YLG’s Legal Basics Series: The 4 Common Types of Businesses in California

What Is Business Entity Formation?
Business entity formation is the legal process of establishing a business structure recognized by the state. The type of business form or entity you choose affects your personal liability, taxes, decision-making authority, how your ownership can be transferred, and how the business can be dissolved.

1. Sole Proprietorship

What is a Sole Proprietorship?

A sole proprietorship is the simplest form of business organization in California. It is when a single person engages in business personally and without any co-owners. As a sole proprietorship, the business does not need to adhere the business formalities and reporting requirements required of corporations and limited liability companies. However, the owner of the business remains personally liable for all business debts and obligations of the business.

How is it formed?

Forming a sole proprietorship in California does not require that the business owner register the business with the California Secretary of State. The sole proprietorship is simply formed by starting the business. However, the business will most likely need to obtain local or municipal business licenses and/or permits and will need to obtain a fictitious business name (a.k.a. “DBA,” for “doing business as”) if you do not want to operate the business under your legal name. If a fictitious business name is used, the owner must file a DBA with the county recorder in the county where the proprietorship’s principal place of business is located as well as in any other county the proprietorship plans to do business.

Who may form a Sole Proprietorship?

A sole proprietorship may be formed by an individual, and all types of businesses may operate as sole proprietorships in California. For example, attorneys, accountants, architects, and medical professionals may offer their professional services as sole proprietors.

How is it managed and controlled?

The sole proprietor will be deemed the manager and operator of the business, but they may have employees as well.

How is it terminated?

A sole proprietorship terminates when the owner discontinues the business, winding up any pending obligations, contracts, and registrations (such as business licenses or permits) and completes all required tax filings regarding income, employees, and related matters.

Is there personal liability for the owner of a Sole Proprietorship?

Yes. The downside of a sole proprietorship is that it exposes the owner of the business, the “proprietor,” to unlimited personal liability. The owner of the sole proprietorship will be responsible for the debts, obligations, and liabilities of the business.

2. General Partnership

What is a General Partnership?

A general partnership involves two or more individuals operating a business together for profit.[1] A partnership is an entity distinct from its partners and may be formed by written, oral, or implied agreement among the partners.[2] However, a well-drafted partnership agreement is highly recommended for a General Partnership.

How is it formed?

Similar to a sole proprietorship, a general partnership does not require that the owners file for registration with the California Secretary of State. A general partnership can be formed when two (2) or more individuals or entities come together to form and carry on a business as co-owners. [3]  A general partnership can be formed by default if a different type of business entity is not chosen and two or more individuals or entities engage in business.[4] However, a general partnership may file a statement of partnership authority with the California Secretary of State, if it chooses, to establish its validity.[5]

Who may form a General Partnership?

Two or more individuals, corporations, business trusts, estates, trusts, partnerships, limited partnerships, LLCs, associations, joint ventures, governments, governmental subdivisions, agency, or instrumentality, or any other legal or commercial entity may form a general partnership. [6]

How is it managed and controlled?

General partnerships do not have a board of directors or officers as corporations do, but instead are managed and operated by the partners themselves, although a general partnership may hire employees to manage the partnership. Each partner is an agent of the partnership and can bind the partnership in the ordinary course of business, though exceptions apply.[7]

How is it terminated?

A partnership is dissolved, and its business shall be wound up, upon the occurrence of any of the following events as listed in Corp C §16801.

For example, in a partnership at-will, the express will to dissolve and wind up the partnership business of at least half of the partners, including partners, other than wrongfully dissociating partners, who have dissociated within the preceding 90 days, and for which purpose a dissociation under paragraph (1) of Section 16601 constitutes an expression of that partner’s will to dissolve and wind up the partnership business. [8]

A partnership continues after dissolution only for the purpose of winding up its business. The partnership is terminated when the winding up of its business is completed. (See Corp C §16802)

Is there personal liability for the owners?

Each general partner is personally liable, jointly and severally, for all debts and obligations and most wrongdoing of the partnership, unless agreed otherwise by the claimant or provided by law, and except for any partnership obligation incurred before a person is admitted as a partner.[9]

3. Corporation (For Profit S-Corp or C-Corp)

What is a Corporation?

A corporation is a business entity structure that offers limited liability protection to its owners, who are referred to as “shareholders.” A corporation is an entity distinct and separate from its owners. A corporation can exist indefinitely, even if its owners change, unlike a sole proprietorship or general partnership. A corporation’s shareholders are generally not liable for the corporation’s debts and obligations solely by reason of being the owners of the business. However, shareholders of a corporation can be held liable for the corporation’s debts and liabilities under certain circumstances.

A corporation provides asset protection to its shareholders, offers a simpler transfer of ownership interest when compared to other types of business entities, and can offer certain tax advantages. The formation process of an S-Corp and C-Corp is similar, as S-Corp and C-Corp are used as tax designations. However, shareholder approval will be required for a corporation to be taxed as an S-Corp, and the corporation will need to qualify for S-Corporation Status.

