One of the most difficult decisions that budding small business owners in the state of California have to make is on what entity they want their company to be. Most entrepreneurs choose between an LLC (limited liability company) and an S corporation formation. The fact is that business structure selection is more complicated than most people perceive. A prudent businessperson should seek the advice of a competent corporate lawyer when choosing what business entity to form.
A Small Business Owner in California, Deciding to be Either an LLC or an S corp
Recently, a business owner approached Andy Gale of Incorporation Attorney. The client owned an E-cigarette business. He had a building where all the manufacturing of his products are performed. He also had an operating business where he would sell the cigarettes. The client’s business was prospering, and he wanted to continue to do so. This California businessman came to Andy to seek legal advice on which business entity is best for his company. He was choosing between the formation of a limited liability company and an S corporation.
Choosing the appropriate business entity for a company is a difficult decision to make. To choose correctly, the businessperson has to first answer 6 basic questions:
- How do you make your money?
- Who will own the company?
- Who’s going to run the company?
- What are the gross revenues?
- What are the projected net revenues?
- How will the profits be split if there’s more than 1 owner?
Answering these 6 questions can be complicated enough, and this is merely the first step of the elaborately complex process of choosing the right entity. This is why it is necessary to hire a competent corporate attorney to help you through the steps of selecting the appropriate structure for your company.
11 Variables to Consider When Choosing an LLC or S Corporation Formation for your California Business
There are many small business owners who think that they can go through the process of entity selection themselves. What they don’t realize is that choosing a structure for your company can be very complicated, and only an experienced business attorney can help an entrepreneur decide on the appropriate entity to form.
Besides answering the 6 basic questions, there are more steps to go through. Once the owner has answered the questions, he or she then has to consider these 11 variables:
1. The Purpose of the Company
The purpose of your company is one of the variables that determine which entity is best for your business. If you are going to build a holding company, a limited liability is the ideal structure for you. A holding company is a business that deals with real estate rentals and royalties. But if you plan to start an operating company, an S corporation is the appropriate entity for you. Operating companies are enterprises that provide services or deals with the sale of products.
2. The Formalities
Most businesspeople in California want to avoid paperwork, and they opt for a structure that does not involve preparing a lot of documents. A limited liability company is the best option for those who want less paperwork. The government requires a huge number of formalities when forming an S corporation.
If you are the type of company owner who wants less paperwork, you should form an LLC. If you still prefer to be an S corp but want to avoid all the tediousness of preparing documents, you should hire a corporate lawyer. A trustworthy business attorney can do all the paperwork necessary to form an S corporation.
It’s important to note that many reliable corporate attorneys strongly suggest that business owners who choose to form LLCs should file for the full alter ego limited liability protection. These experts advise entrepreneurs that maintaining the formalities similar to those of an S corporation are necessary to create the ideal liability-resistant company. Even if your company chooses to be an LLC, you should still prepare and file the necessary formalities to protect your business from liabilities.
This then creates a need that you might not expect or want to manage the right paperwork associated with the formalities. This once again suggests that hiring a small business attorney may be a helpful step, even if you’re forming an LLC.
If a businessperson wants to form an S corporation, the owners of the company must be citizens of the United States, and are currently residing in the country. Simple trusts can also be members, owners, or shareholders of an S corp. For help with building a trust, or finding the right structure for your particular national residency, consult with Andy Gale at Incorporation Attorney to set everything up correctly.
4. Co-Owner Protection
There are business proprietors that prefer a limited liability company structure because of the charging order protection for co-owners. What most of them do not know is that you can get the same type of protection in an S corporation, if you have a buy/sell agreement that is properly drafted between the stockholders. Discussing your business and whether a buy/sell agreement is a smart choice would be a wise conversation to have Incorporation Attorney.
5. Will Professionals be Involved?
In some States, licensed professionals, such as lawyers, nurses, doctors, engineers, and accountants can form a professional limited liability company but not a limited liability company. PLLCs are designed for licensed professionals.
In California, professionals are allowed to form neither PLLCs nor LLCs, but they may form registered limited liability partnerships. If professionals are involved in the formation of your company, an S corp is the only option left for you.
6. The Management
If the owner of an enterprise wants to have an individual manage the business, an S corp is the ideal structure to form. If the owner chooses to have a company manage the business, an LLC should be formed. What fits your business? What management system is most appropriate and what are the legal ramifications for choosing the right structure. These are all questions that need to be answered when forming your business and setting up the right structure.
7. How will the Gains and Losses be Allocated between Owners?
There are owners of businesses who want to put in 1% of the money and have different allocations of gains and losses. For example, there’s one member who wants to put up 10% of the money, but wants to take 90% of the losses. This arrangement can be done in a limited liability company, but not in an S corporation. In an S corp structure, if you are putting up 10% of the money, you are going to get 10% of the losses or 10% of the gains.
8. How Are We Going to Get Cash Out of this California Company?
Money is taken out of limited liability companies through a draw. How you want to take money out of your company will greatly determine what type of business entity you should form.
9. Federal Tax Considerations
Federal tax varies for LLCs depending on what entity the company was before it formed its current structure. If the business used to be a sole proprietorship, a partnership, or an S corporation, no federal tax is required. All taxes pass through to the individual returns. However, tax issues are going to be involved if the company used to be a c corporation.
There are no federal tax requirements for companies that form S corps, because all taxes pass through to each shareholder’s tax return.
10. State Tax Considerations?
In California, both LLCs and S corps have to pay the minimum franchise tax fee of $800. In addition to that charge, LLCs have to pay a gross receipts fee, which depends on what the company’s gross receipts are. S corps, on the other hand, only have to pay a net profit, which varies from one business to another depending on the company’s gross revenues.
11. The Owners’ Personal Taxes
Owners of a limited liability company are going to pay income tax and self-employment tax on a draw. Shareholders of an S corp are going to pay income tax and payroll tax on their salaries.
The big difference between the two entity options is in the taxes on profits and distributions. In a limited liability company, all distributions are subject to self-employment tax or income tax, depending on how the owner is taking them. In S corporations, distributions are subject to income tax, but not to self-employment tax. This difference is one of the common reasons why businesspeople who expect a lot of distributions choose to form an S corporation instead.
Hire a Top California Business Lawyer to Help You Decide Between an LLC or S Corporation Formation
All the questions that need to be asked, plus the variables to consider, show that the process of choosing between the formation of an LLC and S corporation can be a very complicated one. A prudent business owner here in California should hire a competent corporate attorney to help determine the appropriate structure for his or her company. Find a trusted lawyer in California today!