SELECTING AND FORMING

BUSINESS ENTITIES IN CALIFORNIA

            A.        SOLE PROPRIETORSHIP.

                        The most simple form of business is one in which an individual engages in business personally rather than through a separate entity.  The principal advantage of a sole proprietorship is the avoidance of many of the formalities and reporting requirements required of other forms of business organization.  The major drawback is the owner's personal liability for all obligations of the business.

            B.        GENERAL PARTNERSHIP.

                       A partnership is defined as an association of two or more persons to carry on as co-owners a business for profit.  The principal features of a general partnership are:

1. Each partner is an agent of the partnership with authority to bind the partnership in its ordinary course of business.

2. Each partner is personally liable for all obligations of the partnership.

3. The death or withdrawal of any partner dissolves the partnership unless there is a written agreement providing that it continue.

4. The partnership may be dissolved by the express will of at least half of the partners at any time, even if a written agreement provides to the contrary.

                       The term joint venture is often used for an entity formed for a limited or temporary business purpose.  Ordinarily, joint ventures have been treated as general partnerships under California law.  A general partnership may be formed by either an oral or written agreement.  Procedural requirements include the filing of a fictitious business name statement in the county where the partnership conducts business.

            C.        LIMITED PARTNERSHIP

                       A limited partnership is a partnership with one or more "limited partners".  A limited partner is a partner designated in the agreement as a limited partner who does not participate in the control of the business and who is not personally liable for the obligations of the partner­ship.  A limited partnership must have at least one general partner.  A general partner is one who is actively engaged in the management and control of the business and who has unlimited personal liability for the obligations of the partnership business.

            D.        CORPORATION

                        A corporation is a limited liability entity formed under the state law for the purpose of conducting business.  The principal feature of a corporation is that none of the owners known as "shareholders" are liable for the corporation's obligations merely by reason of being a shareholder.  The principal parties involved in the operation of a corporation include the shareholders, directors, and officers.  For federal tax purposes, a corporation may be a C corporation or an S corporation.  There are also various types of nonprofit corporations which may be exempt from federal income tax.

            E.        LIMITED LIABILITY COMPANY

                    A limited liability company is an unincorporated business organization whose members do not have personal liability for the debts of the company.  This type of entity is similar to a corporation in that the owners known as "members" are not liable for the obligations of the business merely because they are "members".  The members are therefore comparable to the shareholders of a corporation.  The entity is like a partnership in that it is generally not subject to federal or California income tax.

            F.        LIMITED LIABILITY PARTNERSHIP

                      California also permits attorneys or accountants to form a limited liability partnership.

            Like a sole proprietor, general partners are personally liable for all of the obligations of the business.  However, in addition to being liable for their own acts or omissions in the course of operating a business, a general partner is jointly liable for the wrongful acts and omissions of any partner acting in the ordinary course of partnership business or with the authority of the partners.  Due to this considerable exposure to liability, many business owners seek to limit their liability by using a limited partnership, corporation, or limited liability company.

            A.        LIMITED PARTNERSHIP

                       Although a general partner of a limited partnership is fully liable for all partnership obligations to the same extent as any partner of a general partnership, the liability of a limited partner is limited to the amount of (1) his agreed capital contribution, and (2) any distributions received by the limited partner from the partnership at a time when the partnership's assets were insufficient to satisfy its liabilities.  A limited partner may lose this protection if he or she becomes active in the business and participates in the control of the partnership business.  However, a limited partner may be a director, officer, or employee of a corporate general partner without losing the protection from liability otherwise available to a limited partner.

            B.        CORPORATION

                       Generally, shareholders, directors, and officers are not personally liable for the debts and obligations of a corporation.  Since the corporation is a separate legal entity, the corporation itself is liable for the obligations of the business.  However, there are four principal areas of exposure for individuals affiliated with the corporation:

1. An individual may be liable for corporate debts which they personally guarantee.

2. An individual may be liable for receipt of improper distributions under Corporations Code Sections 506(a) and 2009(a).

3. If the individual is a director, officer, or controlling shareholder who has a fiduciary duty to the other shareholders of the corporation, the breach of that duty may give rise to personal liability.

4. If the corporation fails to meet certain operational and procedural requirements, the corporate veil may be pierced to impose personal liability on the shareholders.

