An Article by William A. Taylor, Esq. (The Business Lawyer)
What is the scene like now, on the corporate/LLC front? What choices are open to a businessperson desiring to pick a form in which to do business – be that business investing in real estate or running a client-oriented operation employing workers? What are the choices and how do they differ?
From (c)(3)s to LLCs On one end of the taxation spectrum is the non-profit corporation; on the other end of the spectrum is the limited liability company (LLC). In between are the C corporation and the S corporation. Then the LLC category splits into the regular LLC and the series LLC. The taxation spectrum looks like this: 501(c)(3) – C corporation – S corporation – Regular LLC – Series LLC.
501(c)(3) A non-profit corporation is a business that does not have to pay income tax. A non-profit that is exempt under section 501(c)(3) of the federal Internal Revenue Code and section 23701d of the California Revenue and Taxation Code is called a “charity” and not only does not have to pay income tax but also can provide donors a tax deduction for their contributions, because the charity’s purpose is to do something beneficial for society.
Non-profits are businesses, however. If they don’t bring in enough money (from donations or sales of product or services), they will go out of the “business” of doing good, because their expenses of operation will swamp them – just like for-profit businesses.
C corporation Like a non-profit, a C corporation is a corporation. As a corporation, it will be treated like a “person” – separate from its owners and employees so that it can be used to absorb the financial liability created by its employees and owners doing something wrong. Additionally, like a “person,” it must pay income tax. All of the public companies that sell stock on the stock markets are C corporations.
S corporation Like a C corporation, an S corporation is treated in the law like a “person” -separate from its owners and employees so that it can be used to absorb the financial liability created by its employees and owners doing something wrong. However, unlike a C corporation and unlike a “person,” an S corporation does not pay federal income tax.
Taxation of the net profits of an S corporation flows to its owners, in their percentages of ownership. For example, a person who owns 30% of an S corporation’s shares, will include 30% of the corporation’s net profit on their personal income tax return. That person better get a cash distribution from the corporation to pay the tax on that 30% or else pay the tax from themselves.
There is a small (1.5%) California state income tax on the net income that is payable by the corporation to the Franchise Tax Board.
Not every corporation can be an S corporation. An S corporation cannot be owned by a person who is a non-resident alien; a corporation cannot be a shareholder of an S corporation. There can’t be more than 75 shareholders.
Write-offs for Start-Ups S corporations are especially good for start-up businesses because, just as the net profits flow on to the income tax returns of the owners, the more likely net losses (created by the expenses of business operation being greater than the sales income) also flow on to the income tax returns of the owners. In the first few years of a start-up business, when the public doesn’t know the business exists, S corporation status will allow the shareholders (owners) to catch a tax break while they wait for the world to catch up with the brilliance of their business.
LLC The “new kid on the block” is the limited liability company (LLC). It is a blend of a partnership and a corporation. Unlike a partnership (where each and every partner is liable for, and might actually have to, personally absorb the financial liability created by employees or owners doing something wrong), an LLC is like a corporation (where nobody is liable). So, with an LLC type of organization, a businessperson can have the ease of operation of a partnership with the financial liability protections of a corporation.
The LLC’s partnership-style ease of operation allows for a choice: a) either all of the owners can participate in management of the LLC in some voting arrangement of their choosing, or b) the management can be totally separated from the concept of ownership so that investors can be kept in their place. Regardless of management, however, California won’t allow for the practice of a licensed profession in or through an LLC. The licensing agency should be called first, before paying good money to form an LLC.
LLC Taxation Additionally, just like the S corporation, the LLC pays no federal income tax; taxability flows to its owners in their income and loss percentages (which might be different from their ownership percentages – but that’s a subject for another time). And, somewhat similar to the S corporation, the LLC must pay a tax to the state of California – this time, a gross receipts tax, i.e., a tax on the money coming in the door (no deductions). The LLC has no tax liability to California on the first $250,000 of gross receipts. However, the tax is $900 on gross receipts up to $500,000; $2,500 on gross receipts up to $1 million; $6,000 on gross receipts between $1 million and $5 million; and is $11,790 on gross receipts over $5 million.
If you have a business that has a high volume but is in an industry with a low gross profit percentage (like a supermarket – averaging 3%), you don’t want to operate as an LLC.
Series LLC Regarding the issue of liability, about five states (Delaware being the most prominent and Nevada being the closest) have passed laws that allow for the creation of what is called a “series” LLC. Imagine your hand being the LLC and each of the fingers on that hand being a different series – A, B, C, D or 1, 2, 3, 4 or colors or brands of liquor – whatever you want to name the series. Each series has the capacity of “owning” a business enterprise completely separate from the other series and accounting for its income and expenses completely separately from each of the other series. More importantly, a financial loss created by actions within the business of one series cannot be held against the assets of any of the other series or against the LLC as a whole. You can even bankrupt one of the series without that bankruptcy affecting any of the other series or the LLC as a whole.
Imagine the possibilities for someone owning several investment properties through only one LLC, or someone who has multiple business activities, who shields each one from the others using only one LLC. Unfortunately, California does not allow the “series” concept to be formed here and the test case has not yet been reported that the California courts will allow the “liability separation” concept to be upheld here.
You can, however, register with the state of California your “series” LLC (that was created in another state), as long as you pay the $800 per year franchise fee for each of the series of your LLC and pay a gross receipts tax on each series’ gross receipts. (A California court has recently declared unconstitutional the requirement for all foreign LLCs to pay a gross receipts tax on all of its gross receipts. The court challenge is because that tax is not being assessed proportionally to the amount of business done in California – the way foreign corporations are assessed here).
Summary There are more considerations to be taken into account when selecting the type of entity for your business. However, go out and do business. When you need protection, just take your time to choose the form that fits you best.
ABOUT THE AUTHOR: William A. Taylor, attorney at law, does business as “THE BUSINESS LAWYERS.” He can be reached at (510) 893-9465