Chapter 1
Choosing a Legal Structure

Sole Proprietorships..................................................................................... 9

Pass-Through Taxation......................................................................... 10

Personal Liability for Business Debts.................................................... 11

Creating a Sole Proprietorship.............................................................. 11

Partnerships............................................................................................... 12

General Versus Limited Partnerships .................................................. 12

Pass-Through Taxation......................................................................... 13

Personal Liability for Business Debts.................................................... 13

Partnership Agreements ...................................................................... 14

Limited Liability Companies (LLCs)........................................................... 17

Limited Personal Liability....................................................................... 17

LLC Taxation......................................................................................... 18

LLCs Versus S Corporations................................................................. 19

Forming an LLC.................................................................................... 20

Corporations.............................................................................................. 20

Limited Personal Liability....................................................................... 21

Corporate Taxation............................................................................... 22

Forming and Running a Corporation..................................................... 24

Choosing the Best Structure for Your Business........................................ 25

You probably already have a rough idea of the type of legal structure your business
will take, whether you know it or not. That’s because, in large part, the ownership structure that’s right for your business—a sole proprietorship, partnership, LLC, or corporation—depends on how many people will own the business and what type of services or products it will provide, things you’ve undoubtedly thought about quite a bit.

For instance, if you know that you will be the only owner, then a partnership is obviously not your thing. (A partnership by definition has more than one owner.) And if your business will engage in risky activities (for example, trading stocks or repairing roofs), you’ll want not only to buy insurance, but also to consider forming an entity that provides personal liability protection (a corporation or a limited liability company), which can shield your personal assets from business debts and claims. If you plan to raise capital by selling stock to the public or want to give your employees stock options, then you should form a corporation.

If you’ve considered these issues, then you’ll be ahead of the game in choosing a legal structure that’s right for your business. Still, you’ll need to consider the benefits and drawbacks of each type of business structure before you make your final decision.

In California, the basic types of business structures are:

•  sole proprietorships

•  partnerships

•  limited liability companies (LLCs), and

•  corporations.

To help you pick the best structure for your business, this chapter explains the basic attributes of each type, and special rules that apply in California.

This chapter will help you answer the most common question new entrepreneurs ask about choosing a business form: Should I choose a business structure that offers protection from personal liability—a corporation or an LLC? Here’s a hint as to what the best advice will be: If you focus your energy and money on getting your business off the ground as a sole proprietorship or a partnership, you can always incorporate or form an LLC later.

Sole Proprietorships

skip ahead

Sole proprietorships are one-owner businesses. Any business with two or more owners cannot, by definition, be a sole proprietorship. If you know that there will be two or more owners of your business, you can skip ahead to “Partnerships,” below.

A sole proprietorship is simply a business that is owned by one person and that hasn’t filed papers to become a corporation or an LLC. Sole proprietorships are easy to set up and to maintain—so easy that many people own sole proprietorships and don’t even know it. For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions, or an independent contractor who isn’t on an employer’s regular payroll, you are automatically a sole proprietor. This is true whether or not you’ve registered your business with your city or obtained any licenses or permits. And it makes no difference whether you also have a regular day job. As long as you do for-profit work on your own (or sometimes with your spouse—see “Running a Business With Your Spouse,” below) and have not filed papers to become a corporation or a limited liability company, you are a sole proprietor.

CAUTION

Don’t ignore local registration requirements. If you’ve started a business without quite realizing it—for example, you do a little freelance computer programming, which classifies you as a sole proprietor by default—don’t let the fact that you’re technically already a sole proprie­tor fool you into thinking that you’ve satisfied the govern­mental requirements for starting a business. Most cities and counties in California require businesses—even tiny home-based sole proprietorships—to register with them and pay at least a minimum tax. And if you do business under a name different from your own (say, Christina Kennedy does business under the name “Monster Photography”), you must register that name—known as a fictitious business name—with your county. In practice, lots of businesses are small enough to get away with ignoring these require­ments. But if you are caught, you may be subject to back taxes and other penalties. (See Chapter 6 for an explana­tion of how to make the necessary filings with the ­appro­priate government offices.)

