Introduction

To help you make sure that forming a California corporation is the best legal and tax choice for your business, this chapter compares the California corporation to other small business legal structures. Our discussion is based upon recent tax and legal rule changes, and -- most significantly -- the rise in use of the limited liability company. This relatively new business structure shares some of the traditional legal and tax qualities of the corporation, while at the same time offering some of the less formal attributes of a partnership. The corporation continues, however, to stand apart from all other business forms because of its built-in organizational structure and unique access to investment sources and capital markets. It also continues to uniquely answer to a need felt by many business owners for the formality of the corporate form, a quality not shared by the other business structures.

The Different Ways of Doing Business

There are several legal structures or forms you can use to operate a business, including a sole proprietorship, partnership, limited liability company, or corporation. Two of these structures have important variants: The partnership form has spawned the limited partnership and the registered limited liability partnership. And the corporation can be recognized, for tax purposes, as either the standard C corporation or an S corporation. In a standard C corporation, the corporation and its owners are treated as separate taxpaying entities, whereas in an S corporation, business income is passed through the corporate entity and the owners are taxed on their individual tax returns.

Often, business owners start with the simplest legal form, the sole proprietorship, then move on to a more complicated business structure as their business grows. Other businesspeople pick the legal structure they like best from the start, and let their business grow into it. Either way, choosing the legal structure for your business is an important decision you must make when starting a business. The analysis that follows, which includes examples of businesses that might sensibly choose each type of business structure, should help you make a good decision.

For an expanded analysis and comparison of the different limited liability business forms, see LLC or Corporation? by Anthony Mancuso (Nolo).

Sole Proprietorship

A sole proprietorship is the legal name for a one-owner business.

Spousal Business. When a husband and wife carry on a business together and share in the profits and losses, generally they are considered co-owners of a partnership, not a sole proprietorship. There is an exception, however. A husband and wife who own an unincorporated business as community property in the community property states of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin, can choose to treat the business as a sole proprietorship. They do this by filing an IRS form 1040, Schedule C, for the business, listing one of the spouses as the owner. Only the listed spouse pays income and self-employment taxes on the reported Schedule C net profits. Presumably, only the listed Schedule C owner-spouse will receive social security account earning credits for the form SE taxes paid with the Form 1040 return. For this reason, some eligible spouses will decide not to make this Schedule C filing and will continue to file partnership tax returns for their jointly owned business. The IRS treats the filing of a Schedule C for a jointly owned spousal business as the conversion of a partnership to a sole proprietorship, which can have significant tax consequences. For more information, see "Forming a Partnership" in IRS Publication 541, and be sure to check with your tax advisor before deciding on the best way to own a business with your spouse.

Ease of Formation. The sole proprietorship is the easiest to establish legally. Just hang out your shingle or "Open for Business" sign, and you have established a sole proprietorship. Sure, there are other legal steps you may wish to take -- such as registering a fictitious business name different from your own individual name by filing a "dba statement" with the county clerk -- but these steps are not necessary to establish your business legally.

Personal Liability for Business Debts, Liabilities, and Taxes. In this simplest form of small business legal structures, the owner, who usually runs the business, is personally liable for its debts, taxes, and other liabilities. Also, if the owner hires employees, he or she is personally responsible for claims made against these employees acting within the course and scope of their employment.

Simple Tax Treatment. All business profits (and losses) are reported on the owner's personal income tax return each year (using Schedule C, Profit or Loss From Business, filed with the owner's 1040 federal income tax return). And this remains true even if a portion of this money is invested back in the business -- that is, even if the owner doesn't pocket business profits for personal use.

Legal Life Same as Owner's. On the death of its owner, a sole proprietorship simply ends. The assets of the business normally pass under the terms of the deceased owner's will or trust, or by intestate succession (under the state's inheritance statutes) if there is no formal estate plan.

Don't let business assets get stuck in probate. The court process necessary to probate a will can take more than a year. In the meantime, it may be difficult for the inheritors to operate or sell the business or its assets. Often, the best way to avoid having a probate court involved in business operations is for the owner to transfer the assets of the business into a living trust during his or her lifetime; this permits business assets to be transferred to inheritors promptly on the death of the business owner, free of probate. For detailed information on estate planning, including whether or not it makes sense to create a living trust, see Plan Your Estate, by Denis Clifford and Cora Jordan (Nolo).

Sole Proprietorships in Action. Many one-owner or spouse-owned businesses start small with very little advance planning or procedural red tape. Celia Wong is a good example -- Celia is a graphic artist with a full-time salaried job for a local book publishing company. In her spare time she takes on extra work using her home computer to produce audio cassette and CD jacket cover art for musicians. These jobs are usually commissioned on a handshake or phone call. Without thinking much about it, Celia has started her own sole proprietorship business. Celia should include a Schedule C in her yearly federal 1040 individual tax return, showing the net profits (profits minus expenses) or losses of her sole proprietorship. Celia is responsible for paying income taxes on profits, plus self-employment (social security) taxes based on her sole proprietorship income (IRS Form SE is used to compute self-employment taxes; Celia attaches it to her 1040 income tax return).

