Which California Corporate Entity is Right for You?

April 2nd, 2014

We’re frequently asked by business owners, investment partners, and company founders which corporate entity is the best for carrying out their business objectives while at the same time maximizing their liability protection. We’re also asked whether it makes sense to setup a corporate entity in California given the notion that other states, like Delaware, are more favorable toward corporations. While each of these decisions turns on a multitude of factors, here we’ll discuss some basic principles we consider when advising our clients on these issues.

Which California corporate entity is right for you?
Due to increasing demand for simpler, more flexible corporate structures with increased tax benefits, California has been expanding its universe of available corporate entities. While business owners who qualify have the option to operate their business as a Sole Proprietorship, General Partnership, Limited Partnership, Limited Liability Partnership, C-Corporation, S-Corporation, Professional Corporation, Close Corporation, Non-profit Corporation, or Limited Liability Company (“LLC”), for brevity’s sake we’ll focus on a few essential differences between the general C-Corporation and the LLC, both of which are designed to limit the liability of their owners to the extent of their ownership interest in the company.

Corporations are owned by shareholders, meaning that anyone having an ownership interest in the corporation must hold one or more shares of stock in the company. A shareholder’s ownership interest (i.e. entitlement to the corporation’s profits and losses) is determined by the quantity of shares he or she holds relative to the total amount of shares issued by the corporation. Corporations issue at least one class of stock (the most basic is called “common stock”) that when privately held (i.e. not listed on a public stock exchange) is valued based on the agreement of the investors, the fair market value of the corporation’s assets, the anticipated profitability of the company, or all of the above. Corporations are run by a board of directors who are appointed by the shareholders, and the directors in turn appoint officers to assist with management. Shareholders’ voting rights (to influence major transactions and appoint directors) depend on the class of stock they hold. The management and voting structure of the corporation are reflected in the corporate bylaws, which are created, ratified, and amended by the Board, sometimes with shareholder approval. When stocks are issued, certain filings must be made with the Secretary of State, and depending on the number of shareholders and the nature of the transaction, the filing requirements can increase.

LLC’s by contrast are owned by “Members” whose share of ownership, in many cases, are evidenced only by the capital contribution tables in the company’s Operating Agreement (which is akin to a corporation’s bylaws), not by state filings and tangible stock certificates. Members’ interests in the LLC are generally limited to the proportionate share of their investment in the company, however, in some circumstances, members can allocate profits disproportionately. Members are free to manage the LLC however they please: by themselves, without appointment of a Board or Directors, or simply by appointing one manager or set of managers, who may or may not require Member approval for certain transactions depending on the Members’ preferences. The Operating Agreement, which sets forth the company’s ownership structure, governance structure, conditions on distributions, and tax classification elections (among other things) is a comprehensive document which completely controls the company, and can be amended at any time in accordance with its own terms. Aside from filing the Articles of Organization which form the LLC and the annual Statement of Information which keeps public records up to date on the company’s contact information, LLC’s are generally not required to file as many documents with the Secretary of State as corporations.

Depending on the circumstances, a corporation might be preferable over an LLC. For instance, if the company intends to attract financing from serial or institutional investors, like venture capital firms, the corporate form is helpful because these investors are more accustomed to working with corporations. Serial investors often negotiate for the quantity, value, timing, and class of the shares they purchase, which controls their equity, voting power, liquidation preference, and dividends payout they hope to receive in return for their investment. Having familiarity with the terms of their investment allows serial investors to better forecast the return on their investment, and control the dilution of their ownership as the company grows, making it easier for them to want to invest. LLC’s, by contrast, do not have uniform ownership and management structures, therefore a serial investor may have to spend more time contemplating its investment strategy, which makes the investment process more cumbersome and expensive for the investor and the company. The corporate form is virtually a necessity when a company is publicly traded or is going through the initial public offering (IPO) process because stocks, as opposed to memberships, are the most traditional and well understood form of securities. When faced with competition from other public corporations, it makes little sense for new public companies to deviate from the norm.

LLC’s might be preferable in other circumstances. For example, if the company will be owned by a relatively small pool of individuals or entities (e.g. 100 or fewer) who are brought together based on their familiarity with, or particular interest in the underlying business, the LLC allows them maximum latitude in negotiating the company’s ownership and management structure, which is great if the members want to be creative. LLC’s may also be preferable when the company is meant to simply operate as a holding company for valuable assets, like real estate, a vessel, or an aircraft, because members are free to minimize the requisite corporate formalities needed to effectuate a purchase or sale of assets. Small business owners, like non-franchised restaurants, auto body shops, car dealerships, fishing and tour-boat companies, etc., may also prefer to use LLC’s to keep the costs of maintaining corporate records as low as possible to maximize profits. While corporations can generally be used for anything an LLC can (after all, the LLC evolved from the corporate form), an LLC can sometimes be a simpler, more cost-effective mechanism for running a business or making an investment.

While there may be some overlapping tax principles applicable to corporations and LLC’s alike, the tax implications of using a corporation versus an LLC can be significant. Depending on the circumstances, one might turn out to be more beneficial than the other from a tax perspective. You should consult a tax advisor before making the decision. You should also consult with an attorney before deciding which entity is right for you. While in most circumstances an LLC can be converted to a corporation and vice versa, you’ll save money in the long run if you plan ahead.

Where should you setup your corporate entity?
Like choosing the right entity, the answer is “it depends.” Delaware is known for its lenient corporate statutes, strong body of case law, and business-minded population, which make for more predictable outcomes in large corporate transactions and high stakes disputes. Delaware law is also commonly familiar to corporate attorneys and investors across the nation and around the world, so being incorporated/organized in Delaware can help facilitate multi-state and multi-national investment. However, unless the company intends to be publicly traded or operate on a multi-state/national level, we generally recommend incorporating/organizing wherever the company’s business is conducted, or wherever its assets are located to avoid having to pay duplicative fees or taxes. Most states require foreign (out of state) companies that conduct business within state borders to “qualify” to do business in that state. This usually means that an out of state company must go through a corporate application process, similar to initial incorporation, and pay fees or taxes simply to conduct business in another state. For example, foreign business entities conducting business in California (after the first year of operation) are subject to a minimum tax of $800/year and must file an application for qualification. That tax may be significantly more depending on the company’s income derived from business conducted in California. These additional annual fees and/or taxes must be paid on top of the fees and taxes charged by the company’s home state of incorporation/organization. Therefore, if the business is going to operate primarily within a particular state, it makes sense to incorporate there.

Since this question involves serious tax considerations, you should consult with a tax advisor to evaluate the impact of incorporating in one state versus another. You should also consult with an attorney before deciding where to form your business entity.

If you have questions or would like more information, contact Mark E. Tepper at mtepper@cwlfirm.com