Articles Posted in Business Formation & Development

As with most business decisions, the decision regarding which legal entity is best suited for your San Diego business depends on a variety of important factors. Most San Diego business owners interested in the benefits of a formal business organization without the burden of the double taxation that accompanies the C Corporation, turn to either the California Limited Liability Company (LLC) or the S Corporation. Both offer owners protection from unlimited liability and both offer pass through taxation (no double taxation). The question then becomes which is better, the S Corporation or the LLC. The decision is best made with the guidance of a San Diego business entity lawyer and a tax professional. However, with fewer restrictions on the allocation of ownership and profit interests and greater management flexibility, the LLC seems to be the better option although this doesn’t mean it is the better option for every business.

The most significant benefit of the S Corporation is the ability to limit self employment taxes (social security and Medicare taxes). The benefit is available to stockholder/employees who minimize their salary (subject to self employment taxes) and then distribute excess profits as dividends (not subject to self employment taxes). In certain circumstances, this can be a valuable tool. For example, assume an S Corporation is owned entirely by two stockholder/employees (each owning 50% of the stock). The corporation’s profits for the last taxable year were $200,000 of which each salaried stockholder received $50,000 in wages. Each owner would pay self-employment taxes on $50,000 and each would receive a dividend for $50,000 free from self-employment taxes. Based on the current social security and Medicare rates, each owner would save $7,650. However, this benefit is limited by two important factors. First, the IRS requires that salaries paid to owner/employees of corporations be reasonable. There is no guarantee that the IRS will accept the $50,000 incomes in this example, and it has recently become more aggressive in ensuring that stockholder/employee salaries are not too low. It may instead consider the dividend distributions to be wages subject to self-employment taxes. Second, most of the self employment tax is the social security portion which is currently capped when wages reach $106,000. This means that stockholder/employees who earn an annual salary above $106,000 only save 2.9% percent (the Medicare portion) for all dividends paid above their salary.

California LLCs are also subject to a gross receipts tax. The tax is relatively small when compared to the revenues that trigger the tax. The gross receipts tax is $900 for gross receipts between $250,000 and $499,999, $6,000 on for gross receipts above $1,000,000, and $11,790 for gross receipts in excess of $5 million. Profitable businesses will barely notice this tax. For unprofitable businesses or for businesses with a very low profit margin, the gross receipts tax can be problematic since the tax is on gross revenue and not on profits.

For the stockholders in the above example, the tax savings seem to make sense. In fact, tax savings no matter how small always make sense. Nonetheless, the S Corporation suffers from several statutory limitations and lack many of the benefits LLCs offer. First, the S Corporation cannot be owned by another corporation or LLC; it cannot be owned by a foreign person; it cannot have more than 100 shareholders; it cannot issue different classes of stock; and it must distribute profits in equal proportion to ownership interests. While one owner in the example above could pay himself a higher salary for taking on greater responsibility, he would still have to take 50% of the dividends distributed. All distributions must be made simultaneously and on a pro rata basis. If one of the owners above preferred to purchase his interest in the S-Corporation directly from his existing LLC, he couldn’t. The LLC suffers from none of these limitations. The LLC members are free to allocate profits however they like, make contributions however they like and are able manage the company with the greatest flexibility.

Continue reading

One of the first decisions new San Diego business owners make is whether or not to incorporate or form some other formal business entity. The decision often seems daunting and turning to a San Diego Business Lawyer and tax professional are important first steps. If the business owner opts for a limited liability company (“LLC”) or an S-Corporation (which is taxed like a partnership as opposed to the C-Corporation subject to double taxation), double taxation is not an issue. Thus, the first way to avoid double taxation is to choose a business entity that is not double taxed. This includes forming a California Corporation and then electing S-Corporation status with the IRS. Many small business owners have nonetheless formed corporations without electing S-Corporation status. This may be because a tax professional recommended it or because the business owner simply didn’t consider the various business entities available when forming the corporation. Whatever the reason, the choice of a C-Corporation for small businesses isn’t inherently a bad one. It does, however, become imperative that these C-Corporations take steps to avoid or at least limit double taxation.

