What types of entities can California business owners choose for their businesses? What is a sole proprietorship? What is a partnership? What is the difference between general and limited partnerships? How are partnerships taxed? What is the difference between a C-corporation and an S-corporation? How do corporations avoid double taxation? What about owning real estate in a Limited Liability Company? What is a Limited Liability Company? How can business owners maintain limited liability to protect assets? How can business owners save thousands in taxes every year?
By James L. Cunningham Jr., Esq.
Owen has a coffee roasting business that makes a million dollars a year. As a sole proprietor, he forks over nearly half his profits–$410,000—in taxes.
Then a customer spills an extra-hot latte, sues Owen, and cleans him out.
Could Owen have set up his roastery in a way that could have saved him on taxes and protected his personal assets?
Definitely.
The business owner is an entrepreneur. That’s a French word for someone who goes “adventuring,” who “undertakes things,” in other words, a “risk-taker.” The name is apt. Business owners many times are the ones taking huge risks, particularly the risk of losing money. Some of that risk is inevitable…but some can and should be avoided. Business owners shouldn’t risk losing their homes and personal bank accounts if the business goes under or somebody sues. And no owner wants to waste their profits by overpaying taxes.
For starters, entrepreneurs need to choose the right kind of business entity—not a casual decision, because making the right choice can not only protect business owners’ assets, it can save thousands in taxes every year.
What Types of Entities Can Business Owners Choose for Their Businesses?
Here in California, business owners can choose to run a business under one of four basic types of business structures: sole proprietorship, partnership, corporation, and limited liability company (LLC). Each type reflects a different way of structuring the relationships and responsibilities among the owners of the business and those who run it. It’s vital for business owners to carefully consider the various types of business entities and choose the most appropriate structure for their needs, as each comes with important differences in whether the owners are personally liable and how they pay taxes.
We’ll look at each type of entity in turn.
What Is a Sole Proprietorship?
A sole proprietorship means one person owns and runs a business without anyone else. If Owen owns his roastery and runs it himself without forming any kind of business entity, he is a sole proprietor. This is one of the riskiest forms of business entities when it comes to personal finances, and there are many factors to be considered before deciding on sole proprietorship. For example, Owen must report all the income on his own individual income tax return and pay self-employment taxes. Again, that could mean forking over a whopping $410,000 in taxes every year on $1M in income.
Even worse, Owen is personally liable for all the debts the business incurs, including if that hot-latte customer wins a multi-million-dollar judgment.
I’d tell Owen he could save tens of thousands in taxes every year and protect his assets just by choosing another form of entity.
What Is a Business Partnership, Legally Speaking?
A partnership involves two or more people or entities actively running a business they own. The key is that ownership and control of the business are in the same hands. This creates advantages as well as liabilities.
Of all the different business structure types, many aspiring business owners opt for a Partnership because Partnerships allow individuals to pool resources, knowledge, and skills, leading to greater profit potential and spreading the costs for the business.
Partners can be people or other entities, like two LLCs forming a partnership to own and operate a joint venture, but it takes two to tango. You can’t have a partnership by yourself; you need a partner.
Business owners can start partnerships without completing any legal formalities or paying any fees. In California, people can form a partnership without even writing it down. No kidding. Verbally agreeing to start and own a business together and taking steps to do so is enough, even if the partners never say the word “partnership”!
Let’s say Abel and Baker talk and decide to start an ice cream shop, with Abel making ice cream and Baker scooping. They have a partnership if it looks like they own the business together.
How do courts decide if people own a business together? Remember, entrepreneurs are risk-takers, so “partners” are people who share in the risk. That makes the key question: Do the partners share profits and losses?
If Abel keeps all the profits while Baker earns an hourly wage, it looks like Abel alone owns the business, and Baker is just an employee with no real ownership stake. But if Abel and Baker share profits and losses, they are partners in a partnership, even if they don’t know it.
That makes partnerships an easy—and even free—way to start a business. But be VERY careful. Partners in those kinds of partnerships are general partners who also share unlimited personal liability.
“General” Partnerships are often a bad idea for operating businesses because both partners can get sued and cleaned out. If Abel and Baker want to limit their personal liability and protect their assets, they need a different kind of partnership or a different kind of entity altogether.
What Is the Difference Between General and Limited Partnerships?
