Operating as a Joint Venture in California can seem appealing due to its simplicity, low cost to get started, and minimal regulatory requirements. However, the advantages of a California Joint Venture business structure are not without certain drawbacks.

In this article, we will some of the specific disadvantages of being a Joint Venture in California, from personal liability risks to potential tax disadvantages, by comparing a California Joint Venture to the three most commonly used business structures for businesses: the California Corporation, California S-Corp, and California Limited Liability Company (LLC).

Executive Summary of the Disadvantages of Being a Joint Venture in California

The main disadvantage of being a California Joint Venture is the unlimited liability faced by each California Joint Venturer. Unlike the shareholders of a California Corporation or California S-Corp, or members of a California LLC, a California Joint Venture exposes its owners to joint and several liability for all debts, liabilities, obligations, and legal judgments against the California Joint Venture. This exposes their personal assets to a potential risk in the event of a legal claim against the business or if the business incurs debts it cannot repay.

While self-employment tax liability is certainly another disadvantage of a California Joint Venture which may be avoided via a California Corporation or California S-Corp, the unlimited liability alone should be the reason most businesses avoid using California Joint Ventures in favor of selecting a business entity that limits liability for its owners despite the increase in complexity, slight increase in upfront cost, and manageable annual California Franchise Taxation of the limited liability options available.

Choosing the Right Business Entity in California

Choosing the right business entity in California entails a careful examination of the personal liability risks and taxation implications associated with the various business entity choices at your disposal. We briefly introduce California Joint Ventures, California Corporations, California S-Corps, and California LLCs business entities below.

What is a California Joint Venture?

A California Joint Venture is a unique form of business partnership under California law where two or more parties come together to undertake a specific business project or single business enterprise for a specific timeframe with a shared goal. This business relationship, which may be between two or more individuals or two or more businesses, and unlike a long-term business partnership, is typically for business dealings for a specific purpose and duration. The parties involved share both the profits and losses of the California Joint Venture, are governed by a California Joint Venture Agreement, and these California Joint Venture Agreements delineate the contributions of resources such as capital, property, or skills from each of the California Joint Venturers. It is important to understand that each of the California Joint Venturers in California retains its existing legal status while bearing joint and several liability for all debts, liabilities, obligations, and legal judgments against the California Joint Venture.

What is a California Corporation?

A California Corporation is a legal entity separate from its owners, who are known as shareholders. This separation means the personal assets of shareholders are typically not at risk for the debts, liabilities, obligations, or legal judgments against the California Corporation. California Corporations are subject to corporate income tax, and any dividends (distributed profits) paid to shareholders are also taxed, potentially creating a double taxation on the net income of the California Corporation.

What is a California S-Corp?

A California S-Corp is a special type of California Corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for income tax purposes. This allows California S-Corps to avoid double taxation on corporate income. Shareholders of a California S-Corp report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. However, S-Corps have certain restrictions, such as a limited number of shareholders and restrictions on who can be a shareholder.

What is a California LLC?

A California LLC is a type of business entity that combines the most favorable elements of both California General Partnerships and corporations. It provides the personal liability protection of a corporation, meaning the personal assets of owners of a California LLC, referred to as members, are typically not at risk for the debts, liabilities, obligations, and legal judgments against the California LLC. At the same time, a California LLC is flexible in terms of management structure and a California LLC is taxed as a partnership by default, although it may elect the double-taxation structure of a California Corporation or taxation as a California S-Corp by making a relatively simple filing with the Internal Revenue Service.

Personal Liability Risks of Joint Ventures vs California Corporations, California S-Corps, and California LLCs

One of the primary considerations when choosing between business structures is assessing personal liability risks. Personal liability refers to the degree to which the personal assets of the business owner are at risk in the event of a business failure or lawsuit. In some business structures, the personal assets of a business owner are highly exposed to business-related risks, while in others, there is a clear separation between personal and business assets. This distinction heavily influences the level of financial risk a business owner is exposed to, and can ultimately shape the longevity and resilience of the business.

Personal Liability Risks in Joint Ventures in California

Joint Venturers in California face significant personal liability risks due to the joint and several liability for all debts, liabilities, obligations, and legal judgments against the California Joint Venture that California Joint Venturers undertake when they enter into a California Joint Venture. Should the California Joint Venture incur debts or legal liabilities, the personal assets of each of the California Joint Venturers can be directly targeted to meet these obligations. From a legal standpoint, the business debts, liabilities, and obligations of a California Joint Venture are wholly the debt, liability, or obligation of each of the California Joint Venturers. In the event of a successful lawsuit against a California Joint Venture, there is no protective barrier between the business assets and the personal assets of each of the California Joint Venturers. This means that if the business is unable to meet its obligations, the personal assets of each of the California Joint Venturers could be seized to cover the shortfall.

