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The Small Business Start-Up Kit for California

The only California-specific book for small business start-ups

Get your California start-up off the ground with the financial, legal, and practical tools needed to set up and run a small business in the Golden State.  The Small Business Start-Up Kit for California shows how to:

  • write an effective business plan and choose the right business structure
  • raise start-up funding
  • get necessary state and local licenses and permits
  • manage finances and taxes, and
  • market your business successfully.

Includes key business forms and information every California start-up needs!

See below for a full product description.

  • Product Details
  • The Small Business Start-Up Kit for California shows you how to set up a small business quickly and easily. It explains the forms, fees, and regulations you’ll encounter and shows you how to:

    • choose the right business structure, such as an LLC or partnership
    • write an effective business plan
    • pick a winning business name and protect it
    • get needed California licenses and permits
    • hire and manage staff in compliance with California and federal law
    • start a home business
    • manage finances and taxes, and
    • market your business effectively, online and off.

    The 14th edition is updated with the latest legal and tax rules affecting California small businesses, plus social media and e-commerce trends.

    “A good-to-have, step-by-step guide to starting a business in California: forms, licenses, business plan, taxes and more.”—San Francisco Examiner

    “Excellent advice…for would-be small-business owners, and heeding it can help you avoid many early mistakes.”—Los Angeles Times

    ISBN
    9781413329476
    Number of Pages
    480
    Included Forms

    • Partnership Agreement
    • LLC Articles of Organization
    • Sample Articles of Incorporation
    • Certificate of Limited Partnership
    • Limited Liability Partnership Registration
    • Application for Employer Identification Number (IRS Form SS-4)
    • California Fictitious Business Name Statement
    • California Seller's Permit Application and Instructions for Individuals/Partnerships/Corporations/Organizations
    • California Resale Certificate
    • Swap Meets, Flea Markets, or Special Events Certification
    • California Board of Equalization Publications Order Form
    • IRS Form 1040-ES: Estimated Tax Form and Instructions
    • California Estimated Tax Form and Instructions (FTB Form 540-ES)
    • Limited Liability Company Tax Voucher (FTB Form 3522)
    • Entity Classification Election (IRS Form 8832)
    • Election To Have a Tax Year Other Than a Required Tax Year (IRS Form 8716)
    • Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (IRS Form SS-8)
  • About the Author
    • Peri Pakroo, J.D. · University of New Mexico School of Law

      Peri Pakroo (www.peripakroo.com) is a business author and coach, specializing in creative and smart strategies for self-employment and small business. She has started, participated in, and consulted with start-up businesses for more than 20 years. She is the founder and Director of P-Brain Media, an information technology firm that helps small, indie ventures define digital strategy and communicate online.

      Peri received her law degree from the University of New Mexico School of Law in 1995, and a year later began editing and writing for Nolo, specializing in small business and intellectual property issues. She is the author of the top-selling Nolo titles The Women’s Small Business Start-Up Kit, The Small Business Start-Up Kit (national and California editions), and Starting & Building a Nonprofit, and has been featured in numerous national and local publications including Entrepreneur, Real Simple, Investor’s Business Daily, and BusinessWeek.

      For several years Peri taught adult education courses at WESST in Albuquerque, a nonprofit whose mission is to facilitate entrepreneurship among women and minorities in the state of New Mexico. She is active in supporting local, independent businesses and is a co-founder of Sustainable Equitable Economic Democracy New Mexico (SEED NM).

  • Table of Contents
  • Your California Small Business Start-Up Companion

    • As Conditions Change, the Elements of Success Stay the Same
    • Systems Facilitate Success
    • What You’ll Find in This Book—and Why It’s a Must for California Start-Ups
    • Take the Leap

    1. Choosing a Legal Structure

    • Sole Proprietorships
    • Partnerships
    • Limited Liability Companies (LLCs)
    • Corporations
    • Benefit Corporations, L3Cs, and Emerging Business Structures for Socially Conscious, Mission-Driven Businesses
    • Choosing the Best Structure for Your Business

    2. Picking a Winning Business Name

    • An Overview of Trademark Law
    • Trademark Issues Online
    • Name Searches
    • Choosing a Domain Name
    • Trademark Registration
    • Winning Names for Your Business, Products, and Services

