What's your type--of business entity?

Along with employment tax and fringe benefit considerations, choosing the right type of business entity is a critical consideration when starting a business. In fact, choosing the right type of entity is similar to building a home. You want to accommodate current needs, but you must keep an eye on the future. The right business entity should protect you personal assets against legal liability, but provide the flexibility to grow as your business grows.

Each type of entity--whether it's a sole proprietorship, partnership, corporation or limited liability company--carries its own legal and tax significance, the pros and cons of which must be carefully examined from the outset.

SOLE PROPRIETORSHIP

If you're an individual who'd like to go into business, setting up a sole proprietorship is probably the easiest choice. Just open a bank account in your business name and file a fictitious name statement, also called a DBA (doing business as), with your local newspaper.

Remember, opening a business bank account is important, as the segregation of assets and transactions certainly looks better to the IRS. From a tax standpoint, the nice thing about a sole proprietorship is that it only requires a Schedule C in your tax return. It's an easy process.

A sole proprietorship also is the way to go if you're a consultant for a large company and you never deal with the end user. Here, the company bears the brunt of liability, not you.

But the issue of liability complicates the relative ease of setting up a sole proprietorship. The first issue guiding your choice of entity is almost always the legal one: Do your personal assets need protection from legal liability?

Let's say you hire a bookkeeper or an independent contractor, who, from a legal standpoint, could arguably be an employee. And let's say that person is out doing your bidding and is involved in some type of car accident. In the end, if that business/employee relationship can be identified, you could have a huge liability on your hands.

There are all sorts of other liability concerns, such as environmental, slip-and-fall, sexual harassment and wrongful discharge that could leave your personal assets vulnerable.

Given that, the next question becomes: If there is a potential liability, is it easily insurable? If not, would a corporate entity give any added protection? If you could be easily covered with insurance, just having a special entity for that purpose isn't necessarily the way to go.

GENERAL PARTNERSHIP

If you have a couple of people who'd like to go into business, a general partnership is the path of least resistance. In essence, there are no legal filings. Just obtain an employer identification number from the IRS, file a DBA and open a partnership bank account.

But before launching that business, consult with an attorney and assemble a competent partnership agreement.

Unless the agreement says otherwise, all partners have equal rights in managing the partnership--and any partner can bind the entity, with every partner liable for the result. But partnerships are flexible entities and a variety of management structures and controls are available.

In a partnership, there's joint and several liability. This means you are all individually and collectively responsible--100 percent--for any liabilities, including wrongful acts or omissions of any partner.

An insurance agent familiar with your business can identify possible liability sources, and if the liabilities aren't significant, a sole proprietorship or general partnership would be ideal. Again, if insurance can be obtained at a reasonable rate, no change in entity is required.

Also be aware that licensed professionals generally may not be able to form partnerships with nonlicensed professionals.

The tax implications of partnerships include pass-through tax treatment, which avoids the dreaded "double taxation" that befalls certain types of corporations. Double taxation refers to the fact that a corporation pays federal and California income taxes on its earnings and then when it distributes a dividend or liquidates, the shareholders are taxed on the assets distributed to them.

"Pass-through" basically means that income passes through to the shareholder, partner, member or beneficiary and is taxed at the personal level for a general partnership. There is no minimum tax imposed by the Franchise Tax Board as there is for a limited partnership or limited liability company.

A general partnership can use a cash method of accounting, unless it has a C corp as a partner, has gross receipts of more than $5 million or is a tax shelter.

The taxable year of a partnership should correspond to the taxable year of its majority or principal partners. If the majority or principal partners don't have the same taxable year, the partnership must use the calendar year.

In addition, there is no double tax on liquidation, and the entity may make special allocations and pass-through tax losses.

LPs AND LLPs

Once the darling of the real estate arena, limited partnerships are used less and less now since the LLC has come to California.