Personal Liability in California Corporations and California S Corporations

California Corporations and California S-Corps offer a significant reduction in personal liability compared to California Joint Ventures. Corporations and S-Corps in California are considered separate legal entities from their owners, meaning that shareholders (owners) are typically not personally liable for business debts, liabilities, obligations, or legal judgments. The creditors of a California Corporation or S-Corp can only seek payment from the assets of the California Corporation or S-Corp, not the personal assets of shareholders. This legal separation shields the personal assets of the shareholders from being seized to cover business debts or judgments from lawsuits.

However, it is important to note that this protection is not absolute. Shareholders can still be personally liable in certain situations, known as piercing the corporate veil, such as when they provide a personal guaranty for a business loan, engage in fraudulent activities, or commingle personal and business funds. Thus, while California Corporations or S-Corps offer significant personal liability protection, maintaining a clear distinction between personal and business finances and acting in the best interest of the California Corporation or S-Corp is crucial to preserving this benefit.

Personal Liability in California LLCs

Like California Corporations and California S-Corps, a California LLC also offers a considerable level of personal liability protection and is a separate legal entity from its owners, referred to as members. In general, members of a California LLC are protected from personal liability for business debts, liabilities, obligations, or legal judgments, meaning creditors seeking payment can only target the assets of the California LLC, not the personal assets of members.

However, similar to California Corporations and S-Corps, this protection is not absolute. There are certain instances where members may still incur personal liability, like if they cosign or provide a guaranty for a business loan, engage in fraudulent activities, or commingle personal and business funds.

A California LLC has additional liability protection for its members that is not found in a California Joint Venture, California Corporation, or California S-Corp in the form of charging order protection. A charging order is a legal procedure that creditors in California may use against a debtor who is a member of a California LLC that essentially places the ownership interest of a debtor giving a creditor a right to claim any distributions or dividends that would otherwise go to the debtor member without granting any management rights or control over the California LLC to the creditor. This means creditors cannot force the California LLC to liquidate its assets to pay off the personal debts of the debtor member, which protects the interests of the other members of the California LLC from the debts of the debtor member.

Taxation of California Joint Ventures vs

The taxation system for businesses varies considerably depending on the type of business structure. It is an important yet commonly overlooked factor when deciding the best entity type for a business. In this section, the tax implications of a California Joint Venture, California Corporation, California S-Corp, and California LLC are examined.

Taxation of Joint Ventures in California

Federal Taxation of Joint Ventures in California

In terms of federal taxation, a Joint Venture in California follows the rules applicable to a California General Partnership. This means that the entity itself is not taxed on its income. Instead, profits or losses are passed through to the California Joint Venturers who report their respective shares on their tax returns. The tax liability of each California Joint Venturer is determined by their distributive share of the income or loss of the California Joint Venture, which is usually defined in the California Joint Venture Agreement.

Despite the income or loss passing through to the California Joint Venturers, the California Joint Venture is still required to file an information return (Form 1065 U.S. Return of Partnership Income) with the Internal Revenue Service. This form reports the income, gains, losses, deductions, credits, etc., from the operations of the California Joint Venture. Each California Joint Venturer then receives a Schedule K-1 to Internal Revenue Service Form 1065 which outlines their share of the income, deductions, credits, etc., of the California Joint Venture. The California Joint Venturers must then report this information on their tax returns. This pass-through taxation avoids the double taxation issue that is associated with California Corporations, where income is taxed at both the corporate level and again when distributed to shareholders as dividends.

California Taxation of Joint Ventures in California

For state taxation, California Joint Ventures are also taxed as partnerships. The California Joint Venture itself does not pay income tax, instead, the income or losses are passed through to the California Joint Venturers, who then report this on their individual California state tax returns. The share of the income or loss of each California Joint Venturer is usually outlined in a California Joint Venture Agreement.

The California Joint Venture is required to file a California Form 565 (Partnership Return of Income) with the California Franchise Tax Board. This form reports the income, gains, losses, deductions, credits, and other pertinent financial information from the operations of the California Joint Venture. Each California Joint Venturer then receives a Schedule K-1 (565) which outlines their share of the income, deductions, and credits of the California Joint Venture, and each California Joint Venturer must include this information on their California state tax returns.