    3. Choosing a Business Location

    • Picking the Right Spot
    • Complying With Zoning Laws
    • Commercial Leases

    4. Drafting an Effective Business Plan

    • Different Purposes Require Different Plans
    • Describing Your Business and Yourself
    • Making Financial Projections
    • Break-Even Analysis
    • Profit/Loss Forecast
    • Start-Up Cost Estimate
    • Cash Flow Projection
    • Putting It All Together

    5. Raising Start-Up Money

    • Realities of Funding a Start-Up
    • Debt Versus Equity Financing
    • Business Loans
    • Equity Investments
    • What Lenders and Investors Look For
    • Alternatives to Institutional Funders

    6. Pricing, Bidding, and Billing Projects

    • Pricing and Billing for Service Businesses
    • Bidding and Creating Proposals
    • Pricing for Businesses Selling Products

    7. Federal, State, and Local Start-Up Requirements

    • Step 1: File With the Secretary of State
    • Step 2: Obtain a Federal Employer Identification Number (EIN)
    • Step 3: Register Your Fictitious Business Name (FBN)
    • Step 4: Obtain a Local Tax Registration Certificate
    • Step 5: Obtain a State Seller’s Permit
    • Step 6: Obtain Special Licenses or Permits

    8. Risk Management

    • Who Might Sue or Be Sued?
    • Risk Management Strategies
    • Insurance and Warranties

    9. Paying Your Taxes

    • Tax Basics
    • Income Taxes for Sole Proprietors
    • Income Taxes for Partnerships
    • Income Taxes for LLCs
    • Estimating and Paying Your Taxes Quarterly
    • City and County Taxes
    • Sales Taxes

    10. Laws, Taxes, and Other Issues for Home Businesses

    • Home Business Zoning Restrictions
    • The Home Business Tax Deduction
    • Risks and Insurance

    11. Entering Into Contracts and Agreements

    • Contract Basics
    • Using Standard Contracts
    • How to Draft a Contract
    • Reading and Revising a Contract
    • Electronic Contracts

    12. Bookkeeping, Accounting, and Financial Management

    • Accounting Basics
    • Cash Versus Accrual Accounting
    • Step 1: Keeping and Organizing Receipts
    • Step 2: Entering Receipts Into Bookkeeping Software
    • Step 3: Generating Financial Reports
    • Using Technology to Manage Money, Inventory, and Projects

    13. Small Business Marketing 101

    • Defining Your Market
    • Learning About Your Market: Market Research
    • Cost-Effective Marketing Tools

    14. Digital Strategy: Selling and Marketing Online

    • Defining Your Digital Strategy and Goals
    • A Website: Your Online Base Camp
    • Online Outreach Methods
    • E-Commerce: What’s Involved?
    • Website Builders and Affiliate Stores: Do or Don’t?
    • Planning a Website Project
    • Choosing and Working With a Web Developer
    • The Website Development Process
    • Driving Traffic to Your Site
    • Domain Names and Hosting
    • Intellectual Property: Who Owns Your Website?

    15. Planning for Changes in Ownership

    • When You Need a Written Buy-Sell Agreement
    • Buy-Sell Agreement Basics
    • Limiting Ownership Transfers
    • Establishing the Price for Sales: How to Value the Business
    • Implementing Buy‑Sell Provisions
    • Sample Buy-Sell Provisions

    16. Building Your Business and Hiring Workers

    • Employees Versus Independent Contractors
    • Special Hurdles for Employers
    • Hiring and Managing Staff

    17. Getting Legal and Other Professional Help

    • Working With Lawyers
    • Working With Accountants and Other Financial Professionals
    • Internet Legal Research

    Appendix A: California Small Business Resources and Contact Information

    • Government Agencies
    • Associations

    Appendix B: How to Use the Downloadable Forms on the Nolo Website

    • Editing RTFs
    • List of Forms Available on the Nolo Website

    Index

  • Sample Chapter
  • Chapter 1: Choosing a Legal Structure

    You probably already have a rough idea of the type of legal structure your business will take, whether you know it or not. That’s because, in large part, the ownership structure that’s right for your business—a sole proprietorship, partnership, LLC, or corporation—depends on how many people will own the business and what type of services or products it will provide, things you’ve undoubtedly thought about quite a bit.

