As attorneys who advise individuals and businesses, our clients often ask for our advice on how to structure their new business and the requirements for operating that type of business. Typically, most people want to know the pros and cons of being a sole proprietor, a corporation or a limited liability company. Here is a brief synopsis of the differences between these types of entities:
A sole proprietor is a business that is NOT separate from its owner. You may see sole proprietors referred to as “Doing Business As”, “DBAs” or Fictitious Names. In California, to operate under a trade name or fictitious name, the owner must file a fictitious name statement in the county where the business is operating and publish the information concerning the owner of the fictitious name in the local newspaper for a specified period. The business owner remains liable for all debts of the business because the business does not exist separately from its owner. Typically, the income and expenses for a sole proprietor are reported on the owner’s Form 1040 each year. The DBA must be renewed every five years.
A corporation is a separate legal entity that, if properly maintained and operated, can shield its owners from personal liability for the debts of the corporation. The shareholders own the corporation but elect directors who then appoint officers (such as the president, secretary and treasurer) to run the business. The corporation is governed by bylaws and can own property in its name. The corporation can be taxed like a corporation and file its own tax returns or elect to be an S-Corp and pass income and expenses through its shareholders like a partnership, which can avoid taxes being imposed at both the corporate and shareholder level. It is important that all corporate formalities be observed. At a minimum, a corporation should have annual minutes prepared and signed by the Board of Directors which detail and approve the actions of the officers over the year and approve all agreements the corporation enters into during the year.
Another common type of legal entity is the limited liability company (LLC), which is a cross between a corporation and a partnership. It allows the pass-through of profits and losses to the owners, called members, with the added attraction of limiting the owner’s individual liability for the debts of the company, thus adding the protection of a corporation. The LLC is governed by an operating agreement, which sets forth a roadmap by which the LLC will run its business.
Whether you have a corporation or an LLC, we strongly urge you to consider entering into an owners’ agreement or buy-sell agreement to provide for the management of your company as well as to provide a mechanism for selling your own interest or buying out the other principals of the company. The best time to set these agreements in place is typically at the beginning of the corporate existence. These types of agreements can also provide a mechanism for buying out the spouse of one of the principals in the event of a divorce. Typically, you do not want to end up with your business partner’s ex-spouse or the surviving spouse of a deceased partner as your business partner. These types of agreements can assist in preventing this from happening.
In all instances, whether as a sole proprietor, a corporation or a LLC, it is crucial that you consider how your ownership interest in your business will be handled in the event of your death.
There are many different reasons an individual may choose one form of entity over another. We invite you to contact us for a consultation concerning which is best for you and your business.
McDowell Odom LLP
28494 Westinghouse Place, Suite 213
Valencia, California 91355