California Law
California Organizing a Business
Organizing a Business
There are several ways to organize a business, and the option selected depends on various factors. The option chosen by a small family-owned and operated venture may not be the same choice of a company with several owners and many employees. Each option has benefits and drawbacks. The option selected by a business may change over time as the business' needs, identity, size, budget, and liabilities change. A person may start out as a sole proprietor but decide years later to incorporate. Before a person or persons decide what option would best meet their needs, an attorney experienced in business matters should be consulted.
The following is a brief summary of the common forms of business organization. At the end of the chapter, issues affecting all forms of business will be outlined, such as registering an assumed name and obtaining tax identification numbers and licenses.
Sole Proprietorship
A sole proprietorship is the simplest form of business organization. One person owns, manages, and controls the business. A sole proprietorship may have employees, but only the owner is in charge of the business. The owner receives the business profits and losses. This person also is responsible for any debts the business may incur. Income, expenses, and losses are reported on the business owner's individual tax return.
A sole proprietorship is relatively easy to organize. The business owner must acquire appropriate licenses and tax identification numbers, and must register the business name. There are no specific state filing requirements for this business option.
Benefits of the sole proprietorship include having complete control over the business, ease of the initial set-up, and having business profits taxed at the individual taxpayer rate, which is lower than the corporate tax rate.
The biggest drawback to sole proprietorship is that the owner is personally responsible for debts and liabilities of the business. If a business owner has debts that are not paid, creditors can reach the personal assets of the business owner, such as a personal checking account. A business owner may obtain insurance to minimize this drawback. Other drawbacks include lack of continuity--when the business owner dies, the business ceases to exist--and the fact that a sole proprietor is not able to deduct benefits like health, dental, and life insurance premiums on his or her income tax return as business expenses.
Partnership
A partnership is a business owned by two or more parties. There are two types of partnership: general and limited.
General Partnership
A general partnership is a business arrangement in which two or more persons own, manage, and control a business. Persons in a general partnership share the rights, duties, and responsibilities. Partnerships also may have employees; however, only the partners have control of the business activities.
A partnership has more issues to address than a sole proprietorship. Besides obtaining the appropriate licenses and tax numbers and registering the business name, partners must agree on the treatment of business profits, expenses, losses, and other business concerns. Typically, there is a written agreement between the partners to address how these issues will be handled.
A general partnership in California does not have to be registered with the state, and there are no formal requirements for its formation. However, state law governs the conduct, liabilities, and dissolution of a partnership, as well as the relationship between and liabilities of the partners.
One benefit of a general partnership is that the owners control the business. However, unlike a sole proprietor who has exclusive control, partners share control as well as responsibilities. Partners also have the advantage of more than one resource for finances, ideas, and sharing the work load. Formation of the general partnership can be less complicated than other business formats, such as limited partnerships and corporations. Finally, profits from the partnership are included on the partners' individual tax returns and taxed at the individual taxpayer rate, which is lower than the corporate tax rate.
In a general partnership, the partners have personal responsibility for the debts and liabilities of the partnership. A partner can be liable for debts incurred by other partners in furtherance of the business. Like a sole proprietorship, a partnership may obtain insurance to minimize this drawback. Business partners are treated like sole proprietors with regard to deducting benefits provided to themselves. Benefits like health, dental, and life insurance generally may not be deducted on partners' income tax returns as business expenses.
In a general partnership, the business generally dissolves upon the death, retirement, or withdrawal of a partner, unless there is an express agreement to continue the business under such circumstances. If the business is continued, the former partner, or the former partner's legal representative, is entitled to the value of the former partner's interest, or the profits attributable to the use of the former partner's right in the property. By law, if a partnership interest is assigned to another person, that person is only entitled to the partner's profits from the business. That person may not participate in the management or operation of the partnership unless all the partners agree. These legal requirements may be modified by the partnership agreement. The agreement may detail how a partnership interest is to be sold, transferred, or handled upon the death of a partner. Addressing potential issues in an agreement may be one way to prevent disputes from occurring.
Limited Partnership
The limited partnership is similar in many respects to the general partnership. However, in the limited partnership, there are two types of partners--general and limited. California law requires that a limited partnership have one or more general partners and one or more limited partners. The principal difference between the general and limited partner is that the limited partner can limit his or her personal liability for partnership debts to the amount he or she invests in the partnership. The limited partner, in exchange for the reduction in liability, does not control or manage the business. The general partner controls and manages the business and is personally liable for partnership debts.