How is it formed?

In the state of California, a corporation is created by the incorporator filing the Articles of Incorporation with the Secretary of State,  and paying the applicable filing fee.[10] In addition to the filing of the Articles of Incorporation, the formation process of a corporation requires that other corporate documents be prepared as well, since it needs to abide by the formalities and requirements of the California Corporations Code (the "Code"). For example, the corporation will need to adopt bylaws, which set forth the rules and procedures that govern the internal management of the corporation’s business and affairs (See Corp C §213). Bylaws serve two primary functions. First, they can be a useful reference for the corporation’s directors and officers to ensure that their acts comply with the rules and regulations of the corporation. Second, bylaws can vary, to a certain extent, some of the default rules set forth in the Code, and may establish rules in areas not covered by the Code.

Applicable Franchise Fee: (source: Ftb.ca.gov)

Every corporation that is incorporated, registered, or doing business in California must pay the $800 minimum franchise tax.

On or after January 1, 2020, newly incorporated or qualified corporations are not required to pay the minimum franchise tax in their first taxable year.

Corporations are also not subject to the minimum tax if both of the following are true:

• They did not conduct any business in California during the tax year; and
• Their tax year was 15 days or fewer.

Who may form a Corporation?

One or more natural persons, partnerships, associations, or domestic or foreign corporations may form a corporation.[11] However, to be designated as an S-Corp, the corporation will need to comply with IRC Section 1361(b).

Professionals permitted to form professional corporations are attorneys, accountants, and architects, as well as dentists, nurses, chiropractors, psychologists, clinical social workers, and others.

How is it managed and controlled?

The corporation is managed through its board of directors (that are elected annually by the shareholders) and its corporate officers (that are appointed annually by the corporation’s board of directors). Under California law, the corporation is required to have a Chief Executive Officer (CEO), Chief Financial Officer (CFO) and Secretary.[12] In small corporations, the same person can wear different hats and have different titles. For example, the same person can be a shareholder, serve on the board of director(s), and be appointed as an officer of the corporation.[13] Under the title of “shareholder”—the shareholder of a corporation does not exercise any management control or function (except for shareholders of a close corporation, which is a distinct type of corporation not covered in this post, and not to be confused with a closely-held corporation).

How is it terminated?

In order to terminate a corporation, certain rules and procedures as stated in California’s Corporations Code (including proper notice to corporate creditors) need to be followed. A corporation can be terminated and dissolved by voluntary methods (e.g. by action of fifty (50) percent or more of the voting power of the corporation’s shareholders[14]) or by involuntary methods (e.g., through a lawsuit brought by a shareholder owning at least one-third interest in the corporation[15]).

Is there personal liability for the owners?

No. Corporate shareholders are not generally personally liable for corporate debts and obligations. However, they can be if they:

• Personally guarantee corporate debts or obligations;
• Engage in tortious conduct;
• Receive improper distributions; and/or
• Become subject to “alter ego” claims for commingling personal and business matters, failure to follow required corporate formalities, inadequate capitalization, etc.

Shareholders who also serve as officers and directors may have additional liability exposure due to the additional control they have over corporate matters.

4. Limited Liability Company (LLC)

What is a limited liability company?

A limited liability company is a hybrid between a corporation and a general partnership. However, unlike a general partnership, it offers the same limited liability protection to its owners as does a corporation (who, in the case of LLCs, are referred to as members). There are two (2) types of limited liability companies available in California; (1) a member-managed LLC and (2) a manager-managed LLC. Limited liability companies are governed pursuant to the terms of their operating agreements, which are essential legal documents for LLCs. It is very important for an LLC to have a properly drafted operating agreement. If the LLC does not have an operating agreement, the defaults rules as set out in California Revised Uniform Limited Liability Act (RUCLLA) shall apply.

An LLC’s operating agreement is a legally binding contract that outlines the internal rules, structure, and operations of an limited liability company. It generally includes provisions pertaining to ownership structure, members' roles and voting rights, profit and loss allocation and distributions, management governing rules and procedures, dispute resolution procedures, dissolution process, and membership withdrawal and dissociation.

Although an operating agreement may be either written, oral, or implied[16], due to the important role it plays, it should be in writing to avoid any uncertainty as to the terms intended and agreed to by the owners of the business.

How is it formed?

A limited liability company is formed by filing the Articles of Organization for the LLC with the California Secretary of State and paying the applicable filing fee.[17] Best practice is to have the operating agreement prepared and entered before the Articles of Organization are filed with the Secretary of State.

Applicable Franchise Fee: (source: ftb.ca.gov)

Every LLC that is doing business or organized in California must pay an annual tax of $800. For tax years beginning on or after January 1, 2021, and before January 1, 2024, LLCs that organize, register, or file with the Secretary of State to do business in California are not subject to the annual tax of $800 for their first tax year.