Pass-Through Taxation

In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. This is one of the fundamental differences between a sole proprietorship and a corporation or an LLC. And it has two major effects: one related to taxation (explained in this section), and the other to personal liability (explained in the next).

At income tax time, a sole proprietor simply reports all business income or losses on his or her individual income tax return. The business itself is not taxed. The IRS calls this “pass-through” taxation, because business profits pass through the business to be taxed on the business owner’s tax return. You report income from a business just like wages from a job except that, along with Form 1040, you’ll also need to include Schedule C, on which you’ll provide your business’s profit and loss information. One helpful aspect of this arrangement is that if your business loses money—and, of course, many start-ups do in the first year or two—you can use the business losses to offset any taxable income you have earned from other sources.

Example: Rob has a day job at a coffee shop, where he earns a modest salary. His hobby is collecting obscure records at thrift stores and rummage sales. Contemplating the sad fact that he has no extra money to spend at the flea market on Saturday morning, he decides to start selling some of the vinyl gems he’s found. Still working his day job, he starts a small business that he calls Rob’s Revolving Records.

During his first full year in business, he sees that a key to consistently selling his records is developing connections and trust among record collectors. Unfortunately, while he is concentrating on getting to know potential buyers and others in the business, sales are slow. At year-end, he closes out his books and sees that he spent nearly $9,000 on records, his website, marketing items such as business cards, and other incidental supplies, while he made only $3,000 in sales. But there is some good news: Rob’s loss of $6,000 can be counted against his income from his day job, reducing his taxes and translating into a nice refund check, which he’ll put right back into his record business.

CAUTION

Your business can’t lose money forever. See the discussion of tax rules for money-losing businesses in Chapter 8.

Resource

Be ready for the day you’ll owe taxes. Once your business is under way and turning a profit, you’ll have to start paying taxes. (See Chapter 8 for an overview of the taxes small businesses face.) Taxes can get fairly complicated, however, and you may need more in-depth guidance. For detailed information on taxes for the various types of small businesses, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo). This book gives exhaustive information on deductions, record keeping, and audits—all of which will help you reduce your tax bill and stay out of trouble with the IRS.

Personal Liability for Business Debts

Another crucial thing to know about operating your business as a sole proprietor is that you, as the owner of the business, can be held personally liable for business-related obligations. This means that if your business doesn’t pay a supplier, defaults on a debt, loses a lawsuit, or otherwise finds itself in financial hot water, you, personally, can be forced to pay up. This can be a sobering possibility, especially if you own (or soon hope to own) a house, car, or other treasures. Personal liability for business obligations stems from the fundamental legal attri­bute of being a sole proprietor: You and your business are legally one and the same.

As explained in more detail in the sections that discuss corporations and LLCs, below, owners of these businesses enjoy what the law calls “limited personal liability” for business obligations. This means that, unlike sole proprietors and general partners, owners of corporations and LLCs can normally keep their houses, investments, and other personal property, even if the business fails. In short, if you are engaged in a risky business, you may want to consider forming a corporation or an LLC—although a thorough insurance policy can often protect you from lawsuits and claims against the business.

CAUTION

Commercial insurance doesn’t cover business debts. Commercial insurance can protect a business and its owners from some types of liability (for instance, slip-and-fall lawsuits), but insurance never covers business debts. The only way to limit your personal liability for business debts is to use a limited liability business structure such as an LLC or a corporation (or a limited partnership or limited liability partnership).

Creating a Sole Proprietorship

Setting up a sole proprietorship is incredibly easy. Unlike starting an LLC or a corporation, you generally don’t have to file any special forms or pay any special fees to start working as a sole proprietor. You simply declare your business to be a sole proprietorship when completing the general registration requirements that apply to all new businesses, such as getting a business license from your county or city, or a seller’s permit from the California Board of Equalization.

