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California S Corporation or California Limited Liability Company ( LLC ) ? Which is Better?

 
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California S Corporation or California Limited Liability Company ( LLC ) ? Which is Better?

Prepared By: Melissa C. Marsh, Los Angeles Business And Corporate Attorney
Written: March 2009
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If you are in the process of starting a business in California, or thinking about forming a California corporation, you may be debating whether a California limited liability company (LLC), or a California S corporation (S Corp) will best meet your needs, or you may have just assumed that either the LLC, or the S Corp, is the best entity because it will limit the "owners" personal liability for the debts and obligations of the business. Even though a properly maintained LLC, or S - Corp, will generally insulate its shareholders from personal liability, there are some great differences between the LLC and the S - Corp which must be considered before choosing which entity is right for you. Choosing the wrong entity can have severe tax consequences, and no one business entity is right for all people.

Deciding whether to form a California LLC or a California S Corp for a new or existing business can be a daunting task. Typically, the business owner must consider the business itself, parties involved, legal issues, and tax issues. These considerations will often translate into a cost analysis, but performing the analysis can be extremely difficult even for the most experienced professionals. Generally, the analysis breaks down to three key issues: (1) limiting the tax burden; (2) limiting the potential personal liability of the owners from the perceived business risks; and balancing the two with (3) the business owners' unique circumstances. Similarly situated businesses may have different objectives. For example, while the primary goal of one business owner may be to avoid personal liability for the liabilities of the business, another business owner may be more concerned with reducing his or her tax burden. For this reason, the goals of the prospective business entity should dictate which business entity is chosen. Similarly if the primary goal is to reduce the tax burden a business that has high gross revenues would probably be better off with the S-Corp over the LLC because of the gross revenue tax imposed on the California LLC.

It is therefore essential for the business owners to ask what are the primary objectives of the business before selecting whether to form a California LLC or S - Corp. Typically, the major factors that should be considered by the business owner include: 1) the ease of formation; 2) the number of owners; 3) the desired management style and control; 4) the authority of owners and management to bind the entity; 5) the owner's liability for business obligations; 6) the desire for easy transferability of the owners' interest in the business; 7) the desire to raise capital; 8) various tax considerations; and 9) the ease of dissolution, in the event things go badly.

The remainder of this article will outline the main characteristics of the corporation and the limited liability company (LLC).

The California S Corporation.

The S - Corp is a separate legal entity with a perpetual existence that offers personal limited liability protection. What does this mean? Well, this merely means that the owners (shareholders) will not be held personally liable for the debts and obligations of the corporation solely because they are owners (at least if the corporation is properly formed and maintained which does not quite happen in the majority of cases). The C corporation is also a separate taxpaying entity, but it may elect to be taxed as a partnership with pass through taxation by electing sub-chapter S tax status. The S - Corp passes the income earned, or losses incurred, by it directly through to its owners (shareholders). Unlike the C corporation, however, the S corporation cannot own any subsidiaries, it cannot have corporate shareholders, the number of shareholders permitted is limited to 100, it cannot have a non-resident alien shareholder, and it can only have one class of stock - preferred non-voting shares are not permitted.

1. Personal Limited Liability Protection. The owners' personal exposure to the potential liabilities of the business will be minimized if the corporation is properly organized and maintained. What does that mean? It means: (1) the corporation must file ALL of the required documents (not just those completed by some online service) in a timely manner; (2) the corporation must be funded with a sufficient amount of capital (not a mere $100 or $500); (3) the owners of the corporation need to keep the corporation's books in order and up to date, and sign all business related documents as an officer or employee of the corporation; (4) the owners must never co-mingle their personal funds with the corporation's money; and (5) the corporation must properly notice, hold and document not only the annual meetings of the shareholders and directors, but also any special meetings of the board of directors when necessary to authorize and affirm certain corporate acts.

2. Relatively Easy Formation. While formation of the corporation appears quick, easy, and simple (filing of the Articles of Incorporation with the Secretary of State), there are a number of formal requirements that must be adhered to just after formation, which unfortunately online document preparation services are legally prohibited from performing, or simple just don't do. To properly organize a corporation, the corporation typically must adopt and prepare by-laws, properly capitalize the corporation, issue stock to the shareholders, prepare and file a Statement of Information with the Secretary of State, prepare and file the appropriate Notice with the California Commissioner of Corporations, elect the directors, have the directors appoint officers, get an EIN, and file and publish a fictitious business name statement. Once properly formed, the corporation must continue to file its annual Statement of Information in a timely manner and properly notice, hold and document the annual shareholder and director meeting and special meetings of the Board of Directors to affirm certain corporate acts. Even a corporation owned by a single shareholder with a single director must properly notice, hold and document these meetings. Notwithstanding these formalities, the corporation is still much easier to form and organize than a limited liability company (discussed below) because with a corporation there is no need to negotiate a detailed LLC Operating Agreement covering the structure and operation of the company.

