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The Right Fit

by: Andrew K. Jacobson © 2003, Bay Oak Law

In recent years, new business owners have had several entities to choose from, depending on the needs of the business and the owners. The two most important factors in deciding the right business entity are limited liability and the tax treatment.

Limited Liability. “Limited liability” is available when the business respects certain obligations, such as obtaining a license from the state, keeping certain records and keeping the accounts of the business separate from the accounts of the owners. If this is done, the liabilities of the business generally are not passed on to the owners of the business.

Tax Treatment. How the profits of the entity are treated tax-wise is also an important consideration. Corporations pass their profits to their shareholders by dividends; however, the corporation pays taxes on the profits before the distribution to the shareholders, and the shareholders pay taxes on their share of the dividends, at the shareholder’s tax rate (“double taxation”) Some entities, like general partnerships, can “pass-through” their profits to their owners without the problem of “double taxation.”

The task of the new business owner is to choose the entity most compatible with the interests of the owners.

Sole Proprietorships. Sole proprietorships are the classic one person working alone. The owner is fully liable for all liabilities. The business’s income is treated as the income of the owner, and the expenses of the business are taken as a business deduction. However, only one person can be in charge, and the business cannot sell part of itself.

General Partnerships. When two or more people own a business, they can choose to be a general partnership. No paperwork is required, but the owners (“partners”) need to agree who owns how much; that should be in writing and signed by the owners. There is no limit to the liability of the partners for the debts of the partnership. The profits are distributed to the partners. The partnership ends when one of the partners leaves.

Corporations. The “classic” entity form is the corporation. The owners enjoy the right to limit their liability for the debts of the corporation – an important consideration in a society that can attack businesses decades later for issues like asbestos, tobacco, or mold. However, California has an annual franchise tax of $800, plus taxes on the profits of the business.

Limited Liability Companies. A new form of business is the limited liability company (“LLC”). While an LLC enjoys the right to limit the liability of owners, it can have the tax treatment of a partnership (no double taxation). However, the LLC form is not available in professions subject to certain government licensing requirements, like general contractors, lawyers, or doctors.

Confused? Talk to your lawyer or accountant to decide what is best for you. While the initial cost can seem bothersome, the right choice can save tens of thousands of dollars later.

Andrew K. Jacobson is the founder of Bay Oak Law in Oakland, California, and has been practicing law for entrepreneurial clients since 1990.

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