Business Entity Formation

Business Entity Formation

Experienced Entity Formation and Incorporation Attorney Serving San Jose, Santa Clara County, and the San Francisco Bay Area

Any lawyer can form a corporation or other entity, but entrepreneurs are well-advised to hire legal counsel who has extensive experience in this area. There are many types of business entities, among them partnerships, corporations, and limited liability companies (LLC’s), and picking the right entity can be critical. Make the wrong choice, and the consequences can range from annoying to dire.

If there is one owner, the principal choices are sole proprietorship (which technically is not a type of entity), corporation, or LLC.

If there is more than one owner, the principal choices are partnership (either a general partnership or a limited partnership), corporation, or LLC.

For certain professionals, a limited liability partnership (also referred to as a registered limited liability partnership) is available, but that is limited to partnerships engaged in the practice of law, public accountancy, architecture, engineering, or land surveying.

There is also a form of business known as a business trust, but it is not commonly used in California.

In determining which form of entity to choose, several factors should be considered.

Limited Liability

The first factor to consider is limited liability. What this refers to is that, with certain types of entities, the obligation of the owner (or owners) is limited to the money or other property contributed to the business (as well as any money or other property that an owner has committed to contribute to the business in the future).

For an entity that is not a limited liability entity, the owner (or owners) is fully liable for the obligations of the business, even if the owner has not committed to contribute to it in the future. The owners of sole proprietorships and partnerships do not enjoy limited liability for the obligations of the business.

The owners of corporations and LLC’s enjoy limited liability for the obligations of corporation or LLC.

The limited partners in a limited partnership also enjoy limited liability, but each general partner of a limited partnership is fully liable for all the obligations of the limited partnership.

Tax Factors

After the issue of limited liability is resolved, counsel typically next considers the tax aspects of the different forms of business organization, often with the guidance of the client’s accountant.

One of the most significant tax aspects is whether the business is a “flow-through” entity. What this means is that income of the business flows through to the owners of the business for tax purposes, and each owner pays income tax on his share of the business’s income. This avoids (either mostly or entirely) any income tax at the entity level, with the result that the owners of the organization pay tax only once on the income of the business. Of course, an owner must have cash with which to pay the tax on his share of the business’s income, and the ability to withdraw the cash from the business without adverse tax consequences is one of the factors considered by counsel in advising on the correct form of business entity.

If a business is losing money, “a flow-through” entity allows the owners to deduct the losses of the business on their personal tax returns. Tax law imposes significant limitations on the ability on owners to deduct the losses of the business on their personal tax returns, and the choice of entity can have an important bearing on whether the losses can be used personally.

Eligibility Restrictions

Not every form of business organization is available for every kind of business. Because of regulatory restrictions, some businesses can be operated only in corporate or partnership form (or as sole proprietorships). For example, an LLC is not eligible to operate certain kinds of business in California. In other cases, only a corporation is permitted to operate certain types of businesses. These regulatory constraints must be taken into account in choosing the right form of entity.

One of the most popular forms of business organization is the S corporation, which is a type of flow-through entity. The tax law imposes restrictions on who is eligible to be a shareholder of an S corporation. For example, individual shareholders must either be U.S. citizens or hold a “green card” (that is, be resident aliens). Generally speaking, corporations and partnerships may not be shareholders of an S corporation. While trusts are generally permitted to be shareholders of an S corporation, some types of trusts will result in increased taxation. Having ineligible shareholders of a corporation will disable the corporation from electing to be an S corporation.

Capital Structure and Allocation of Profit and Loss

Partnerships and LLC’s lend themselves more readily to complicated capital structures, with more flexible sharing of profits and losses, than do corporations. With a sole owner or small group of owners, this is usually not an issue since the capital structures of such businesses are typically straightforward and not complicated. But flexibility of capital structure is a problem with S corporations, for they are not permitted to have more than one class of stock. Thus, allocating profit and loss in something other than a straight bottom-line fashion is problematic for corporate entities.

Control

One of the most important issues to owners of businesses is control. Control can be more easily and flexibly allocated in a non-corporate form, such as a partnership or LLC. Nonetheless, knowledgeable counsel can achieve much of the desired flexibility in corporate form, though typically the legal fees are higher since the corporate form is less flexible and requires more legal work to achieve the desired flexibility.

Getting Started Right

Contact us today to speak with an experienced business entity formation attorney. Richard G. Burt helps entrepreneurs have the assurance of knowing that he or she has the assistance of experienced counsel in forming a business entity. Call (408) 286-7333 for a free telephone consultation about setting up a business entity or to set up an appointment to discuss your particular circumstances. Or send an email using the form on the contact page.