Because limited partnerships must meet specific California statutory requirements, they can be more complicated to establish. A limited partnership must file a certificate of limited partnership with the Secretary of State. A limited partnership must maintain certain records and must follow specific requirements for registering the business name. A limited partnership is not permitted to engage in the banking, insurance, or trust company business.
The benefits of the limited partnership depend on whether one is a general or limited partner. The general partner enjoys control and management responsibilities. The limited partner receives limited personal liability. Profits for both types of partners are included on the partners' individual tax returns and taxed at the individual taxpayer rate, which is lower than the corporate tax rate.
The drawbacks of the limited partnership also depend on whether one is a general or limited partner. The general partner is personally responsible for the business debts while the limited partner is only liable for debts up to the amount he or she has invested in the partnership. The limited partner does not participate in the management or the control of the business. Business partners in a limited partnership are treated like sole proprietors with regard to deducting benefits provided to themselves. Benefits like health, dental, and life insurance generally may not be deducted on partners' income tax returns as business expenses.
Unlike a sole proprietorship or general partnership, when a limited partnership wishes to dissolve, it must file a certificate of cancellation with the California Secretary of State in order to cancel its certificate of limited partnership. As mentioned previously, laws such as this one that apply to limited partnerships specifically make this format of organization more time-consuming and complex.
A limited partnership can continue after the death or departure of a partner. The departing partner (or his or her beneficiaries) may be entitled to the fair market value of the partnership interest. The beneficiaries also may have the option of becoming limited partners.
A partner's interest in a limited partnership may be assigned. However, the party receiving the assignment is only entitled to the profits that the assigning partner would have received. The partners may agree that the person receiving the assignment becomes a limited partner. This legal requirement may be modified by the partnership agreement. The agreement also may detail the conditions of how a partnership interest is to be sold, transferred, or handled upon the departure or death of a partner.
Limited Liability Company
Since 1994, businesses in California have had the option of filing as limited liability companies. A member in a registered limited liability company generally is not liable for the debts or liabilities of the company except to the same extent a corporate shareholder would be personally liable for the corporation's debts or liabilities (see below).
A limited liability company must file articles of organization and a fee with the California Secretary of State. The company also must file a statement of information annually. There also are restrictions on the name such a company may use. In many respects, the limited liability company operates like a general partnership.
Corporation
The creation of a corporation is the creation of an artificial person. For legal and tax purposes, a corporation is a separate entity from its owners. A corporation can make purchases, enter into contracts, pay taxes, and sue and be sued.
Corporations must be established in compliance with requirements set forth in California law. Shareholders are the owners of a corporation. Management and control of the corporation are the responsibility of the board of directors, who may or may not be shareholders. Income, expenses, and losses of the business are filed on the corporation's tax returns.
The major benefit of the corporation is that the shareholders are protected from business debts and responsibilities in most cases. Unlike the business options previously discussed, in a corporation the business' creditors may not seek to collect debts from the owners of the corporation. However, owners of a new corporation may be required by financial institutions to give personal financial assurances in order to receive funding.
There is continuity of a corporate business regardless of individual shareholder status. Even if several shareholders sell their shares in a business or a principal stockholder dies, the existence of the corporation is not affected. Also, a corporation may sell stock or shares in its business to raise capital. Corporations may have several types of stocks or shares available, such as voting shares and nonvoting shares.
The biggest drawback of corporate status is double taxation. The corporation files its own tax return and pays taxes on its profits before paying dividends to the shareholders. When the shareholders receive the dividends, these profits are included on the individual shareholders' tax returns and taxed.
Subchapter S Corporation
A Subchapter S corporation derives its name from a section of the Internal Revenue Code. Under Subchapter S in the Internal Revenue Code, a corporation that meets certain requirements may be treated as a corporation for liability purposes but treated as a partnership for taxation purposes. Shareholders of an S corporation receive limited liability protection, and their profits from the business are included on their individual income tax returns. California has similar tax treatment for such corporations. There is a corporate tax, however, in addition to the individual tax on shareholder income.
