Advantages and Disadvantages of the Most Common Business Structures in California
Choosing a business structure is one of the first decisions an entrepreneur must make when starting a new venture. Below is an overview of the advantages and disadvantages of the most common business structures in California.
CORPORATION
Advantages
A corporation provides limited liability for its owners. A corporation is a business entity that is distinct and separate from its shareholders, the owners. This means that the owners are generally not personally liable for the debts and obligations of the corporation; owners are typically only liable for their personal torts, such as assault, battery, or negligence. An owner’s financial risk in owning a corporation is generally limited to the amount of money that owner put into the corporation.
Ownership of a corporation is generally easier to transfer than ownership of a Limited Liability Company (LLC). Unless restricted by the bylaws, a shareholders’ agreement, or some other corporate governing document, shareholders of a corporation can generally transfer their ownership interests more easily than members of an LLC.
Investors are more likely to invest in a business structured as a corporation. In addition to shares being more easily transferable as discussed above, corporations allow for preferred stock and initial public offerings. These benefits are often attractive to investors because they increase investors’ ability to obtain a return on their investments.
Disadvantages
A corporation must follow several corporate formalities to maintain limited liability for its owners. Some of the corporate formalities include holding annual board and shareholder meetings and keeping meeting minutes. Disregarding the corporate formalities can lead to a “piercing of the corporate veil,” which means that the owners no longer benefit from limited liability protection, and their personal assets are vulnerable if someone sues the business.
Corporations experience double taxation. A corporation’s income is taxed at the corporate level and again at the shareholder level after income is distributed to the owners. And while a corporation can avoid double taxation of its income by electing S corporation status, S corporation status has some disadvantages as the corporation must meet strict requirements to elect and maintain the status. One of these requirements is that no corporation or partnership can be a shareholder of the S corporation, and this can deter some potential investors, such as venture capital funds, which are often structured as partnerships.
A corporation must be registered with the state. An incorporator must file articles of incorporation with the California Secretary of State to form a corporation. This can be a complicated process that requires compliance with several California laws.
Annual reporting requirements. A corporation must annually file a statement of information with the California Secretary of State. Failure to file the annual statement of information can result in penalties, suspension, or forfeiture.
LIMITED LIABILITY COMPANY
Advantages
Like corporations discussed above, an LLC provides limited liability protection to its owners, which are called members. The owners of an LLC are not personally liable for the debts, obligations, or liabilities of the LLC solely because they are owners. But, like with corporations, owners are personally liable for their personal torts, such as assault, battery, or negligence.
More management and operations flexibility. Unlike corporations, which have rigid statutory formalities, LLC statutes contain many default provisions that can be altered through the LLC’s operating agreement, one of an LLC’s governing documents.
Less formalities required to maintain limited liability. Because LLCs do not need to abide by as many rigid statutory requirements as corporations, it is easier to maintain the LLC’s limited liability shield for its owners.
LLCs have pass-through taxation. An LLC can be treated as a partnership for tax purposes. This means that the LLC does not pay income tax at the entity level. Instead, the owners report the LLC’s profits and losses on their individual tax returns, which avoids the double taxation corporations experience.
Disadvantages
Investors often will not invest in a business structured as an LLC. Some investors, like venture capital funds, cannot invest in LLCs because some of the investor’s partners do not want to receive income due to the partner’s tax-exempt status. Some investors avoid investing in LLCs simply because they are more familiar with the C corporation entity structure.
An LLC cannot go public. This limits the business’s ability to grow, raise capital, increase liquidity, attract and compensate employees with stock and stock options, and create publicity.
Must be registered with the state. To form an LLC, an organizer must file articles of organization with the California Secretary of State.
Annual reporting requirements. An LLC must biennially file a statement of information with the California Secretary of State. Failure to file the biennial statement of information can result in penalties, suspension, or forfeiture.
LIMITED PARTNERSHIP
Advantages
Like the owners of corporations and LLCs, the limited partners in a limited partnership (LP) benefit from limited liability. An LP must have at least one limited partner and one general partner. The limited partners are generally not liable for the debts, obligations, or liabilities of the limited partnership.
LPs can be treated as pass-through entities for taxes. The LP “passes through” profits or losses to its partners. Each of the partners reports their share of the partnership’s income or loss on their personal tax returns.
Disadvantages
General partners have unlimited liability. While the limited partners benefit from limited liability, the general partners do not. Because an LP cannot exist without at least one general partner, there will always be at least one person or entity in an LP that has unlimited liability.
Limited partners cannot participate in management without risking their limited liability protection. If a limited partner participates in the control of the business, then that partner may be considered a general partner and become exposed to unlimited liability.
Must be registered with the state. To form an LP, a certificate of limited partnership must be filed with the California Secretary of State.
LIMITED LIABILITY PARTNERSHIP
Advantages
Like corporations, LLCs, and LPs discussed above, limited liability partnerships (LLPs) generally provide limited liability for all partners. Unlike an LP that is required to have a general partner with unlimited liability, all of the partners in an LLP have limited liability.
Pass-through taxation. Like LLCs and LPs, LLPs experience pass-through taxation.
Disadvantages
Most businesses cannot be structured as an LLP. Only licensed attorneys, architects, and accountants can structure their practices as LLPs.
Must be registered with the state. To form an LLP, an application to register a limited liability partnership must be filed with the California Secretary of State.
GENERAL PARTNERSHIP
Advantages
Pass-through taxation. General partnerships (GPs), like LLCs, LPs, and LLPs, experience pass-through taxation.
No state filings required. A GP is formed when two or more people associate to be co-owners of a business for profit. This means there are no filing requirements to form a GP.
Disadvantages
Unlimited liability for all partners. All the partners in a GP are personally liable for debts, obligations, and liabilities of the GP. This means, for example, if the GP has an employee that injures someone while acting within the scope of employment, the partners of the GP may be liable to the injured person.
A GP can be created inadvertently. Because a GP is formed when two or more people associate to be co-owners of a business for profit, entrepreneurs can accidentally create a GP. For example, if two friends agreed to work together to sell widgets, they may have created a GP. This can be a problem because the partners can be personally liable for the debts and liabilities of each other and be personally bound by the actions of the other partner(s), among other issues.
SOLE PROPRIETORSHIP
Advantages
It is the easiest way to structure a business. A sole proprietorship is the default business structure if a business operates without forming a partnership or entity.
Disadvantages
Unlimited liability for the sole proprietor. By operating a business as a sole proprietorship, the sole proprietor remains personally liable for all debts, obligations, and liabilities of the sole proprietorship.
The text above is intended for informational purposes only and is not legal advice. For advice tailored to your situation, please consult with an attorney.