    For instance, if you know that you will be the only owner, then a partnership is obviously not your thing. (A partnership by definition has more than one owner.) And if your business will engage in risky activities (for example, providing financial planning advice or repairing roofs), you’ll want to buy insurance and consider forming an entity (like a corporation or limited liability company), which provides personal liability protection to shield your personal assets from business debts and claims. If you plan to seek venture capital or want to give your employees stock options, you should form a corporation.

    If you’ve already considered these issues, you’ll be ahead of the game in choosing a legal structure that’s right for your business. Still, you’ll need to consider the benefits and drawbacks of each type of business structure before making your final decision.

    Limited Liability

    One basic distinction that you’ll probably hear mentioned lots of times is the difference between businesses that provide their owners with “limited liability” and those that don’t. Corporations and LLCs each provide owners with limited personal liability. Sole proprietorships and general partnerships do not.

    Limited liability basically means that the creditors of the business typically can’t go after the owners’ personal assets to pay for business debts and claims arising from business-related lawsuits. (Liability for business debts is discussed in detail later in this chapter.)

    As you read about business types, you’ll see how a decision to form a limited liability entity (a corporation or an LLC) can dramatically affect how you run your business. On the other hand, sole proprietorships and partnerships (which are simpler to run than corporations and LLCs) might leave an owner personally vulnerable to business lawsuits and debts.

     

    In California, the basic types of business structures are:

    • sole proprietorships
    • partnerships
    • limited liability companies (LLCs), and
    • corporations.

    To help you pick the best structure for your business, this chapter explains the basic attributes of each type, and special rules that apply in California.

    This chapter will also help you answer the most common question entrepreneurs ask about choosing a business form: Should I choose a business structure that offers protection from personal liability—a corporation or an LLC? Here’s a preview of what you’ll learn: If you focus your energy and money on getting your business off the ground as a sole proprietorship or a partnership, you can always incorporate or form an LLC later.

    Making the Decision to Go Official

    Some of you might be grappling with a more preliminary question than which legal structure you should choose. You might be wondering whether to formalize your business at all (register with appropriate state agencies). For instance, maybe you’ve been doing freelance graphics work on the side for a number of years, but now you’re thinking of quitting your 9-to-5 job to take on graphics work full time.

    Generally speaking, anyone with a good-sized or otherwise visible business should bite the bullet and complete all of the necessary registration tasks to become official. A business operating under the table can be exposed all too easily, and the government can come after you with fines and penalties for operating without the necessary paperwork. And if you’re making a profit, ignoring the IRS is definitely a bad idea. Along with fines and back taxes, you could even face jail time for tax evasion.

    On the other hand, tiny, home-based, hobby-type businesses can often operate for quite some time without meeting registration requirements. If you’re braiding hair or screen printing T-shirts or holding an occasional junk sale out of your garage, for instance, you can probably get by without formal business registration—at least for a while. But just because it might be possible doesn’t mean it’s the best option. Often, you benefit from formally registering your business because you can write off business expenses and reduce your personal taxes. In Chapter 9, we’ll talk more about hobby businesses, including how tax laws deal with businesses that continually lose money.

    If you’re not sure whether you want to register your business and open it up to the world of government regulations, the information about registration requirements in this book will give you the information you need to make a decision. Chapter 7 walks you through the many government regulations that apply to all new businesses and explains how to find and satisfy any additional requirements that apply to your business.

     

    Sole Proprietorships

    SKIP AHEAD
    Sole proprietorships are one-owner businesses. Any business with two or more owners can’t, by definition, be a sole proprietorship. If you know that your business will have two or more owners, you can skip ahead to “Partnerships,” below.

    A sole proprietorship is a business that’s owned by one person and hasn’t filed papers to become a corporation or an LLC. Sole proprietorships are easy to set up and to maintain—so easy that many people own sole proprietorships and don’t even know it. For example, if you’re a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions, or an independent contractor who isn’t on an employer’s regular payroll, you are automatically a sole proprietor. This is true whether you’ve registered your business with your city or applied for any licenses or permits. And it makes no difference whether you also have a regular day job. If you do for-profit work on your own (or sometimes with your spouse—see “Running a Business With Your Spouse,” below) and you haven’t filed papers to become a corporation or a limited liability company, you are a sole proprietor.