For example, when filing for a business tax registration certificate with your city, you’ll often be asked to declare what kind of business you’re starting. Some cities require only that you check a “sole proprietorship” box on a form, while others have separate tax registration forms for sole proprietorships. Similarly, other forms you’ll file, such as those to register a fictitious business name and to obtain a seller’s permit, will also ask for this information. (These and other start-up requirements are discussed in detail in Chapter 6.)

Partnerships

Bring two or more entrepreneurs together into a business venture, stir gently, and—poof!—you’ve got a partnership. By definition, a partnership is a business that has more than one owner and that has not filed papers with the state to become a corporation or an LLC (or a limited partnership or limited liability partnership).

CAUTION

Beware of local registration requirements. If you’re going into business with others, don’t let the fact that you’re automatically a partnership fool you into thinking that you’ve satisfied the governmental requirements for starting a business. Most cities and counties in California require all businesses to register with them and pay at least a minimum tax. And if you do business under a name other than the partners’ names, you must register that name—known as a fictitious business name—with your county. (See Chapter 6 for an explanation of how to make the necessary filings with the appropriate government offices.)

General Versus Limited Partnerships

Usually, when you hear the term “partnership,” it means a general partnership. As we discuss in more detail below, general partners are personally liable for all business debts, including court judgments. In addition, each individual partner can be sued for the full amount of any business debt (though that partner can turn around and sue the other partners for their shares of the debt).

Another very important aspect of general partnerships is that any individual partner can bind the whole business to a contract or business deal—in other words, each partner has “agency authority” for the partnership. And remember, each of the partners is fully personally liable for a business deal gone sour, no matter which partner signed the contract. So choose your partners carefully.

There are also a couple of special kinds of partnerships, called limited partnerships and limited liability partnerships. They operate under very ­different rules and are relatively uncommon, so they are only briefly described here.

A limited partnership requires at least one general partner and at least one limited partner. The general partner has the same role as in a general partnership: He or she controls the company’s day-to-day operations and is personally liable for business debts. The limited partner contributes financially to the business (for example, invests $100,000 in a real estate partnership) but has minimal control over business decisions or operations and normally cannot bind the partnership to business deals. In return for giving up management power, a limited partner gets the benefit of protection from personal liability. This means that a limited partner can’t be forced to pay off business debts or claims with personal assets, but can lose the entire investment in the business. But beware: A limited partner who tires of being passive and starts tinkering under the hood of the business should understand that personal liability can quickly become unlimited that way. If a creditor can prove that the limited partner acted in a way that led the creditor to believe that he or she was a general partner, that limited partner can be held fully and personally liable for the creditor’s claims.

Another kind of partnership in California, called a limited liability partnership (LLP), provides all of its owners with limited personal liability. These partnerships are only available to professionals—licensed lawyers, accountants, and architects—and are particularly well suited to them. Most professionals aren’t keen on general partnerships because they don’t want to be personally liable for another partner’s problems—particularly those involving malpractice claims. Forming a corporation to protect personal assets may be too much trouble, and California won’t allow these professionals to form an LLC. The solution is often a limited liability partnership. This business structure protects each partner from debts against the partnership arising from professional malpractice lawsuits against another partner. (A partner who loses a malpractice suit for his or her own mistakes, however, doesn’t escape liability.)

As attractive as they are, limited partnerships and limited liability partnerships (and limited liability companies, discussed below) are not cheap to create. The filing fee is just $70, but California also charges a minimum annual tax of $800 for both types of limited partnerships. The tax is due in the first quarter of operations, whether or not you’re making a profit.

Pass-Through Taxation

Similar to a sole proprietorship, a partnership (general or limited) is not a separate tax entity from its owners; instead it’s what the IRS calls a “pass-through entity.” This means the partnership itself does not pay any income taxes; rather, income passes through the business to each partner, who pays taxes on an individual share of profit (or deducts a share of losses) on an individual income tax return (Form 1040, with Schedule E attached). However, the partnership must also file what the IRS calls an “informational return”—Form 1065—to let the government know how much the business earned or lost that year. No tax is paid with this return. Just think of it as the feds’ way of letting you know they’re watching.

