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Most new business owners have to eventually face the proposition of whether or not they should seek protection under the California Corporations Code. Although other vehicles exist, this article will only focus on corporations and limited liability companies (LLCs). Unfortunately, the public is not really educated on the benefits and nuances between a corporation and LLC, and hopefully this article will give a cursory overview for a better understanding of the implications involved.

The objective of forming one of these vehicles is to create an artificial legal entity that is recognized to do business on behalf of an individual (or group of individuals), and that entity would be solely responsible for the liability of such undertakings. Consequently, the "shield" of incorporating or forming an LLC poses many advantages, effectively limiting the individual participants' exposure to the amount of money they have respectively invested in the entity. The common misnomer that most people believe, however, is that if you form a corporation or LLC, then no matter what you do in your business, your personal assets are inviolable against creditors and lawsuits. In many cases of fraudulent, illegal or deceptive conduct, however, California courts have "pierced the corporate veil" in order to find personal liability for directors and officers of such California entities. Therefore, the unfettered abuse of such legal vehicles will not afford protection, and should be treated with the same degree of care as any endeavor for the success of ones' business.

In order to decide whether a legal entity is appropriate for a business, there are a number of questions that a business owner must first answer in order to assess the need for such protection.

1. Do I have a significant economic stake (e.g. personal assets, home, car, good credit, etcÄ) that warrants protection against any liability resulting from the operation of my business?
2. Are there other trade, tax, professional or other benefits to operating as a legal entity as opposed to a sole proprietorship?
3. Does my business afford the type of foreseeable tax, creditor, or other type of exposure that would warrant the necessity of protecting my personal assets?
4. Does my commercial liability insurance not sufficiently protect me, that would necessitate the consideration of alternative forms of protection?

If you answered "perhaps" or "yes" to any of these, then you may wish to consult both your tax advisor and legal counsel on whether or not you should move forward with the process.

The next issue to address is whether to form a corporation or an LLC for your business. Although there is not much difference in terms of liability protection, there are fundamental differences in structure and tax consequences for each. Moreover, a vehicle may not be available for some types of businesses. For example, any occupation that requires state licensor (e.g. attorneys, doctors, architects, etcÄ) cannot form an LLC for their business, but can form a corporation or other legal entities.

In terms of corporations, there are two types: the "C" corporation and the Subchapter "S" corporation. The distinction has significant tax consequences for your business. In a "C" corporation, the business will be taxed twice: first at the corporate rate, then at the individual rate. This structure is usually recommended for businesses looking to scale up with multiple shareholders (over 75), institutional or professional investors, and a potential public offering. It also ensures privacy of some shareholders as both domestic and international corporations, LLCês and other legal entities can be shareholders, giving anonymity to individuals behind such entities. Most local businesses, however, elect to organize as a closely held Subchapter "S" corporation because this structure has less formality, the business will only get taxed once on an individual distribution level, and they never plan to have more than seventy five individual shareholders (35 if it is a closely held corporation). Unlike a "C" corporation however, only individuals can be shareholders.

Basically, the structure of an LLC is treated much like a Subchapter S corporation for tax purposes, but there are other nuances related to self-employment taxes, pensions, health insurance deductions and state franchise tax fees that should be discussed with your accountant. From a legal standpoint, you would enjoy the same protection from liability as a corporation, but an LLC offers more flexibility in structure than a typical subchapter S Corporation. LLCs do not have the same restrictions on the number of members, and its members can be both entities and individuals. Many entertainment and real estate endeavors use the LLC vehicle because of its simplicity and scalability, however, most tax advisers prefer the Subchapter S structure because there is significant case history with the IRS.

One final word of warning about forming these types of entities is the California franchise tax consequences. Both corporations and LLCês have to pay a minimum franchise tax of $800.00 (irrespective of revenues), due within 90 days of filing with the Secretary of State and on April 15th thereafter. Corporations have a first year waiver of this tax, while LLCês do not. Therefore, without careful planning and timing, an unsuspecting LLC may get hit twice for this tax within a short period of time without making any revenues. As every business has different needs, it is strongly recommended that you consult competent legal and tax professionals in addressing the next steps for your business.

David Michail has been a business and corporate attorney since 1996. This article is intended for informational purposes only, and shall not be construed as legal advice. For more information about establishing a legal entity for your business, please feel free to contact Mr. Michail at (310) 559-4333 or at david.michail@michaillaw.com.