The easiest way to avoid double taxation is to elect to be taxed as an S-Corporation with the Internal Revenue Service. However, to qualify for S-Corporation status the IRS requires that your corporation be a domestic corporation, issue only one class of stock, distribute profits and losses in proportion to shareholder interests and have no more than 100 shareholders who are natural persons and U.S. citizens. Another corporation or LLC cannot own stock in an S-Corporation nor can foreign nationals. If opting for S-Corporation taxation, it is important to timely file Form 2553 with the IRS – no later than the 15th day of the third month following the date of incorporation. If a business is already incorporated, it can still opt for S-Corporation taxation the following year by filing Form 2553 by December 31st. However, it’s important to consult with a tax professional before doing so especially where the company was initially advised not to elect S-Corporation status.

If you are a small corporation and do not elect S-Corporation status, the following is a short list of legitimate ways to minimize double taxation:

Accumulate Earnings: Leaving profits in the corporation avoids double taxation since there are no dividends to tax. Saving is advantageous so long as the money is eventually re-invested toward growth. It is a good short term plan. However, if too much profit is retained, the corporation can face an additional Accumulated Earnings Tax (a substantial penalty in addition to the regular corporate tax). The goal is to prevent corporations from accumulating profits for the sole purpose of avoiding income tax. The IRS looks to see if the corporation is accumulating earnings and profits beyond the reasonable needs of the business. Generally, accumulated earnings up to $250,000 ($150,000 for some personal service corporations) are considered reasonable. For earnings in excess of this amount, corporations may still show the IRS that the retained earnings are reasonable based on the needs of the business. If you choose to retain earnings, consult with your tax professional.

Continue reading

Most people are generally familiar with the concept of double taxation. Corporate attorneys and accountants regularly raise the issue when asked by entrepreneurs about choosing the right business entity for a new company (or for an existing company looking to grow and insulate its owners from personal liability). Moreover, double taxation remains a hot button political issue. Whatever political side one falls on, double taxation is real and new and existing business owners need to be informed as they make critical business decisions regarding incorporation or the creation of some other formal entity.

The concept of double taxation itself is simple enough – the Internal Revenue Service (IRS) and state taxing authorities tax corporations based on their profits. In addition, when those profits are distributed to the corporate shareholders in the form of dividends, the individual shareholders are taxed again creating a significantly higher actual tax rate on the corporate profits. Say a corporation generated profits of $100,000 in a given tax year. The federal corporate tax rate on profits of $100,000 is currently 34% so the corporation owes a tax of $34,000. If you and a co-owner each own 50% of the stock in the corporation and issue yourselves each a $50,000 dividend, you will each add the $50,000 to your income for the tax year. Assuming you both end up in the 35% tax bracket, each of you will both pay an additional $17,500 in taxes. In effect, the $100,000 in corporate profits is hit with a total tax bill of $69,000 or an actual tax rate of 69%. While this picture is much more complicated for most corporations, the concept remains the same – corporate profits are taxed twice.

The most common reason business owners incorporate is to insulate themselves from the liabilities of the business. This goal can be accomplished in ways that avoid double taxation, including the formation of a Limited Liability Company (LLC) or, if a corporation meets certain qualifications, by electing to be taxed as an S-Corporation. S-Corporations are taxed the same as partnerships (pass-through taxation). The profits are divided amongst the individual shareholders who are then taxed as individuals. The Corporation’s profits are not taxed separately. If an S-Corporation election is not made, then the entity is considered a C-Corporation and is taxed accordingly (double taxation).

Ownership of investment property in San Diego can be a rewarding venture.  However, as with all investments, a return is never guaranteed.  It’s important to evaluate the property’s value up front factoring in: the property’s relative worth compared to alternatives; the market value of rental income in the geographic area for similar properties; the property’s potential for appreciation; management costs; and potential liability and tax implications.  This article focuses on the choice of business entity that best protects investors from liability and negative tax implications.  Whether or not you already own investment property or are considering purchasing investment property, choosing how to structure your ownership is crucial.  Consultation with an experienced San Diego business lawyer and a real estate professional are the best ways to maximize your personal protection.  

There is a reason the prevailing wisdom favors the Limited Liability Company (“LLC”) as the best form of ownership in California for investment properties.  California LLCs are relatively flexible business entities that have proven particularly beneficial when it comes to ownership of investment properties.  First, LLCs allow for pass through taxation avoiding the double taxation associated with C-Corporations (C-Corporations are taxed first on their profits and taxed again on the profits shareholders receive as dividends).  Second, like most formal business entities, LLCs provide personal protection from the liabilities associated with an investment property.  A member’s personal assets are protected from claims against the LLC.  Personal ownership in an investment property or ownership as a partnership leaves the owners vulnerable to liability for accidents that occur on the property.  Liabilities are often extensive and can exceed insurance policy limits, particularly where permanent injury or death is involved.  