Personal Liability for Business Debts

Since a partnership is legally inseparable from its owners, just like a sole proprietorship, general partners are personally liable for business-related obligations. What’s more, in a general partnership, the business actions of any one partner bind the other partners, who can be held personally liable for those actions. So, if your business partner takes out an ill-advised high-interest loan on behalf of the partnership, makes a terrible business deal, or gets in some other business mischief without your knowledge, you could be held personally responsible for any debts that result.

Example: Jamie and Kent are partners in a profitable landscape gardening company. They’ve been in business for five years and have earned healthy profits, allowing them each to buy a house, decent wheels, and even a few luxuries—including Jamie’s collection of garden sculptures and Kent’s roomful of vintage musical instruments. One day Jamie, without telling Kent, orders a shipment of exotic poppy plants that he is sure will be a big hit with customers. But when the shipment arrives, so do agents of the federal drug enforcement agency who confiscate the plants, claiming they could be turned into narcotics. Soon thereafter, criminal charges are filed against Jamie and Kent, resulting in several newspaper stories. Though the partners are ultimately cleared, their attorney fees come to $50,000 and they lose several key accounts, with the result that the business runs up hefty debts. As a general partner, Kent is personally liable for these debts even though he had nothing to do with the ill-fated poppy purchase.

Before you get too worried about personal liability, keep in mind that many small businesses don’t face much of a risk of racking up large debts. For instance, if you’re engaged in a low-risk enterprise, such as freelance editing, landscaping, or running a small band that plays weddings and other social events, your risk of facing massive debt or a huge lawsuit is pretty small. For these types of small, low-risk businesses, a good business insurance policy that covers most liability risks is almost always enough to protect owners from a catastrophe such as a lawsuit or fire. Insurance won’t cover regular business debts, however. If you have significant personal assets, like fat bank accounts or real estate, and plan to rack up some business debt, you may want to limit your personal liability with a different business structure, such as an LLC or a corporation.

Partnership Agreements

By drafting a partnership agreement, you can struc­­ture your relationship with your partners pretty much however you want. You and your partners can establish the respective shares of profits (or losses) each will receive, what the responsibilities of each partner will be, what should happen to the partnership if a partner leaves, and how any number of other issues will be handled. It is not legally necessary for a partnership to have a written agreement. The simple act of two or more people doing business together creates a partnership. But only with a clear written agreement will all partners be sure of the important—and sometimes touchy—details of their business arrangement.

In the absence of a partnership agreement, California’s version of the Revised Uniform Partnership Act (RUPA) kicks in as a standard, bottom-line guide to the rights and responsibilities of each partner. For example, if you don’t have a partnership agreement, then California’s RUPA states that each partner has an equal share in the business’s profits, losses, and management power. Similarly, unless you provide otherwise in a written agreement, a California partnership won’t be able to add a new partner without the unanimous consent of all partners. (Cal. Corp. Code § 16401.) But you can override many of the legal provisions contained in the California RUPA if you and your partners have your own written agreement.

There’s nothing terribly complex about drafting partnership agreements. They’re usually only a few pages long and cover basic issues that you’ve probably thought over to some degree already. Partnership agreements typically include at least the following information:

•  name of partnership and partnership business

•  date of partnership creation

•  purpose of partnership

•  contributions (cash, property, and work) of each partner to the partnership

•  each partner’s share of profits and losses

•  provisions for taking profits out of the company (often called partners’ draws)

•  each partner’s management power and
duties

•  how the partnership will handle departure of a partner, including buy-out terms

•  provisions for adding or expelling a partner, and

•  dispute resolution procedures.

These and any other terms you include in a partnership agreement can be dealt with in more or less detail. Some partnership agreements cover each topic with a sentence or two; others spend up to a few pages on each provision. Of course, you need an agreement that’s appropriate for the size and formality of your business, but it’s not a good idea to skimp on your partnership agreement.

