Becoming a Sole Proprietor in California can seem appealing due to its simplicity, low cost to get started, and minimal regulatory requirements. However, the advantages of a Sole Proprietorship business structure are not without certain drawbacks.

In this article, we will delve into the specific disadvantages entrepreneurs might face when opting for Sole Proprietorship in California, from personal liability risks to potential tax disadvantages, by comparing a Sole Proprietorship to the two most commonly used business structures for small businesses: the California S Corporation and California Limited Liability Company (LLC).

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.

Each business entity comes with pros and cons, and some similarities like the requirement that they obtain business licenses or may obtain an employer identification number. The key is to align these attributes with your specific business plans and long-term objectives. As a business owner, your choice of entity will not only influence how much you pay in taxes but also the personal liability you face. It is therefore crucial to make an informed decision that leverages the benefits while mitigating potential downsides.

Personal Liability Risks of Small Business Entities

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. Let’s delve into the personal liability risks of Sole Proprietorships, S Corporations, and LLCs.

Personal Liability Risks of Sole Proprietors in California

Sole Proprietors in California face significant personal liability risks due to the lack of legal distinction between the business owner and the business itself as an unincorporated business entity. Should the business incur debts or legal liabilities, the personal assets of the Sole Proprietor, for example, the home, savings, and vehicle of the Sole Proprietor, can be directly targeted to meet these obligations because it is an unincorporated business owned by the Sole Proprietor. From a legal standpoint, the business debts are the debts of the Sole Proprietor. In the unfortunate event of a lawsuit, there is no protective barrier between the business assets and the personal assets of the Sole Proprietor. This means that if the business is unable to meet its obligations, the personal assets of the Sole Proprietor could be seized to cover the shortfall, potentially leading to personal financial ruin. It is this intertwining of personal and business finances that makes Sole Proprietorship a high-risk business structure in terms of personal liability.

Personal Liability of California S Corporations

California S Corporations offer a significant reduction in personal liability compared to Sole Proprietorships. S Corporations in California are considered separate legal entities from their owners, meaning that shareholders (owners) are typically not personally liable for business debts or liabilities. The creditors of a California S Corporation can only seek payment from the assets of the California S Corporation, not the personal assets of shareholders. This legal separation shields the personal assets of the California S Corporation shareholder, like their homes, cars, and personal bank accounts 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 S Corporations offer significant personal liability protection, maintaining a clear distinction between personal and business finances and acting in the best interest of the California S Corporation is crucial to preserving this benefit.

Personal Liability of California LLCs

Like California S Corporations, 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 or claims, meaning creditors seeking payment can only target the assets of the California LLC, not the personal assets of members. This legal structure acts as a shield, protecting the personal assets of a member, such as homes, cars, or personal bank accounts, from being seized to cover the liabilities of the California LLC.

However, similar to California S Corporations, 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. Such circumstances could lead to a legal action known as “piercing the corporate veil”, where courts disregard the separate business entity status of the California LLC and hold its member personally liable for business obligations.

Taxation of Small Business Entities

The taxation system for small 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 your business. Just as we have explored the personal liability risks associated with different business structures, we now explore the tax implications of Sole Proprietorships, California S Corporations, and California LLCs with respect to business and personal taxes.

Taxation of Sole Proprietors in California

In California, the tax obligations of a Sole Proprietor to pay taxes are directly tied to their personal income tax, due to the legal inseparability of the owner from the business. This characteristic of a Sole Proprietorship has significant tax implications that can influence the financial health of both the business and the owner.

Federal Taxation of Sole Proprietors in California

Sole Proprietors in California are subject to federal income tax on business profits. All business income and expenses are reported on Internal Revenue Service Form 1040, Schedule C, which is the personal income tax return of the Sole Proprietor. The net profit or loss is calculated by subtracting business expenses from business income. If the business earns a profit, that amount is included in the total income of the Sole Proprietor and taxed at their individual income tax rates.

California Taxation of Sole Proprietors in California

For California income tax purposes, the income earned by the business is also the income of the Sole Proprietor and is reported on the personal income tax return of the Sole Proprietor on California Franchise Tax Board Form 540. This income is taxed at the progressive individual income tax rates of California, which range from 1% to 13.3%, depending on the total taxable income of the proprietor.

Business expenses that are deductible on the federal tax return are generally also deductible on the California state tax return. This can help to reduce the overall taxable income of the proprietor.

