different voting, distribution, and other rights between the classes.

Capital contributions from members may be made in cash, real property, tangible personal property, intangible personal property, the performance or provision of services, negotiable instruments, evidence of indebtedness, or agreements and contracts for the provision of the same. California Corporation Code §17704.02. However, care should be taken when capital contributions are made in the form of the provision of services, or agreements or contracts for the provision of services, as these capital contributions may create significant tax liabilities for the California LLC and/or the member making such contribution. Care should also be taken with regard to valuing membership interests and the value assigned to property used as a capital contribution, as this too may create significant tax liabilities for the California LLC and/or the member making such a contribution.

No member is obligated to make any additional contributions to a California LLC after their initial capital contribution unless the Articles of Organization or Operating Agreement of the California LLC creates such a requirement. California Corporations Code §17704.02(a). The Articles of Organization or Operating Agreement of a California LLC may require some or all members to make additional capital contributions, and the conditions under which additional capital contributions must be made should be very clearly specified, especially when not all members may be required to make additional capital contributions. The Articles of Organization or Operating Agreement of a California LLC may also allow some or all members to voluntarily make additional capital contributions, and the conditions under which additional capital contributions may be made voluntarily should also be very clearly specified.

Whether or not members make additional contributions, a California LLC always has the power to borrow money regardless of whether or not some or all members are required to make additional capital contributions or may make additional capital contributions voluntarily, which is often a preferable path for voluntary additional capital contributions. California Corporations Code §§17701.05(d), (h).

A member is not required to make a capital contribution to a California LLC and may be admitted as a member without a capital contribution. California Corporations Code §17704.01(d). However, when a capital contribution is required, a member may not be excused from making such capital contribution except as permitted in the Articles of Organization or Operating Agreement. California Corporations Code §17704.03(a). If a member fails to make any required capital contribution, a California LLC may bring a collection action against that member, and a creditor of the California LLC may enforce that obligation against that member personally. California Corporations Code §17704.03(c). In addition, the Operating Agreement of a California LLC may include contract remedies for failure to make a required capital contribution.

Federal, State, and California Securities Laws

Treatment of a membership interest in a California LLC as a security is determined on a case-by-case basis. Unless all members engage actively in the management of the California LLC, and all members hold equal ownership percentages or numbers or units, the minority membership interests must be treated as a security. California Corporations Code §§25000-25707. All offers and sales of securities in California require qualification with the Commissioner of Corporations unless either the transaction or the security itself is exempted from qualification. California Corporations Code §§25000-25707; 10 California Code of Regulations §§250.9-260.617.

When treated as a security, membership interests are subject to both federal and state securities laws, including California securities laws. Securities of a California LLC must be registered with the Securities and Exchange Commission or qualify for an exemption from registration. Similarly, securities of a California LLC must be qualified with the California Department of Financial Protection and Innovation or qualify for an exemption from qualification.

While a complete treatise of all possible securities registration, qualification, and exemption requirements is beyond the scope of this writing, the most commonly used securities exemptions for membership interests in California LLCs will be introduced below.

Federal Securities Exemption under Section 4(a)(2) of the Securities Act of 1933

Under Section 4(a)(2) of the Securities Act of 1933, a California LLC can issue membership interests without registration, and without an exemption filing, when the transaction does not involve a public offering. The rationale behind this exemption is that registration is unnecessary for transactions not involving public offerings due to the ability of the offerees to fend for themselves.

To assess whether the exemption applies, factors such as the relationship between the offerees and the issuer, the nature, scope and size of the offering, and the manner of the offering are considered. In general, this exemption is best used only as an exemption from federal securities laws by and among co-founders at the time when the founders are issued membership interests, but not for issuing membership interests to non-founders or apart from the initial issuance of membership interests.

However, this exemption is interpreted quite narrowly and members or managers of a California LLC should exercise extreme caution in relying upon it without seeking competent legal advice. Misapplication of this exemption may result in severe legal and financial consequences, so consult a securities attorney to ensure compliance when issuing membership interests in reliance on Section 4(a)(2) of the Securities Act of 1933.

Securities and Exchange Commission Form D Under Regulation D

When a California LLC must exempt the issuance of its membership interests from federal securities registration requirements and Section 4(a)(2) of the Securities Act of 1933 cannot be used, Securities and Exchange Commission Form D under Regulation D is an option for a California LLC issuing membership interests that are considered securities.

Securities and Exchange Commission Form D is a notice filing that includes the names and addresses of the promoters, managers, and other information about the California LLC as well as some details regarding the membership interest issuance being claimed exempt under Regulation D.

Regulation D includes three SEC rules still used for exemptions, namely Rule 504, Rule 506(b), and Rule 506(c), that provide exemptions from the registration requirements of the federal securities laws. Subject to certain restrictions, these rules enable California LLCs to offer and sell their membership interest securities without having to register the securities with the SEC. While California LLCs using a Regulation D exemption do not have to register their securities and usually do not have to file reports with the Securities and Exchange Commission, Form D must be filed within fifteen (15) days of the first offer or sale of securities. Filing Form D requires establishing an EDGAR filing account for the California LLC, which in turn requires certain documents be drafted and submitted to the SEC for review, so members or managers of a California LLC should not wait until the last minute to contact a securities attorney for assistance with a Form D filing.

