BUSINESS ENTITY FORMATION
PRODIGY LAW® is experienced at forming your new business entities in California, Delaware or Nevada. We represent new business entities and their owners throughout the San Francisco Bay Area and Silicon Valley. Prodigy Law's Business Entity Formation practice consists of:

Step One:  Assisting clients select the proper business entity to create.
Step Two:  Preparing and filing all appropriate legal paperwork.
Step Three:  Counseling clients on best practices for starting-up a new business.

We handle formation of:
• Limited Liability Companies
• Partnerships
• Corporations



CONSIDERATIONS FOR SELECTING A BUSINESS ENTITY*

Selecting the most advantageous business organization form involves weighing many practical and legal considerations. Important distinctions among the available forms of business enterprise include:

1.    Cost and formality of organization;
2.    Transferability of ownership interests;
3.    Continuity of the business' existence;
4.    Vesting of management and control;
5.    Ability to obtain capital and credit;
6.    The method of participation in profits;
7.    Vulnerability to liability; and
8.    Taxation of the business.

California recognizes most typical forms of business enterprises, including partnerships, limited partnerships, limited liability companies and corporations.

Each of these forms of business enterprise is adaptable to the small business venture, and it is important to compare each in terms of the various considerations discussed herein.

A.     GENERAL COMPARISON OF FORM

    1.     Sole Proprietorship.  The sole proprietorship is the simplest and the most common form of business enterprise. The distinguishing characteristic of a sole proprietorship is that it is owned and managed by one person. The individual proprietor owns all business assets and carries on the business for himself or herself. The individual proprietor may hire employees and agents, but he or she has ultimate responsibility and authority for all business decisions. Generally, no legal formalities are necessary to create sole proprietorship. The sole proprietor is entitled to all business profits and, broadly speaking, he or she can enter and exit from the business as he or she pleases.

    2.     General Partnership.  The hallmarks of a general partnership include the profit sharing and co-ownership. As defined in the Uniform Partnership Act: "A partnership is an association of two or more persons to carry on as co-owners a business for profit." A partnership is created by agreement, either oral or written, and the relations of the partners are largely governed by that agreement and by the Uniform Partnership Act as adopted by California.

Required Agreement:  The partnership agreement may be informal, although a formal contract is preferable. The partners must agree to share in business profits, losses and assets during operation and upon dissolution.

Liability Concern:  For many purposes, a partnership is not considered a separate legal entity distinct from the partners, although this is not always a disadvantage (e.g., qualification is not necessary to do business in other states). Today, a partnership is recognized for some purposes as a separate entity; it may own real property in its own name, and may be sued in the names of the individuals doing business as a partnership, in the firm name, or both.

A partner is a "co-owner" with his or her partners of specific partnership property "holding as a tenant in partnership." Under the Uniform Partnership Act, all property originally brought into the partnership or subsequently acquired, by purchase or otherwise, on the partnership's account is partnership property and, unless there is a contrary intention, property acquired with partnership funds is partnership property. The partners may provide in their agreement that title to partnership property may remain in the name of one or more partners. Generally, property purchased by a partner in his or her own name after the organization of the partnership is not partnership property, unless so provided by the partnership agreement or unless there is a clear intention that it is to be partnership property.

Partners Duty of Loyalty:  Apart from the rights, duties, and liabilities arising from the partnership agreement, a fiduciary relationship also exists between partners as a matter of law, and each is bound to act in the utmost good faith in all dealings and transactions that affect the others in the partnership business. The Uniform Partnership Act provides that the partnership must indemnify every partner with respect to payments made and personal liabilities reasonably incurred by him or her in the ordinary and proper conduct of the business or for the preservation of the partnership business or property. It is possible to vary this indemnification requirement by agreement.

The fact that the relationship is a fiduciary one does not bar a partner from dealing with the firm as an individual. However, a partner cannot engage in a business in competition with the partnership without the consent of his or her partners.

Liability:  Finally, it is important to note that each partner is personally liable for partnership debts and other liabilities. This is clearly a disadvantage to the partnership business form.