Self-Employment Taxation of Sole Proprietors in California

In addition to income tax, sole proprietors are also responsible for paying self-employment taxes, which cover Social Security and Medicare taxes. These taxes are calculated on Internal Revenue Service Form 1040, Schedule SE. Self-employment taxes are computed based on the net earnings from the business, and the current rate is 15.3%, where 12.4% goes towards Social Security and 2.9% towards Medicare. There’s an income cap for Social Security tax that generally increases annually, but there is no cap for the Medicare tax.

Taxation of California S Corporations

California S Corporations operate under a different taxation framework compared to sole proprietorships. California S Corporations, while more complex, can offer significant tax advantages if managed correctly. In this section, we will provide an overview of the tax responsibilities associated with running a California S Corporation, including both federal and state tax obligations.

Federal Taxation of California S Corporations

Federal taxation of California S Corporations is pass-through taxation. This means the California S Corporation itself is not subject to federal income tax. Instead, the profits or losses of the California S Corporation are passed through to their shareholders and are reported on the individual tax returns of the California S Corporation shareholders. The net profit of a California S Corporation is taxed at each personal income tax rate of the shareholder, hence avoiding the double taxation typically associated with traditional corporations (where the corporation is taxed on its profits and the shareholders are taxed on dividends).

To facilitate this process, the S Corporation 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 Corporations are subjected to several state-level tax obligations. A California S Corporation 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 the S Corporation itself and must be paid using Form 100S, California S Corporation Franchise or Income Tax Return.

While the S Corporation itself does not pay federal income tax, the pass-through characteristic of an S Corporation brings about income tax implications for the shareholders. Similar to federal taxation, the profits or losses of the S Corporation 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

California S Corporations do not subject shareholders to self-employment taxation.

On the employment tax front, when an S Corporation pays salaries to its shareholder-employees, it must withhold federal income tax and the employee portion of Social Security and Medicare taxes from these wages. The corporation must also pay the employer portion of Social Security, Medicare, and Federal Unemployment Tax Act (FUTA) taxes.

Therefore, unless a California S Corporation pays all of its net income to shareholder-employees, the employment taxes paid by a California S Corporation will likely be less than the self-employment tax liability a Sole Proprietorship creates. For example, if there is a $100,000 net profit in a Sole Proprietorship, a Sole Proprietor will pay self-employment taxes totaling approximately $15,000. However, under a California S Corporation, if a shareholder-employee were to split that same $100,000 net profit into a $50,000 salary and a $50,000 shareholder distribution, the shareholder-employee would only pay approximately $7,500 in employment taxes, a 50% savings in employment-based taxes.

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 Sole Proprietorships in California, we will not discuss partnership taxation, which requires that the California LLC have two or more members, and also not discuss taxation of a California LLC as a corporation, since we are discussing small businesses and C Corporation taxation would likely be ill-advised for most small business owners.

Taxation of California LLCs with Only One Member Electing S Corporation Taxation

If a California LLC with only one member elects to be treated as an S Corporation for tax purposes, it will be taxed identically to the discussion of the taxation of a California S Corporation discussed above in all respects. If an S Election is made for the LLC, it is treated as an S Corporation in all respects.

Taxation of California LLCs with Only One Member Not Making a Tax Election

However, if a California LLC with only one member does not make an election to be taxed as an S Corporation, it will be taxed identically to the discussion of the taxation of a Sole Proprietorship discussed above in all respects with two significant additions.

The first addition to the tax discussion for Sole Proprietorships for a California LLC with only one member that is disregarded for tax purposes 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.

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.

The Disadvantages of Sole Proprietorships in California versus 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 first main disadvantage of a Sole Proprietorship in California is the unlimited liability faced by the Sole Proprietor. Unlike the shareholders of California S Corporations or members of California LLCs, a Sole Proprietor is personally accountable for all the debts and obligations of the business. 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.

The other main disadvantage of a Sole Proprietorship in California is the self-employment tax liability imposed upon the total net income of the Sole Proprietorship compared to the ability to reduce employment tax liability with the use of a California S Corporation or California LLC taxed as an S Corporation. This can result in significant tax savings for the shareholder-employee of a California S Corporation or California LLC taxed as an S Corporation.

San Diego Corporate Law is Here to Help!

Navigating the advantages and disadvantages of a Sole Proprietorship 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 Sole Proprietorships, California S Corporations, and California LLCs. We are committed to aligning these intricacies with your specific business plans and long-term objectives, ensuring you choose the most beneficial business structure for your unique circumstances. Reach out to us today to schedule a consultation and take the first step toward starting your business right the first time.