S-Corporations are a tempting alternative to the LLC, and in some business contexts the S-Corporation may make sense.  In addition to liability protection, qualifying corporations that make an S-Corporation election with the Internal Revenue Service also benefit from pass-through taxation.  However, S-Corporations lack the flexibility that LLCs offer.  To maintain S-Corporation status, corporations must be domestic, have only one class of stock, distribute profits and losses in proportion to each shareholder’s ownership interest and cannot have more than 100 shareholders who are natural persons and U.S. citizens.  LLCs, on the other hand, allow for unequal allocation of income, deductions and losses.  Members can choose how profits are allocated regardless of each member’s contribution or level of management responsibility.  This is especially convenient for family owned investment properties or where one owner will be more actively involved in the management of the property.  Members of an LLC can also be a corporation or other LLC.  In addition, if an S-Corporation transfers property to another entity or sells a property to another entity in exchange for another property, it immediately incurs a capital gains tax.  These transactions, if done properly, can be tax free for LLCs.

Continue reading

Continued from “Choosing the Right Business Entity for Your New Business“.

Now that you have a business plan and the capital to get started, the next step is to secure necessary raw materials, wholesale goods, manufacturing equipment, vendors, licensing, contracts and other necessary procurements all of which will be unique to your business. Securing a commercial lease on the other hand is common for virtually all businesses and, unless you plan to operate out of a home office, will have a critical impact a business’ success. First, by entering into negotiations for any commercial lease, you are making a fundamental choice about the location of the business. The location chosen can make or break any new venture. Second, the particular terms of the lease impact the bottom line. Rental payments, annual rental increases, inducements, common area maintenance expenses (CAMs), the term of the lease, options to renew and other rights and obligations set forth in the lease directly impact profits. Lowering monthly rents is obvious, but there are other less obvious costs that new tenants must concern themselves with many of which are intertwined with CAMs. For instance, most commercial leases require tenants to cover property taxes as part of the annual CAMs. Tenants are often shocked to learn later that the property was sold and a lump sum property tax was due sometimes tens of thousands of dollars or more per tenant.

Often, entrepreneurs fall in love with a particular location and begin to negotiate for a lease from a weak position. If prospective tenants have no other options, they are typically willing to accept almost anything from the landlord so long as the rental payments seem reasonable. This is a mistake. The better approach is to choose among multiple locations all of which have positive features. Of course, there is almost always a “better” location for the entrepreneur, and there’s nothing inherently wrong with pursuing choice one first. However, knowing that other options exist better equips the entrepreneur to walk away from really bad deals. On the other hand, unrealistic expectations about lease terms can be just as detrimental to a new business. It remains important to understand relative bargaining power and make reasonable determinations about acceptable lease terms. Landlords also have other options, and are generally savvy real estate professionals. They understand what the market will bear and work from there. The negotiation requires tact and subtlety, and most importantly a hierarchy of priorities.

Because the commercial lease is of critical importance to any business, it is best to consult with an experienced San Diego Lease Lawyer before signing any lease. If hiring an attorney is not practical, take the time to review your proposed lease and diligently research all of the issues you are unclear about. There is a wealth of information available on the web.

Continued in “Starting a New Business In California – Hiring Employees“.

Continue reading

A California Close Corporation is a corporation designed to give its shareholders more control over the operation of their business.  Instead of sitting back and letting others run the company, the owners of a Close Corporation typically act as the company’s managers.  By complying with specific statutory requirements, Close Corporations can forego many of the corporate formalities other corporations are required to comply with.  This in turn reduces the risk that others will be able to pierce the corporate veil and reach the owners’ personal assets.  Section 300 of the California Corporations Code states: “The failure of a close corporation to observe corporate formalities relating to meetings of directors and shareholders in connection with the management of its affairs, pursuant to an agreement authorized by sudivision (b), shall not be considered a factor tending to establish that the shareholders have personal liability for corporate obligations”.  However, shareholders who manage the Close Corporation are subject to the same fiduciary duties any director of officer of a corporation has.  

