There are several different ways to own a business, each with its own characteristics, advantages and disadvantages. The first factor in choosing a form of ownership is the level of personal liability you are willing to accept. If you are willing to risk all your personal assets you can own the business yourself as a sole proprietorship, or with one or more others as a partnership. If you prefer to limit your potential liability to the amount you invest in the business, you need to form an entity, such as a corporation or Limited Liability Company, which will own the business.
Sole Proprietorship – A sole proprietorship is no entity at all, just you doing business. Because your suppliers and customers are doing business with you, creditors can reach all your assets, not just those connected with the business.
Partnership – A partnership is automatically created by an agreement between two or more people to own something together. A business partnership is the partners doing business; like a sole proprietorship, creditors can reach the partners’ personal assets. Although a partnership can be created without a written partnership agreement, it is advisable to have a written agreement in order to provide guidance and limit problems in the event of disagreements between the partners, or unplanned circumstances such as a partner’s death.
Limited Liability Entities – There are several legal entities which enable the owners to do business without risking more than they are able or willing to invest. These entities do not come into existence automatically, they must be formed in compliance with state law, and registered with and authorized to do business by a state. Because they are legal entities, they exist separately from their owners, which can limit the owners’ liability to the businesses’ creditors. However, it also means that unlike sole proprietorships and partnerships the entity can be subject to tax separately from its owners. You should consult a CPA or tax advisor to help you determine which entity is best for you from a tax perspective.
Corporation – A corporation is an entity owned by one or more shareholders. The shareholders elect a board of directors, which runs the company. Generally, if the corporation was initially sufficiently capitalized and observes some simple formalities, the shareholders are not liable to the corporation’s creditors, so their risk is limited to the amount of their investment. “S corporations” are corporations which satisfy certain requirements and “elect” not to be taxed as a corporation, but to pass their income through to the shareholders, like a partnership. In California, regardless of an S election, corporations pay an annual franchise tax based on their net income, for the privilege of doing business as a corporation. The minimum franchise tax is $800.
Limited Liability Companies – An LLC is an entity which is owned by one or more members, rather than shareholders. An LLC is run by its managing member or managing members. LLCs are required to observe fewer formalities than corporations to maintain the members’ limited lability. LLCs are automatically treated like sole proprietorships or partnerships for income tax purposes, but can elect to be taxed like corporations. In California LLCs are also subject to an annual franchise tax and to a separate fee based on its California income. The franchise tax is $800, and the fee becomes payable when California income reaches $250,000.
Limited partnerships – A limited partnership has two types of partners. The general partners manage the partnership, and like partners in an ordinary partnership are liable to the limited partnership’s creditors. The limited partners are like a corporation’s shareholders; they own a share of the business but have no direct role in managing it, and their liability is limited to the amount of their investment. Limited partnerships must file a certificate with and pay a fee to the California Secretary of State. Limited partnerships are not taxed as entities, however limited partnerships doing business in California are required to pay the $800 annual franchise tax.