If Celia has any business debts (she usually owes on a charge account at a local art supply house), or a disgruntled client successfully sues her in small claims court for failing to deliver prepaid art work, Celia is personally liable to pay this money. In other words, she can't simply fold up Wong Designs and walk away from her debts claiming that they are the legal responsibility of her business only.

Put some profits aside to buy business insurance. Once Celia begins to make enough money, she should consider taking out a commercial liability insurance policy to cover legal claims against her business. While insurance normally won't protect you from business mistakes (like performing incomplete or late work or failing to pay bills), it can cover many risks including slip-and-fall lawsuits, damage to your or a client's property, or fire, theft, and other casualties that might occur in a home-based business.

Running the business as an informal sole proprietorship serves Celia's needs for the present. Assuming her small business succeeds, she will eventually need to put it on a more formal footing by establishing a separate business checking account, possibly coming up with a fancier name and registering it as a dba with the county clerk. If she hires employees, she will need to obtain a federal Employer Identification Number (EIN) from the IRS. She may also feel ready to renovate her house to separate her office space from her living quarters (this can also help make the portion of the mortgage or rent paid for the office deductible as a business expense on her Schedule C).

Celia can do all of this and still keep her sole proprietorship legal status. Unless her business grows significantly or she takes on work that puts her at a much higher risk of being sued -- and therefore being held personally liable for business debts -- it makes sense for her to continue to operate her business as a sole proprietorship.

A great source of practical information on how to start and operate a small sole proprietorship is Small Time Operator, by Bernard Kamoroff (Bell Springs Press). Also, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo), a small business guide to taxes, which includes a full discussion of setting up and deducting the expenses of a home-based business.

Partnership

A partnership is simply an enterprise in which two or more co-owners agree to share in the profits of a business activity. No written partnership agreement is necessary. If two people go into business together, and do not incorporate or form a limited liability company, they automatically establish a legal partnership. Partnerships are governed by each state's partnership law. But since all states have adopted a version of the Uniform Partnership Act, laws are very similar throughout the U.S. mostly, these laws contain basic rules that provide for an equal division of profits and losses among partners and establish the partners' legal relationship with one another. These rules are not mandatory in most cases, and you can (and should) spell out your own rules for dividing profits and losses and operating your partnership in a written partnership agreement. If you don't prepare your own partnership agreement, all provisions of California's partnership law apply to your partnership.

A general partnership has the following characteristics:

Each partner has personal liability. Like the owner of a sole proprietorship, each partner is personally liable for the debts and taxes of the partnership. In other words, if the partnership assets and insurance are insufficient to satisfy a creditor's claim or legal judgment, the partners' personal assets can be attached and sold to pay the debt.

The act or signature of each partner can bind the partnership. Each partner is an agent for the partnership and can individually hire employees, borrow money, sign contracts, and perform any act necessary to the operation of the business. All partners are personally liable for these debts and obligations. This rule makes it essential that the partners trust each other to act in the best interests of the partnership and each of the other partners.

Partners report and pay individual income taxes on profits. A partnership files a yearly IRS Form 1065, U.S. Partnership Return of Income, which includes a schedule showing the allocation of profits, losses, and other tax items to all partners (Schedule K). The partnership must mail individual schedules (Schedule K-1s) to each partner at the end of each year, showing the items of income, loss, credits, and deductions allocated to each partner. When a partner files an individual income tax return, she reports her allocated share of partnership profits (taken from the partner's Schedule K-1), and pays individual income taxes on these profits. As with the sole proprietorship, partners owe tax on business profits even if they are plowed back into the business.

Partnership dissolves when a partner leaves. Legally, when a partner ceases to be associated with carrying on the business of the partnership (when he or she withdraws or dies), the partnership is dissolved. However, a properly written partnership agreement provides in advance for these eventualities, and allows for the continuation of the partnership by permitting the remaining partners to buy out the interest of the departing or deceased partner. Of course, if one person in a two-partner business leaves or dies, the partnership is legally dissolved -- you need at least two people to have a partnership.

Watch out for a partnership tax termination. A partnership terminates for tax purposes if 50% or more of the interest in the partnership's capital and profits are sold or exchanged within a 12-month period. Under these circumstances, the partnership might continue legally under the terms of the partnership agreement, but would terminate for tax purposes. Upon the deemed termination of partnership, each partner could owe significant income taxes. (I.R.C. § 708(b).)

For a much more thorough look at the legal and tax characteristics of partnerships, and for a clause-by-clause approach to preparing a partnership agreement, see The Partnership Book, by Denis Clifford and Ralph Warner (Nolo).