Who can form an LLC?

One or more individuals, partnerships, limited partnerships, trusts, estates, associations, corporations, LLCs, or other entities may form an LLC.[18]

Limited liability companies may not be formed to render professional services, as defined in Corp C §§13401(a) and 13401.3.[19] Therefore, attorneys, accountants, architects, and medical professionals are not permitted to practice through an LLC under California law.

How is an LLC managed and controlled?

Limited liability companies are structured more flexibly than corporations, vesting management in either the owners of the business (member-managed LLCs) or in a designated manager (manager-managed LLC) pursuant to the terms of the operating agreement. If permitted by the operating agreement, a limited liability company may have officers such as a president, CFO, or secretary.[20]

How is it terminated?

Generally, an LLC is dissolved and its affairs wound up pursuant to the terms of its operating agreement. Pursuant to Corp C Section 17707.01, a limited liability company is dissolved, and its activities shall be wound up, upon the happening of the first to occur of the following:

(a) On the happening of an event set forth in a written operating agreement or the articles of organization.

(b) By the vote of 50 percent or more of the voting interests of the members of the limited liability company or a greater percentage of the voting interests of members as may be specified in the articles of organization, or a written operating agreement.

(c) The passage of 90 consecutive days during which the limited liability company has no members, except that, on the death of a natural person who is the sole member of a limited liability company, the status of the member, including a membership interest, may pass to one or more heirs, successors, and assigns of the member by will or applicable law. An heir, successor, or assign of the member’s interest becomes a substituted member pursuant to paragraph (4) of subdivision (c) of Section 17704.01, subject to administration as provided by applicable law, without the permission or consent of the heirs, successors, or assigns or those administering the estate of the deceased member.

(d) Entry of a decree of judicial dissolution pursuant to Section 17707.03.

A certificate of dissolution of the LLC will need to be filed with the Secretary of State to effectuate the dissolution of the LLC. Notwithstanding the filing of a certificate of dissolution, a majority in interest of the LLC’s members may file a certificate of continuation.[21]

The filing of a certificate of dissolution does not cause the extinction of the legal entity. The filing of a certificate of dissolution merely announces the commencement of the winding-up process.[22] Even after the filing of a certificate of cancellation, the legal entity continues in existence for the restricted corporate purpose of winding up its affairs, prosecuting and defending actions by or against it to collect and discharge obligations, disposing of and conveying its property, and collecting and dividing its assets.[23] The LLC is not authorized to continue its pre-dissolution business activities, except as necessary for its winding up.

Is there personal liability for the owners?

No. Members of an LLC are not generally personally liable for debts and obligations of the LLC. However, they can be if they:

• Personally guarantee debts of the LLC;
• Participate in tortious conduct;
• Receive improper distributions; and/or
• Become subject to “alter ego” claims.

Conclusion

Choosing the right business form or entity is not just a matter of paperwork—it’s a legal decision that can significantly impact your personal liability, tax obligations, and long-term business success. While online resources can be helpful and informative, they cannot replace the tailored advice of a qualified attorney.

If you are forming a business in California, you should consult with a knowledgeable business attorney. An experienced attorney can help you evaluate your options, ensure compliance with state law, and structure your business to protect your interests from the start.

To learn more about how we can support your needs regarding your business entity, explore our Business Formation & Restructuring, Corporate Law & Governance, or Contract Law Services.

Call YLG Counsel® at (424) 270-0064 now to schedule your FREE Introductory Consultation or click here to schedule it for yourself.

Disclaimer:  The content of this posts and the information provided herein is for informational and educational purposes only. It does not constitute as legal advice or legal representation, and no attorney-client relationship will be formed through your review or use of the content or information in this post. Further, please know it is provided “as-is” without any guarantee as to the accuracy of its content and information provided.

Footnotes/References:

[1]  See Corp C §§16101(a)(9) and 16202(a)

[2] See Corp C §16201; Corp C §16101 (a)(10); Corp C §16202(a)

[3] See Corp C §16202(a)

[4] See Corp C §16202(a)

[5] See Corp C §16303(a)

[6] See Corp C §16101 (a)(13).

[7] See  Corp C §16301(1).

[8] See Corp C §16801(1).

[9] See Corp C §16306(a)–(b).

[10] See Corp C §200(c).

[11] See  Corp C §200(a).

[12] See Corp C §312.

[13] See Corp C §§ 212(a) and 312.

[14] See Corp C §1900.

[15] See Corp C §1800.

[16] See Corp C §17701.02(s).

[17] See Corp C §17702.01.

[18] See Corp C §17701.02(k), (p), (v).

[19] See Corp C §17701.04(e).

[20] See Corp C § 17704.07(a)(4).

[21] See Corp C §17707.09.

[22] See Corp C §17707.06(a).

[23] See Corp C §17707.06(a).