California Limited Offering Exemption Notice

The California Limited Offering Exemption Notice, pursuant to California Corporations Code §25102(f), is a filing required for certain private securities offerings in the State of California. The California Limited Offering Exemption Notice is a required filing when relying upon the applicable exemption from the qualification requirements of California securities laws for certain types of limited securities offerings. Specifically, the exemption applies to those offerings made to a restricted group of people or to those who are purchasing for investment purposes only and not for the purpose of further distribution.

A California LLC must file this notice with the California Department of Financial Protection and Innovation when it intends to issue membership interests under this exemption. The notice must be filed within fifteen (15) days of the first sale of membership interests. This process requires detailed disclosure about the entity, the offering, and the qualified purchasers. There is a filing fee associated with the filing based upon the issuance price of the securities sold in reliance on the exemption. The filing fees scale is as follows:

• $25 Filing Fee for Securities Issued up to $25,000;
• $35 Filing Fee for Securities Issued up to $100,000;
• $50 Filing Fee for Securities Issued up to $500,000;
• $150 Filing Fee for Securities Issued up to $1,000,000;
• $300 Filing Fee for Securities Issued more than $1,000,000.

It is recommended for members or managers of a California LLC to consult with a securities attorney to ensure compliance with this exemption, as non-compliance could lead to severe penalties.

Other State Securities Issues

The securities laws (also referred to as blue sky laws) of other states may also apply to offers or sales of California LLC membership interests. Consult a securities attorney for advice and counsel.

California LLC Taxation

By default, a California LLC will either be disregarded for income tax purposes or taxed as a partnership depending on the number of members. Default taxation of a California LLC with one member is as a disregarded entity, whereas a California LLC with more than one member is taxed as a partnership by default. However, irrespective of the number of members, a California LLC can elect to be taxed as a corporation or S Corporation, providing members of a California LLC the ultimate flexibility with regard to taxation. The following sections discuss the intricacies of each of these tax structures.

California LLC Disregarded for Tax Purposes

When a California LLC is deemed as disregarded for tax purposes, it means that the LLC is not recognized as a separate entity from its owner for the purpose of tax liability. This is the default taxation for a California LLC with only one member.

Federal Income Taxation of a California LLC Disregarded for Tax Purposes

Under federal income tax law, a California LLC with only one member is disregarded for tax purposes by default and is treated as an extension of its owner, rather than as a separate entity. This means that the California LLC itself does not pay taxes or file a federal income tax return. Instead, all profits and losses of the California LLC flow directly to the owner, who reports them on their personal federal income tax return. If the sole member is an individual, the LLC’s income would be reported on the individual’s Schedule C of the Form 1040 (U.S. Individual Income Tax Return). The owner would then pay individual federal income tax on the profits of the California LLC. On the other hand, if the single member of the California LLC is a corporation or S-Corp, the income of the California LLC would be reported on the federal corporate income tax return of the sole member on Internal Revenue Service Form 1120 or 1120S, respectively.

Federal Self-Employment Taxation of a California LLC Disregarded for Tax Purposes

Because a California LLC is disregarded for tax purposes and the Internal Revenue Service treats it as an extension of its owner, the income generated by such California LLC is subjected to self-employment taxes, similar to a sole proprietorship or partnership. Self-employment taxes are the self-employed equivalent to the Social Security and Medicare taxes withheld from the pay of most wage earners. They are calculated based on net earnings from self-employment, which typically means the profit that remains after all business expenses have been deducted from gross revenue. At the time of this writing, the self-employment tax rate is 15.3%. This rate is comprised of two parts: 12.4% for Social Security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). For the 2024 tax year, only the first $168,600 of combined wages and net earnings is subject to the Social Security tax, but there is no cap on the Medicare portion. The cap on Social Security tax usually increased annually (the cap was $160,200 for 2023 and $147,000 for 2022). In addition to the standard Medicare tax, there is an Additional Medicare Tax of 0.9% on top of the standard 2.9% that applies to individuals with wages, compensation, and self-employment earnings above $200,000 for single filers, $250,000 if married individuals filing jointly, and $125,000 for married individuals filing separately. To pay these taxes, the sole member of a California LLC disregarded for tax purposes must complete Schedule SE (Self-Employment Tax) and attach it to their federal income tax return (Form 1040 or 1040-SR). The owner then pays individual federal income tax on the profits of the California LLC, in addition to the self-employment tax.

California Income Taxation of California LLC Disregarded for Tax Purposes

For California income tax purposes, a California LLC is disregarded for tax purposes, the net income is reported on the tax return of the sole member, which for a natural person is California Franchise Tax Board Form 540, California Resident Income Tax Return, and the sole member pays tax on this income at their individual tax rate. If the sole member is a corporation or S-Corp, the income of the California LLC would be reported on the corporate income tax return of the sole member. While the single-member LLC does not pay income taxes directly, it is a pass-through entity. This means the profits and losses pass through to the tax return of the sole member, where they are subject to California state income tax.

California Franchise Taxation of a California LLC Disregarded for Tax Purposes

For California income tax purposes, a disregarded California LLC must also file California Franchise Tax Board Form 568 (Limited Liability Company Return of Income) and pay the annual LLC tax, calculated at a flat rate of $800, regardless of the income. This is due by the 15th day of the fourth month of the taxable year, usually April 15.