Resource

More information on partnerships. Form a Partnership: The Complete Legal Guide, by Denis Clifford and Ralph Warner, is an excellent step-by-step guide to putting together a solid, comprehensive partnership agreement. Also, Business Buyout Agreements: A Step-by-Step Guide for Co-Owners, by Anthony Mancuso and Bethany K. Laurence, explains how to draft terms that will enable you to deal with business ownership transitions. (Both books are published by Nolo.)

If you think you may need more than the simple partnership agreements provided in this book, there are more detailed partnership agreement forms on CD (as well as many other resources for running your business) in Quicken Legal Business Pro 2012. You can learn more about all of these resources at www.nolo.com.

Take a look at the two short sample partnership agreements on the following pages to see how a very basic partnership agreement can be put together. (You’ll also find a downloadable partnership agreement on the Nolo website; See Appendix B for the link.) These sample agreements are about as basic as it gets—the bare minimum—and you’ll almost surely want to use something more detailed for your business.

Limited Liability Companies (LLCs)

Like many business owners just starting out, you might find yourself in this common quandary: On the one hand, having to cope with the risk of personal liability for business misfortunes scares you; on the other, you would rather not deal with the red tape of starting and operating a corporation.

Fortunately for you and many other entrepreneurs, you can avoid these problems by taking advantage of a relatively new form of business called the ­limited liability company, commonly known as an LLC. LLCs combine the pass-through taxation of a sole proprietorship or partnership (business taxes are paid on each owner’s individual income tax returns) with the same protection against personal liability that corporations offer. And now that ­California no longer requires LLCs to have at least two members, solo business owners also have the option of forming an LLC.

However, professional services businesses may not use the LLC structure in California. “Professional services” are “any type of professional services that may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act” or the Yacht and Ship Brokers Act. (Cal. Corp. Code §§ 13401(a), 13401.3.)

If you’re a professional services provider and want a business structure with limited personal ­liability for the principals, all is not lost. You may recall from the discussion of partnerships, above, that accountants, lawyers, and architects may form limited liability partnerships (LLPs). If you want limited personal liability with another type of professional services business, you’ll need to use the corporate business structure, discussed below (see “Corporations”).

Limited Personal Liability

Generally speaking, owners of an LLC (called “members”) are not ­personally liable for the LLC’s debts. (There are some exceptions to this rule, discussed below.) This protects the members from legal and financial liability in case their business fails or loses a lawsuit and can’t pay its debts. In those situations, creditors can take all of the LLC’s assets, but they generally can’t get at the personal assets of the LLC’s members. Losing your business is no picnic, but it’s a lot better to lose only what you put into the business than to say goodbye to everything you own.

Example: Callie forms her own one-person mail-order business, using most of her $25,000 in savings to establish a cool website and buy mailing lists. Callie realizes that she’ll have to buy a significant portion of her sales inventory up front to be able to ship goods to her customers on time, so she plans to buy those items on credit. While she is willing to risk her $25,000 investment to pursue her dream, she is worried that if her mail-order business fails, she will be buried under a pile of debt. Callie decides to form an LLC so that if her business should fail, she’ll only lose the $25,000; no one will be able to sue her personally for the business debt that she owes. She feels more secure going into business knowing that even if her business fails, she can walk away without the risk of losing her house or her car.

While some LLCs opt for a structure in which the company is run by specially designated managers, most LLCs are simply managed by the members. This more common setup is called a “member-managed” LLC; one that is run by managers (who are elected by the members) is called a “manager-managed” LLC. A manager-managed LLC might be appropriate if some of the LLCs owners are passive investors (similar to limited partners), while a smaller group intends to actively run the company. If all the LLC owners intend to actively manage the company, you’ll generally use the more common member-managed structure.

With this in mind, remember that, like a general partner in a partnership, any member of a member-managed LLC can legally bind the entire LLC to a contract or business transaction. In other words, each member can act as an agent of the LLC. In manager-managed LLCs, any manager can bind the LLC to a business contract or deal.

