BUSINESS ENTITY BASICS

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1 LEGAL SERVICES FOR ENTREPRENEURS , Ext. 217 BUSINESS ENTITY BASICS Presented By Lisa Li, Wilmer Hale LLP

2 DISCLAIMER The information contained in this presentation has been prepared by the Lawyers Committee for Civil Rights and Wilmer Hale LLP. It is not intended to constitute legal advice. The Lawyers Committee and Wilmer Hale LLP have made reasonable efforts to collect, prepare and provide this information, but do not guarantee the accuracy, completeness, adequacy, or currency of the information contained in this presentation. The publication and distribution of this presentation is not intended to create, and receipt does not constitute, an attorney-client relationship.

3 AGENDA I. Direct Ownership (Sole proprietor, Partnership) II. Choosing a Business Structure (Entity) III. Legal Entities (Corporation, LLC) IV. Which Business Structure Should I Choose? V. Other Considerations VI. Questions 3

4 CHOOSING A BUSINESS ENTITY 1

5 WHAT ARE THE LEGAL STRUCTURES FOR A BUSINESS? A business can be owned and managed by: - One person directly - Sole Proprietorship - Two or more people together - Partnership - One person or more through a legal entity - Corporation - Limited Liability Company (LLC) 5

6 WHY DO I NEED A BUSINESS ENTITY & WHAT ARE KEY FACTORS TO HELP ME CHOOSE? Liability protecting your personal assets Entity Types Management and Shared Ownership determining who gets what in the organization Taxes and Fees managing taxes and accounting Sole Proprietorship Partnership C. Corp LLC S. Corp LP/LLP

7 WHAT IS LIMITED LIABILITY? Liability limited to the assets in the business Business creditors cannot reach personal assets of owners Lawsuits cannot reach personal assets of owners Limited Liability No Limited Liability S-Corp or C-Corp, LLC, LP or LLP (if not General Partner) Sole Proprietorship, Partnership

8 LIMITED LIABILITY IMPORTANT TIPS Keep business and personal assets separate Sign contracts as the entity, not as an individual Maintain good records of board/manager decisions Consider insurance instead (or in addition) Obtain insurance through a broker or trade association Understand exceptions from coverage Obtain the correct type and an adequate amount of coverage for your business

9 DIRECT OWNERSHIP 2

10 SOLE PROPRIETORSHIP Business owned and operated by 1 person. All of the business property is property of the owner. Liability: Unlimited liability for obligations, injuries Control: The owner directs the business Formalities: No formal requirements to form or conduct business; may have a DBA or fictitious business name Tax: Pay tax on operating profits, as an individual, at ordinary income rates for selfemployment wages, and quarterly self-employment tax 10

11 PARTNERSHIP A business conducted by 2 or more people, partners A partnership can be created with two types of partners: General Partners: have unlimited joint and several liability for debts and obligations of the business Limited Partners: liability for the business debts is limited to the amount invested Maximum flexibility in sharing profits and losses 11

12 GENERAL PARTNERSHIP Liability: unlimited Governance: Partners have right to direct and enter into written partnership agreement Formalities & Costs: No forms or formalities required. Partnership agreement strongly recommended Taxes: The partnership does not pay federal or state income tax; it is a passthrough entity 12

13 LEGAL ENTITIES 3

14 LIMITED PARTNERSHIP Liability: At least one general partner with unlimited liability, the others have limited liability Governance: General partner manages business and limited partners are passive with no management authority Formalities & Costs: Register the LP with the state. Partnership agreement strongly recommended Taxes: $800 California Franchise Tax on business; members taxed according to their percentage of the earnings 14

15 LIMITED LIABILITY PARTNERSHIP Liability: All owners have limited personal liability for business debt and other partners are not liable for malpractice lawsuit against another partner Governance: All the partners can take an active role in managing the day-to-day affairs of the business. Formalities & Costs: Register the LLP with the state and purchase malpractice insurance. Partnership agreement strongly recommended Taxes: $800 California Franchise Tax on business; partners are taxed according to their percentage of the earnings

16 LIMITED LIABILITY COMPANY (LLC) Liability: Liability limited to the LLC s assets; members are not liable for LLC s obligations Governance: Owners are members (may be one person) who enter into an Operating Agreement to guide them in directing the business. May hire a manager to manage business. Formalities: State filings, no meetings nor bylaws required but written Operating Agreement highly recommended Taxation: $800 minimum California Franchise Tax on business; members are taxed according to their percentage of the earnings, like an S corporation or partnership. May elect to be taxed as a C Corp. 16

17 Liability: Limited to company assets Management: Shareholders: own (can be just one) Directors: manage (can be just one) CORPORATION Officers: run the business (one person can hold multiple positions) Formalities: state filings, meetings, minutes Taxes: File annual tax returns; how taxed depends upon whether the business is a C or an S Corp (see next slide) 17