Instead of a General Partnership, it’s possible that Abel and Baker could control their risk through a Limited Partnership.
The key difference between “general” and “limited” partnerships is that a Limited Partnership protects some of the partners, called limited partners, from personal liability. A General Partner has unlimited personal liability.
Liability follows whoever is responsible for operating the business because that’s who makes the decisions. In a Limited Partnership, one or more General Partners manage the business, while the Limited Partners only contribute capital. General Partners oversee and run the business, while the Limited Partners are along for the ride. Again, the General Partners have unlimited personal liability for the partnership’s debts, while the Limited Partners risk only the amount of money each contributed. That protects the limited partners’ assets from seizure by creditors of the business.
But beware: Limited Partnerships require formalities including a well-written partnership agreement. If partners don’t follow all the rules, it exposes limited partners to personal liability.
That means if Abel and Baker start a partnership without any written agreement and without registering it with the state, each has unlimited personal liability.
A Business Can Have Enormous Liability Even If Only 1% at Fault
Let’s say these two well-meaning fellows hire Charlie to drive their ice cream delivery truck. A drunk driver rear-ends Charlie while he is making a delivery. The collision pushes the ice cream truck into a bus, causing debilitating injuries among several of the passengers.
A jury decides Charlie was just one percent at fault.
In California, Abel and Baker are jointly and severally liable together for the special damages, meaning all the medical bills, even though Charlie was only one percent at fault. Abel and Baker have what is called “agency” or “vicarious liability” for Charlie’s acts while making deliveries because he was acting as their agent and making deliveries within the scope of his employment. The medical bills exceed $10 million. Abel and Baker are both 100 percent liable for $10 million and will lose all their assets in that scenario.
Does that sound crazy? Maybe. But it’s the way the system works here in the Golden State.
Let’s say that instead, Abel and Baker set up a Limited Partnership. But first, Abel creates a corporation called Abel, Inc. Abel is the president of Abel, Inc., but Abel, Inc. is the General Partner in the ice cream business and Baker is the Limited Partner. In California, they have to register the Limited Partnership and pay the $800 minimum franchise tax. But the franchise tax is a small price to pay for Limited Liability. Abel, Inc. has unlimited liability, but Abel himself does not. Abel has limited his potential loss to the amount of money he put into the business. Baker’s loss is also limited to the amount of money he put in as a Limited Partner.
Now when Charlie is found one percent at fault, the Limited Partnership is jointly and severally liable for special damages, but not Abel and Baker individually. Abel Inc. is responsible as General Partner, but only to the extent of the capital that Abel put into Abel Inc. That means the medical bills for the bus passengers still exceed $10 million. The ice cream shop may fold, but the bills won’t ruin Abel and Baker personally.
Did Abel and Baker need a qualified lawyer to set all this up? You bet.
How Are Partnerships Taxed?
Partnerships are taxed similarly to sole proprietorships, except income is allocated among the partners individually. Partnerships are known as pass-through or flow-through entities, meaning the income and losses go straight through the partnership without being taxed at the partnership level. The partners each report their shares of income, losses, deductions, and credits on their individual tax returns. That means each dollar the partnership earns is taxed only once, at the partner level. This is an important difference from the double taxation imposed on some corporations covered in the next section.
What Is a Corporation, Exactly?
A corporation is a business structure that separates the role of the business owner from the roles of those who run the business. Shareholders own shares or stock in the company, while corporate officers that make up the management team run the business. If the shareholders own stock with voting rights, they can vote to select who serves as members of the board of directors, but those directors appoint the executives who run the company. The shareholders take a back-seat role, uninvolved in day-to-day operations. Of course, in a very small corporation, this could be one shareholder, one member of the board of directors, and one person who runs the company.
Having a limited role protects shareholders from liability. Shareholders usually have no personal liability for corporate debts, meaning creditors cannot reach their personal assets. Instead, all shareholders stand to lose is the amount they invested in the company—no more than the dollars they paid for their shares.
One person can have both ownership and control of a corporation. One person can own all the shares and be chief executive officer, secretary, and head bottle washer. That means one person alone can be a corporation, but not a partnership.
But one person both owning and controlling a corporation must be especially careful to preserve limited liability. Otherwise, one person both owning and running a business looks like what lawyers call the corporation’s alter ego, like the corporation and the person are not separate. If a sole owner is really just the corporation’s alter ego, courts will pierce the corporate veil and allow business creditors to reach the owner’s personal assets.