Partnerships in action. George and Tamatha are good friends who have been working together in a rented warehouse space where they share a kiln used to make blown glass pieces. They recently collaborated on the design and production of a batch of hand-blown halogen light fixtures, which immediately become popular with local lighting vendors. Believing that they can streamline the production of these custom pieces, they plan to solicit and fill larger orders with retailers, and look into wholesale distribution. They shake hands on their new venture, which they name "Halo Light Sculptures." Although they obtain a business license and file a dba statement with the county clerk showing that they are working together as "Halo Light Sculptures," they don't bother to write up a partnership agreement. Their only agreement is a verbal one to equally share in the work of making the glass pieces and splitting expenses and any profits that result.

This type of informal arrangement can make sense for the very early days of a co-owned business, where the owners, like George and Tamatha, wish to split work, expenses, profits, and losses equally. However, for the reasons mentioned earlier, from the moment the business looks like it has long-term potential, the partners should prepare and sign a written partnership agreement. Furthermore, if either partner is worried about personal liability for business debts or the possibility of lawsuits by purchasers of the fixtures, then forming a limited liability company or a corporation probably would be a better business choice.

The Limited Liability Company

The limited liability company (LLC) is the new kid on the block of business organizations. It has become popular with many small business owners, in part because it was custom-designed by state legislatures to overcome particular limitations of each of the other business forms, including the corporation. Essentially, the LLC is a legal ownership structure that allows owners to pay business taxes on their individual income tax returns like partners (or, for a one-person LLC, like a sole proprietorship), but also gives the owners the legal protection of personal limited liability for business debts and judgments as if they had formed a corporation. Or, put another way, with an LLC you can simultaneously achieve the twin goals of one-level taxation of business profits and limited personal liability for business debts.

Licensed professionals can't form an LLC in California. Only businesses that render services under nonprofessional, occupational licenses can form an LLC in California. Professionals who must form a professional corporation if they incorporate (doctors, architects, lawyers, pharmacists, and so on) are the same group of professionals who can't form an LLC in the state. There may be others, however, who fall into this group. If you provide any type of licensed service that might be considered a professional service, contact your state licensing board and ask if you are allowed to form an LLC in California before getting started on the process.

Here are some of the most important LLC characteristics:

Limited liability. The owners (members) of an LLC are not personally responsible for the LLC's debts and other liabilities. Specifically, members are not personally liable for any debt, obligation, or liability of the LLC, whether that liability or obligation comes from a contract dispute, tort (injury to other persons or damage to their property), or any other type of claim. This type of sweeping personal legal liability protection is the same as that enjoyed by shareholders of a California corporation. In short, the LLC and the corporation offer the same level of limited personal liability protection.

Pass-through taxation. Federal tax law normally treats an LLC like a partnership, unless the LLC elects to be taxed as a corporation (by filing IRS Form 8832). The California Franchise Tax Board treats a California LLC for state income tax purposes as it is treated for federal income tax purposes. An LLC with an annual gross income of $250,000 or more must pay an additional annual fee, based upon a graduated fee schedule that is subject to adjustment from year to year.

If an LLC is treated as a partnership at the federal and state levels, it files a standard partnership tax return (IRS Form 1065, Schedules K and K-1) with the IRS (and Form 568 with the state). The LLC members (owners) pay taxes on their share of LLC profits on their individual federal and state income tax returns. An LLC that elects corporate tax treatment files federal and state corporate income tax returns.

Ownership requirements. You can form an LLC with only one owner (member). Members need not be residents of California, or even the U.S. for that matter. Other business entities, such as a corporation or another LLC, can be LLC owners.

Management flexibility. LLCs are normally managed by all the owners (members) -- this is known as member-management. But state law also allows for management by one or more specially appointed managers (who may be members or nonmembers). Not surprisingly, this arrangement is known as manager-management. In other words, an LLC can appoint one or more of its members, one of its CEOs, or even a person contracted from outside the LLC, to manage its affairs. This setup makes sense if one person wishes to assume full-time control of the LLC while the other owners act as passive investors in the enterprise.

Formation requirements. Like a corporation, LLCs require paperwork to get going. Articles of organization must be filed with the California Secretary of State. And if the LLC is to maintain a business presence in another state, such as a branch office, it also must file registration or qualification papers with the other state's secretary of state or department of state. California's LLC formation fee is $70. California LLCs, like California corporations and limited partnerships, must pay an annual minimum $800 tax to the Franchise Tax Board. There is an additional LLC annual fee, with a tiered rate structure, for LLCs with annual gross incomes of $250,000 or more. The additional fee may be anywhere from $900 to $11,790.

Add in the cost of goods sold when computing annual gross income. A California LLC engaged in an active trade or business must include its cost of goods sold. (Typically, the cost of goods sold is subtracted from gross income.) This means that even unprofitable LLCs can be subject to the annual LLC fee. Ask your tax advisor for more information.

