Business entity selection: S corporation versus LLC (single-member or multi-member), C corporation versus S corporation, and the like - is a crucial decision in the life of any business, best made in conjunction with this firm or another business attorney, plus an accountant. To properly choose between an S corporation and a limited liability company, one must know and understand each of the four different ways an LLC can be taxed under federal law, among other things.
No one business entity type is the right choice for all circumstances, businesses, or owners, and anyone who says otherwise ("Always use an LLC.") is either not very knowledgeable or is deliberately trying to cut the corners of analysis to save time and make everyone fit into his or her one favorite box, bringing to mind the saying, "The general rule applies to no one in particular."
Even when one entity type is initially preferred, it may not always be available, due to IRS rules or other legal restrictions. For example, some states prohibit professional LLCs, while others allow them. Another example: a corporation desiring to elect Internal Revenue Code Subchapter S pass-through corporation taxation must qualify as a small business corporation under IRS rules. Some shareholders will not qualify as S corporation shareholders, and thus an LLC or C corporation may need to be considered instead. Alternatively, work-around solutions to overcome some of the apparent obstacles to S corp. classification may be utilized where appropriate.
Choice of jurisdiction: Likewise, determining what state you should incorporate in - or form your LLC or LLP in - is a key portion of the firm's legal services to its California business incorporation/organization clients, and one online incorporation services and paralegals cannot provide. As a general rule, it it more efficient and less expensive to make these choice of entity and state of incorporation (jurisdiction) decisions correctly initially, rather than to change things when problems later arise.
As with entity selection, there is, again, no one answer for everyone or every business as to whether Nevada, Delaware, Wyoming, or your home state is the right corporate home for your business. Full consideration of a wide range of factors is required to advise you as to what is best for your particular situation. Thus, no online article or book can adequately address these questions. Additionally, on a cautionary note, there are numerous Nevada incorporation myths, online and elsewhere, regarding the privacy and tax advantages of forming a Nevada corporation or LLC, as well as some genuine reasons to incorporate in Nevada under some circumstances. I am licensed to practice law in California and Nevada, so either way, I can assist you with unbiased advice and proper formation of the appropriate business entity or entities.
With this in mind, the following is a brief overview of the most commonly used entity types to aid in understanding the decisions to be made and in understanding some commonly-used terms. It is not intended to be comprehensive and is unlikely to provide enough information for the lay person to make an entity choice, which should be made in conjunction with a business attorney and accountant. It focuses on California business entities:
C Corporation: Most large companies are C corporations, which provide a lot of flexibility. For example, multiple classes of stock, unlimited number of and types of shareholders, a fiscal year rather than calendar tax year may be elected, the corporation can retain income to fund future growth. Net income is reported on Form 1120 or 1120A and taxed by the IRS on a sliding scale starting at 15% for $0-50,000 in income unless classified as a personal service corporation ("PSC"s, those corps whose shareholders are primarily engaged in the performance of personal services such as consulting and architecture, pay 35% flat from dollar one of net profit, making this a generally undesirable entity type for PSCs). C corporations are subject to double taxation (corp. income taxed once at corporate level, then at shareholder level on their personal tax returns when profits are distributed via dividends to shareholders; in smaller C corps., this may sometimes be avoided by carefully zeroing out of net income each year by paying enough out to shareholder-employees that there is no net income; for large C corp's, it's just a cost of doing business). The California tax rate for C corporations is 8.84% of net income, with an $800 minimum, except no minimum amount is applied in the first year of corporate existence. Health insurance may paid for employees, including employee-shareholders, on a pre-tax basis. A C corporation may also adopt a medical reimbursement plan for its employees to pay its employees’ other medical expenses on a pre-tax basis. Governing document is bylaws. Shareholder-owners elect directors, who in California elect a minimum of a chief executive officer (CEO), chief financial officer (CFO), and a secretary, who run the business or hire others to run it for them. An annual meeting is required per the California Corporations Code. Provides limited liability protection and potential tax benefits in most instances if properly established and maintained. All corporations are "born" as C corps.; some that qualify then go on to elect S corporation tax treatment.
S Corporation: Generally simpler, but less flexible, than a C corporation. Only a limited number of shareholders, usually individuals only, and no foreign nationals shareholders are allowed. Must with few exceptions use a calendar year for tax reporting. Net profit or loss after expenses, including salaries paid to employees and shareholder-employees, is reported on federal Form 1120S and passed through – hence the name pass-through entity – to shareholders’ personal tax return via Schedule K-1, where it avoids payroll taxes and is subject only to income taxes. Pass-through losses are limited to the taxpayer's basis in the stock of the S corporation. In a profitable S corp., these savings can easily pay for the corporations’s expenses of organization, tax returns, and maintenance and provide additional tax savings, as well. The incentive, then, is to not pay any salaries, which are subject to payroll taxes, and take all net income as profit distributions; IRS rules, however, require that reasonably salaries must be paid to shareholder-employees and the failure to do so is considered a hot audit area. What’s reasonable is debatable and is something your CPA will assist in determining. On the state level, California levies a 1.5% tax on net income, with an $800 annual minimum franchise tax, except for year one of corporate existence, where no minimum applies. Health insurance an S corporation pays for its shareholders is treated as a corporate business expense but also as income to the shareholder. No medical reimbursement plan for other medical expenses is available. As with a C corporation, the management structure is that the shareholder-owners elect directors, who elect a CEO, CFO, and secretary, who run the business or hire others to run it, and properly custom drafted and implemented bylaws determine the rights and responsiblities of the shareholders, directors, and officers. An annual meeting is required per California law. S corporations provide limited liability protection and potential tax benefits in most instances if properly established and maintained.
Limited Liability Company (LLC) - Single Member or Multi-Member: An LLC provides significant flexibility in terms of the treatment of capital contributions and allocation of profits and losses to owners – called members. Members can include corporations and other LLCs. Members usually manage the LLC, but a member-manager or outside manager can be appointed instead. Small business LLCs are usually member managed. Like most if not all other states, California allows single-member LLCs, but unlike most other states, does not permit professional LLCs. The governing document of the LLC is the operating agreement, and there is no "standard" operating agreement; rather, it should be customized to meet the needs and expectations of the LLC members. An LLC is, like an S corporation, also a pass-through entity at the federal level: it is treated as a partnership, with income reported on Form 1065 and then distributed to owners via Schedule K-1, unless it’s a single-member LLC (including a married couple filing jointly), in which case the LLC files a Schedule C (unless of course the LLC elects to be taxed as a corporation). Profits/losses to members, and any ‘salaries’ (guaranteed payments) paid to them are considered self-employment income and are subject to self-employment taxes. At the California level, an $800 per year minimum franchise tax applies commencing in year one or portion thereof of existence, plus an addtional total income (gross receipts plus cost of goods sold) tax levied on total incomes above $250,000 per year. LLCs generally must use the calendar year. They provide limited liability protection in most instances if properly established and maintained, but usually few or no tax benefits versus a Schedule C sole proprietorship or general partnership.
