Frequently Asked Questions

• Advantage: Simple to form and run
• Advantage: No double taxation on profits
• Disadvantage: Only one owner is responsible for all business decisions
• Disadvantage: The owner is responsible for all business losses.
• Disadvantage: Judgment creditors can get whatever the owner has — whether or not invested in the business. In other words, the owner has no shield against liability.

• Advantage: Few legal formalities and very flexible
• Advantage: Limited partner may be a lucrative capital investor.
• Disadvantage: General partners have unlimited personal liability for business losses and are legally responsible for the business actions of each partner.
• Disadvantage: Limited partners must take care to not exert control over the business that could open them up to general partner liability.

Similar to limited partners, the owners, called members, of the LLC risk losing only that money that has been invested in the LLC. Only LLC assets are used to pay the LLC’s debts. Therefore, with certain exceptions, the members of the LLC are protected from personal liability. As in a partnership, LLC owners report profits and losses on their personal income tax returns. Therefore, the LLC is not a separate taxable entity.

• Advantage: Owners risk losing only the money that they invested in the LLC, with certain exceptions.
• Advantage: Flexibility in rules of management
• Advantage: Pass-Through taxation at the individual level like General Partnership
• Disadvantage: Can be complex to set up and manage

A corporation is a legal and tax entity that is separate from the people who own, control and manage it. A corporation is a legal person. Effectively, this means that the corporation can enter into contracts, take on debt and pay taxes apart from its owners. Therefore, with some exceptions, the owners of the corporation are personally protected from the corporation’s liabilities and creditors. Generally, an owner stands to lose only what he or she has invested in the corporation.

Each state has its own procedure for establishing a new corporation, but most states require the filing of articles of incorporation with the secretary of state. Other matters at start-up usually include drafting corporate bylaws, holding the initial meeting of the board of directors and issuing ownership stock.

Advantages and Disadvantages of Corporation

• Advantage: Owners have limited liability.
• Advantage: Centralized management and control structure
• Advantage: Ownership interests are more readily divisible and transferable.
• Disadvantage: Costly and complicated to set up
• Disadvantage: Complex management responsibilities
• Disadvantage: Double taxation at corporate and individual levels

What are the differences between C and S Corporations?

The Internal Revenue Code allows for two different levels of corporate tax treatment.

Subchapter C corporations include most large, publicly held businesses. These corporations face double taxation on their profits if they pay dividends: C corporations file their own tax returns and pay taxes on profits before paying dividends to shareholders, which are subsequently taxed on the shareholders’ individual returns.

Subchapter S corporations meet certain requirements that allow the business to insulate shareholders from corporate debts but to avoid the double taxation that is imposed by subchapter C. To receive subchapter S treatment, corporations:

• Must be domestic
• Must not be affiliated with a larger corporate group
• Must have no more than one hundred shareholders
• Must have only one class of stock
• Must not have any corporate or partnership shareholders
• Must not have any nonresident alien shareholders

Also, after a business is incorporated, all shareholders must agree to subchapter S treatment prior to electing that option with the Internal Revenue Service. The limitations imposed by the subchapter may affect the transferability and marketability of corporate shares.

What types of legal procedures should Corporations maintain?

Once incorporators establish a new business, the directors must ensure that it maintains its legal status. Depending on the business form, certain legal formalities must be followed for this purpose. Once incorporated, an ongoing business’s obligations include:

• Obtaining federal and state tax-identification numbers for the business and filing needed tax returns annually
• Issuing shares of stock as mandated by the articles of incorporation and federal securities law
• Establishing and maintaining corporate books and records, including accounting ledgers, shareholder records and corporate minutes
• Calling and conducting an initial meeting of the board of directors or shareholders, as required in the articles of incorporation
• Conforming all decisions and internal procedures set forth by the articles of incorporation
• Recording all actions and decisions of the board of directors in the corporate minutes
• Maintaining annual registration with the state government, as required by law.

Also, some businesses must comply with licensing requirements or professional standards to preserve their status. These businesses may need to maintain further records or use special procedures or equipment based on rules for their specific industries.

In many situations, a failure to abide by corporate obligations can result in personal liability for directors, officers, or shareholders for business obligations and debts. Because of these harsh consequences and because the specific legal requirements vary depending on the business’s location and form, businesses should seek professional legal advice.

How often should a Corporation hold meetings and update its minutes?