While LLC owners enjoy limited personal liability for many of their business debts, this protection is not absolute. There are several situations in which an LLC owner may become personally liable for business debts or claims. However, this drawback is not unique to LLCs. The limited liability protection given to LLC members is just as strong as (if not stronger than) that enjoyed by the corporate ­shareholders of small corporations. Here are the main situations in which LLC owners can still be held personally liable for debts:

•  Personal guarantees. If you give a personal guaran­tee on a loan to the LLC, then you are personally liable for repaying that loan. Because personal guarantees are often required by banks and other lenders, this is a good reason to be a conservative borrower. Of course, if no personal guarantee is made, then only the LLC—not the members—are liable for the debt.

• Taxes. The IRS or the California Franchise Tax Board may go after the personal assets of LLC owners for overdue federal and state business tax debts, particularly overdue payroll taxes. This is most likely to happen to members of small LLCs who have an active hand in managing the business, rather than to passive members.

•  Negligent or intentional acts. An LLC owner who intentionally, or even carelessly, hurts someone will usually face personal liability. For example, if an LLC owner takes a client to lunch, has a few martinis and injures the client in a car accident on the way home, the LLC owner can be held personally liable for the client’s injuries.

•  Breach of fiduciary duty. LLC owners have a legal duty to act in the best interest of their company and its members. This legal obligation is known as a “fiduciary duty,” or is sometimes simply called a “duty of care.” LLC owners who violate this duty can be held personally liable for any damages that result from their actions (or inactions). Fortunately for LLC owners, they normally will not be held personally responsible for any honest mistakes or acts of poor judgment they commit in doing their jobs. Most often, breach of duty is found only for serious indiscretions, such as fraud or other illegal behavior.

•  Blurring the boundaries between the LLC and its owners. When owners fail to respect the separate legal existence of their LLC, but instead treat it as an extension of their personal affairs, a court may rule that the owners are personally liable for business debts and liabilities. Generally, this is more likely to occur in one-member LLCs; in reality, it only happens in extreme cases. You can easily avoid it by opening a separate LLC checking account, getting a federal employer identification number, keeping separate accounting books for your LLC, and funding your LLC adequately enough to be able to meet foreseeable expenses.

tip

There’s a new flavor of LLC on the scene: the low-profit limited liability company, or L3C. An L3C is similar to a nonprofit in that its primary purpose must be to benefit the public. But an L3C is run like a regular profit-making business and is allowed to make a profit as a secondary goal. This type of business structure was born so that charitably-oriented LLCs could receive seed money (specifically, “program-related investments,” or PRIs) from large nonprofit foundations, taking advantage of IRS rules that allow foundations to invest in businesses principally formed to advance a charitable purpose. A small but growing number of states allow L3Cs, including Illinois, Louisiana, Maine, Michigan, North Carolina, Rhode Island, Utah, Vermont, and Wyoming. However, because it’s such a new business structure and definitive rulings on various aspects of L3Cs have not yet been issued by the IRS, plenty of questions remain. Keep an ear to the ground as the L3C develops.

LLC Taxation

Like a sole proprietorship or partnership, an LLC is not a separate tax entity from its owners; instead, it’s what the IRS calls a “pass-through entity.” This means the LLC itself does not pay any income taxes; instead, income passes through the business to each LLC owner, who pays taxes on the individual share of profit (or deducts his or her share of losses) on an income tax return (for the feds, Form 1040 with Schedule E attached). But a multiowner LLC, like a partnership, does have to file Form 1065—an “informational return”—to let the government know how much the business earned or lost that year. No tax is paid with this return.

LLCs give members the flexibility to choose to have the company taxed like a corporation rather than as a pass-through entity. In fact, partnerships now have this option as well. (See IRS Form 8832, ­Entity Classification Election, on the Nolo website; see Appendix B for the link.)

You may wonder why LLC owners would choose to be taxed as a corporation—after all, pass-through taxation is one of the most popular features of an LLC. The answer is that, because of the income-splitting strategy of corporations (discussed in “Corporate Taxation,” below), LLC members can sometimes come out ahead by having their business taxed as a separate entity at corporate tax rates.