18 CORPORATE TAXATION A C Corporation is a separate taxpayer o Tax is based on business net income o Business distributes its profits to its shareholders (i.e., dividends ), which are taxed on the individual level Cannot deduct C- corporation s losses on their personal income tax return An S Corporation pays taxes like a partnership. o Owner/shareholders taxed according to their percentage of profits o Can deduct S corporation s losses on their personal income tax return o California imposes a 1.5% tax on S Corp taxable income o $800 annual minimum California franchise tax

19 S CORPORATION (CONT'D) Special S Corporation requirements: Must file S election with IRS No more than 100 shareholders Shareholders must be individuals, qualified trusts, or charities (NOT other for-profit businesses) Shareholders must be U.S. citizens or Residents May have only 1 class of stock All shares must have identical economic rights Shares may have different voting rights 19

20 SOCIAL PURPOSE CORPORATION Must have a specific purpose (in founding docs) that a non-profit corporation is allowed to pursue under CA law Must publish publicly available annual report identifying progress/efforts toward purpose May be able to avoid this if it has < 100 shareholders Taxed like C corporation Same general rights as C corp for shareholders Directors may consider its purpose beyond just profit Less burdensome than a Benefit Corporation (see next slide) 20

21 BENEFIT CORPORATION Must have a general public benefit to help society and the environment (in founding docs) May also pursue specific public benefit Must measure progress to 3 rd party standard, and also publish publicly available annual report Taxed like C corporation Shareholders, directors, certain beneficiaries may sue to enforce pursuit of public benefit Shareholders rights not considered above public benefit, employees, customers, etc. More burdensome than a Flexible Purpose Corporation 21

22 WHAT SHOULD I CHOOSE? 4

23 I AM THE ONLY OWNER OF A SMALL BUSINESS WITH A LOW RISK OF LOSS You should consider a sole proprietorship. It costs the least to start and you will save in accountant and attorney fees You can change to a different entity form later, if desired Reasons to consider a different business form: There is more than one owner or you seek investors You run the risk of liability The business grows in size: invoicing, employees For market reasons you prefer an entity. 23

24 I AM ONE OF TWO OR MORE OWNERS (PARTNERS) OF A SMALL BUSINESS You should consider a legal entity like a corporation or LLC. Partnerships are not recommended, except in specific situations, because partners have joint and several liability. It is not expensive to create a partnership but you will need a partnership agreement and accounting controls so it is not as inexpensive as it first appears. 24

25 I NEED AN ENTITY BUT WHICH? The majority of businesses that choose an entity choose between: LLC S Corp C Corp Your choice depends largely on: Taxation Governance Whether looking for investors In terms of taxation, LLC and S Corp can be similar. 25

26 LLCs OWNERSHIP AND MANAGEMENT Managers have decision-making power STRUCTURE BASICS Members have ownership (but can also act as managers) Corporations Directors and officers have decisionmaking power Stockholders have ownership Partnerships Partners have decision-making power, unless a limited partner in a LP Partners have ownership

27 OWNERSHIP AND MANAGEMENT STRUCTURE IMPORTANT TIPS Clarify Ownership Who owns what percentage of the company? Will it change over time? How is it determined? Incentives / Vesting Use % ownership to bring on new expertise or resources; set milestones to be reached Stockholder / member contributes time or resources before receiving full benefits of ownership Clarify who does what jobs in the company Formalize management relationships Put down on paper who is responsible for decision-making in the company including who has the power to change management. Top management should meet regularly.

28 ENTITY TYPES BREAKDOWN Limited Liability Company (LLC) 1+ owners Owners or managers manage Limited liability (more on this later) Fewer legal formalities C-Corporation Unlimited shareholders Board of directors manages Limited liability Easy to expand Double taxation Limited Partnership (LP) 2+ owners Partners manage 1+ partners have liability 1+ partners have limited liability S-Corporation Up to 100 shareholders Board of directors manages Limited liability No foreign shareholders Shareholders must be natural persons (w/ some exceptions)

29 WHEN SHOULD I CONSIDER A C CORP? 1. In some tax situations, specifically where you want to re-invest the business profits to grow the business 2. When looking to sell shares to investors 3. When you want to offer certain types of employee benefits 4. Business may seek venture capital

30 We Want To Create a Cooperative A worker cooperative can be formed as an LLC (workers are members ), or as a corporation (workers are shareholders ) It is not recommended to make a cooperative as a partnership because all of the partners have unlimited joint liability. LSE can help you learn more about forming a worker coop. (415) x

31 My Organization Isn t Just Profit-Oriented You can form a non-profit corporation. Two new California corporation types permit for- profit businesses to pursue social interests: California Benefit Corporations, and Social Purpose Corporations CORP can help you learn more about forming a nonprofit. LSE can help you form a for-profit business for social good: 31