Any time a corporation undertakes a major change or transaction, it should be reflected in its minutes. In addition, meetings of shareholders and directors should take place at least annually if for no other reason than to elect new officers and directors. Failure to adhere to the formality of regular meetings can jeopardize the corporation’s ability to shield its officers, directors and shareholders from personal liability for the corporation’s actions.

What is “Piercing the Corporate Veil?”

Sometimes, courts will allow plaintiffs to receive compensation from corporate officers, directors, or shareholders for damages rather than limiting recovery to corporate resources. This procedure avoids the usual corporate immunity for organizational wrongdoing, and may be imposed in a variety of situations. The specific criteria for piercing the corporate veil vary somewhat from state to state and may include the following:

• If a business is indistinguishable from its owners in practical terms, courts will not allow owners to benefit from limited liability.
  • Example: Joe Tractors, Inc. and Joe share the same banking account. Joe signs business contracts in his own name. Joe may be liable for breaching a business contract because he and his company are legally indistinct.
• If a corporation is formed for fraudulent purposes, courts will allow recourse to the owners.
• If a business fails to follow corporate formalities in areas such as record-keeping and decision-making procedures, a court may impose liability on the individuals controlling the business.
• The potential for personal liability encourages businesses to observe legal requirements and to avoid damage to third parties.

What is the difference between Joint Ventures and Partnerships?

Joint ventures and partnerships share certain characteristics. A joint venture is a sort of partnership where two or more entities join together for a particular “short term” purpose. In both partnerships and joint ventures, each partner has equal ability to legally bind the entire entity. A partner can represent the entire organization in the normal course of business and his or her legal actions on behalf of the joint venture or partnership create legal obligations.

Although the powers of individual partners in a partnership or joint venture can be limited by agreement, such agreements do not bind third parties. Because business contacts outside of the partnership may have no knowledge of the limitations, they may be entitled to rely on the apparent authority of an individual partner as determined by the usual course of dealing or customs in the trade.

What is a Non-Profit Organization?

A non-profit corporation is a corporation formed to carry out a charitable, educational, religious, literary or scientific purpose. A nonprofit corporation doesn’t pay federal or state income taxes on profits it makes from activities in which it engages to carry out its objectives. This is because the IRS and state tax agencies believe that the benefits the public derives from these organizations’ activities entitle them to a special tax-exempt status.

The most common federal tax exemption for nonprofits comes from Section 501(c)(3) of the Internal Revenue Code, which is why nonprofits are sometimes called 501(c)(3) corporations.

Will the business be heavily dependent on investors for its capital?

Some businesses rely on sales to build their capital, whereas others must rely on investors to raise the amount of money they need to get started or to expand. One business that might depend on investment is a company that produces software; although it may have an excellent idea, the company cannot pay its staff of developers or market its product until it has something to sell. If a business will need a large amount of invested money, its organizers should select an entity that will be attractive to the type of investors that best fit its needs.

What type of investors is the business seeking?

When deciding what business form to choose, a business should consider its financial needs. Investors may come in the form of friends and family, individuals involved in the business, partner companies, venture capitalists and others.

Each type of investor has different needs. A partner company that is financing a venture that will be crucial to its own success may want some control over the business’s management. An employee may want a share of the profits but may not wish to be directly involved in the day-to-day management.

Some business entities may be limited by law as to who can own their shares. For example, a professional corporation may have shares owned only by individuals licensed to provide its type of professional services.

What business forms are most attractive to investors?

Investors want to minimize their risk. Generally, a business entity that shields investors from liability is preferable.

In a General Partnership, an investor becomes a partner by contributing capital. A partner has the right to share profits, but partnership debts are also shared by partners.

A Limited Partnership can receive investment contributions from either general partners or limited partners. A general partner has no liability shield. A limited partner’s liability, however, is limited to the amount of his or her contribution.

Members in a limited liability company (LLC) also enjoy a liability limitation. An LLC could also be advantageous to potential investors if the business anticipates start-up losses.

Corporations provide a liability shield to all investors. Corporations can also issue stock either as voting shares (which allow shareholders some control of the company) or non-voting shares. A corporation can issue just a few shares to a small number of shareholders, including investors, or it can make a public offering to the broader market of investors.

USEFUL LINKS

CA Department of Corporations

CA Franchise Tax Board

The IRS

CA State Board of Equalization