3. Centralized Management. The corporation is managed through the Board of Directors. The Board of Directors appoints officers to run the day-to-day business operations of the corporation. Shareholders (the owners) elect the Board of Directors, but have no right to participate in the day-to-day management of the corporation, unless elected as a director, or appointed as an officer. The officers are considered the agents of the corporation, and neither the shareholders nor directors have the authority to bind the corporation (only the officers). If a corporation has one shareholder, then the corporation is only required to have one director. Similarly, if a corporation has two shareholders, the corporation is required to have at least 2 directors. If a corporation has three or more shareholders, the corporation is required to have at least 3 directors. We strongly suggest a corporation always maintain an odd number of directors to prevent a deadlock.

4. Transferability. Ownership of the corporation, which is evidenced by share certificates, can easily be transferred absent a buy-sell agreement which may place some limits on the transferability of the stock.

5. Ability to Raise Capital. Generally, capital is raised through equity contributions by the shareholders, loans from shareholders, and secured and unsecured loans from third parties. But be careful. You must properly capitalize your corporation before resorting to shareholder loans, and if a loan is made it MUST be properly documented unless you want the IRS to reclassify the loan as income. This is an example of where many California S - corporations get into trouble because money is being loaned between the shareholders and the corporation without the proper documentation (a promissory note and special minutes).

6. Tax. Unless the corporation is structured as an S - Corp, the corporation and its shareholders may be subject to double taxation. First, the corporation pays federal and state taxes on its income at the corporate tax rate and it is not allowed to deduct the dividends issued to its shareholders. Second, the shareholders then pay tax on the dividends they receive from the corporation at the capital gains tax rate. This double taxation, however, can be minimized (e.g. paying salaries to shareholders and/or implementing shareholder loans). In addition, the corporation offers the ability to lower and defer income taxes on profits and the ability to use tax losses to offset future gains.

A qualifying corporation organized as an "S" corporation can avoid this double federal taxation by having its profits, losses and tax credits skip taxation at the corporate level and pass directly through to the shareholders, and unlike a California limited liability company, a California corporation is not required to pay a "gross revenue tax."

7. Perpetual Life and Dissolution. Unlike the limited liability company, which can have a designated life (typically 5 to 30 years), the corporation lasts in perpetuity until affirmatively dissolved, by filing dissolution papers with the appropriate state agency.

The California Limited Liability Company.

Both the LLC and the S - Corp, if properly formed and maintained, offer personal limited liability protection and pass-through tax treatment. While the LLC is generally more difficult to properly form because of the need for a detailed LLC Operating Agreement and while the LLC can have a much higher tax burden (tax on gross revenues), a California LLC is a much more flexible in terms of structure and management and less burdensome in terms of local and state reporting requirements than the S - Corp. Typically we will suggest the use of an LLC only when one of the following exist: (1) when the owners have desperate interests in the company (e.g., one owner has 70% and the other 30%, and the two owners agree that they will not have an equal say in the operations of the business); (2) where the owners will have an equal interest in the business, but not an equal right to profits and losses; or where (3) the purpose of the entity is to hold or own investment property. When the business entity to be formed will be owned by a single individual, husband and wife, or domestic partners we typically find that either the LLC or the S corporation will work, but that the main concerns of the to be owner quickly bring to light which entity will better suit their needs.

1. Limited Liability Protection. Just like the corporation, the owners' personal exposure to the potential liabilities of the business will be minimized if the limited liability company is properly organized and maintained. Although meetings are not required, we suggest that the owner(s) still properly notice, hold and document meetings of the members to preserve the personal limited liability protection afforded by the LLC to its owners.

2. LLC Formation. To form a California LLC, the individual must file Articles of Organization, execute a written Operating Agreement, file a Statement of Information with the Secretary of State, and pay $800 to the Franchise Tax Board (which is waived for a California corporation during its first year of existence). For a single member LLC (including an LLC owned by a husband and wife or domestic partners), the LLC Operating Agreement can be somewhat easy to prepare, but when a multi-member LLC is formed a comprehensive detailed LLC Operating Agreement should be prepared and this can be somewhat costly. As a result, when there will be multiple owners, the corporation wins when it comes to ease of formation and expense.

3. LLC Flexibility. The LLC is probably the most flexible entity in terms of management and structuring economic sharing arrangements among the owners. The LLC can be managed by either its members (member-managed LLC) or an elected centralized management team (a manager-managed LLC). In addition, where one owner agrees to contribute all of the cash needed for the business, and another owner agrees to contribute services by operating the business on a full-time basis, the parties might want to structure a preferred cash-on-cash return to the money partner. This can be easily done with an LLC, but would be very difficult to accomplish with an S corporation.