    3.     Limited Liability Company.  All members of a limited liability company enjoy limited liability for obligations and liabilities of the limited liability company, even if the members participate in management.  There is no limitation on the number or types of members. All states allow for the creation of single member or multiple member LLCs.

    Management is flexible. All members may be involved in management, as with a partnership, or management authority may be vested in one or more managers, as with a corporation or limited partnership. Business profits are subject to only one tax, at the individual member level, and are not subject to double tax as would be the case if the profits were earned by a C corporation. Losses are available on the members' personal income tax returns and can offset other income (subject to the passive loss rules and at risk rules).  Special allocations may be made for income tax purposes. Disproportionate distributions may be made to members.

    An LLC may be converted to a partnership, limited partnership, C corporation, or S corporation in what is ordinarily a tax-free transaction.

    The disadvantages of an LLC organization are that it requires a state level filing, and compliance with operating formalities may be required to preserve limited liability. Additionally, you need to a qualification for doing business in other states. Regular reporting to governmental entities is required. Unless otherwise provided by agreement, termination may result from the death, dissolution, incompetence, bankruptcy, or withdrawal of a member. Business profits are taxed as income to the individual members and will be subject to self-employment tax unless the LLC is manager managed and there are members who do not participate in management. Transfer of interests may be subject to securities law regulation.

    4.     Business Corporation.  A corporation is an artificial person or legal entity created by, or under, the laws of a state or of the United States. It can be owned by one or more shareholders, who themselves may be natural or legal persons. It is regarded, in law, as having a personality and existence distinct from that of its members. It can acquire, hold, and convey property, sue and be sued in its own name, and generally can do all things in a legal sense which a natural person may do.

    The shareholders' rights are determined by the corporation's charter and the applicable statutes. While the shareholders are the corporation's owners, they are not its agents (unless they are also officers or employees). Unless shareholders are officers, directors, or controlling shareholders, they do not owe a fiduciary duty to the corporation.

    As an entity created by statute, a corporation cannot do business in states other than the one which created it without first qualifying, and it is not entitled to the "Privileges and Immunities" of a citizen under Article IV, ยง 2, of the United States Constitution. It is a citizen of a state for purposes of "diversity of citizenship" when seeking to invoke the jurisdiction of the federal courts.

    A business corporation is subject to greater governmental regulation than other entities, and the statutory formalities respecting the formation and operation of corporations must be strictly observed. For a small business these may be nuisance factors which must be considered in determining the appropriate form of business organization.

B.     INITIAL COSTS

Sole Proprietorship or General Partnership

If the organizer of the business decides to operate as a sole proprietorship, or if the organizers decide to operate as a general partnership, there are no state or local taxes to be paid for the privilege of organizing the business. The sole proprietorship or partnership must comply with the applicable tax and license laws, but there are, at present, no taxes or fees for organizing an unincorporated business other than a $70.00 filing fee and a very nominal publication cost which is incurred under the "Fictitious Business Name" statutes.

Limited Liability Company

To file the articles of organization of an LLC the cost in California is $70.00. There is a need to file a statement of information for $20.00 within 90 days of filing the articles of organization.

Incorporation Fees for Corporations

Persons desiring to incorporate a business corporation under law are required to pay a fee of $100.00 for filing the articles of incorporation with the Secretary of State and for the issuance of a certificate of incorporation. Biennially thereafter, a statement of information, including a $25 fee must be filed. These fees are subject to change on an annual basis.

C.     TAX CONSIDERATIONS (Please see a tax specialist for more information.)?

    1.     Individual or Sole Proprietorship. The federal and state laws regarding the taxation of a sole proprietorship may constitute an advantage in some cases. All business income or loss is treated as the individual's income or loss and taxed accordingly. The sole proprietor declares this income on a separate schedule (Schedule C) of his or her individual tax return and his or her individual income tax rates are applied. After the Tax Reform Act of 1986, individual tax rates are generally lower than corporate rates. If early business losses are expected, the loss may operate as a shelter for other personal income of the sole proprietor and may thereby result in direct tax savings. Individual proprietors may qualify for certain retirement plan-type deductions.

