Corporations are business entities separate and apart from their individual shareholders.
Corporations are business entities separate and apart from their individual shareholders. Where corporate formalities are followed (among so so many other things), the corporation’s shareholders, directors and officers are generally protected from the claims against the corporation. A shareholder’s liability is usually limited to the amount of his or her investment in the business, and no more. If, however, anyone is deemed to have behaved badly within the corporation, that person can always be held personally liable for his or her actions. Recent examples of this include, on a larger scale, the executives of Enron. “C-corporations” are corporations that have not elected to be taxed as a “small business” for state and federal tax purposes (see below).
Under certain conditions a corporation and its shareholders may elect to have the corporation treated as a “small business” corporation for the purpose of federal income taxes. This election permits the taxable income of a corporation making the election to be taxed to the shareholders, rather than the corporation.
There are numerous requirements which must be satisfied to qualify a corporation and its shareholders to make an election to be taxed in this fashion. The officers of the corporation should consult with the corporation’s counsel and accountant to determine whether the corporation is eligible to make such an election and to consider the consequences, advantages or disadvantages of making the election. The election typically must be made and filed within 75 days from incorporation.
A partnership is defined as an association of 2 or more persons to carry on as co-owners a business for profit. In California, there are general partnerships, limited partnerships, and LLCs electing to be treated as partnerships. S Corporations are also treated in most ways like a partnership for tax purposes. Typical of partnerships is the characteristic that the tax benefits (and, gulp, corresponding burdens) flow-through to the individual taxpayers, typically in proportion to their percentage of interest in the profits, but not always. And frequently two people find themselves in a partnership without even knowing it. As a result, they find themselves obligated to each other, and taxing authorities, in ways that are frequently a shock to them.
In a general partnership, each partner, and that partner’s personal assets, is liable for the partnership’s liabilities, and for each other partners’ liabilities incurred on behalf of the partnership. Limited partnerships, on the other hand, limit the liability of the limited partners up to each of their investments. Members of a limited liability company are generally treated the same as limited partners. Of course, anything a partner does personally that is, well, bad, will likely expose that partner to personal liability.
Every entity has its purpose and usefulness. General partnerships should be used when there’s more than one person in the enterprise, partners trust (ahem) each other, and there is little concern about being sued. However, if you can think of an enterprise in today’s economic and political climate where being sued is not likely, please call us.
Limited partnerships are very useful in ventures where there is a desire to have one corporation or person managing an enterprise, and the rest of the participants desire to be passive investors, or “silent” partners. However, LLCs are being used more and more for this purpose, including in the area of real estate investments.
An LLC, or limited liability company, is a recent invention, combining the limited liability of a corporation, with the pass-through taxation characteristics of a partnership. It is formed, and its existence commences, when articles of organization are filed with the California Secretary of State. Typically, the management and operation of a limited liability company is governed by an “operating agreement”. This is the equivalent of a partnership agreement and the bylaws of a corporation. An LLC can have 1 or more members.
Typically people like to use, and we recommend using, an LLC, almost whenever possible. Compliance with corporate-like characteristics is optional. However, LLCs can not be used for most professional business enterprises, and there are certain tax disadvantages to LLCs.
Articles of Incorporation
The articles of incorporation are contained in one document which, when filed with the Secretary of State (for a nominal fee), bring a corporation to life. Prior to the articles being filed, the corporation is not a corporation at all, but merely an enterprise, or a corporation “in formation”. The articles define the name of the corporation, and certain other required and optional information about the corporation, which information can only be changed by following certain statutory formalities.
Every new business, including a new corporation, must obtain an Employer Identification Number from the Internal Revenue Service. The number must be used on all federal tax returns and related documents. The corporation’s accountant or counsel can assist in filing Form SS-4 to obtain this number. One of the few times this may not be necessary is when forming a single-member LLC without any employees.
Corporate shares, LLC memberships, and partnership interests are considered securities for purposes of federal securities laws and, generally, will be a security under California securities laws. Under California securities laws, any “offer” or “sale” of “securities” must be qualified with a permit from the California Department of Corporations, unless either the security or the transaction is exempt under the California Securities Law or preempted by federal law.
Section 25012(f) of the California Corporations Code provides a limited offering transaction exemption for offers and sales of securities to up to 35 purchasers within or outside of California. Huh? This exemption means that, if certain guidelines are followed, there is no need to comply with the voluminous (literally) state and Federal securities laws. There are a number of exemption requirements. One of them is the filing of the form named after the statute, the 25102(f) Notice of Transaction Form. This form is filed with the Department of Corporations, must be done online, and must be accompanied with the appropriate filing fee.
Some businesses don’t file one, and though not filing one is acceptable, the fee for filing will go up dramatically if, for some reason, the Department of Corporations makes a demand for such filing.
Close corporations, or closely-held corporations, are corporations which have chosen to be governed by certain statutory rules. Typically these are chosen by people who do not want to have to deal with the ongoing corporate book maintenance issues of minutes and such, but who aren’t aware of the corresponding downsides and obligations, or these are chosen by people who simply thing that if there are a few shareholders, that it’s good to be “close”.
Generally speaking, we do not recommend this type of entity, unless it is under some very specific circumstances. Shareholders in close corporations are required to enter into an agreement for purposes of governing corporate operations and share restriction. And though we recommend this anyway for all corporations, it is required here. In addition, there are some other rules which restrict the day-to-day governance and decision-making process. Typically it involves the ongoing participation of all shareholders, whether majority or minority. And though that might work for some, generally we find that having one person in charge makes life easier, and subjecting that person to the typical corporate scrutiny of fellow shareholders or directors.
Starting a new business, or growing one, can be very exciting, and daunting. Do not let the plethora of information in this article, or otherwise available to you, overwhelm you. You’ve already done the right thing by reading this article. When it comes to your business, you can never know too much.