    CAUTION
    Don’t ignore local registration requirements. If you’ve started a business without quite realizing it—for example, you do a little freelance website development, which classifies you as a sole proprietor by default—be aware that you probably haven’t satisfied the local governmental requirements for starting a business. Most cities and many counties require businesses—even tiny home-based sole proprietorships—to register with them and pay at least a minimum tax. And if you do business under a name different from your own (say, Christina Kennedy does business under the name “Monster Photography”), you typically have to register that name—known as a fictitious business name—with your county. In practice, lots of businesses are small enough to get away with ignoring these requirements. But if you aren’t in compliance and you’re caught, you might have to pay back taxes and face other penalties. (See Chapter 7 for an explanation of how to make the necessary filings with the appropriate government offices.)

    Pass-Through Taxation

    In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. This characteristic is one of the fundamental differences between a sole proprietorship and a corporation or an LLC. And it has two major effects: one related to taxation (explained in this section), and the other to personal liability (explained in the next).

    Running a Business With Your Spouse

    If you plan to start a sole proprietorship and expect that your spouse might occasionally help out with business tasks, you should take advantage of a fuzzy area in federal tax law that can save you money. The IRS typically allows a spouse to help out with the other spouse’s business without being classified as an owner or employee (a situation sometimes misleadingly called a “husband-wife sole proprietorship”).

    The general rule is that a person who does work for your business must be (from a legal standpoint) a co-owner, an employee, or an independent contractor. But your spouse can volunteer—that is, work without pay—for your sole proprietorship without being classified as an employee, freeing the business from paying payroll tax for the spouse’s labor. This arrangement saves you money—and, if you have no other employees, also allows you to avoid the time-consuming record keeping involved in being an employer. Similarly, a spouse who is not classified as a partner or an independent contractor won’t have to pay self-employment taxes, and your business won’t have to file a partnership tax return.

    Be aware that California is a “community property” state, which means that if a business is started or significantly changed when a couple is married, both spouses will have an equal ownership interest in the business, regardless of whose name is on the ownership document. A premarital agreement (a.k.a. “prenup”) might prevent this outcome.

    If you are concerned about the possible consequences of divorce, read Chapter 15, “Planning for Changes in Ownership.” You will learn how divorce and other life events, such as retirement and death, can affect ownership of a business and how to plan in advance to adapt to the possibilities. You might also want to check with a lawyer who is experienced in handling marital property issues to see how your business could be affected in the event of a divorce.

    Finally, if you and your spouse both want to be active partners in a co-owned business—each with an official say in management—you should create a partnership or an LLC or corporation, even though doing so will mean filing somewhat more complicated tax returns and other business paperwork. If your spouse tries to squeak by as a volunteer in a so-called “husband-wife sole proprietorship” when you’re really working together as a partnership, and you’re audited by the IRS, your spouse could get hit with back self-employment taxes and penalties.

    At income tax time, sole proprietors simply report all business income or losses on their individual income tax returns. The business itself is not taxed. The IRS calls this “pass-through” taxation, because business profits pass through the business to be taxed on the business owner’s tax return. You report income from a business just like wages from a job. You’ll need to file your usual Form 1040 and a Schedule C, which will include your business’s profit and loss information. One helpful aspect of this arrangement is that if your business loses money—and, of course, many start-ups do in the first few years—you can use the business losses to offset any taxable income you’ve earned from other sources.

    EXAMPLE: Rob has a day job at a coffee shop, where he earns a modest salary. His hobby is collecting obscure records at thrift stores and garage sales. He decides to start selling some of the vinyl gems he’s found. Still working his day job, he starts a small business that he calls Rob’s Revolving Records.

    During his first full year in business, he sees that a key to consistently selling his records is developing connections and trust among record collectors. Unfortunately, while he is concentrating on getting to know potential buyers and others in the business, sales are slow.

    At year-end, he closes out his books and sees that he spent nearly $9,000 on his business, including records, his website, marketing items (like business cards), and other supplies. He made only $3,000 in sales. But there is some good news: Rob’s loss of $6,000 can be counted against his income from his day job, reducing his taxes and translating into a nice refund check, which he’ll put right back into his record business.