What Is the Difference Between a C-Corporation and an S-Corporation?
Corporations come in two basic flavors: C-corporations and S-corporations. The nicknames come from which section of the federal tax laws apply. The IRS taxes C-corporations under subchapter C of the Internal Revenue Code and S-corporations under subchapter S. Only C-corporations existed before the 1950s when Congress enacted subchapter S.
C-corporations are usually larger than S-corporations. C-corporations are types of business structures not limited in the number of shareholders they can have, making them optimal for an organization planning to expand, attract investors, or even go public. The tax laws currently limit the size of S-corporations to no more than 100 shareholders. Apple Inc. is a C-corporation, but the guy who fixes Apple products at a mall kiosk is probably an S-corporation if he is incorporated.
But the key difference is how C- and S-corporations are taxed. C-corporations pay state and federal taxes on the income the corporation earns. As of this writing, C-corporations pay a flat income tax rate of 21% to the IRS, plus state income tax, which is 8.84% in California, so a total tax rate of 29.84%. Then when that same income is paid out to shareholders as dividends, the shareholders pay income tax on the dividends. So, the IRS and California tax the same money twice, called double taxation. That’s right, every dollar gets taxed twice.
How Do Corporations Avoid Double Taxation?
A check-the-box election is how businesses that qualify choose taxation as an S-corporation. If you set up a corporation and do nothing, the IRS automatically treats it as a C-corporation. To avoid double taxation, you must check the box on Form 2553 and file it for S-corporation tax treatment.
Avoiding double taxation means S-corporations offer significant tax advantages over C-corporations. However, special rules apply. If you own stock in an S-corporation, or could inherit stock in one, make sure your living trust includes technical provisions specific to S-corporations. Your advisors can make sure that your living trust provisions are right for your situation. If you don’t have advisors, reach out to us at CunninghamLegal.
What About Owning Real Estate in a Corporation?
Usually, owning real estate in a corporation is a really, really bad idea from a tax standpoint. Most corporations are operating businesses, like Apple. But many of our clients who own real estate in a corporation do so because their parents or grandparents bought the property with a Corporation. Most of those clients are farmers or ranchers with “legacy” corporations that own their land.
Using a corporation to own real estate has a huge downside—and is not typically part of good estate planning for business owners trying to pass on their assets to future generations while reducing tax liabilities. Real estate in a corporation does not get an adjusted cost basis if one owner passes away. Let’s say a couple has a corporation that owns real estate. The corporation buys a piece of property for $100,000 that increases in value to $1 million. If one spouse passes away, the basis in the property is still only $100,000, so the corporation may be subject to hefty taxes on a $900,000 gain when the property sells.
That rule applies to any property a corporation owns, whether a C- or an S-corporation. So if you own property in a corporation, ask your team of advisors how to take it out. You can convert an entity from a Corporation to a Partnership (preferred for owning real estate). After five years, the property gets more favorable tax treatment. Your team may also be able to structure a strategy to take the property out over time. A savvy attorney can help you and your family avoid hundreds of thousands in taxes down the road.
What Is an LLC?
An LLC or limited liability company is a modern form of business that gives owners more flexibility. LLCs are more elegant solutions that combine the best of a corporation and a partnership and put them together in a great way. Among many other uses, LLCs may be a great way for you to own investment real estate.
In an LLC, members both own and run the business, but also have limited liability and can choose how the LLC is taxed. Unlike a partnership, an LLC can have just one member. LLCs can be taxed like a partnership, a corporation, or something called a disregarded entity. A disregarded entity means the IRS ignores the LLC for tax purposes. The LLC does, however, file a state income tax return, but no federal income tax return. Instead, members report their shares of income or losses on their individual tax returns. These types of LLCs also avoid double taxation.
Each state sets its own rules for LLCs, with different reporting and formal requirements. However, in general, LLCs have less stringent technical requirements than corporations, making veil-piercing less likely.
That means Owen could have set up an LLC for his roastery to avoid double taxation and still have limited liability—a possible solution. An LLC, used appropriately, can also be part of estate planning for business owners trying to pass on their assets to future generations while reducing their tax liabilities.