The requirements of an S corporation include:
- No more than 35 shareholders
- Shareholders must be natural persons (not corporations or partnerships)
- Shareholders cannot be nonresident aliens
- One class of stock
After a business has incorporated, all shareholders must consent to Subchapter S treatment. The election to be treated as an S corporation must be filed with the Internal Revenue Service in a timely manner.
Nonprofit Corporation
In order to be considered nonprofit, a corporation must have been formed for a purpose other than the financial benefit of its shareholders. Also, a nonprofit corporation may no pay dividends or provide other financial rewards to its shareholders. There are specific California laws for nonprofit corporations.
To receive tax exempt status, one of the biggest advantages to nonprofit status, an organization first must incorporate as a nonprofit corporation. After incorporation, applications for tax exempt status must be filed with the Internal Revenue Service and the California Franchise Tax Board. In order for contributions to the organization to be tax deductible, other requirements must be met. Certain charitable organizations also must register with the Charitable Trusts Registry at the California Attorney General's Office. More information about nonprofit corporations can be found in the Associations and Nonprofit Corporations Law Chapter.
Franchise
A franchise is a method of selling and distributing goods and services. Franchises are available for many types of ventures. A franchise, unlike the options previously discussed, is not a form of business organization. A franchise is an arrangement between at least two parties, in which one party pays the other a fee for the right to engage in a particular business venture. Franchises are regulated by the Federal Trade Commission and the California Commissioner of Corporations. Franchises are discussed further in the Franchise and Dealership Law Chapter.
General Business Issues
There are a number of issues that affect businesses, regardless of form. The following summarizes the most common of these issues.
Name Registration
California law states that any company regularly doing business in California under a name other than the full name of the business owner must register the fictitious name in the office of the county clerk of each county in which the company conducts business. The business owner must file a fictitious business name statement and submit the proper fee. Notice of filing of the statement must be published in a newspaper in the county where application is made once a week for four consecutive weeks. After the owner submits proof of publication to the county clerk, the name is valid for five years. Requirements for partnerships, corporations, and limited liability companies are similar, but may have additional restrictions.
Licenses and Tax Identification Numbers
A business in California must obtain a federal employer identification number. This identification number is the equivalent of a social security number for individuals. While sole proprietors without employees generally use their own social security numbers, other businesses obtain identification numbers by filing Form SS-4 with the Internal Revenue Service.
A business with employees also must register with the California Employment Development Department if the employer pays over $100 in wages during a year.
A business that sells goods or services must obtain a seller's permit. This permit can be obtained through any office of the California Board of Equalization.
Businesses operating in California also may be required to obtain federal, state, or local licenses. A smart businessperson should determine which licenses and permits are required before beginning his or her venture.
Resources
For information on forming or registering a corporation or limited partnership, contact the California Secretary of State, 1500 11th Street, Sacramento, CA 95814, Limited Partnership Division (916) 653-3365 or Corporate Division (916) 657-5448. For additional information on corporations, contact the California Corporations Department, 3700 Wilshire Boulevard #600, Los Angeles, CA 90010-2901, (213) 736-3481. For information on franchises contact the Corporations Department, Franchise Information Division, 1390 Market Street, San Francisco, CA 94102, (415) 557-3787.
For tax forms and tax information for various forms of business, contact the California Franchise Tax Board, P.O. Box 115, Rancho Cordova, CA 95741-0115, (800) 852-5711 or the Fast Answers about State Taxes (F.A.S.T.) toll-free telephone service at (800) 338-0505. Federal tax forms are available from the Internal Revenue Service, (800) 829-1040.
New businesses with employees should contact the California Employment Development Department, 805 R Street, Sacramento, CA 95814, for a free copy of the California Employer's Guide.
Small businesses also should contact the California Trade and Commerce Agency, Small Business Division, 801 K Street #1700, Sacramento, CA 95814, (916) 322-2252. The Small Business Administration (SBA) also has useful information and programs for small businesses.
There is a variety of information generally available on starting a new business. Two useful resources are:
Volunteer Lawyers for the Arts, How to Form a Nonprofit Corporation (available by sending $39.95 plus $5.00 shipping and handling to VLA, Publications, 1 53rd Street East, New York, NY 10022); and Volunteer Lawyers for the Arts, The Partnership Book: How to Write a Partnership Agreement (available by sending $24.95 plus $4.00 shipping and handling to VLA, Publications, 153rd Street East, New York, NY 10022).