    CAUTION
    Your business can't lose forever. See the discussion of tax rules for money- losing businesses in Chapter 9.

    RESOURCE
    Be ready for the day you’ll owe taxes. Once your business is under way and turning a profit, you’ll have to start paying taxes. (See Chapter 9 for an overview of the taxes small businesses face.) Taxes can get fairly complicated, and you might need more in-depth guidance. For detailed information on taxes for the various types of small businesses, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo). This book gives exhaustive information on deductions, record keeping, and audits—all of which will help you reduce your tax bill and stay out of trouble with the IRS.

    Personal Liability for Business Debts

    Another crucial thing to know about operating your business as a sole proprietor is that you, as the owner of the business, can be held personally liable for business-related obligations. This means that if your business doesn’t pay a supplier, defaults on a debt, loses a lawsuit, or otherwise finds itself in financial hot water, you can be forced to pay up. This can be a real concern, especially if you own (or soon hope to own) a house, car, or other assets. Personal liability for business obligations stems from the fundamental legal attribute of being a sole proprietor: You and your business are legally one and the same.

    CAUTION
    Commercial insurance doesn’t cover business debts. Commercial insurance can protect a business and its owners from some types of liability (for instance, slip-and-fall lawsuits), but insurance never covers business debts. The only way to limit your personal liability for business debts is to use a limited liability business structure such as an LLC or a corporation (or a limited partnership or limited liability partnership). And it’s important to keep in mind that even if you have an LLC or corporation in place, your personal assets might be on the line if you are asked to sign personal guarantees for loans, leases or other obligations. New businesses that don’t have a solid credit history are often asked for such guarantees when applying for loans, lines of credit, or vendor accounts. Considering these risks is part of the important task of risk management, which we discuss in Chapter 8.

    As explained in more detail in the sections that discuss corporations and LLCs, owners of these businesses enjoy what the law calls “limited personal liability” for business obligations. This means that, unlike sole proprietors and general partners, owners of corporations and LLCs can normally keep their houses, investments, and other personal property, even if the business fails. In short, if you are engaged in a risky business, you might want to consider forming a corporation or an LLC—although small business insurance might protect you from claims that your business caused personal injury or property damage to someone else.

    Creating a Sole Proprietorship

    Setting up a sole proprietorship is easy. Unlike starting an LLC or a corporation, you generally don’t have to file special forms or pay special fees to start working as a sole proprietor. You simply declare your business to be a sole proprietorship when completing the general registration requirements that apply to all new businesses, like getting a business license from your county or city, or a seller’s permit from the California Department of Tax and Fee Administration (CDTFA).

    For example, when filing for a business tax registration certificate with your city, you’ll often be asked to declare what kind of business you’re starting. Some cities require only that you check a “sole proprietorship” box on a form, while others have separate tax registration forms for sole proprietorships. You might also have to identify your business as a sole proprietorship when you register a fictitious business name or obtain a seller’s permit. (These and other start-up requirements are discussed in detail in Chapter 7.)

    Partnerships

    Bring two or more entrepreneurs together, stir gently into a business venture, and—poof!—you’ve got a partnership. A partnership is a business with more than one owner that hasn’t filed papers with the state to become a corporation or an LLC (or a limited partnership or limited liability partnership).

    CAUTION
    Beware of local registration requirements. If you’re going into business with others, don’t let the fact that you’re automatically a partnership fool you into thinking that you’ve satisfied the governmental requirements for starting a business. Most cities and counties require all businesses to register with them and pay at least a minimum tax. And if you do business under a name other than the partners’ names, you must register that name—known as a fictitious business name—with your county. (See Chapter 7 for an explanation of how to make the necessary filings with the appropriate government offices.)

    General Versus Limited Partnerships

    Most partnerships consist of partners who are personally responsible for the business; these partnerships are known as “general” partnerships. The partners are personally liable for all business debts, including court judgments, and each can be sued for the full amount of any business debt (though that partner can turn around and sue the other partners for their share of the debt).