32 OTHER CONSIDERATIONS 5

33 ENTITY CONSIDERATIONS: FEES & TAXES Initial fee + maintenance fees Annual tax requirements Sole Limited Liability C Proprietorship Company (LLC) Corporation "S" Corporation Limited Partnership (LP)/Limited Liability Partnership (LLP) Filing Fees (one time) $47 for fictitious name statement (SF County) $70 for SOS filing $100 for SOS filing $100 for SOS filing $70 for SOS filing Statement of Information (yearly) None $10 ($20 every other year) Minimum State Franchise of $800 (+LLC None Taxes (yearly) fee if revenues *minimum tax waived first exceed year. $250k) $25 $25 None Minimum of $800* (actual tax is 8.84% of net income) Minimum of $800* (actual tax is 1.5% of net income) $800

34 ENTITY CONSIDERATIONS: FEES & TAXES Sole Proprietorship LP/LLP/LLC C Corporation "S" Corporation Taxation Tax Rate Use of Tax Credits/ Losses Net profit is computed on Schedule C and is reported as income on the owner s Form Taxed at individual level. Used to offset individual s taxes. Partnership income and expenses flow through to the partners/members. Taxed at individual partner/member level Passed thru to partners/members (losses deductible to the extent of basis). C corporation pays tax on profits. When the shareholders take profits from the corporation, the distributions are taxable dividends. 35% (with slight increase for very high taxable income) Used to offset corporate taxes. Taxed in the same manner as LP/LLC. Income and expenses flow through to shareholders. Generally taxed at individual shareholder level. Passed thru to shareholders to be applied to their taxes Distribution to Owners Nontaxable Nontaxable to extent of basis in LP/LLP/LLC. Not deductible by corporation. Generally ordinary income to shareholder. Nontaxable to extent of basis in stock.

35 ENTITY CONSIDERATIONS: FEES & TAXES Sole Proprietorship LP/LLP/LLC C Corporation "S" Corporation Wages and Self- Employment (SE) Taxes Fringe Benefits Owner subject to SE tax of 15.3% of net earnings. Computed on Schedule SE and reported on owner s tax return. Amounts paid on behalf of owner are not deductible. General partner s / member s share of business income is subject to SE tax. Limited partner s share of business income is usually not subject to SE tax unless performs services. Passive items are passed through to owner. Generally amounts paid on behalf of partners must be included in partner s income. Shareholders who perform services for corporation are treated as employees. Wages of all corporate employees are subject to payroll tax and withholdings. Other distributions not subject to SE tax. Owner-employees are entitled to same tax-free fringe benefits as other employees. Same as for C corporation. Wages must be reasonable. Additional profits are passed through to the shareholder, but are not subject to SE tax. Same as for C corporation, except must be included in wages of employeeshareholders that own more than 2% of the corporation.

36 ENTITY CONSIDERATIONS: FEES & TAXES C-Corp has Double Taxation : taxed once on net business income + taxed again on shareholder dividends Avoid, unless: no plans to declare dividends (often when those who plan to make money from the biz are working for the biz, and are not passive shareholders) or otherwise need C-Corp Double Taxation No Double Taxation ( pass through taxation) C-Corp Sole Proprietorship, Partnership, Limited Partnership, LLC, S-Corp BOTTOM LINE: Tax analysis is very fact-specific. Ask an accountant or tax attorney about your business.

37 IMMIGRATION S Corp: all shareholders must be Citizens or Legal Permanent Residents. C Corp: any person can be a shareholder. LLC: any person may be a member. >> Whether the business is an S Corp, C Corp, or LLC, its employees must submit an I-9 form to show that they are authorized work. 37

38 OTHER CONSIDERATIONS - NAME You can reserve name with Secretary of State before filing Articles of Incorporation (Corp), Articles of Organization (LLC), or Certificate of Limited Partnership (LLP) E.g., California Secretary of State Check name availability in other states if plan to operate the business outside of California Trade name should be distinctive Avoid consumer confusion & trademark infringements 38

39 OTHER CONSIDERATIONS State License or Permit City/County Licenses or Permits Fictitious Business Name Statement If you operate your business under a fictitious name or d/b/a you must file a Fictitious Business Name Statement with the county recorder, and publish notice in a local newspaper Qualify in other states where you do business 39

40 OTHER CONSIDERATIONS Conducting Business As A Corporation, Limited Partnership or LLC? - Make sure third parties are aware you are acting as agent for corporation, limited partnership or LLC - On all contracts and correspondence, identify the entity, and then yourself as agent. For example: ABC Company, Incorporated Signed By: Jane Smith, President 40

41 OTHER RESOURCES (good small business legal guide, also available in book form at the library) The Small Business Administration, California Business Portal, Secretary of State, ABA Legal Guide for Small Business (available at most major bookstores) 41

42 THANK YOU FOR COMING! Legal Services for Entrepreneurs (LSE) provides free legal assistance to low-income entrepreneurs. For more information: ext

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