Limited partnerships can be structured with more streamlined management and control than a general partnership or corporation. This type of entity is managed by a general partner, who lays claim to all the liability. The limited partners are only liable to the extent of the assets they've contributed. But limited partners who participate in the control of the business may lose their limited liability.

Before signing those partnership agreements, read them carefully. They could be a financial black hole that's deeper than planned. For example, some agreements include the right to assess an additional sum of money for "necessary operating capital."

The limited partnership is a pass-through entity, but must pay an $800 California minimum tax per year.

While licensed professionals cannot use this entity in California, lawyers, accountants and architects are permitted to use registered limited liability partnerships.

LLCs

In almost any other state (other than Texas and Pennsylvania, which impose a franchise tax on LLCs), the LLC is the perfect vehicle for most businesses. It can be a single member entity, which gives you all the liability protection--but none of the bureaucracy--of a corporation; they are very flexible; and management can be decentralized and informal, or a corporate management structure can be instituted. Also, members generally are not liable for the obligations of the LLC.

But almost any business that's required to be licensed under any state's business and professions code--doctors, accountants, hairdressers, locksmiths and contractors, for example--cannot be conducted by an LLC.

Where it works, and is extremely popular, is for real estate investments. There are tens of thousands of real estate LLCs all over California. It's a way to protect against legal liability, and also receive pass-through treatment, enjoying no double taxation.

However, California imposes an annual, minimum tax of $800 and a gross receipt tax as well, that goes up to $11,790, starting at $900 for $250,000 in revenue. An LLC may use the cash method of accounting, unless it is a tax shelter.

Steven Spielberg's DreamWorks, for instance, eschewed the corporate form and chose to be an LLC. The tax advantage of an LLC over a corporation can be enormous, especially when, like DreamWorks, your company makes hundreds of millions of dollars.

Although there is a gross revenue fee for LLCs that goes up to $11,790, the fee is capped there, so DreamWorks will never pay more California franchise tax than that $11,790, plus the $800 minimum tax.

But this entity isn't for everyone, says Pam Hedblad, a CPA with San Jose-based Pascuzzi, Hedblad + Co.

"Whether you make money or not, in California an LLC is subject to a tax on the gross revenue versus a tax on the taxable income. If you're not so profitable, it could be a bad choice," she says.

Also, for a company that's looking to go public, an LLC doesn't make a lot of sense. In fact, I've heard attorneys say that if there is any possibility that a business will go public within the following few years, it could be malpractice not to advise a client to form a corporation as opposed to an LLC.

However, for a business that looks to stay in the family, the noncorporate structure is preferable. "If you're using an LLC or a limited partnership, it can make for an easier vehicle to adapt to whatever the ultimate family needs are," says Los Angeles-based CPA Kip Dellinger. "The noncorporate structure allows for a lot of bells and whistles to be added, without having to deal with the limitations that apply to a C corp and S corp."

C CORPORATIONS

C corps are legal entities and must issue stock as evidence of ownership. A C corp can issue more than one class of stock. Managed by or under the supervision of a board of directors, the capital structure can be altered by voting and non-voting classes of stock. Usually, shareholders aren't liable for the corporation's obligations.

A major benefit of a C corp is that non-personal service businesses, such as construction companies or retail stores, can choose any month for its fiscal year end. But personal service corporations, such as accountants, doctors and lawyers, are required to have a calendar year.

Unlike S corps, a C corp may be a member of an affiliated group and can own subsidiaries without the restrictions S corps face.

C corps are subject to double taxation on earnings, obligated to pay the full California franchise tax, as well as a minimum $800 yearly tax. They also must use the accrual method of accounting, unless gross receipts are less than $5 million or it's a qualified personal service corporation.

Shareholders are generally taxed on corporate distributions, and for those corporations and shareholders in the highest tax bracket, the tax rate on distributed income can exceed 60 percent, combining federal and state rates. The double taxation, as well as potential liability problems, may render the C corp a risky choice.

S CORPORATIONS

The S corp is treated as a pass-through entity, thereby avoiding the double taxation of a C corp Unlike an LLC, there's no limitation on who can be an S corp.