Like a partnership, an LLC should prepare an operating agreement to spell out how the LLC will be owned, how profits and losses will be divided, how departing or deceased members will be bought out, and other essential ownership details. However, preparation of an LLC operating agreement is not legally required. If it is not prepared, the default provisions of California's LLC act will apply to the operation of the LLC. Because LLC owners will want to control exactly how profits and losses are apportioned among the members rather than following the default rules set out in the LLC Act, preparing an LLC operating agreement is a practical necessity.

See Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo). It contains instructions on how to form a California LLC, prepare an operating agreement (member- and manager-managed agreements are included), and handle all other LLC formation formalities.

LLCs in action. Under the name "Aunt Jessica's Floral Arrangements," Barry and Sam jointly own and run a flower shop that specializes in unique flower arrangements (the name stems from the fact that Barry used to work for his aunt Jessica, who taught him the ropes of floral bouquet design). Lately, business has been particularly rosy, and the two men plan to sign a long-term contract with a flower importer to supply them with larger quantities of seasonal flowers. Once they receive the additional flowers, they will be able to create more floral pieces and wholesale them to a wider market. Both men are aware that they will encounter more risks as their business grows. Accordingly, they decide to protect their personal assets from business risks by converting their partnership to an LLC. They could accomplish the same result by incorporating, but they prefer the simplicity of paying taxes on their business income on their individual income tax returns (rather than reporting profits and paying business taxes on a separate corporate income tax return). They also realize that they can convert their LLC to a corporation later to obtain the advantage of lower corporate tax rates on money kept in the flower business or, even more simply, make an IRS election to have their LLC taxed as a corporation without changing its legal structure.

The Corporation

Now let's look at the basic attributes of the corporation, the type of business organization this book shows you how to organize.

A corporation is a statutory creature, created and regulated by state law. In short, if you want the privilege -- as the courts call it -- of turning your business enterprise into a California corporation, you must follow the requirements of the California Corporations Code.

What sets the corporation apart from all other types of businesses is that it is a legal entity separate from any of the people who own, control, manage, or operate it. The state corporation and federal and state tax laws view the corporation as a legal person -- it can enter into contracts, incur debts, and pay taxes separately from its owners.

Limited Personal Liability

Like the owners (members) of an LLC, the owners (shareholders) of a corporation are not personally liable for the corporation's business debts, claims, or other liabilities. This means that a person who invests in a corporation (a shareholder) normally only stands to lose the amount of money or the value of the property which he or she has paid for its stock. As a result, if the corporation does not succeed and cannot pay its debts or other financial obligations, creditors cannot seize or sell the corporate investor's home, car, or other personal assets.

EXAMPLE: Rackafrax Dry Cleaners, Inc., a California corporation, has several bad years in a row. When it finally files for bankruptcy it owes $50,000 to a number of suppliers and $80,000 as a result of a lawsuit for uninsured losses stemming from a fire. Stock in Rackafrax is owned by Harry Rack, Edith Frax, and John Quincy Taft. Their personal assets cannot be taken to pay the money Rackafrax owes.

Exceptions to the Rule of Personal Limited Liability Protection

In some situations, corporate directors, officers, and shareholders of a corporation can be held responsible for debts owed by their corporation. Here are a few of the most common exceptions to the rule of limited personal liability (these exceptions also apply to other limited liability business structures, such as the LLC):

Personal guarantees. When a bank or other lender makes a loan to a small corporation, particularly a newly formed one, it often requires that the people who own the corporation agree to repay it from their personal assets should the corporation default on the loan. Shareholders may even have to pledge equity in a house or other personal assets as security for repayment of the debt. Of course, shareholders can just say no -- but if they do, their corporation may not qualify for the loan.

Federal and state taxes. If a corporation fails to pay income, payroll, or other taxes, the IRS and the California Franchise Tax Board are likely to attempt to recover the unpaid taxes from responsible employees -- a category that often includes the principal directors, officers, and shareholders of a small corporation.

Unlawful or unauthorized transactions. If you use the corporation as a device to defraud third parties, or if you deliberately make a decision (or fail to make one) that results in physical harm to others or their property (such as failing to maintain premises or a work site properly, manufacturing unsafe products, or causing environmental pollution), a court may pierce the corporate veil and hold the shareholders of a small corporation individually liable for damages (monetary losses) caused to others.

Fortunately, most of the problem areas where you might be held personally liable for corporate obligations can be avoided by following a few commonsense rules (rules you'll probably adhere to anyway). First, don't do anything that is dishonest or illegal. Second, make sure your corporation does the same, by having it obtain necessary permits, licenses, or clearances for its business operations. Third, pay employee wages and withhold and pay corporate income and payroll taxes on time. Fourth, don't personally obligate yourself to repay corporate debts or obligations unless you fully understand and accept the consequences.

