Business Structure Essentials — Incorporating a Business in California
Many businesses in California reach a point where it is good practice to consider forming a separate entity to operate the business. The first question to be answered is whether the structure should be a sole proprietorship, a partnership or a corporation, of which there are several types.
The default operation for a business is a sole proprietorship, where there is no legal difference between the owner of the business and the business itself. While this type of operation is simple and streamlined, there are several problems that can arise that can cost the business owner significant time and money.
Business Litigation Lawyers to Protect Your Company
In a sole proprietorship, the owner is the business. If something goes wrong at the business and a lawsuit arises, the business owner is the person on the hook. Litigation can arise from a variety of sources. Disgruntled employees or former employees may file employment law claims. Unhappy customers may file litigation over unsatisfactory business deals or products. Employees out driving on company errands may negligently injure someone in a car accident. In any of these situations, not only are the assets of the business potentially at risk, but the personal assets of the business owner are as well.
Tax Impact of Not Incorporating
The owner of a sole proprietorship gets to file the business income and debts on his or her personal tax return. While this simplifies accounting and taxation to some degree, the often-unexpected pitfall of this arrangement is that the business owner will often be subject to self-employment tax. This tax can run as much as fifteen percent of the business owner’s total income, on top of the regular income taxes the owner pays to the federal and state government. In addition, sole proprietorships often are unable to take advantage of accelerated depreciation schedules and other write-offs that may be available to other entities.
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Death and Incapacity
Because there is no difference between a business and its owner in a sole proprietorship, significant problems can arise when the owner dies or becomes incapacitated. The business may grind to a halt, even if the main business activities are handled by employees, not the owner. The business bank accounts may be in the owner’s name alone, with nobody else able to pay bills or make payroll. Business phone lines, leases, and other business arrangements may be the personal obligations of the owner, and subject to cancellation if the owner passes away or is unable to act.
For these and many other reasons, business owners in California often choose to set up an entity, such as a corporation or limited liability company (LLC) to hold business assets and conduct the business itself. Setting up an entity provides several benefits to a business owner, as outlined below.
The Corporate Veil
A corporation, LLC, or other entity is a considered a separate legal person than the business owner. Because of this, if a person wants to sue the business, that person will generally be required to sue the entity, not the business owner personally. Between the entity and the business owner is a liability shield called the corporate veil. This veil protects the personal assets of the business owner from being subject to lawsuits against the business. As long as the business owner treats the entity as a separate legal structure, with its own bank accounts, business operations, and legal formalities, the entity should provide significant protection in the event of a lawsuit against the business.
Tax Strategies for Corporations
Through the use of a properly structured business entity, a business owner has the ability to split his or her income into multiple streams. For example, a business owner can be an employee of the business, and pay himself or herself a salary. This salary is taxable income, but is also subject to Social Security, FICA, and other withholding rules. A business owner who has the right kind of entity can take a reasonable salary and then choose to receive the rest of the business profits as dividend income, which is generally exempt from those same withholding requirements and is also exempt from self-employment tax. For many businesses, this tax strategy can save the business owner thousands upon thousands of dollars in taxes every year.
Business Succession Planning for Corporations
A properly structured business entity allows the business to continue to grow and thrive even in the absence of the business owner. Because the entity is able to maintain its own legal status, the business can continue to pay bills, enter into contracts, serve customer needs, and maximize profits, even if the business owner is unable to actively participate. When a business owner passes away, the entity continues to exist, and the ownership, much like a home, car, bank account, or other asset, can be passed on as part of the owner’s estate. Similarly, in the event of incapacity, the owner’s family can step in and ensure that the business continues to operate. For many closely-held businesses, being set up within an entity can mean the difference between thriving into a new generation or simply disappearing.
Choosing the Proper Entity
For most closely held businesses, the choice of entity will either be an S-Corporation or a limited liability company (LLC). Discussion of the various characteristics of these two entities is outside the scope of this article. However, both of these entities offer a business owner tax pass-through status, corporate-veil protection, and the ability to plan for the long-term viability of the business.
Choosing the proper entity for a business involves significant analysis and discussion with a CPA and an attorney skilled in business structuring. For some businesses, a simple entity will be all that’s required. For other businesses, especially those with significant assets or real estate, a multi-tiered structure may provide optimal protection and the ability to take advantage of tax planning opportunities.
To learn more about how we can help you select and create the best business structure for your California company, contact us at (916) 789-9810.