    2.     General Partnership. The partnership itself pays no federal income tax. However, each partner is required to declare his or her share of partnership income or loss on his or her tax return. The partnership is thus treated very much like the sole proprietorship for tax purposes, with the exception that the income or loss will be spread over the partners in their respective proportions rather than being applied to one person. Profits earned during the year are applied to the individual incomes of the partners whether they have been distributed or not. Losses from the business, as they are attributed personally to the partners, may be offset against other personal income, subject to limitations for passive activities and other rules. The sale of a partner's interest in the partnership generally results in a capital gain or loss much the same as the shareholder's sale of corporate stock.

    3.     Limited Liability Company. An LLC with two or more members is taxed as a partnership and is a pass-through entity for federal income tax purposes ("S" corporation), unless it makes an election to be taxed as a "C" corporation. The income or loss of the LLC is passed through to its members and must be reported on the members' income tax returns. From a substantive law standpoint, there are no restrictions on how members may agree to split profits and losses among themselves. But there are income tax law limitations designed to prevent LLC members from making allocations that give members tax benefits without subjecting them to any economic consequences.

    4.     Business Corporation. As a separate entity, a corporation is subject to separate tax procedures and rates by the federal and state authorities. Unlike a partnership, where income flows through to the individuals who comprise the enterprise, a corporation is separately taxed on its own income. This causes some advantages and some disadvantages, all of which must be carefully considered.

    Corporate taxation may result in "double taxation." Income received by the corporation is taxed at the corporate level according to the corporate rates then in effect. The profit remaining after taxes is then available to be distributed as dividends, which are taxed again as personal income to the shareholder. This double taxation can be a distinct disadvantage for the corporate form, as compared with other forms of business enterprise. Larger corporations with many shareholders simply accept the disadvantage, but in smaller, closely held corporations, double taxation must be minimized. There are several possibilities.

        a. Salaries. Whenever shareholders are officers or employees of the corporation, they may be paid salaries which are deductible as a corporate expense, and thereby be compensated otherwise than with dividend distributions. Salaries are deductible only to the extent that they are reasonable and necessary.

        b. Loans. The small corporation may be structured so that a significant portion of its capital comes from loans to the business rather than shareholder investment. Having established sufficient equity capital, the remaining funds needed for the business may be raised through interest-bearing loans and the interest is deductible to the corporation as an expense. The interest paid to the creditor is individual income to him or her, but it substitutes for dividends and is not subject to double taxation.

        c. Subchapter S Election. The small business corporation may elect not to be taxed at the corporate level, but to have its income (whether distributed or not) passed through and taxed pro rata to its shareholders. The S election can also permit shareholders to take advantage of losses in the early stages of the business. The following requirements must be met for a corporation to qualify to be taxed as an S corporation:

1. There may be no more than thirty-five (35) shareholders;

2. Shareholders must be natural persons, and cannot be another corporation or partnership; except that estates and certain trusts may own shares;

3. The corporation may only have one class of stock, and may not be a member of an affiliated group;

4. The corporation cannot have a nonresident alien as a shareholder; and

5. The corporation's foreign income and "passive investment income" may not exceed certain limitations. All shareholders must consent to the S election, by signing a statement of consent which is submitted with the application electing taxation under Subchapter S.


*PRODIGY LAW ARTICLES ARE FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY. ANY SUGGESTIONS CONTAINED IN THE ARTICLE ARE THE GENERAL OPINION OF PRODIGY LAW. PRODIGY LAW ARTICLES ARE NOT WRITTEN WITH ANY SPECIFIC FACT PATTERN OR CASE IN MIND. ARTICLES DO NOT REPLACE ORIGINAL LEGAL RESEARCH AND CONSULTATION WITH AN ATTORNEY REGARDING YOUR SPECIFIC MATTER OR CASE. PRODIGY LAW ARTICLES ARE PRESENTED "AS-IS" AND DO NOT GUARANTEE THE ACCURACY OF THE INFORMATION CONTAINED THEREIN, SINCE CASE LAW AND LAW CAN CHANGE RAPIDLY.