Choosing the Right Business Entity a Critical Decision

9:11 pm Business Formation

choice e1336511185349 Choosing the Right Business Entity a Critical DecisionOne of the first important decisions a business owner or practicing professional has to address is selecting the proper form of business entity.  This is a crucial decision because of its ongoing legal and tax consequences.

Liability protection is the most important non-tax consideration in the business entity selection process.  The business owner has to have a shield or umbrella of liability covering his/her business activities in order to protect their other non-business assets from liability exposure.  There should be no debate over whether or not to create a liability-shielded entity in which to operate the business or to go “bare” and operate as a proprietorship or a general partnership.  The business owner has to either incorporate and operate as a corporation or set up a limited liability company and operate the business as an LLC.

A corporation is a separate legal entity that is state chartered and created.  For tax purposes, a corporation is either a C Corporation, which is taxed as a completely separate entity from the shareholders, or an S Corporation, which is a pass through entity that is taxed similarly to a partnership.  For legal purposes, there is no distinction between a C Corp and an S Corp.

The major advantage of a corporation is that it affords a shield of liability protecting the shareholder owners from claims against the business.  It is a perpetual entity and, therefore, is a good vehicle for estate planning purposes.

The major disadvantage of a C Corporation, with respect to tax considerations, is the fact that a double tax can result on corporate profits.  The profits are taxed at the corporate level and then again at the shareholder level if they are distributed as dividends.  In a closely held corporation whose owners are involved in the corporate business, the problem of double taxation can be avoided by taking the profits as salaries.  If there are passive investors such as shareholders who do not directly work for the corporation, double tax remains a major problem.  The S Corporation is highly favored because of the double tax situation that occurs not only with respect to the operating income of the business, but also upon the eventual sale of the business.

For more information on choosing the right business entity for your California business, contact our Orange County law firm.

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