California LLC Fee for a California LLC Disregarded for Tax Purposes

In addition to the annual LLC tax, a disregarded California LLC may be subject to an annual fee based on the total income derived or attributable to California. The fee ranges from $0 for LLCs with gross revenue of less than $250,000 to $11,790 for LLCs with gross revenue of $5,000,000 or more. The exact California LLC Fee structure is as follows:

California LLC Fee = $0 for California Income Under $250,000

California LLC Fee = $900 for California Income of $250,000 to $499,999

California LLC Fee = $2,500 for California Income of $500,000 to $999,999

California LLC Fee = $6,000 for California Income of $1,000,000 to $4,999,999

California LLC Fee = $11,790 for California Income of $5,000,000 or more.

Federal Capital Gains Taxation of a California LLC Disregarded for Tax Purposes

In terms of federal taxation, capital gains or losses from a single-member LLC disregarded for tax purposes are reported on the federal income tax return of the sole member. Capital gains refer to the profits realized when a capital asset—like shares, real property, or a business—is sold for a higher price than its purchase cost. These gains are subject to capital gains tax, which can be either short-term (for assets held for a year or less) or long-term (for assets held for more than a year). The short-term capital gains are taxed as ordinary income, at rates up to 37% for 2024. Long-term capital gains are taxed at a lower rate, which can be 0%, 15%, or 20% depending on the individual’s taxable income. The long-term capital gains rates are generally much lower than the rates on ordinary income, which makes it advantageous to hold assets for more than one year.

California Capital Gains Taxation of a California LLC Disregarded for Tax Purposes

From a California taxation perspective, the treatment is similar to the federal approach. Capital gains, whether short-term or long-term, are taxed as ordinary income for state tax purposes. This means that these gains are included in the owner’s taxable income and subject to the California state income tax rates. As of 2024, these rates range from 1% to 13.3% depending on the total taxable income. California does not provide for a lower tax rate for long-term capital gains. Therefore, the distinction between short-term and long-term capital gains that exist for federal tax purposes does not apply for California tax purposes.

Summary of Taxation of a California LLC Disregarded for Tax Purposes

This disregarded entity status simplifies tax reporting by eliminating the need for separate LLC tax returns. This is beneficial for businesses with low gross revenue that do not trigger the California LLC Fee and correspondingly low net profits that do not make self-employment taxes high, however, a California LLC disregarded for tax purposes rapidly becomes inefficient for tax purposes as either gross revenue or net profits increase, and very tax inefficient if both gross revenue and net profits increase.

Notwithstanding the foregoing, a California LLC disregarded for tax purposes should be used for holding appreciating assets such as real estate when the California LLC will only have one member because, unlike a California LLC taxed as an S Corporation or Corporation, a California LLC disregarded for tax purposes can treat qualifying dispositions of property as capital gains, whereas neither S Corporation nor Corporation taxation has access to capital gains taxation, and all gains that would otherwise be treated as capital gains would instead be treated as ordinary income.

While the Internal Revenue Service disregards the California LLC for income tax purposes, the California LLC still provides its owner with limited liability protection from the debts, liabilities, obligations, and legal judgments against the California LLC under California law, preserving the key benefit of liability limitation of the California LLC structure.

Therefore, a California LLC disregarded for tax purposes is only an appropriate choice of business entity for businesses with low gross revenue and low net profit when a business owner is seeking liability protection or holding appreciating assets. Otherwise, a California LLC should elect a different tax treatment or a different business entity should be chosen to provide both liability protection and tax efficiency.

California LLC Taxed as a Partnership

When a California LLC is taxed as a partnership, it means that the LLC is not recognized as a separate entity from its owners for the purpose of tax liability. This is the default taxation for a California LLC with two or more members.

Federal Income Taxation of a California LLC Taxed as a Partnership

Under Federal Income Taxation, a California LLC taxed as a partnership operates as a pass-through entity. This means that the California LLC taxed as a partnership does not pay any federal income taxes itself. Instead, the profits and losses of the business of the California LLC taxed as a partnership are passed through to its members, who report this income on their own individual income tax returns.

The share of the profits and losses of the California LLC taxed as a partnership of each member, also known as distributive shares, are set out in the Operating Agreement of the California LLC taxed as a partnership. If the Operating Agreement does not specify the distributive shares, they are divided equally among the members.

To report income, the California LLC taxed as a partnership must complete Internal Revenue Service Form 1065 (U.S. Return of Partnership Income). This form is an informational return that the Internal Revenue Service uses to check the individual tax returns of members for accuracy. The California LLC taxed as a partnership must also provide Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.) to all members. Each member uses the information on Schedule K-1 to complete their own individual federal tax return.

It is worth noting that even though the California LLC taxed as a partnership itself does not pay federal income taxes, it may still be required to pay other federal taxes, such as certain excise taxes. Furthermore, the members of a California LLC taxed as a partnership must pay individual federal income tax on their share of the profits, even if they leave the profits in the business for use in the following year.

Federal Self-Employment Taxation of a California LLC Taxed as a Partnership

The members of a California LLC taxed as a partnership are typically subject to Federal Self-Employment taxes on their share of the business income. This tax is equivalent to the combined employer and employee share of Social Security and Medicare taxes that employees pay. As of the time of this writing, the self-employment tax rate is 15.3%, which is made up of 12.4% for Social Security (up to an annual income ceiling that generally increases annually) and 2.9% for Medicare, with no income limit. For the 2024 tax year, only the first $168,600 of combined wages and net earnings is subject to the Social Security tax, but there is no cap on the Medicare portion. The cap on Social Security tax usually increased annually (the cap was $160,200 for 2023 and $147,000 for 2022). In addition to the standard Medicare tax, there is an Additional Medicare Tax of 0.9% on top of the standard 2.9% that applies to individuals with wages, compensation, and self-employment earnings above $200,000 for single filers, $250,000 if married individuals filing jointly, and $125,000 for married individuals filing separately.