    Another very important aspect of general partnerships is that any individual partner can bind the whole business to a contract or business deal—in other words, each partner has “agency authority” for the partnership. And each partner is fully personally liable for a business deal gone sour, no matter which partner signed the contract. So choose your partners carefully.

    Limited partnerships and limited liability partnerships differ from the general model, and are relatively uncommon:

    • A limited partnership requires at least one general partner and at least one limited partner. General partners have the same role as in a general partnership: They control the company’s operations and are personally liable for business debts. Limited partners contribute financially to the business, but have minimal control over business operations and normally can’t bind the partnership to business deals. In return for giving up management power, limited partners get the benefit of protection from personal liability. Still, they can lose their entire investment in the business. A limited partner who acts more like a general partner risks being treated like one: If a creditor can prove that a limited partner acted in a way that led the creditor to believe that the limited partner was a general partner, that limited partner can be held fully and personally liable for the creditor’s claims.
    • A limited liability partnership (LLP) provides all of its owners with limited personal liability. These partnerships are available only to certain professionals. Examples of professionals who can form LLPs include licensed lawyers, accountants, architects, engineers, and land surveyors. Most professionals aren’t keen on general partnerships because they don’t want to be personally liable when another partner gets sued for malpractice. Forming a corporation to protect personal assets might be too much trouble, and California won’t allow these professionals to form an LLC. The solution is often a limited liability partnership, where only the partner who loses the malpractice lawsuit is on the hook for the mistake.

    As attractive as they are, limited partnerships and limited liability partnerships (and limited liability companies, discussed below) are not cheap to create. The filing fee is just $70, but the state charges a minimum annual tax of $800 for both types of limited partnerships. The tax is due in the first quarter of operations, whether or not you’re making a profit.

    Pass-Through Taxation

    Similar to a sole proprietorship, a partnership (general or limited) is not a separate tax entity from its owners; instead it’s what the IRS calls a “pass-through entity.” This means the partnership itself doesn’t pay income taxes; rather, income passes through the business to each partner, who pays taxes on a share of profit (or deducts a share of losses) on an individual income tax return (Form 1040, with Schedule E attached). However, the partnership must also file a federal “informational return”—Form 1065—to let the government know how much the business earned or lost that year. This return doesn’t require you to pay tax; just think of it as the Feds’ way of letting you know they’re watching.

    Personal Liability for Business Debts

    Because a partnership is legally inseparable from its owners, just like a sole proprietorship, general partners are personally liable for business-related obligations. What’s more, in a general partnership, the business actions of any one partner bind the other partners, who can be held personally liable for those actions. So, if your business partner takes out an ill-advised high-interest loan on behalf of the partnership, makes a terrible business deal, or gets in some other business mischief without your knowledge, you could be held personally responsible for any debts that result.

    EXAMPLE: Jamie and Kent are partners in a profitable landscape gardening company. They’ve been in business for five years and have earned healthy profits, allowing them each to buy a house, decent wheels, and even a few luxuries—including Jamie’s collection of garden sculptures and Kent’s roomful of vintage musical instruments. One day Jamie, without telling Kent, orders a shipment of exotic poppy plants that he is sure will be a big hit with customers. But when the shipment arrives, so do agents of the federal drug enforcement agency who confiscate the plants, claiming they could be turned into narcotics. Soon after, criminal charges are filed against Jamie and Kent, resulting in several newspaper stories. Though the criminal charges against the partners are eventually dropped, their attorneys’ fees come to $50,000 and they lose several key accounts. As a result, the business runs up hefty debts. As a general partner, Kent is personally liable for these debts even though he had nothing to do with the ill-fated poppy purchase.

    Before you get too worried about personal liability, keep in mind that many small businesses don’t risk racking up too much debt. For instance, if you’re engaged in a low-risk enterprise, such as freelance editing, selling handmade ceramics, or offering tailoring and alteration services, your risk of facing massive debt or a huge lawsuit is pretty small. For these types of small, low-risk businesses, a good business insurance policy is almost always enough to protect owners from a customer’s trip- and-fall or fire. Insurance won’t cover regular business debts, however. If you have significant personal assets, like fat bank accounts or real estate, and plan to rack up some business debt, you might want to limit your personal liability with a different business structure, such as an LLC or a corporation.