5. An individual employee is liable for his or her own wrongful acts.

            C.        LIMITED LIABILITY COMPANY

                        Like the shareholders of a corporation, the members of a limited liability company are not personally liable for the debts and obligations of the limited liability company solely by reason of being a member of a company.  However, an individual may be liable in the following instances:

1. Liability arises to the extent that the individual personally guarantees debts of the limited liability company.

2. A member is liable to third parties for the member's participation in tortuous conduct.

3. A member is liable to the extent he or she agreed to be personally bound in the Articles of Organization or a written operating agreement that creates a liability pursuant to Corporations Code Section 17101(e).

4. A member may be obligated to return or be personally liable with respect to distributions from the limited liability company in violation of certain provisions of the Corporations Code.

5. A member may be liable if the company veil of the limited liability company is pierced to impose personal liability on members.

            A.        SOLE PROPRIETORSHIP

                        Formation of a sole proprietorship requires no filings, fees, or minimum annual taxes.  If the business will operate under a name different than that of the owner, a fictitious business name statement should be filed and published in each county in which the business will operate.

            B.        GENERAL PARTNERSHIP

                        Formation of a general partnership requires no filings, fees, or minimum annual taxes.  The partnership agreement may be oral or written.  It is highly recommended that a written agreement be used.  Where there is no written agreement, the partners are generally deemed to be equal partners.

            C.        LIMITED PARTNERSHIP

                        Formation of a limited partnership requires the filing of a certificate of limited partnership executed by all of the general partners.  This must be filed with the Secretary of State with a filing fee of $70.  A limited partnership agreement must be entered into by all of the partners either prior to or after filing of the certificate.  It is highly recommended that the agreement be written even though the Corporations Code does permit an oral agreement.  Typically, this agreement is more complex than a general partnership agreement.  Since a limited partnership is required to pay an annual franchise tax of $800 for the privilege of doing business in California, this fee must generally be paid on the due date of the partnership's tax return.  Installment payments of estimated taxes are due earlier in the initial year of the partnership.

            D.        CORPORATION

                       Formation of a corporation is accomplished by the filing of Articles of Incorporation with the California Secretary of State.  The Articles are signed by an individual known as the incorporator who need not be a shareholder or director.  A filing fee of $100 must accompany the Articles when filed with the Secretary of State.  In addition, a minimum franchise tax of $800 is payable each year.

                       After the Articles are filed, the incorporator appoints the initial members of the Board of Directors who hold the first meeting of the Directors.  At that meeting, the action taken typically includes adoption of bylaws, issuance of shares of stock, election of officers, determination of salaries, authorizing the establishment of bank accounts, selection of a fiscal year, the making of certain tax elections, and all other matters necessary to the organization of the business.  Within 90 days after the Articles are filed, the corporation must file with the Secretary of State a "Statement By Domestic Stock Corporation" which indicates the names and addresses of the corporation's directors and officers, the general nature of the corporation's principal business, the address of the corporation's business, and the agent for service of process.

                        If the corporation will be a C corporation taxed in the ordinary manner under the Internal Revenue Code, no special filing is required under federal income tax law.  However, if the corporation desires to be taxed as an S corporation under subchapter S of the Internal Revenue Code, an election must be filed on form 2553 on or before the 15th day of the third month of the corporation's fiscal year.

            E.        LIMITED LIABILITY COMPANY

                     Formation of a limited liability company is accomplished by filing Articles of Organization on a prescribed form known as form LLC-1 with the Secretary of State.  The Articles are signed by the organizer of the company who need not be a member or manager.  A filing fee of $70 must be paid to the Secretary of State with the filing of the Articles.

                        The members of the company must enter into an operating agreement either before or after filing the Articles of Organization.  Although the operating agreement may be oral, it is highly advisable that it be written and that it address all material issues among the members.

                        Within 90 days after the Articles of Organization are filed, the company must file with the Secretary of State a statement of information identifying the name and address of the managers, the nature of the business activity to be conducted, the name and address of the agent for service of process and the address for the principal business office in California.  Like a corporation, an annual franchise tax of $800 is required for the privilege of doing business in California.  This tax is not due when the Articles are filed as it is with corporations.  Rather, it is due on or before the 15th day of the fourth month of the taxable year of the company.

            A.            SOLE PROPRIETORSHIP

                        In a sole proprietorship, management and control of the business is entirely under the direction of the owner.  No formal records or procedures must be followed in operating the business.

            B.        GENERAL PARTNERSHIP

                        A general partnership is ordinarily operated in accordance with the terms of the written partnership agreement.  In the absence of a written agreement providing otherwise, all partners have equal rights to manage and conduct partnership business.  It is important to recognize that each partner is an agent of the partner­ship for the purpose of conducting the business of the partnership.  Consequently, the act of any partner for the apparent purpose of carrying on the partnership's business in the usual manner binds the partnership and each of the other partners.  A written partnership agreement may restrict the authority of a particular partner to bind the partnership.  This restriction will not be effective against third parties unless they have knowledge of the restriction.  Under the theory of ostensible authority, a partner acting within the scope of his or her apparent authority may bind the partnership to an agreement and subject other partners to liability even though a partner is not actually authorized to enter into the agreement.