Members of the LLC must report their share of the income and expenses of the California LLC taxed as a partnership on Schedule SE (Self-Employment Tax) and submit it along with their Annual Federal Tax Return, Internal Revenue Service Form 1040. The net profit or loss of the business, as reported on Schedule SE, is used to calculate the amount of self-employment tax owed.

It is important to note that the entire net income of the member of a California LLC taxed as a partnership is subject to these self-employment taxes, not just the share of profits that are distributed to them.

California Income Taxation of California LLC Taxed as a Partnership

Under California law, a California LLC taxed as a partnership is treated as a pass-through entity for California income tax purposes. This means that the California LLC taxed as a partnership does not itself pay income tax. Instead, the income or loss of the LLC is passed through to its members, who report this on their individual state tax returns.

The California Franchise Tax Board (FTB) requires each LLC to file Form 568, Limited Liability Company Return of Income, annually. This form serves to report the LLC’s income, deductions, and credits, as well as to calculate annual LLC tax and fee. In certain circumstances California Franchise Tax Board Form 565 should be used instead of Form 568; consult your tax advisor for details.

The California LLC taxed as a partnership must also issue California Schedule K-1 to California Franchise Tax Board Form 568, Member’s Share of Income, Deductions, Credits, etc., to each member. This state version of Schedule K-1 reports the share of income or loss of the California LLC taxed as a partnership to each member, which member, which the members must report on their individual California tax returns.

California Franchise Taxation of a California LLC Taxed as a Partnership

For California income tax purposes, a disregarded California LLC must also file California Franchise Tax Board Form 568 (Limited Liability Company Return of Income) and pay the annual LLC tax, calculated at a flat rate of $800, regardless of the income. This is due by the 15th day of the fourth month of the taxable year, usually April 15.

California LLC Fee for a California LLC Taxed as a Partnership

In addition to the annual LLC tax, a disregarded California LLC may be subject to an annual fee based on the total income derived or attributable to California. The fee ranges from $0 for LLCs with gross revenue of less than $250,000 to $11,790 for LLCs with gross revenue of $5,000,000 or more. The exact California LLC Fee structure is as follows:

California LLC Fee = $0 for California Income Under $250,000

California LLC Fee = $900 for California Income of $250,000 to $499,999

California LLC Fee = $2,500 for California Income of $500,000 to $999,999

California LLC Fee = $6,000 for California Income of $1,000,000 to $4,999,999

California LLC Fee = $11,790 for California Income of $5,000,000 or more.

Federal Capital Gains Taxation of a California LLC Taxed as a Partnership

When a California LLC taxed as a partnership sells a capital asset, such as real estate or shares, the gain from the sale is considered a capital gain and is subject to federal capital gains taxation. This tax is levied on the difference between the sale price of the asset and its original purchase price, also known as the “basis”.

Long-term capital gains, on assets held for more than a year, are taxed at a lower rate than short-term capital gains, which apply to assets held for a year or less. As of the time of this writing, the long-term capital gains tax rate varies from 0%, 15%, to 20% depending on the tax bracket of the individual member. Short-term capital gains are taxed at the regular income tax rate of the member.

California Capital Gains Taxation of a California LLC Taxed as a Partnership

When a California LLC is taxed as a partnership and realizes capital gains from the sale of a capital asset is subject to California Capital Gains Tax. Like the federal tax system, California treats capital gains based on the holding period of the asset.

Short-term capital gains, from assets held for one year or less, are taxed at the LLC members’ regular income tax rates. These rates can range anywhere from 1% to a maximum of 13.3%, depending on the taxpayer’s income level.

Long-term capital gains, from assets held for more than one year, are generally taxed at a lower rate. However, unlike the federal tax system, California does not have a separate lower rate for long-term capital gains. They are taxed at the same rate as ordinary income.

Every member of the LLC is responsible for reporting their share of the capital gains on their individual California income tax returns, California Franchise Tax Board Form 540. The state version of Schedule K-1, which the LLC provides to each member, contains the information needed to complete this step. Members must include both their net short-term capital gains and net long-term capital gains in their taxable income for California state tax purposes. The tax is then calculated using the tax rates applicable to the member’s total taxable income.

Summary of Taxation of a California LLC Taxed as a Partnership

Partnership taxation of a California LLC is beneficial for businesses with low gross revenue that do not trigger the California LLC Fee and correspondingly low net profits that do not make self-employment taxes high, however, a California LLC taxed as a partnership rapidly becomes inefficient for tax purposes as either gross revenue or net profits increase, and very tax inefficient if both gross revenue and net profits increase.

Notwithstanding the foregoing, a California LLC taxed as a partnership should be used for holding appreciating assets such as real estate when the California LLC will have more than one member because, unlike a California LLC taxed as an S Corporation or Corporation, a California LLC taxed as a partnership can treat qualifying dispositions of property as capital gains, whereas neither S Corporation nor Corporation taxation has access to capital gains taxation, and all gains that would otherwise be treated as capital gains are instead treated as ordinary income.