4. LLC Transferability. Like the corporation, transferability of a member's interest can be easily accomplished so long as the Operating Agreement permits such a transfer. With an LLC, however, the Operating Agreement can be drafted to easily permit a member to transfer his or her economic interest, but require formalities or restrict the ability to transfer the voting and management rights associated with that member's interest.

5. LLC Raising Capital. Capital is raised through capital contributions from members, loans from members, and secured and unsecured loans from third parties. If seeking capital, the corporation will more easily facilitate equity and capital financing arrangements because nearly all investors are familiar with the issues and documentation associated with investing in a corporation.

6. LLC Formalities. The LLC is less formal than both the C and S corporation. The LLC is not required to follow the strict procedures to which corporations must adhere. Most corporate attorneys, however, recommend the LLC still hold annual meetings of the members and/or managers to limit the possibility of a court piercing the LLC veil and holding the individual members personally liable for a corporate debt or obligation.

7. LLC Tax. Some of the positive tax treatment that can be achieved in a corporate setting are unavailable when dealing with a LLC, and owners of a LLC may find themselves subject to a number of tax burdens that could have been avoided under the corporate structure. Unlike a California corporation, a California LLC is required not only to pay the $800 California state franchise tax, but an additional tax on its gross receipts over $250,000. This annual tax can range anywhere from a low of $900 to $11,750. Ouch!

Conclusion.

Despite some of the negative tax aspects and the higher formation costs, the LLC has become the premier entity choice when: (1) its purpose is to hold real estate; or (2) the co-owners want a non-traditional operating structure, or profit/loss distribution system. If neither of these two situations reflects your personal circumstances, you will probably be better served by an S - Corporation.

Please Please do not form either an LLC or a Corporation without the assistance of a licensed California business attorney. I do not care if you select me as your counsel, or another corporate lawyer. More and more I am seeing people in my office who have had their LLC, or corporation, formed by their accountant (who should stick to tax matters, not legal ones), or by a low cost online service company. Unfortunately those instant savings typically turn into huge economic losses because it always costs more to fix a problem than it does to prevent one in the first place. Your entity selection and its formation is the foundation of your business. Like a house, if the foundation is weak the structure can be an economic dissaster waiting to happen. When these short cuts are taken, the owners often find out the hard way that their entity selection either was a costly tax mistake, or didn't provide the limited liability protection they thought they were purchasing. An LLC, like a corporation, only protects its owner's personal assets IF it is properly formed, properly funded, and properly maintained. If you cannot afford to have an attorney form your corporation or LLC, then start off as a sole proprietorship or partnership.

If you would like to have Los Angeles, California business law attorney, Melissa Marsh, with 15+ years of experience help you decide which entity (a simple sole proprietorship, LLC, or corporation) will best suit your needs or go over the requirements to properly fund and maintain a structure you have already formed, please schedule a low cost 30 minute Telephone Consultation. If you would like assistance in properly forming, organizing, and maintaining a California corporation, or LLC, call 818-849-5206 or E-mail Your Request.


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California business lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves individuals and businesses throughout Los Angeles County, including: West Hollywood, Miracle Mile, Beverly Hills, Century City, Santa Monica, Burbank, North Hollywood, Valley Village, Toluca Lake, Studio City, Sherman Oaks, Van Nuys, Encino, and Woodland Hills.

© 2009 Melissa C. Marsh. All Rights Reserved.

 
 

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Disclaimer: The information presented on this web site was prepared by Melissa C. Marsh for general informational purposes only and does not constitute legal advice. The information provided in my articles and alerts should not be relied upon, or used as a substitute for professional legal advice from an attorney you retain to advise or represent you. Your use of this Internet site does not create an attorney- client relationship. Transmission of this article is not intended to create, and receipt of it does not constitute, an attorney-client relationship. All uses of the contents of this site, other than personal uses, are prohibited. You may print or email a copy of any information posted on this web site for your own personal, non-commercial, use, but you may not publish any of the articles or posts on this web site without the Express Written Permission of Melissa C. Marsh.


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Located in Los Angeles, California, the Law Office of Melissa C. Marsh handles business law and corporation law matters as a lawyer for clients throughout Los Angeles including Burbank, Sherman Oaks, Studio City, Valley Village, North Hollywood, Woodland Hills, Hollywood, West LA as well as Riverside County, San Fernando, Ventura County, and Santa Clarita. Attorney Melissa C. Marsh has considerable experience handling business matters both nationally and internationally. We routinely assist our clients with incorporation, forming a California corporation, forming a California llc, partnership, annual minutes, shareholder meetings, director meetings, getting a taxpayer ID number (EIN), buying a business, selling a business, commercial lease review, employee disputes, independent contractors, construction, and personal matters such as preparing a will, living trust, power of attorney, health care directive, and more.