What form of small business entity is most appropriate for my business? There are several options that you have for selecting and forming a small business entity. The two most popular forms are sub-chapter S corporations (S corporation) and Limited Liability Companies (LLC). Both S corporations and LLCs are separate and distinct legal entities that operate separately from the owners of the business. Both business entities may own property, enter into contracts and conduct business under its own name.

An LLC is a relatively new form of business in California created under The Beverly Killea Limited Liability Act. This Act governs the organization and operations of LLCs doing business in California. A LLC combines corporate characteristics of limited liability for its equity holders, or "members", with the "pass-through" tax advantages of a partnership.

Besides the "pass-through" taxation and ownership's limited liability, other advantages of a Limited Liability Company include simplicity of understanding and compliance with formation and operational requirements, decreased annual paperwork, and flexibility of management structure and ownership, including freedom to creatively arrange differential capital contributions, profit distributions, loss allocations, preferential payments and voting arrangements between owners. One common disadvantage to the LLC entity is society's unfamiliarity with the structure. Furthermore, in California the largest disadvantage to operating a business using the LLC entity is the franchise fee. (LLCs must pay the same $800 annual franchise tax that corporations must pay, although corporations are exempt from paying a minimum franchise tax the first year but still must pay quarterly estimated taxes and actual taxes based on net income.) A California LLC must pay an additional annual franchise "fee" based upon its total income. The franchise fee ranges from a low of $1,042 for an LLC having total gross income between $250,000 and $499,999 to a high of $9, 377 for an LLC with total income of $5 million or more.

Advantages of doing business under the corporate form include limited liability for owners (shareholders) and ability to offer employees stock options and stock bonus incentives. There are additional advantages for small businesses to incorporate and elect to be treated as a sub-chapter S corporation. An "S corporation" is a business that has incorporated and filed an election for a special tax designation (IRS form 2553) and the IRS has granted the designation. This election, in general allows for the income of the S corporation to be taxed to the shareholder of the corporation as opposed to the corporation (i.e. "pass-through" tax treatment). In addition, an S corporation does not pay additional California franchise fee on gross receipts of $250,000 or more, is one of the few limited liability organization available to medical and dental profession and avoids the double taxation of a regular corporation (sub-chapter C corporation). There is also self-employment tax (FICA) benefits derived from operating a business as an S corporation. The IRS collects 15.3% tax on the first $84,900 earned by a self-employed person and a 2.9% tax on earnings above that amount. This is commonly known as the self-employment tax. For an S corporation, the rules on the self-employment tax are well established; as an S corporation shareholder and employee, a person pays the self-employment tax on money he or she receives as compensation for services rendered, but not on profits that are automatically pass through to him or her as a shareholder. For example: If a shareholders share of S corporation income is $100,000 and the shareholder is also an employee who performs services for the corporation reasonably worth $65,000, the shareholder/employee will owe the 15.3% self-employment tax on the $65,000 but not on the remaining $35,000. By comparison, the IRS has not yet issued any regulations giving an LLC the same favorable tax treatment. Therefore, it should be assumed that an LLC would pay tax on 100% of an LLC member's earnings.

Disadvantages of an S corporation include restrictions on the number of shareholders, type of shareholders, available tax year, management structure and more annual paperwork. At the commencement of your corporation, the officers of the corporation will need to adopt bylaws to establish the way the business is to be run. You will then need to hold an initial meeting of the officers to establish the date of your annual meeting. After that, you will need to have annual meetings with your officers to discuss the progress or status of your corporation. Additionally, you will need to log the annual meeting with minutes from your meeting each year.

Given the advantages and disadvantages of the LLC and S corporation, how does a business owner decide which business form is right for his or her small business? An S corporation could become advantageous for you if your business is relatively small and in the early stages of development. Even though the LLC is currently the business entity of choice in most states, for small businesses in California, many choose the S corporation. Avoiding the minimum California franchise tax for the first year, avoiding the annual California franchise fee (i.e. business penalty tax) and saving thousands of dollar in self employment taxes (FICA) are all good reasons for a California small business to elect to operate as an S Corporation.

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