    Partnership Agreements

    It is not legally necessary for a partnership to have a written agreement. The simple act of two or more people doing business together creates a partnership. But only with a clear written agreement will all partners know the important—and sometimes touchy—details of their business arrangement.

    In particular, a written partnership agreement allows you to structure your ownership relationship with your partners. You and your partners can establish the respective shares of profits (or losses) each will receive, the responsibilities of each partner, what will happen to the partnership if a partner leaves, and how other issues will be handled.

    In the absence of a partnership agreement, California’s version of the Revised Uniform Partnership Act (RUPA) kicks in as a standard, bottom-line guide to the rights and responsibilities of each partner. For example, if you don’t have a partnership agreement, then California’s RUPA states that each partner has an equal share in the business’s profits, losses, and management power. Similarly, unless you provide otherwise in a written agreement, a California partnership won’t be able to add a new partner without the unanimous consent of all partners. (Cal. Corp. Code § 16401.) You can override many of the legal provisions contained in the California RUPA if you and your partners have your own written agreement.

    There’s nothing terribly complex about drafting partnership agreements. They’re usually only a few pages long and cover basic issues that you’ve probably thought over already to some degree. Partnership agreements typically include at least the following information:

    • the name of the partnership and partnership business
    • the date of partnership creation
    • the purpose of the partnership
    • contributions (cash, property, and work) of each partner to the partnership
    • each partner’s share of profits and losses
    • provisions for taking profits out of the company (often called partners’ draws)
    • each partner’s management power and duties
    • how the partnership will handle the departure of a partner, including buyout terms
    • provisions for adding or expelling a partner, and
    • dispute resolution procedures.

    These and any other terms you include in a partnership agreement can be dealt with in more or less detail. Some partnership agreements cover each topic with a sentence or two; others spend up to a few pages on each provision. You need an agreement that’s appropriate for the size and formality of your business. Don’t go overboard, but also make sure you don’t gloss over important details.

    Take a look at the two short sample partnership agreements on the following pages to see how to structure a basic partnership agreement. (You’ll also find a downloadable partnership agreement on the Nolo website; See Appendix B for the link.) These sample agreements are as simple as it gets—the bare minimum—and you’ll almost surely want to use something more detailed for your business.

    RESOURCE
    More information on partnerships. Form a Partnership: The Complete Legal Guide, by Denis Clifford and Ralph Warner, is an excellent step-by-step guide to putting together a solid comprehensive partnership agreement. Also, Business Buyout Agreements: Plan Now for All Types of Business Transitions, by Bethany Laurence and Anthony Mancuso, explains how to draft terms that will enable you to deal with business ownership transitions. (Both books are published by Nolo.)

    If you think you may need more than the simple partnership agreements provided in this book, there are more detailed partnership agreement forms (as well as many other resources for running your business) in Quicken Legal Business Pro software. You can learn more about all of these resources at www.nolo.com.

    What a Partnership Agreement Can’t Do

    Although a general partnership agreement is a powerful tool for defining ownership interests, work responsibilities, and other rights of partners, there are some things it can’t do. Partnership agreements can’t:

    • free partners from personal liability for business debts
    • restrict any partner’s right to inspect business books and records
    • affect the rights of third parties in relation to the partnership—for example, limit the ability of vendors and contractors to enforce contracts signed by a partner who isn’t authorized to sign contracts; or
    • eliminate or weaken the duty of trust (the fiduciary duty) each partner owes to the other partners.

     

    Limited Liability Companies (LLCs)

    Like many business owners just starting out, you might find yourself in this common quandary: On the one hand, having to cope with the risk of personal liability for business misfortunes scares you; on the other, you would rather not deal with the red tape of starting and operating a corporation.

    Fortunately, you can avoid these problems by creating a limited liability company, commonly known as an LLC. LLCs allow owners (called “members”) to pay taxes on the LLC’s profits on their individual income tax returns (pass-through taxation), while offering them the same protection against personal liability that a corporation provides. California, like all states, allows single-member LLCs.

    Businesses that provide professional services typically can’t use the LLC structure in California. “Professional services” are “services that require a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act” or the Yacht and Ship Brokers Act. (Cal. Corp. Code §§ 13401(a), 13401.3.)