The California Corporations Code imposes the following requirements for qualification as a Statutory Close Corporation:  

1.    The Corporation cannot have more than 35 shareholders.  However, for the purposes of satisfying this requirement, spouses are considered to be a single shareholder as are corporations, trusts, partnerships or other business associations unless the primary purpose of the entity was to acquire the close corporation’s shares.  

2.    The Articles of Incorporation must include a provision that the corporation cannot have more than 35 shareholders and specifically state that the corporation is a close corporation.

3.    The corporation’s share certificates must contain a conspicuous legend stating: “This corporation is a close corporation. The number of holders of record of its shares of all classes cannot exceed 35. Any attempted voluntary inter vivos transfer which would violate this requirement is void. Refer to the articles, bylaws and any agreements on file with the secretary of the corporation for further restrictions.”

4.    The Shareholders must enter into a written agreement setting forth the matters upon which the shareholders, rather than the board, will exercise control.  The shareholders’ agreement must be lodged with the Secretary of the Corporation and available for inspection by prospective purchasers.  It is common for Shareholders’ agreements to include buy-sell provisions limiting transferability of shares providing existing shareholders with a right of first refusal.  Moreover, close corporations may provide for greater control by minority shareholders and disproportionate distributions of profit.  

In addition to these statutory requirements, Close Corporations cannot go public.
Continue reading

Continued from How to Fund Your New San Diego Business.

Choosing the right business entity for your new San Diego venture is a critical step that should be made early in the process.  It’s important to diligently examine the pros and cons of each choice before deciding on what business entity to go with.  In some cases, opting for a sole proprietorship or general partnership remains a practical option.  In other cases, the owner or owners desire the creation of a more formal entity such as a corporation, limited liability company (LLC), limited liability partnership or professional corporation.  The ultimate choice will depend on the nature of the business, the number of owners and the capital investments being made.  The goal is to minimize potential liabilities including taxes.  The correct business entity choice for any particular company will depend on the individual characteristics of that company.  Your accountant and business attorney can provide guidance.  Nonetheless, there are some general issues to keep in mind:  

Limiting Liability:  One of the main reasons people opt for a formal business entity is to insulate owners from company liabilities.  Limiting the liability of owners encourages investment offering a distinct advantage over operating as a sole proprietorship or general partnership.  However in most cases, the owners of new businesses are required to give personal guarantees for commercial leases, loans and contractor agreements.  If so, the benefits of the formal business entity become less relevant, particularly if the business is adequately insured and intends to form an LLC or S-Corporation resulting in pass-through taxation.  If the owners have to personally guarantee loans and commercial leases, have insurance to cover civil liabilities and are going to elect pass through taxation so that they are taxed as individuals, there is little incentive to go through the expense of forming a formal entity.  

The Limited Liability Company (LLC) or S Corporation:  Most people forming new businesses end up narrowing the choice of business entity to an LLC or S-Corporation.  This is because they want pass through taxation to avoid the prospects of double taxation associated with C-Corporations.  If you are forming a new business and your main goal is to limit owner liability, the LLC is generally a good choice.  It offers more flexibility than the S-Corporation, and allows for unequal allocation of income, deductions and losses to the owners.  On the other hand, the S Corporation may offer some advantages to those concerned with self employment and FICA taxes.  If there is any doubt between these two forms of business entities, it’s best to consult with your accountant (preferably a CPA) or tax advisor for input.
Continue reading

Continued from Be Prepared Before Undertaking a New Business Venture.

Marshalling the resources necessary to fund a new San Diego business can be intimidating. In fact, it’s probably the biggest reason many decide against a new venture. How in the world will I come up with the capital necessary to: purchase an inventory; purchase equipment; lease commercial space; hire employees; pay an accountant and/or a business attorney; and/or pay for insurance? And even if I come up with the necessary funding to open my doors, will I be able to continue paying the company’s expenses? What about my personal expenses? These are important questions and they require a funding plan that takes into account start up requirements as well as the company’s short term and long term financial needs.

To properly evaluate a business’ capital needs, it’s important to have a strong business plan that clearly defines the company’s strategy for success and sets forth detailed projections of the company’s short term and long term finances. It will also define how an infusion of capital will be spent (whether on operating expenses or capital expenditures necessary for real estate and equipment). A critical analysis of the financial landscape aids in determining just what level of funding is needed and whether additional funding will be needed down the road. The more detailed and well reasoned your business plan, the more likely lenders and investors will provide needed capital. They will want to know how the money will be spent.