Corporate Tax Treatment

Let's now look at a few of the most important tax characteristics of the corporation. We'll start with the dual level of taxation built into the corporate business structure.

Dual Taxation and Income Splitting

The corporation is a taxpayer, with its own income tax rates and tax returns separate from the tax rates and tax returns of its owners. This separate layer of taxation allows corporate profits to be kept in the business and taxed at the initial corporate tax rates, which are generally lower than the marginal (top) tax rates of the corporation's owners. The result of this type of business income splitting between the corporation and its owners can result in an overall tax savings for the owners (compared to pass-through taxation of all business profits to the owners, which is the standard tax treatment of sole proprietorships, partnerships, and LLCs).

EXAMPLE: Jeff and Sally own and work for their own two-person corporation, Hair Looms, Inc., a mail order synthetic wig supply business that is starting to enjoy popularity with overseas purchasers. To keep pace with the surge in orders, they need to expand by reinvesting a portion of their profits back in the business. Since Hair Looms is incorporated, only the portion of the profits paid to Jeff and Sally as salary is reported and taxed to them on their individual tax returns -- let's assume their marginal (top) tax rate is over 30%. By contrast, the first $50,000 in profits left in the business for expansion is reported on Hair Looms' corporate income tax return and taxed at the lowest corporate tax rate of only 15%. The next $25,000 is taxed at 25%.

Corporate tax rates max out at 34% for most corporations. Even though corporate tax rates can go up to 39%, all corporate net income below $10 million is subject to an effective flat tax rate of 34%. (See Chapter 4.)

LLCs and partnerships can elect corporate tax treatment. Dual taxation and income splitting are no longer unique to corporations. Partnerships and LLCs can elect to be taxed as corporations if they wish to keep money in the business and have it taxed at corporate rates. (See "Partnerships Can Choose to Be Taxed As Corporations," above.)

Corporations Can Elect Pass-Through Taxation of Profits

Just as partnerships and LLCs have the ability to request corporate tax treatment, corporations can change their tax treatment to the type of pass-through taxation that normally applies to partnerships and LLCs. A corporation accomplishes this by making an S corporation tax election with the IRS.

When just starting out, form an LLC instead. An LLC, like an S corporation, gives its owners pass-through taxation of business profits plus limited personal liability for business debts. It also is more flexible than an S corporation for technical reasons (see "LLCs and Partnerships Have Technical Tax Advantages Over S Corporations," below). Therefore, it usually makes more sense to form an LLC when you are just starting to organize your business.

If you are already doing business as a corporation, switching over to S corporation tax status -- by making an S corporation tax election -- makes sense if you wish to keep your corporation intact but want pass-through treatment of profits and losses to save tax dollars. This might be true, for example, for a corporation that no longer wishes to keep profits in the business, but can't pay all of them out to shareholders as salaries (if some shareholders don't work for the corporation or if the payout of all profits as salaries would render them excessive and subject to IRS attack, for example). It also may be true if a corporation begins to lose money and the owners want to deduct these losses on their individual income tax returns to offset other income (a number of technical hurdles must be overcome for this pass-through of losses in an S corporation to work -- see "LLCs and Partnerships Have Technical Tax Advantages Over S Corporations," below, for more information).

The only other way an existing corporation can get the limited liability protection and pass-through tax treatment of the S corporation is to dissolve, then reorganize as an LLC. This can be costly from a legal and tax perspective and a lot more trouble than simply electing S corporation tax status.

U.S. corporations with 100 or fewer shareholders who are U.S. citizens or residents can elect federal S corporation tax treatment by filing IRS Form 2553. Once an S corporation election is made with the IRS, the corporation is automatically treated as a California S corporation. It can opt out of S corporation treatment by filing FTB Form 3560 with the California Franchise Tax Board. An S corporation has all its profits, losses, credits, and deductions passed through to its shareholders, who report these items on their individual tax returns. In effect, this allows the corporation to sidestep federal corporate income taxes on business profits, passing the profits (and the taxes that go with them) along to the shareholders. Each S corporation shareholder is allocated a portion of the corporation's profits and losses according to her percentage of stock ownership in the corporation (a 50% shareholder reports and pays individual income taxes on 50% of the corporation's annual profits, for example).

These profits are allocated to the shareholders whether the profits are actually paid to them or kept in the corporation.