Self-Employment Taxation of Joint Ventures in California

California Joint Venturers may be subject to self-employment taxes. Self-employment tax is a federal tax that applies to self-employed individuals, and it is used to fund Social Security and Medicare programs. This tax is calculated on the net earnings from self-employment, which generally includes the share of income or loss that a California Joint Venturer that is an individual or business entity taxed as a partnership receives from the California Joint Venture (the liability for a business entity taxed as a partnership will be passed through that business entity to the self-employed owners of that California Joint Venturer entity).

The self-employment tax rate is currently 15.3%. This consists of two parts: 12.4% for Social Security and 2.9% for Medicare. The Social Security portion is subject to a statutory maximum that is adjusted (usually higher) on an annual basis, but there is no such statutory cap on the Medicare portion of self-employment taxes.

Taxation of California Corporations

Federal Taxation of California Corporations

California Corporations are subject to federal income tax at the corporate level. This form of taxation is often referred to as double taxation. The double taxation issue arises because the California Corporation is first taxed on its income at the corporate level, and then, when the after-tax income is distributed to the shareholders as dividends, it is taxed again at the individual level.

The federal tax for California Corporations, as per the Internal Revenue Code, is levied on the taxable income of the California Corporation. The taxable income is determined by deducting allowable expenses, such as salaries, administrative expenses, marketing expenses, depreciation, and other costs associated with running the business, from the gross income. The corporate tax rate in the United States is a flat rate of 21% following the Tax Cuts and Jobs Act of 2017. This is a significant reduction from the previous tax rate, which ranged up to 35%.

Despite the inherent disadvantage of double taxation, incorporation offers some benefits in the tax realm. California Corporations are eligible to claim a wider range of deductions and tax credits than are typically available to business entities taxed as partnerships and Subchapter S of the Internal Revenue Code. For example, California Corporations can deduct the full cost of benefits provided to employees such as health insurance and retirement plans.

While California Corporations are taxed on net profits, the shareholders are only taxed on the dividends they receive. If the corporation retains its earnings instead of distributing them as dividends, the shareholders will not be taxed on those retained earnings (however, excessive accumulation of earnings can result in a penalty tax).

California Taxation of California Corporations

In terms of income tax, California follows a structure similar to the federal level. The corporate income tax rate in California, as mandated by the California Revenue and Taxation Code, is imposed on the taxable income of a California Corporation. This income is calculated by subtracting allowable expenses, such as administrative costs, employee salaries, marketing costs, and business-related expenses from the gross income of the California Corporation. The state tax rate for California Corporations is a flat 8.84% subject to an annual minimum of $800 regardless of whether or not the corporation earns a profit.

The double taxation issue is also present at the California state level. The income is taxed initially at the corporate level, and then if the after-tax income is distributed to the shareholders as dividends, it is taxed again on the California tax returns of those individuals.

Despite these taxes, California Corporations still have certain tax advantages. For instance, California Corporations have access to a larger array of deductions and tax credits compared to other business entities. Corporations can deduct the full cost of employee benefits like health insurance and retirement plans. Furthermore, shareholders are only taxed on the dividends they receive. If the corporation keeps its earnings instead of distributing them as dividends, the shareholders will not be taxed on those retained earnings (although excessive accumulation of earnings can lead to a penalty tax).

Self-Employment Taxation of California Corporations

Employees of California Corporations who are also shareholders do not pay self-employment taxes on their share of corporate profits. Instead, their compensation is subject to employee payroll taxes, which the California Corporation deducts as a business expense. These payroll taxes are split between the California Corporation and the employee, each paying half of the total amount. The payroll tax is similar to the self-employment tax in that it funds Social Security and Medicare programs, and the total payroll tax rate is 15.3%, with 12.4% going to Social Security and 2.9% going to Medicare, mirroring the rates for self-employment tax. However, since this tax is divided equally between the California Corporation and the employee, each pays only 7.65%, which is significantly less than the full self-employment tax rate.

Taxation of California S Corporations

Federal Taxation of California S Corporations

Federal taxation of California S-Corp is pass-through taxation, similar to that of partnerships. This means a California S-Corp is not subject to federal income tax. Instead, the profits or losses of a California S-Corp are passed through to its shareholders and are reported on the individual tax returns of the California S-Corp shareholders. The net profit of a California S-Corp is taxed at each personal income tax rate of the shareholder, hence avoiding the double taxation typically associated with California Corporations.