From a planning standpoint, an S corp election is a safe bet for a new business looking to avoid double taxation. And for any firm that's looking to go public, a C corp or S corp election has advantages over an LLC in its ability to bring in the millions that IPOs can reap.

"The biggest reason for being an S corp is if you're going to sell down the road, you avoid the double tax," Hedblad says. "With a C corp, you need to know where you'll be at the end of the year. With an S corp, it's all going to be taxed at the same place at the same rate as salary or pass-through income on the individual return."

However, there are some pitfalls and some pretty strict regulations governing S corps.

An S corp, for example, cannot have more than 75 owners; cannot have owners other than individuals, estates and certain trusts; and cannot have nonresident alien owners.

An S corp also cannot issue more than one class of stock, although differences in voting rights can be permitted in some cases. Except in a few circumstances, an S corp cannot be a member of an affiliated group. An S corp may, however, own some or all of the stock of a C corp, even a parent of all affiliated group.

Note that a bill pending in the California legislature may tax S corps with revenue exceeding $20 million as C corps.

While a pass-through entity, an S corp is subject to a 1.5 percent tax in California on net income or a minimum yearly tax of $800, whichever is greater. For a qualified new corporation, however, that minimum tax may only reach $300 or $500.

To revisit the DreamWorks example, if Spielberg had elected an S corp over an LLC, that 1.5 percent net income tax would be about $50,000 for $30 million in profits. By virtue of its LLC status, DreamWorks only has to pay a capped gross revenue fee of $11,790, plus an $800 minimum tax.

One of the pitfalls of an S corp is its fragility and ability to be terminated.

"The eligibility rules of an S corp are a huge consideration, and the fact that if you fail one of those rules, you become a C corp subject to the double tax," says Bill Staley, a Woodland Hills-based attorney who specializes in corporate issues. "S corp status is a fragile thing."

Staley believes that LLC status is often preferable to S corp status. "I tell my clients the S corp is like a Toyota Camry and the LLC is like a Lexus. You won't notice the difference the first few months, but after a while, when things change, you'll be happier with the Lexus."

A variety of structures are available when starting your business, each with its own rewards and perils. When choosing a business entity, look to the future. Remember, you're laying the foundation for the success of your business and turning a current cottage into tomorrow's mansion.

What works for you? A quick glance

                       C Corp                   S Corp

Pass-through tax       No                       Yes
treatment (do entity
and owners avoid
double taxation on
earnings?)

May the entity have    Yes                      No
more than 75 owners?

May the entity have    Yes                      No
owners other than
individuals, estates
and certain trusts?

May the entity own     Yes                      Only a Qualified
subsidiaries?                                   Sub-Chapter S

California tax         Subject to California    Subject to 1.5% tax
treatment              franchise tax.           on net income or
                       Minimum tax $800         minimum yearly tax
                                                of $800, whichever
                                                is greater.
Method of              Accrual method, except   Cash method,
accounting             if gross receipts        unless it's a
                       are less than $5         tax shelter
                       million and except for
                       personal service
                       corps.

                        Partnerships           LLCs

Pass-through tax        Yes                    Yes
treatment (do entity
and owners avoid
double taxation on
earnings?)

May the entity have     Yes                    Yes
more than 75 owners?

May the entity have     Yes                    Yes
owners other than
individuals, estates
and certain trusts?

May the entity own      Yes                    Yes
subsidiaries?

California tax          Limited partnership    Minimum tax
treatment               must pay annual        $800, plus annual
                        minimum tax of $800.   fee based on gross
                        General partnerships   revenue.
                        do not.
Method of               Cash method, unless    Cash method,
accounting              it has a C corp.       unless it's a tax
                        as a partner           shelter
                        and gross receipts
                        of more than $5
                        million or it is a
                        tax shelter

Source: Golden Gate University

Ernest Howard, CPA is based in Playa Del Rey. You can reach him at [e-mail].