For example, if the owners of an LLC become successful enough to keep some profits in the business at the end of the year (or regularly need to keep significant profits in the business for upcoming expenses), paying tax at corporate tax rates can save them money. That’s because federal income tax rates for corporations start at a lower rate than the rates for individuals. For this reason, many LLCs start out being taxed as partnerships, and when they make enough profit to justify keeping some in the business (rather than doling it out as salaries and bonuses), they opt for corporate-style taxation.

LLCs face significant taxes and fees at the state level. California charges a minimum annual tax of $800, which is due in the first quarter of operations, whether or not you’re making a profit. Additional fees may be charged as well. (LLC taxes and fees are discussed in more detail in Chapter 8.)

LLCs Versus S Corporations

Before LLCs came along, the only way all owners of a business could get limited personal liability was to form a corporation. Problem was, many entrepreneurs didn’t want the hassle and expense of incorporating, not to mention the headache of dealing with corporate taxation. One easier option was to form a special type of corporation known as an S corporation, which is like a normal corporation in most respects, except that business profits pass through to the owner (as in a sole proprietorship or partnership), rather than being taxed to the corporation at corporate tax rates. In other words, S corporations offered the limited liability of a corporation with the pass-through taxation of a sole proprietorship or partnership. For a long time, this was an okay compromise for small to medium-sized businesses, though they still had to deal with many of the corporate requirements of running an S corporation (discussed in more detail below).

Now, however, LLCs offer a better option. LLCs are indeed similar to S corporations in that they combine limited personal liability with pass-through tax status. But a significant difference ­between these two types of businesses is that LLCs are not bound by the many regulations that govern S corporations.

Here’s a quick rundown of the major areas of difference between S corporations and LLCs. (Keep in mind that corporations, including S corporations, are explained in more detail in the next ­section.)

•  Ownership restrictions. An S corporation may not have more than 75 shareholders, all of whom must be U.S. citizens or residents. This means that some of the C corporation’s main benefits—namely, the ability to set up stock option and bonus plans and to bring in public capital—are pretty much out of the question for S corporations. And even if an S corporation initially meets the U.S. citizen or resident requirement, its shareholders can’t sell shares to another company (like a corporation or an LLC) or a foreign citizen, on pain of losing S corporation tax status. In an LLC, any type of person or entity can become a member—a U.S. citizen, a citizen of a foreign country, or another LLC, corporation, or limited partnership.

•  Allocation of profits and losses. Shareholders of an S corporation must allocate profits according to the percentage of stock each owner has. For example, a 25% owner has to receive 25% of the profits (or losses), even if the owners want a different division. Owners of an LLC, on the other hand, may distribute profits (and the tax burden that goes with them) however they see fit, without regard to each member’s ownership share in the company. For instance, a member of an LLC who owns 25% of the business can receive 50% of the profits if the other members agree (subject to a few IRS rules).

•  Corporate meeting and record-keeping rules. For S corporation shareholders to keep their limited liability protection, they have to follow the corporate rules—issuing stock, electing officers, holding regular board of directors’ and shareholders’ meetings, keeping corporate minutes of all meetings, and following the mandatory rules found in the corporation code. By contrast, LLC owners don’t need to jump through most of these legal hoops—they just have to make sure their management team is in agreement on major decisions and go about their business.

•  Tax treatment of losses. S corporation share­holders are at a disadvantage if their company goes into substantial debt—for instance, if it borrows money to open the business or buy real estate. That’s because an S corporation’s business debt cannot be passed along to its shareholders unless they have personally cosigned and guaranteed the debt. LLC owners, on the other hand, normally can reap the tax benefits of any business debt, cosigned or not. This can translate into a nice tax break for owners of LLCs that carry debt.

Forming an LLC

To form an LLC, you must file Articles of Organization with the California Secretary of State (www.sos.ca.gov). You should also execute an operating agreement, which governs the internal workings of your LLC. Be aware that an LLC is generally not as cheap to start as a