Corporations vs. Limited Liability Companies
and Where do I Incorporate?

Forming a business entity is an involved process and should be thought out before you do it. In my experience, the decision to incorporate is largely tax driven - you make enough money that your accountant determines there are tax advantages to incorporating. The other reason for the decision is that you hire employees, and more specifically, put your employees on the road. Frankly, until you do either of these, there is no reason to incorporate - a title holding trust works better and makes life simpler.

The first issue is corporation vs. the limited liability company (LLC). The similarities are (1) both are required to be registered with the Secretary of State (2) both are required to pay a minimum $800 franchise tax (or more) and both are subject to annual state reporting requirements. Either entity can be formed by a single individual. The mechanics of forming a corporation vs. an LLC are remarkably similar, and any good attorney or incorporation service should be able to create both.

The advantages to the limited liability company are (1) a single tax rate (at the member's rate) and (2) no need to keep minutes, bylaws or hold meetings. They are easily formed, and are treated essentially as partnerships. The disadvantage of the LLC is that the California state minimum tax rates are different for the LLC than the corporation, and you escalate up the corporate tax rates more rapidly with an LLC than you will a corporation. In addition, if you hold a state professional license, you cannot form an LLC for business purposes.

The advantages of a corporation are (1) they are a more familiar concept to most people (2) you can make tax elections which are not available to the LLC (3) more favorable state tax treatment and (4) you can be very brave about your tax deductions. The disadvantages of a corporation is that your mom and pop corporation are subject to the exact same rules and regulations as General Electric - annual meetings, minutes of annual meetings, shareholder review, etc.

You may have heard of "C" and "S" corporations. Those are federal tax designations and for daily use the outside world need not know what type of corporation you are using. The advantage of the "C" corporation is that you can select your fiscal year, the tax deductions allowed are breathtaking, and you can accumulate all the cash you want within the entity without triggering a taxable event (Microsoft keeps some $25 billion in cash on hand at any time). The disadvantage of the "C" corporation is that it pays income tax, then the distributions to the shareholders are also taxed, creating double taxation. However, proper tax planning can minimize this problem.

An "S" corporation is taxed as a partnership and does not pay tax at the entity level, but at the shareholder level. Because of this, your fiscal year is fixed as a calendar year (the process to change this is very cumbersome) and there are limits to both deductions and cash retention within the entity.

The big debate in entity formation is where to do it. Generally speaking, if you are doing most of your work in California, form a California entity. It makes life simpler because you are dealing with a single state bureaucracy vs. two state bureaucracies. Even if you form your entity in Nevada, you must still register to do business with the California Secretary of State. This means you get to pay the annual $800 tax, file the same annual documents, and submit to California law. In addition, you need to pay the Nevada annual fees as well.