To paraphrase an old bard, “To incorporate or not to incorporate, that is the question.”
Actually, that’s not the question. The first question I ask a client considering incorporation is: “What are you trying to accomplish?” By understanding the client’s ultimate goals, I can focus additional questions and legal analysis to advise the client on the best form of entity for the client’s particular situation.
A corporation may or may not be the best form of entity. In California, the usual forms of business include sole proprietorship, general partnership, limited partnership, limited liability company, limited liability partnership (available to attorneys, accountants, architects, engineers, and land surveyors), and corporations. Other forms of business, such as a Massachusetts business trust or Illinois land trust, are seldom used in California.
There are advantages and disadvantages to each form of business. A sole proprietorship is relatively simple and less expensive, but there is no limitation on personal liability. A general partnership pays no California franchise taxes, can provide tax planning opportunities and business flexibility, but may expose its partners to unlimited personal liability.
A limited partnership can provide flexibility, and shield the limited partners from liability, but the limited partnership must be registered with the state and pay a California franchise tax every year, even if the limited partnership is not making a profit. The general partner has personal liability for the debts of the partnership.
California limited liability companies have been authorized since 1994. The LLC combines the flexibility of a general partnership with the personal liability protection of a corporation. However, the California franchise tax for an LLC is a minimum of $800.00 per year, and could be more than $12,000.00 per year depending on the gross (not net) revenue of the LLC. Most importantly, some businesses in California are not permitted to be operated in the form of an LLC.
A corporation has the advantages of centralized management and perpetual existence, while shielding its shareholders from personal liability. The disadvantages include taxing profits at both the corporate and shareholders levels, and more formalities and less flexibility. Corporate shareholders can elect to have the corporation taxed under Subchapter S of the Internal Revenue Code. The S Corp generally avoids federal income tax at the corporate level, but there is a California income tax on S Corp profits. The tax election does not change the basic corporate structure.
There are other factors to be analyzed in a careful selection of the proper entity, such as state of formation, capital structure, and exit strategy. Failing to consider all the factors can result in an expensive mistake.