Although taxed as a partnership, California LLC taxed as a partnership provides its owners with limited liability protection from the debts, liabilities, obligations, and legal judgments against the California LLC under California law, preserving the key benefit of liability limitation of the California LLC structure not available in a California General Partnership or for general partners of a California Limited Partnership.

Therefore, a California LLC taxed as a partnership is only an appropriate choice of business entity for businesses with low gross revenue and low net profit when the business owners are seeking liability protection or holding appreciating assets. Otherwise, a California LLC should elect a different tax treatment or a different business entity should be chosen to provide both liability protection and tax efficiency.

California LLC Taxed as an S Corporation

Taxation as an S Corporation is another tax status that a California LLC can elect. When a California LLC opts for taxation as an S Corporation, it combines the legal advantages of a California LLC, such flexibility of management structure and liability protection, with the tax benefits of an S Corporation, including income pass-through and potential savings on self-employment taxes and the California LLC Fee. While the S Corporation status can provide significant tax savings for certain types of businesses, it is important to note that not all California LLCs will qualify for electing the S Corporation tax status and it may not be the best fit for every business scenario, notably when the California LLC will be used to hold appreciating assets, such as real estate.

Federal Income Taxation of a California LLC Taxed as an S Corporation

When a California LLC makes an election for taxation as an S Corporation, it is treated as a pass-through entity for federal income tax purposes. This means that the profits or losses of the California LLC pass through to its members, who report them on their individual federal income tax returns. This avoids the “double taxation” scenario common with C Corporations, where profits are taxed at the corporate level and again at the individual level when dividends are distributed.

The S Corporation status allows for bifurcation of income, a unique income splitting potential, where part of the income can be taken as a reasonable salary by the California LLC members who actively participate in running the business, and the remaining income can be distributed to the members without being subject to self-employment tax. The Internal Revenue Service does scrutinize the definition of a reasonable salary, so the guidance of a tax professional should be followed when setting reasonable salaries.

A California LLC taxed as an S Corporation files an annual federal income tax return using Internal Revenue Service Form 1120S. This form reports the income, deductions, and credits for the California LLC and provides a Schedule K-1 to each member which they use to report their share of the income of the California LLC on their individual Internal Revenue Service Form 1040 tax return.

One potential downside of the S Corporation status is the limitation on the number and type of members allowed. A California LLC taxed as an S Corporation cannot have more than 100 members, all members must be U.S. citizens or residents, and they cannot be other corporations, partnerships, or other limited liability companies (except under certain specific circumstances).

It’s also important to note that the LLC must meet certain requirements to maintain its S Corporation status, such as holding annual meetings and keeping minutes, which increases administrative tasks.

Federal Self-Employment Taxation of a California LLC Taxed as an S Corporation

A California LLC taxed as an S Corporation is subject to a unique set of rules with regard to federal self-employment taxes. Members of a California LLC taxed as an S Corporation who are also employees and who provide more than minor services to the California LLC are required to pay standard payroll taxes on their wages, but not on their share of the net income of the California LLC based upon its tax classification as an S Corporation. This system can potentially save members substantial amounts in self-employment taxes compared to a California LLC taxed as a partnership or a California LLC disregarded for tax purposes.

Under the S Corporation structure, income is divided into two categories: salary and net profit. Salary, paid to members who perform services for the company, is subject to self-employment taxes (Medicare and Social Security taxes), while S Corporation net profits allocated to members are not subject to either self-employment taxes or standard payroll taxes.

A key point to note is that the Internal Revenue Service requires that members who work for the company must be paid a reasonable salary. The idea is to prevent businesses from avoiding self-employment taxes by classifying all income as net profits without subjecting any portion to salary. If the Internal Revenue Service deems a salary to be unreasonably low, it can reclassify all or part of the net profit as salary and require payment of back taxes, penalties, and interest.

The potential tax savings from this structure is one of the main reasons many California LLCs elect to be taxed as S Corporations. However, it is worth noting that the additional compliance requirements and scrutiny from the IRS may offset some of these benefits.

California Income Taxation of California LLC Taxed as an S Corporation

For California income tax purposes, a California LLC taxed as an S Corporation is treated similarly to how it is treated for federal income tax purposes. The net profit of the California LLC passes through to its members, who report their share of the income on their individual California income tax returns.

When a California LLC is taxed as an S Corporation, its members must report their share of the net profit of the California LLC on their individual California tax returns filed with the California Franchise Tax Board and pay personal income tax on it. The tax rate for individuals in California ranges from 1% to 13.3%, depending on the income bracket of the taxpayer.

It should be noted that for California taxation, both the reasonable salary and the net income allocated to members are subject to California state income tax.

California Franchise Taxation of a California LLC Taxed as an S Corporation

A California LLC taxed as an S Corporation is also subject to the California Franchise Tax. This tax is imposed on all corporations and limited liability companies that are doing business in the State of California, regardless of their tax status at the federal level. The current minimum franchise tax in California is $800, and this annual Franchise Tax (the 15th day of the 4th month of the tax year) is required annually.

The Franchise Tax for a California LLC taxed as an S Corporation the greater of 1.5% of the net income of the California LLC, but the tax cannot be less than the minimum $800. Moreover, the tax applies even if the California LLC is inactive or operates at a loss. This means that even if the LLC does not make any profits in a given year, it still owes the minimum franchise tax amount.