There are numerous ways to finance a new business’ operations. In most cases, new businesses are funded via a combination of resources. Personal assets, credit cards, bank loans, third party loans, 2nd mortgages, loans from friends and family, partners’ capital, sale of a corporation’s shares or a limited liability company’s membership interest, venture capital, sale of personal assets such as stocks, automobiles and boats are all common and legitimate means of raising capital. The first step is to inventory your personal resources. Whether via the sale of assets, withdrawal of cash from checking and savings accounts or via a second mortgage on your home, tally the dollar amount of the investment you are able to make. In deciding the amount of personal assets to invest in your new business venture, be sure to consider the need to meet personal expenses over time (preferably two years). Under your business plan, will you be paid a salary? Will you have enough money set aside as a cushion should the business prove unable to pay your salary or worse fail? These are important questions. Remember that you can opt to keep some reserves and make up the difference in needed capital via other means.

Continue reading

Continued from Starting Your Own Business – Be Willing to Commit.

Before starting up a new business, it’s important to have a plan.  This may seem obvious, but all too often young entrepreneurs incorrectly believe that the idea itself is good enough.  They are hungry for success and anxious to get started.  In many cases, an important facet of the new business is in place providing a false sense of security.  For instance, it may be that a head chef discovers an ideal restaurant space is for lease.  He or she knows the broker and learns that excellent commercial lease terms are being offered.  Rather than diligently examining the business’ prospects, the excited chef dives in taking out loans with unfavorable terms, entering into oral partnerships, engaging the services of the first vendors that come along and/or exposing his or her personal assets without the benefit of adequate insurance or the formation of a corporation or limited liability company.  

If the head chef’s plans for a successful restaurant are sound, they won’t depend solely on the restaurant’s location.  It is best to first diligently analyze all aspects of the business and develop a business plan before starting any business venture. Consult with trusted advisors such as your business attorney, accountant, banker and insurance agent to ensure that you are prepared for all of the professional requirements of business ownership.   In the above case, this is true even if it means losing out on the favorable lease terms being offered.  The development of a sound business plan includes: identifying the target market for the goods and services being offered; developing a marketing strategy that includes an examination of the prospects for capturing and maintaining a profitable share of that market; strategies for growth; securing funding and capitalization; consideration of employment and management structures; personal income needs; analysis of potential risks; and consideration of alternatives such as purchasing an existing business or franchise.  This is not an exhaustive list and an in-depth analysis of the development of a business plan is beyond the scope of this article.  See Writing an Effective Business Plan.  

Starting your own San Diego business is as scary as it is rewarding.  It requires an entrepreneurial spirit, common sense, commitment, organization and resources.  This series looks generally at the process in order to focus the young San Diego entrepreneur on the task at hand beginning with the opening move.  The series is not for those with unlimited resources.  For most of these folks, business opportunities abound whether expanding on already successful business models or selecting among numerous business ventures proposed by others, those with unlimited resources can afford to risk their capital.  They simply choose among the most lucrative options, if they choose at all. For most of the rest of us, we pour everything into a new business and each decision is life affecting.  

In this writer’s opinion, the single most important factor in the success of a business venture is the owner’s steadfast commitment.  While the phrase is perhaps an overused cliché, “No Fear” should be the guiding light for the young entrepreneur.  A timid part-time attempt at developing and nurturing a new business idea rarely pays off.  This is not to suggest that the young business owner should ignore reality and dive head first into an empty pool.  What it does mean is that after carefully surveying the territory, taking inventory of his or her resources, doing the leg work necessary to evaluate the business venture’s potential (due diligence), determining the income necessary to maintain a living wage (including that necessary to support his or her family) and evaluating worse case scenarios and exit strategies, the entrepreneur can make an informed decision, and upon making that decision should commit to it.   

The prevailing wisdom is that one should have two years worth of living expenses set aside before starting a new business.  This is of course hard to argue against.  Nonetheless, putting aside that much money is not always practical for every entrepreneur and the ultimate decision depends on one’s individual risk profile.  Someone with a family of five will be far more concerned with risk than the unmarried graduate just out of college.  Whatever one’s risk profile, there are other ways to marshal resources including business loans, investment capital, selling and collateralizing existing assets, revolving credit and the assistance of friends and family.  While the topic of marshaling resources will be dealt with later in this series, it is illustrative here as one of the advance considerations one makes before committing to the business venture.
Continue reading