What type of corporation should I create?
cor·po·ra·tion
ˌkôrpəˈrāSH(ə)n/
noun
a company or group of people authorized to act as a single entity (legally a person) and recognized as such in law.
There are many options when it comes to creating a business entity; this article focuses on California businesses.
You can form a corporation or LLC to create a separate legal entity, which offers protection from personal liability and helps separately record and report business operations.
The first step to create an entity begins on the state level- by filing documents, known as, "Articles of Incorporation," or "Articles of Organization" (for LLCs) with the California Secretary of State.
It is advisable to create Corporate Bylaws and/or an Operating Agreement upon formation and obtain an EIN (employer ID #) from the IRS as soon as possible (unless you are forming a single member LLC or sole proprietorship, see below).
Once these steps are complete, a separate bank account should be opened for the business, as this will track the business' performance and help maintain records.
Below are some characteristics of business structures available in California.
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Sole Proprietorship
These are not corporations, and therefore offer no liability protection. They do not require filing of Articles of Incorporation/Organization and are not subject to the annual FTB Tax of $800. They are taxed at individual tax rates. Local taxes like LA City Business tax may apply.
For reference, federal tax rates for single & Married Filing Joint (MFJ) Year 2018 are listed below:
RATE Single MFJ
10% up to $9,525: up to $19,050
12% $9,525 to $38,700 $19,050 to $77,400
22% $38,701 to $82,500 $77,401 to $165,000
24% $82,501 to $157,500 $165,001 to 315,000
32% $157,501 to 200,000 $315,001 to $400,000
35% $200,001 to $500,000 $400,001 to 600,000
37% $500,001 + $600,001 +
California state income taxes range from 1%-13.30%, on a similar sliding scale.
See https://www.ftb.ca.gov/forms/2018-California-Tax-Rates-and-Exemptions.shtml
FORMS FILED: Sch C on 1040/540 individual return
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C-Corporations are taxed as separate entities. In this sense, they are "true corporations," unlike so-called "pass-through" entities (see below).
IRS taxes profits generated by C-Corporations at 21%
C-Corps are also taxed by the state of CA at 8.84%
Net income not paid or otherwise distributed to officers or shareholders by the end of the year is subject to tax. This income is taxed AGAIN on the individual level, which is referred to as "double taxation," - a very bad thing! For this reason, it is important to "bonus out" the profits of a C-Corporations before the end of the year (12/31 for non-"Fiscal Year" corporations).
Subject to the annual FTB Tax of $800
C-Corps offer unlimited growth potential through the sale of stocks, which means you can attract some very wealthy investors. Plus, there is no limit to the number of shareholders, and C Corps also enjoy more deductible expenses than other entities.
FORMS FILED: 1120/100 (CA).
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"Pass-through" entities: Any entity that is considered a "pass-through" pays tax on the individual level, which means that the corporation itself is not taxed, but the individual owners or shareholders will pay tax when they receive their portion of income/profits.
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S-Corporations
Since it is a "pass-through," the S-Corporation is not subject to the federal tax on profits. However, owners are taxed at the individual rates (see above).
S-Corporations are subject to California state tax rate of 1.5% and the annual FTB Tax of $800.
There is a limit of 100 shareholders and only the issuance of common (not preferred) stock with S-Corps., which further differentiates them from C-Corps.
An S corp can save a business owner Social Security and Medicare taxes. However, this has become a hot button issue with the IRS. There is a requirement to pay officers a "reasonable salary," for services rendered to the S-Corp, in order to ensure payment of payroll tax.
FORMS FILED: 1120S/100S (CA). Shareholders receive K1s.
Must file Form 2553 for Small Business Corp election within two months and 15 days after the start of the tax year when the election is to take effect.
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Partnerships
Partnerships are either general partnerships (GP) or limited partnerships (LP).
A GP involves two or more persons who agree to create a business and share the profits and losses. All of the partners share equal rights and responsibilities in managing the business. In addition, each general partner assumes full personal liability for the debts and obligations of the partnership.
An LP involves two or more persons who agree to create a business and share the profits and losses. A limited partnership has at least one general partner and at least one limited partner. The general partner is responsible for managing the business affairs, while the limited partner typically provides only capital to the partnership. Similar to the general partnership, each general partner assumes full personal liability for the debts and obligations of the partnership. The limited partner’s liability is limited to their investment in the business. (https://www.ftb.ca.gov/businesses/bus_structures/partner.shtml) Limited Liability Partnership (LLPs) In LLPs, one partner is not responsible or liable for another partner's misconduct or negligence. LLP is similar to a general partnership in that all the partners can take an active role managing the day-to-day affairs of the business. The LLP form of ownership is limited in the State of California to persons licensed to practice in the fields of public accountancy, law, or architecture.
FORMS FILED: 1065 /565 (CA) Partners receive K1s
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Limited Liability Company (LLC) or SMLLC (single member LLC):
An LLC is a hybrid business entity that blends elements of partnership and corporate structures. The LLC’s main advantage over a partnership is that, like the owners (shareholders) of a civil law corporation, the liability of the owners (members) of an LLC for debts and obligations of the LLC is limited to their financial investment. However, like a general partnership, members of an LLC have the right to participate in management of the LLC, and profit or losses flow through to its members.
LLC is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.
Due to their flexibility, LLCs are more popular than partnerships.
See individual tax rates above.
In addition, there is $800 FTB TAX due every year on 4/15, for calendar year entities.
There is also an FTB FEE (due 6/15) which is based on GROSS income in the amounts below:
> $250K Gross Income $900
>$500K Gross Income $2,500
> $1M Gross Income $6,000
> $5M Gross Income $11,790
The main difference between LLCs and SMLLCs is that there is no federal form or K1 required for SMLLC's, and they can only have one member (hence the name). Simply report the gross receipts on California state Form 565/568 and report the total activity on Sch C of your 1040 individual return, as you would with a SOLE PROPRIETORSHIP (see above).
FORMS FILED: 1065/ 568 or 565 (CA) / Partners or Members get K1s from LLC (not from SMLLC).
Questions? Comments? Please send a message!
We will update this post regularly to add more information.