The Franchise Tax does not pass through to the members of the California LLC taxed as an S Corporation. The tax is at the entity level, meaning it is a separate tax that the California LLC taxed as an S Corporation itself pays. It does not affect the individual tax liabilities of the members.

California LLC Fee for a California LLC Taxed as an S Corporation

The California LLC fee is not applied to a California LLC taxed as an S Corporation.

Federal Capital Gains Taxation of a California LLC Taxed as an S Corporation

Capital gains taxation is an important aspect to consider for a California LLC taxed as an S Corporation. If the LLC sells an asset, such as real estate or business equipment, for more than its original purchase price, the profit is considered a capital gain.

The tax rates for capital gains of a California LLC that is disregarded for tax purposes with an individual as an owner and a California LLC taxed as a partnership depend on how long the asset was held before it was sold. If the asset was held for more than a year, it qualifies for long-term capital gains tax rates, which are typically lower than ordinary income tax rates and range from 0% to 20%. On the contrary, if the asset was held for a year or less, the capital gains are considered short-term and are taxed at the ordinary income tax rate of the member.

However, capital gains of a California LLC taxed as an S Corporation are passed through to the members, similar to the pass-through mechanism for regular income. These gains are reported on the personal tax return of each member and taxed at the ordinary income tax rate of the member, not at a lower capital gains tax rate regardless of how long the asset was held before it was sold.

Due to the implications of capital gains taxation for California LLCs taxed as S Corporations, appreciating assets like real estate should seldom be held in an entity taxed either as a corporation or an S corporation. The reason lies in the taxation method – capital gains are passed through to the members and taxed at their personal income tax rates. This means that unlike other entities, such as partnerships or California LLCs disregarded for tax purposes or California LLCs taxed as partnerships, California LLCs taxed as S Corporations do not benefit from lower long-term capital gains tax rates, despite how long the asset was held prior to selling. Consequently, placing appreciating assets such as real estate in an entity taxed as a corporation or an S corporation may result in higher tax liabilities, underscoring the need for strategic tax planning when considering asset placement.

California Capital Gains Taxation of a California LLC Taxed as an S Corporation

The California Capital Gains Taxation works in tandem with the federal tax system, affecting an LLC taxed as an S Corporation at the state level. California does not offer a preferential tax rate for long-term capital gains as seen on a federal level. Instead, capital gains, whether short-term or long-term, are taxed as regular income under California tax laws. The members of the California LLC are required to report their share of the capital gains on their individual California income tax returns and pay tax at their individual tax rates, which range from 1% to 13.3%.

While there may be no benefit or detriment for long-term capital gains under California tax laws, members of a California LLC taxed as an S Corporation in California must still carefully consider the implications of capital gains taxation, and in particular the benefits of the lower federal tax rate for long-term gains despite the lack of a lower tax rate for long-term gains under California tax laws.

Summary of Taxation of a California LLC Taxed as an S Corporation

S Corporation taxation of a California LLC is beneficial for businesses with higher gross revenue that would otherwise trigger the California LLC Fee and correspondingly higher net profits that would subject members to high self-employment taxes, however, a California LLC taxed as an S Corporation can be more cumbersome to operate if unless it is overcoming the California LLC Fee or reducing employment tax liabilities.

Notwithstanding the foregoing, a California LLC taxed as an S Corporation should rarely (and only with a specific tax plan) be used for holding appreciating assets such as real estate due to the inability of S Corporation taxation to allow for a lower federal capital gains tax rate on long-term capital gains.

Although taxed as an S Corporation, California LLC taxed as an S Corporation provides its owners with limited liability protection from the debts, liabilities, obligations, and legal judgments against the California LLC under California law, preserving the key benefit of liability limitation of the California LLC structure.

Therefore, a California LLC taxed as an S Corporation is an appropriate choice of business entity for businesses with higher gross revenue and higher net profit when the business owners are seeking to reduce liability under the California LLC Fee and/or self-employment taxes while enjoying liability protection, but not holding appreciating assets.

California LLC Taxed as a Corporation

Taxation as a corporation is another tax status that a California LLC can elect. When a California LLC opts for taxation as a corporation, it combines the legal advantages of a California LLC, such flexibility of management structure and liability protection, with the tax treatment of a corporation, including potential savings on self-employment taxes and the California LLC Fee. While the corporation status can provide significant tax savings for certain types of businesses, it is important to note that not all California LLCs should elect corporate taxation and it may not be the best fit for every business scenario, notably when the California LLC will be used to hold appreciating assets, such as real estate, or when a California LLC might otherwise elect to be taxed as an S Corporation.

Federal Income Taxation of a California LLC Taxed as a Corporation

When a California LLC elects to be taxed as a corporation at the federal level, it subjects itself to the corporate taxation structure. This means it becomes a separate tax entity, distinct from its owners. In essence, the LLC will be taxed like a traditional corporation, which involves a tax structure commonly referred to as double taxation.

Double taxation arises because profits earned by the corporation are first taxed at the corporate level. The applicable federal corporate tax rate is currently a flat 21% following the Tax Cuts and Jobs Act of 2017. This is called the corporate tax. After the corporate tax is paid, any distributable profits, called dividends, may be given to the LLC members, and these dividends are subject to a second round of taxation at the member level.

Dividends fall into two categories for tax purposes: qualified and non-qualified dividends.