To facilitate this process, a California S-Corp files an informational federal return using Internal Revenue Service Form 1120S. This form reports the income, deductions, and credits of the California S Corporation, and provides a Schedule K-1 for each shareholder, representing their share of the financial activity of the California S Corporation for inclusion on their personal tax return.

California Taxation of California S Corporations

In California, S-Corps are subjected to several state-level tax obligations. A California S-Corp pays a franchise tax of 1.5% of its net income with a minimum tax of $800, regardless of whether it is active, operates at a loss, or does not do business. This tax is imposed on a California S-Corp itself and must be paid using Form 100S, California S Corporation Franchise or Income Tax Return.

While a California S-Corp itself does not pay federal income tax, the pass-through characteristic of a California S-Corp brings about income tax implications for the shareholders. Similar to federal taxation, the profits or losses of a California S-Corp are passed directly to shareholders and must be reported on their individual state tax returns, with the income taxed at the personal income tax rate of the shareholder.

Self-Employment Taxation of California S Corporations

Just as with California Corporations, employees of California S-Corps who are also shareholders do not pay self-employment taxes on their share of corporate profits. Instead, their compensation is subject to employee payroll taxes, which the California S-Corp deducts as a business expense. These payroll taxes are split between the California S-Corp and the employee, each paying half of the total amount. The payroll tax is similar to the self-employment tax in that it funds Social Security and Medicare programs, and the total payroll tax rate is 15.3%, with 12.4% going to Social Security and 2.9% going to Medicare, mirroring the rates for self-employment tax. However, since this tax is divided equally between the California S-Corp and the employee, each pays only 7.65%, which is significantly less than the full self-employment tax rate.

Taxation of California LLCs

A California Limited Liability Company has a flexible tax structure in which the taxation of an LLC can vary based on the number of members and tax elections made by the LLC. Since we are comparing business entity choices with a California Joint Venture, which by definition requires two or more business owners, we will not discuss the taxation of a California LLC with only one owner, instead focusing on a California LLC with two or more owners.

Taxation of California LLC Taxed as a Partnership

By default, a California LLC with two or more members is taxed as a partnership. This taxation will be identical to the taxation of a California Joint Venture with the addition of two additional taxes:

1. The first addition to the tax discussion for a California LLC taxed as a partnership is the requirement to pay an annual franchise tax of $800 per year, payable to the California Franchise Tax Board. This obligation applies even if the LLC is inactive, operates at a loss, or does not conduct business; and
2. The second addition to the tax discussion for Sole Proprietorships for a California LLC with only one member that is disregarded for tax purposes is the California LLC Fee. The California LLC fee is in addition to the $800 annual franchise tax and is calculated based on the gross revenue, not the net income, of the California LLC. The California LLC Fee ranges from $0 for California LLCs with gross income less than $250,000 to $11,790 per year for California LLCs with gross income of $5,000,000 or more annually.

Taxation of California LLC Taxed as a Corporation

If a California LLC chooses to be taxed as a corporation, it must file Internal Revenue Service Form 8832, Entity Classification Election, with the Internal Revenue Service. This allows the LLC to be taxed as an S Corporation for federal income, California income, and self-employment tax purposes, identical to the discussion of California Corporation taxation discussed above.

Taxation of a California LLC Taxed as an S Corporation

If a California LLC chooses to be taxed as an S Corporation, it must file Internal Revenue Service Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service. This allows the LLC to be taxed as an S Corporation for federal income, California income, and self-employment tax purposes, identical to the discussion of California S-Corp taxation discussed above.

The Disadvantages of Joint Ventures in California versus California Corporations, California S Corporations, and California LLCs

In conclusion, the configuration of business entity type plays a pivotal role in tax implications and liability exposure. The liability exposure of a California Joint Venture coupled with the potential tax advantages of a California Corporation, California S-Corp, or California LLC should lead most business owners into one of those business entities instead of a California Joint Venture.

San Diego Corporate Law is Here to Help!

Navigating the advantages and disadvantages of a California Joint Venture and other business structures can be daunting, but you do not have to do it alone. The experienced attorneys at San Diego Corporate Law are well-versed in the nuances of choosing the best California legal entity for a small business, including California Joint Ventures, California Corporations, California S-Corps, and California LLCs. Reach out to us today to schedule a consultation and take the first step toward starting your business right the first time.