EXAMPLE: Fred's furniture and appliance was incorporated during a period of fast business growth, when Fred brought in two relatives as investors and moved his business to a larger storefront in an upscale neighborhood. He chose the corporate form to limit his and the investors' personal liability and to accommodate his investors by issuing them shares in his business. With the business growing fast, the investors wanted to see some return of profits. Fred elects S corporation tax treatment. Net profits of the business pass through to the S shareholders directly and are taxed on their individual income tax returns. This meets the investors' needs and avoids the double tax that would have been paid if profits were distributed to the investors as dividends. This also helps Fred, since he can keep his corporate salary reasonably low and still get money out of his corporation. Also, S corporation profits allocated to shareholders, unlike salaries, are not subject to self-employment taxes. (See Chapter 4.) This means Fred ends up with more after-tax money in his pocket.

Tax Consequences of Corporate Dissolution

You should consider an additional tax aspect of forming a corporation before deciding to incorporate -- the tax consequences of ending the corporation when it is dissolved or sold. The general rule is that when a corporation is sold or dissolved, both the corporation and its shareholders have to pay tax on appreciated corporate assets. However, there are ways to minimize this double tax, if you plan in advance. The primary strategy is to arrange for a sale of stock (not assets) when the corporation is sold. (Best of all is a tax-free sale of stock/assets as part of a tax-free reorganization that is a merger with an acquiring corporation.) Check with your tax advisor on the eventual tax ramifications of dissolving your corporation right from the start. One of the most important pre-incorporation services your tax advisor can provide is to make sure that the future dissolution or sale of your corporation will not result in an unexpectedly hefty tax bill for your corporation and its owners.

Owners Who Work in the Business Are Treated as Employees

A potential benefit of the corporate structure is that business owners who also work in the business become employees. This means that you, in your role as an employee, become eligible for tax-deductible corporate fringe benefits, some of which you would not qualify for as a sole proprietor, partner, or an LLC member.

For example, Henry incorporates his California sole proprietorship, "Big Sur Shoes, Inc." He now works as a full-time corporate employee and is entitled to tax-deductible corporate perks, such as reimbursement for medical expenses and $50,000 worth of group term life insurance paid for by his business. If he gave himself these perks in his unincorporated business, his business could deduct them as ordinary and necessary business expenses, but he would have to report them as income and pay income taxes on them. Corporation employees also receive special tax benefits if they are issued qualified incentive stock options, restricted stock, and other forms of equity-sharing participation interests unique to corporations. (See Chapter 4 for more on corporate fringe and equity benefits.)

Built-In Organizational Structure

Perhaps the most unique benefit of forming a corporation is the ability to divide management, executive decision making, and ownership into separate areas of corporate activity. This separation is achieved automatically because of the separate legal roles which reside in the corporate form: the roles of directors (managers), executives (officers), and owners (shareholders). Unlike partnerships and LLCs, the corporate structure comes ready-made with a built-in separation of these three roles, each with its own legal authority, rules, and ability to participate in corporate income and profits.

EXAMPLE 1: Myra, Danielle, and Rocco form their own three-person corporation, Skate City, Incorporated, a skate and bike shop in Venice Beach, Los Angeles. Storefront access to the Venice Beach rollerblade, skating, and bike path makes it popular with local rollerbladers and bicyclists. Needing more cash, the three approach relatives for investment capital. Rocco's brother, Tony, and Danielle's sister, Collette, chip in $10,000 each in return for shares in the business. Myra's Aunt Kate lends the corporation $25,000 in return for an interest-only promissory note, with the principal amount to be repaid at the end of five years. Here's how the management, executive, and financial structure of the corporation breaks down:

Board of Directors. The management team, which meets once each quarter to analyze and project financial performance and review store operations, consists of the three founders, Myra, Danielle, and Rocco, and one of the other three investors. The investor board position is a one-year rotating seat. This year Tony has the investor board seat; next year, Collette; the third year, Aunt Kate. This pattern repeats every three years. Directors have one vote apiece, regardless of share ownership -- this means the founders can always outvote the investor vote on the board, but this also guarantees that each of the investors will have an opportunity to hear board discussions and give input on major management decisions.

Executive Team. The officers or executive team charged with overseeing day-to-day business; supervising employees; keeping track of ordering, inventory, and sales activities; and generally putting into practice the goals set by the board are Myra (president) and Danielle (vice president). Rocco fills the remaining officer positions of secretary/treasurer of the corporation, but this is a part-time administrative task only. Rocco's real vocation -- or avocation -- is blading along the beach and training to be a professional, touring rollerblader with his own corporate sponsor (maybe Skate City if profits continue to roll in).

Participation in Profits. Corporate net profits are used to stock inventory, pay rent on the West End storefront, and pay all the other usual and customary expenses of doing business. The two full-time executives, Myra and Danielle, get a corporate salary, plus a year-end bonus when profits are good. Rocco gets a small stipend (hourly pay) for his part-time work. Otherwise, he and the two investor shareholders are simply sitting on their shares. Skate City is not in a position yet to pay dividends -- all excess profits of the corporation are used to continue expanding the store's product lines and add a new service facility at the back of the store. Even if dividends are never paid, all three know that their stock will be worth a good deal if the business is successful. They can cash in their shares when the business sells or when they decide to sell their shares back to the corporation (or, who knows, if Skate City goes public someday). Aunt Kate, the most conservative of the investment group, will look to ongoing interest payments as her share in corporate profits, getting her capital back when the principal amount of her loan is repaid.