• Qualified Dividends: These are dividends that meet certain criteria to be eligible for a lower tax rate. According to the Internal Revenue Service, qualified dividends are taxed at the capital gains tax rate, which is less than the standard income tax rate. Specifically, the tax rate for qualified dividends is 0%, 15%, or 20%, depending on the taxable income and filing status of the taxpayer.
• Non-Qualified Dividends: Also known as ordinary dividends, these are subject to the same tax rate as ordinary income. The tax rate for non-qualified dividends thus depends on the income bracket and filing status of the taxpayer and can range from 10% to 37%.

Not all payments to members of a California LLC taxed as a corporation are subject to this second layer of taxation. For instance, salaries and wages paid to employees (including members who are paid a salary from a California LLC taxed as a corporation) are considered business expenses and are therefore deducted from net profit before the corporate tax is calculated.

It should also be noted that while the concept of “double taxation” may seem discouraging, electing to be a California LLC taxed as a corporation status can be advantageous in certain circumstances. For example, the 21% corporate tax rate is lower than the top individual tax rate. Therefore, for high-earning businesses, keeping profits within the corporation (rather than distributing them as dividends) can be a tax-saving strategy. However, when the Tax Cuts and Jobs Act of 2017 expires, the corporate tax rate could potentially revert to the previous rate of 35%, up from the current flat rate of 21%. This would represent a significant increase in corporate tax liability for a California LLC taxed as a corporation. Future changes depend on legislative actions, and the exact outcome is uncertain.

Federal Self-Employment Taxation of a California LLC Taxed as a Corporation

Just as the federal income tax structure differs for a California LLC taxed as a corporation, so does the approach to self-employment taxes. Self-employment taxes are Social Security and Medicare taxes primarily for individuals who work for themselves.

As a general rule, members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax. However, when a California LLC is taxed as a corporation, the self-employment tax is not applicable.

For a California LLC taxed as a corporation, the members who are also employees and who provide more than minor services to the California LLC are treated as employees of the corporation for tax purposes. This means that if a member works for the corporation, they receive a salary, and payroll taxes (including Social Security and Medicare contributions) are withheld from their earnings just as they would be for a traditional employee. These payroll taxes are a deductible expense for the corporation.

The key advantage here is that only the salary paid to members is subject to employment tax. Any additional profits distributed to the members as dividends are not subject to self-employment taxes. This can represent significant tax savings for businesses that generate higher profits.

However, it is important to maintain a reasonable balance between salary and dividends to avoid investigation and audit by the Internal Revenue Service. The Internal Revenue Service is aware that this taxation structure incentivizes businesses to reduce salaries and increase dividends to lower their tax liability. As a result, the Internal Revenue Service requires that members working for a California LLC taxed as a corporation be paid a reasonable salary commensurate with their responsibilities and industry standards.

California Income Taxation of California LLC Taxed as a Corporation

In California, an LLC that elects to be taxed as a corporation is subject to corporate income tax under the tax laws of California. This California corporate tax is imposed on the net income of the corporation derived from activities within California.

The California corporate income tax rate is a flat 8.84%, which is one of the highest corporate tax rates in the United States. This tax is paid on the corporate profits (revenue minus expenses, including the cost of goods sold and depreciation) before any dividends are paid out. Thus, this tax is paid in addition to the federal corporate income tax.

After the corporate tax is paid, any remaining profits can be distributed to the members as dividends. Unlike federal tax treatment of qualified dividends, these dividends are then subject to personal income tax in California, as California does not maintain a separate dividend tax rate for dividends. California has a progressive income tax, which means the rate of taxation increases as the taxable amount of income increases. The rates range from 1% to 13.3%, depending on the income of the individual LLC member.

Just as with federal taxation, not all payments to members are subject to this second layer of taxation. Just like at the federal level, salaries and wages paid to employees (including members who are employed by the LLC) are deducted from the net profit of the California LLC taxed as a corporation before the corporate tax is calculated.

California Franchise Taxation of a California LLC Taxed as a Corporation

A California LLC that elects to be taxed as a corporation is subject to the California Franchise Tax. This tax is imposed by the California Franchise Tax Board on all entities that are chartered, registered, or doing business within the State of California. The Franchise Tax is a minimum of $800 per year, payable to the Franchise Tax Board. This minimum tax is due on the 15th day of the third month of the taxable year and is payable regardless of whether the company is active, operates at a loss, or does not do any business. However, if the California corporate income tax for a tax year exceeds the minimum of $800, the California corporate income tax will be assessed without the addition of the $800 minimum.

The Franchise Tax does not pass through to the members of the California LLC taxed as a corporation. The tax is at the entity level, meaning it is a separate tax that the California LLC taxed as a corporation itself pays. It does not affect the individual tax liabilities of the members.

California LLC Fee for a California LLC Taxed as a Corporation

The California LLC fee is not applied to a California LLC taxed as a corporation.

Federal Capital Gains Taxation of a California LLC Taxed as a Corporation

Federal capital gains tax applies to a California LLC taxed as a corporation when the corporation sells assets at a profit. Capital gains are the profits realized from the sale of assets such as property or investments.

For a California LLC disregarded for tax purposes or a California LLC taxed as a partnership, the rate at which these gains are taxed depends on the length of time the asset was held before being sold. Assets held for less than a year generate short-term capital gains, which are taxed at an ordinary income tax rate, whereas assets held for over a year generate long-term capital gains, typically taxed at a lower rate.