But an LLC is not the best solution for all businesses. Many professionals, including attorneys, physicians, and real estate brokers, cannot operate their practices as LLCs in California. Whether an LLC is right for your business hinges on the facts of your particular situation. It is important to sit down with your team of advisors, including your attorney and accountant, to choose the structure that will work best in your situation. Contact us to discuss your options.
How Can Business Owners Maintain Limited Liability to Protect Assets?
Many business owners use limited partnerships, corporations, or LLCs to limit their personal liability and protect their assets, especially those with significant wealth. But every entity that offers limited liability also comes with technical rules that business owners must follow to maintain limited liability, including special limits in California.
For starters, business owners must keep up with all the formalities required by law. All too often, business owners form a business, register it, and pay the first year’s fees, then drop the ball on technicalities the second year. Failure to keep up with requirements like holding an annual meeting and filing corporate reports could mean creditors can do something lawyers call “piercing the corporate veil.” Piercing the veil means creditors can get courts to disregard or ignore the corporate form and the limited liability that comes along with it.
All the work Abel and Baker did to limit their liability is wasted if they stop doing the formalities that keep the veil intact.
The second key is to adequately fund the business and keep business and personal finances separate. Inadequate capitalization, failure to follow corporate formalities, and commingling assets are common ways creditors pierce the corporate veil and reach personal assets. If Abel alone sets up a corporation to make ice cream but doesn’t even put in enough money to pay vendors and employees, those people might reach Abel’s personal assets to cover his bills. Likewise, if Abel mixes personal and business funds or does not keep proper accounts, he will have a hard time keeping business creditors from draining his personal accounts.
The third key is to have written agreements that say the business will indemnify you for any losses and pay to defend you from lawsuits. You can also carry business liability insurance. The type of coverage you need depends on the risks involved in your specific business, but can even provide replacement income if something interrupts your business. Again, your team of advisors including your attorney and accountant, can ensure you have the right coverage for your business so your assets stay protected.
How Can Business Owners Save Tens of Thousands in Taxes Every Year?
A key strategy our business owner clients use to save on taxes is to use either a corporation or an LLC and take a salary, then take the rest of the profits as dividends or distributions.
Let’s take Owen’s coffee-roasting business earning $1 million per year. Before incorporating, Owen pays $410,000 in income taxes. Owen comes to us asking how to cut his tax bill. We tell Owen he could set up an S-corporation and pay himself an annual salary of $42,800, which Google says is the average rate for coffee roasters in the area, then take the rest as dividends.
Owen has to use a reasonable salary for coffee roasters, but that is an easy number to find on Google or by using Department of Labor statistics.
As an S-corporation, Owen avoids paying self-employment taxes, but he has to pay 1.5 percent taxes on the S-corporation’s profits, or $7,500. That means Owen saves himself a total of about $34,000 per year in taxes.
An S-corporation also helps Owen avoid audits. If you run an operating business as a sole proprietor, you’re about 20 times more likely to get audited if you report all the income from self-employment on a schedule C than if you set up a corporation and report a reasonable salary and the rest as dividends.
What if Owen uses an LLC instead?
In that case, Owen sets up an LLC, pays himself the same annual salary, and takes the rest as distributions. Owen doesn’t avoid California’s 1.5% tax and is subject to a gross receipts tax, but the LLC has less formality.
That’s why it’s important to look at both types of entities through an economic analysis to see which offers the most advantages. And of course, the process of determining which of the types of business structures is right for your company involves careful consideration of government regulations for your particular industry.
The bottom line? Making the right choices up front can save you tens of thousands every year—and ensure that your translation of entrepreneur comes out more like “adventurer” than “risk-taker.”
What Do We Do as California Estate and Tax Planning Attorney Specialists?
The lawyers and staff at CunninghamLegal help people plan for some of the most critical times in their lives and then guide them through when those times come. We also help people structure their businesses to avoid personal liability, protect their assets, and preserve wealth.
Make an appointment to meet with CunninghamLegal for Corporate and Tax Planning, Estate Planning, and much more. We have offices throughout California with expert estate and tax planning attorneys and invite you to contact us for help and advice on how to best structure your business. We offer in-person, phone, and virtual appointments. Just call (866) 988-3956 or book an appointment online.
We look forward to working with you!
Best, Jim
James L. Cunningham Jr., Esq.
Founder, CunninghamLegal
At Cunningham Legal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.