As you can see from this example, the mechanisms to put this custom-tailored management, executive, and investment structure into place are built into the Skate City corporation. To erect it, all that is needed is to fill in a few blanks on standard incorporation forms, including stock certificates, and prepare a standard promissory note. To duplicate this structure as a partnership or LLC would require a specially drafted partnership or LLC operating agreement with custom language and plenty of review by the founders and investment group (and, no doubt, their lawyers). The corporate form is designed to handle this division of management, day-to-day responsibilities, and investment with little extra time, trouble, or expense.

There is a flip side to this division of corporate positions and participation in profits. Some business people -- particularly those who run a business by themselves or who prefer to run a co-owned business informally -- feel that the extra levels of corporate operation and paperwork are a nuisance. That's why incorporating may be a bit of an overload for small start-up companies -- they may be better and more comfortably served by the less formal business structures of the sole proprietorship or partnership, or, if limited legal liability is an overriding concern, by the LLC legal structure.

But for many business owners, the ability to separate out corporate management and oversight from day-to-day executive decisions, plus the ability to treat people who invest in the business strictly in their capacities as co-owners and not as active day-to-day participants, makes the corporate model extremely attractive. The fact that there are legal differences among directors, officers, and shareholders becomes particularly attractive as a business grows and people from outside the initial circle of incorporators become involved in the business (as investors, lenders, or even public shareholders).

EXAMPLE 2: Leila runs a lunch counter business that provides her both a decent income and an escape from the cubicled office environment in which she was once unhappily ensconced. Business has been slow, but Leila has a new idea to give the business more appeal, as well as make it more fun for her. She changes the decor to reflect a tropical motif, installs a salt water aquarium facing the lunch counter, adds coral reef (metal halide) lighting and light-reflective wall paneling, and renames the business the "The Tide Pool." The standard lunch counter fare is augmented with a special bouillabaisse soup entrée and a selection of organic salads and fruit juice drinks, and a seafood and sushi dinner menu is added to cater to the after-work crowd. Leila has her hands full, doing most of the remodeling work herself and preparing the expanded menu each day.

The new operation enjoys great success, and a newspaper in the nearby capital city features the Tide Pool in an article on trendy eating spots, giving it a rave review. Patronage increases and Leila hires a cook and three waiters to help her.

A local entrepreneur, Sally, who represents an investment group, asks Leila if she would be interested in franchising other Tide Pools throughout the country. Sally says an investment group would help develop a franchise plan, plus fund the new operation. Leila would be asked to travel to help set up franchise operations for the first year, and would have a managerial role and substantial stake in the new venture.

Leila likes the idea -- sure, she'll have to get back into the working world, but on her own terms, and as a consultant and business owner. Besides, she's feeling overworked running the Tide Pool by herself, and it would be a relief to have the new venture take over the business. The investment group wants a managerial role in the franchise operation, plus a comprehensive set of financial controls. Leila and the investment group agree to incorporate the new venture as "Tide Pool Franchising, Inc." The corporate business structure is a good fit. Leila will assume a managerial role as a director of the new company, along with Sally and a member of the venture capital firm. The new firm hires two seasoned small business people, one as president and one as treasurer, to run the new franchise operation. Business begins with the original Tide Pool as the first franchise, and Leila gets started working for a good salary, plus commission, setting up other franchise locations.

If the new venture makes a go of it, Leila and the investment group can either sell their shares back to the corporation at a healthy profit or, if growth is substantial and consistent, take the company public in a few years, selling their stock in the corporation at a sizable profit once a market has been established for the corporation's publicly held shares.

Raising Money -- Corporate Access to Private, Venture, and Public Capital

Corporations offer a terrific structure for raising money from friends, family, and business associates. There is something special about stock ownership, even in a small business, that attracts others. The corporate structure is designed to accommodate various capital interests -- for example, you can issue common voting shares to the initial owner-employees, set up a special nonvoting class of shares to distribute to key employees as an incentive to remain loyal to the business, and issue yet another preferred class of stock (one that gives investors a preference if dividends are declared or the corporation is sold) to venture capitalists willing to help fund future expansion of your corporation.

Incorporated businesses also have an easier time obtaining loans from banks and other capital investment firms (assuming a corporation's balance sheet and cash flow statements look good). That's partially due to the increased structural formality of the corporation (discussed above). In addition, loans can be made part of a package where the bank or investment company obtains special rights to choose one or more board members, or has special voting prerogatives in matters of corporate governance or finance. For example, a lender may require veto power over expenditures exceeding a specified amount. The range of capital arrangements possible, even for a small corporation, is almost limitless, which helps the corporation attract outside investment.