However, for California LLCs taxed as a corporation, these lower rates don’t apply. Instead, all net capital gains are taxed at the regular corporate rate of 21 percent, as introduced by the Tax Cuts and Jobs Act of 2017. This tax must be paid by the LLC taxed as a corporation before any profits are distributed to members. When these profits, or dividends, are distributed to the members, they may be subject to an additional tax depending upon the personal income tax bracket of the member and how long the member held their interest in the LLC.

California Capital Gains Taxation of a California LLC Taxed as a Corporation

Just like with federal taxes, capital gains tax applies at the state level in California for an LLC taxed as a corporation when it sells assets for a profit. These capital gains are considered part of the income of the corporation and are taxed at the California corporate tax rate of 8.84%. California does not apply a separate capital gains tax rate; instead, it treats capital gains as regular income for both individuals and corporations. Just like with federal taxes, these gains are taxed irrespective of the length of time the asset was held before being sold.

Summary of Taxation of a California LLC Taxed as a Corporation

Corporation taxation of a California LLC is beneficial for businesses with higher gross revenue that would otherwise trigger the California LLC Fee and correspondingly higher net profits that would subject members to high self-employment taxes, however, a California LLC taxed as a corporation can be less tax efficient than a California LLC taxed as an S Corporation.

Notwithstanding the foregoing, a California LLC taxed as a corporation should almost never be used for holding appreciating assets such as real estate due to the inability of corporation taxation to allow for a lower federal capital gains tax rate on long-term capital gains.

Although taxed as a corporation, a California LLC taxed as a corporation provides its owners with limited liability protection from the debts, liabilities, obligations, and legal judgments against the California LLC under California law, preserving the key benefit of liability limitation of the California LLC structure.

Therefore, a California LLC taxed as a corporation is an appropriate choice of business entity for businesses with higher gross revenue and higher net profit when the business owners are seeking to reduce liability under the California LLC Fee and/or self-employment taxes while enjoying liability protection, but not holding appreciating assets, but when the identity of members or some other factor prevents taxation as an S Corporation.

Ownership Changes

The right of a transferee of a transferable interest in a California LLC to receive distributions from the California LLC without the consent of the members is subject to any restrictions contained in the Operating Agreement. California Corporation Code §17701.02(aa). Such transfer without the consent of the members does not transfer voting rights and other rights other than the receipt of distributions, but such transferee is entitled to receive written information from the California LLC related to the interest of the transferee. California Corporations Code §§17705.02, 17704.10. In such case, the transferor retains the voting rights associated with the transferred interest unless and until they are dissociated from the California LLC. California Corporations Code §17706.03.

A transferee cannot be admitted as a member without the consent of all other members unless permitted by the Operating Agreement. California Corporations Code §§17704.01(c), 17705.02. An Operating Agreement may allow for the admission of transferees without the consent of all members. California Corporations Code §§17701.10, 17704.01(c).

Termination

A California LLC may be dissolved upon the happening of a certain event set forth in its Articles of Organization or Operating Agreement or on the vote of fifty percent (50%) or more of the voting interest of its members (unless a majority or super-majority vote is required by the Articles of Organization or Operating Agreement. California Corporations Code §§17707.01(a), 17707.01(d). No provision of Articles of Organization or an Operating Agreement may eliminate the right of a member to vote for dissolution. California Corporations Code §17704.07(t). Entry of a judicial decree for dissolution also serves to dissolve a California LLC. California Corporation Code §17707.01(d). Except for a California LLC with only one member who is a natural person who dies, a California LLC will dissolve if it has no members for ninety days in a row. California Corporations Code §17707.01(c).

After dissolution, a California LLC ceases business operations except as required to facilitate its winding up. California Corporations Code §17707.06(a). Written notice of the initiation of winding up must be sent by mail to all known creditors and potential claimants of the California LLC. California Corporations Code §17707.04(a).

The dissolution of a California LLC does not affect the management structure of a California LLC, however the right to participate in management is lost by a manager who wrongfully initiated the dissolution of a California LLC, but managers who have not wrongfully initiated the dissolution of a California LLC may participate in the winding up of a California LLC. California Corporations Code §§17704.07(d). If there are no managers, then the members may wind up the California LLC. 17707.04(a). In the absence of members, a majority of those persons who signed the Articles of Organization are permitted to wind up the California LLC. California Corporations Code §17707.04(a). If a California LLC does not wind up its affairs, a manager, member, or three or more creditors may petition a court to order a winding up of the California LLC, and the court may designate a person to undertake the winding up of the California LLC and order reasonable compensation to that person. California Corporations Code §§17707.04(b)-(c).

Pricing Assumptions

The organization of a California LLC for $1,295.00 assumes one member or a married couple who jointly file federal and state income tax returns. The organization of a California LLC for $1,895.00 assumes more than one member where all members manage and have equal rights of ownership. The organization of manager-managed California LLCs, multi-member California LLCs where not all members have equal rights of ownership, and California LLCs appropriate for use with third-party investors are available by quotation. Optional California Secretary of State 24-hour processing of Form LLC-1 for $650.00 on the terms and conditions provided by the California Secretary of State, including loss of filing fee for any rejection of Form LLC-1 after filing. Financial Crimes Enforcement Network (FinCEN) Beneficial Ownership Information Reporting pricing to be determined on or after January 1, 2024.

California LLC Additional Resources