            C.        LIMITED PARTNERSHIPS

                        In a limited partnership, the business is managed by the general partner or partners.  Limited partners are not allowed to participate in the control of the business without risking the loss of their limited liability.  If there is only one general partner, he or she may operate with much more independence and autonomy than a board of corporate directors who are subject to annual election by the shareholders and generally number 3 or more unless there are less than 3 shareholders.  The result is that a limited partnership may centralize management and control in one individual to a greater extent than a corporation in some instances.

            D.              CORPORATIONS

                        Management and control of a corporation involves action by shareholders, directors, and officers.  Shareholders meet at least annually to review financial matters and elect a board of directors.  The directors meet annually following the shareholders meeting and at other times of the year as necessary.  The directors elect officers who run the business on a day to day basis.  Transactions outside the ordinary scope of daily business must be approved by the directors either at a special meeting of the board of directors or by a resolution adopted by unanimous written consent.

                        It is the function of the directors to determine corporate policy as well as approve action outside the ordinary course of business.  Those types of actions include raising capital, borrowing money, establishing salaries of officer/shareholders, lending money, major purchases, long term leases, and other matters that are particularly significant in the long term operation of the business.  Adherence to the formalities of properly conducting meetings and preparing minutes is essential to avoid a piercing of the corporate veil for liability purposes.

            E.        LIMITED LIABILITY COMPANY

                        A limited liability company is managed by its members unless the Articles of Organization state that the business will be managed by "managers".  Ordinarily, the written operating agreement specifies the manner in which the managers may conduct the business of the company.  In particular, it states any limitations on the rights of managers to act on behalf of a company.

                        Limited liability companies do not have particular requirements for annual meetings or the preparation of minutes as is true with respect to a corporation.  Generally, a limited liability company is managed more like a partnership than a corporation.  This is particularly true where the members are also the managers.

            A.        FEDERAL INCOME TAX CONSIDERATIONS

1. Sole Proprietorship: Schedule C is the form attached to the owner's 1040 return to report income and expenses of the business.

2. Partnership: K-1: A partnership files an income tax return but pays no federal tax.  All of the income is taxable to the partners at their individual rates regardless of whether the income is distributed or not.  Each partner receives a K-1 form showing his or her share of the partner's income or loss for that year. Each partner also must pay self-employment tax on his or her share of the partnership income.  It is noteworthy that there is no self-employment tax on a limited partner (or a member of a limited liability company) unless the member has personal liability, authority to contract on behalf of the company, or more than $500 of participation in the business each calendar year.  The foregoing applies to limited liability companies which are taxed as a partnership for federal income tax purposes.

3. C Corporation

                                         75,000                     100,000         13,750 + 34%                      75,000

            4. S Corporation: No federal income tax

                        The principal features of an S Corporation include the following:

                        a. Not more than 75 shareholders.

                        b. Each shareholder must be an individual, an estate, a tax exempt organization, or a qualified subchapter S trust.

                        c. Nonresident alien not permitted to be a shareholder.

                            d. One class of stock.

                           e. Insurance companies, foreign corporations, and domestic international sales corporations may not be S corporations.

                           f. If election terminates intentionally or inadvertently, the election may not normally be made again for 5 years.

                          g. A shareholder is taxed on his or her share of S corporation income, regardless of whether a distribution is made to the shareholder.

                          h. An S corporation is generally required to use a calendar year rather than a fiscal year.  See IRC Section 441.

            5. Transfer of Property to entity upon formation

                        a. Contribution of property to corporation will be taxable unless Section 351 applies where shareholder has 80% control after the transfer.

                         b. Contribution of services to corporation generally constitutes taxable income to the shareholder.

                       c. Contribution of services to a partnership in exchange for a partnership interest is generally not taxable if the partner receives only an interest in the profits.  If the partner receives an interest in the capital in exchange for contribution of services, the interest acquired may constitute taxable income.

            B.        STATE TAXATION

            1. Annual Franchise Tax of $800 applies to Corporations, Limited Partnerships and Limited Liability Companies

             2. C Corporation income tax rate: 8.84%

             3. S Corporation income tax rate: 1.5%

             4. Limited Liability Company fee on total income