Employees often prefer to work for corporations. Key employees are more likely to work for a business that offers them a chance to profit if future growth is strong through the issuance of stock options and stock bonuses -- financial incentives that only the corporate form can provide.

Perpetual Existence

A corporation is, in some senses, immortal. Unlike a sole proprietorship, partnership, or an LLC, which can terminate upon the death or withdrawal of the owner or owners, a corporation has an independent legal existence that continues despite changeovers in management or ownership. Of course, like any business, a corporation can be terminated by the mutual consent of the owners for personal or economic reasons and, in some cases, involuntarily, as in corporate bankruptcy proceedings. Nonetheless, the fact that a corporation does not depend for its legal existence on the life or continual ownership interest of a particular individual does influence creditors, employees, and others to participate in the operations of the business. This is particularly true as the business grows.

Downsides of Incorporating

Just about everything, including the advantage of incorporating, comes at a price. And, of course, the answer to the question "How much does it cost?" is an important factor to weigh when considering whether to incorporate your business. For starters, a corporation, unlike a sole proprietorship or general partnership, requires the filing of formation papers -- articles of incorporation -- with the California Secretary of State. The filing cost is $100. corporations must pay an annual franchise tax (as explained in Chapter 4). Ongoing paperwork is generally not burdensome, but you will have to hold and document annual meetings of shareholders and directors and keep minutes of important corporate meetings. Creating this paper trail is a good way to show the IRS, in case of an audit (or the courts, in case of a lawsuit which tries to hold shareholders personally liable), that you have, in fact, respected the corporate form and are entitled to claim (hide behind) its insulating layer of limited personal liability.

You can take care of ongoing corporate paperwork at minimal expense by using The Corporate Records Handbook, by Anthony Mancuso (Nolo). This book contains minute forms to hold corporate meetings and helps corporations cope with the tax, business, legal, and financial decisions and transactions that commonly arise during the life of the business.

The other main disadvantage of incorporating has traditionally been the $1,000 to $2,000 (or more) you could expect to pay an attorney for creating the initial paperwork. This book, together with a little effort on your part, should significantly reduce, if not eliminate, this cost.

Corporations in action. Sal Sr. and his son, Sal Jr., co-own and run Sal's Mimeo and Copy Center, a family business run for over 30 years as a partnership with a minimum of legal paperwork. In fact, before Sal Jr. joined the partnership firm, Sal Sr. ran the business as a sole proprietorship. Sal Sr. is retiring, letting Sal Jr., a business school grad, take over operational control.

Sal Jr. plans to expand the business by bringing in two business school friends, Ellen and Wilbur, as investors. Sal Jr. will contribute the business and its assets (including a long-term commercial lease to its storefront location and goodwill), to the new operation. Ellen and Wilbur will invest cash in two ways: Each will pay cash in return for shares, and each will also lend money to the business in exchange for promissory notes, which will be repaid by the firm. Interest only will be paid by the business on the notes over a five-year period, with repayment of the principal amount at the end of loan term. Ellen and Wilbur hope that in five to seven years they can sell their shares back to Sal Jr. at an increased price per share, or to another company wishing to buy into Sal's business. In the meantime, they are content to look to the interest payments on their notes as an adequate return on their investment in the business.

Sal Jr. will work as full-time manager of the business, which will continue to offer traditional copying services. In addition, the new capital will be used to expand into desktop publishing aimed at both the small business and the student markets.

Sal Jr., seeing that a change in business structure is needed to give Ellen and Wilbur a stake in the business, decides to incorporate. The investors like the corporate form because it limits their personal liability for its debts and other liabilities. Incorporating also should give the business a lift in its lending status at the local bank, which likes the fact that Sal Jr. is formalizing and expanding his business operations. Sal Jr. also realizes that forming a corporation will have tax advantages since it is one good way to split business income between the business entity, the investors, and himself. Specifically, the corporate form allows Sal to leave profits in the business, part of which will be used to pay back and retire Ellen's and Wilbur's promissory notes. Of course, the corporation will get to deduct Sal's salary and fringe benefits (as well as those of his employees) as well as the interest paid on the investors' notes. In short, the corporate form, with its built-in limited liability legal status, income- and tax-splitting capability and stock ownership structure, suits Sal's new business needs to a T.

Comparing Business Entities at a Glance

In the tables that follow, we highlight and compare general and specific legal and tax traits of each type of business entity. We include a few technical issues in our chart to tweak your interest. Should any of the additional points of comparison seem relevant to your particular business operation, we encourage you to talk them over with a legal or tax professional.

For an in-depth legal and tax comparison of limited liability entities, see LLC or Corporation? by Anthony Mancuso (Nolo).

[Business Entity Comparison Tables] omitted for online sample chapter.