    But California’s revised LLC Act states that an LLC can render “nonprofessional” services in California if the Business and Professions Code, the Chiropractic Act, the Osteopathic Act, or the Yacht and Ship Brokers Act specifically authorizes a particular type of licensee to render services through an LLC. The question comes down to whether the service that requires a license is considered to be a “professional” service. Some services, like veterinary services, are “professional.” Others, like private investigators, are not. If you’re required to be licensed to perform services but are not sure if those services meet the legal definition of “professional” services, or think your business might fall into this gray area, you’ll need to do more research or talk to a lawyer about whether an LLC is an option for your business. If it’s not, you can form an LLP or a corporation.

    Limited Personal Liability

    Members (again, that’s what LLC owners are called) of an LLC will not be personally liable for the LLC’s debts as long as the members have run their business honestly and have kept their personal and business income and expenses separate (more on that below). If the business fails or loses a lawsuit and the business can’t pay its debts, creditors can take all of the LLC’s assets, but they can’t get at the personal assets of the LLC’s members. Losing your business is no picnic, but it’s a lot better to lose only what you put into the business than to say goodbye to your home and personal savings.

    EXAMPLE: Cara starts an event planning firm with $25,000 in savings as seed money. Cara plans to focus on large events that will require a lot of cash to pay for venues, infrastructure, vendors, and sponsors. Cara is willing to risk her $25,000 investment, but she is worried that if an event flops, or a vendor sues her, she will be buried under a pile of debt. Cara decides to purchase appropriate business insurance and form an LLC, so that if her business fails, she’ll only lose her $25,000 investment. She won’t be personally on the hook if someone sues her business for debts or damages that exceed her insurance policy limits. She feels more secure going into business knowing that even if her business fails, she can walk away without losing her house or other assets.

    While some LLC members opt for a structure in which the company will be run by designated managers, most LLCs are managed by the members. When members manage the LLC, it’s called a “member-managed” LLC. LLCs managed by designated managers are called “manager-managed” LLCs. A manager- managed LLC might be appropriate when some of the LLC’s owners are passive investors (similar to limited partners), while a smaller group intends to actively run the company. When all the LLC owners intend to actively manage the company, they usually use the more common member-managed structure.

    Like a general partner in a partnership, any member of a member-managed LLC can legally bind the entire LLC to a contract or business transaction. In other words, each member can act as an agent of the LLC. In manager-managed LLCs, any manager can bind the LLC to a business contract or deal.

    While LLC owners enjoy limited personal liability for many of their business debts, this protection is not absolute. In several situations, an LLC owner might become personally liable for business debts or claims:

    • Personal guarantees. If you give a personal guarantee on a loan to the LLC, you are personally liable for repaying that loan (without a guarantee, only the assets of the business are on the line). Because banks and other lenders often require personal guarantees, you have good reason to be a conservative borrower.
    • Taxes. The IRS or the California Franchise Tax Board can go after the personal assets of LLC owners for overdue federal and state business tax debts, particularly overdue payroll taxes. This drastic result is most likely to happen to members of small LLCs who have an active hand in managing the business, rather than to passive members.
    • Negligent or intentional acts. An LLC owner who intentionally, or even carelessly, hurts someone will usually face personal liability. For example, if an LLC owner takes a client to lunch, has a few martinis, and injures the client in a car accident on the way home, the LLC owner can be held personally liable for the client’s injuries.
    • Breach of fiduciary duty. LLC owners have a legal duty to act in the best interest of their company and its members. This legal obligation is known as a “fiduciary duty,” or is sometimes simply called a “duty of care.” LLC owners who violate this duty can be held personally liable for any damages that result from their actions (or inactions). Fortunately for LLC owners, they normally will not be held personally responsible for any honest mistakes or acts of poor judgment they commit in doing their jobs. Most often, breach of duty is found only for serious indiscretions, such as fraud or other illegal behavior.
    • Blurring the boundaries between the LLC and its owners. When owners fail to respect the separate legal existence of their LLC, but instead treat it as an extension of their personal affairs, a court can ignore the existence of the LLC and rule that the owners are personally liable for business debts and liabilities. This result is more likely to occur in one-member LLCs than in those that have several members; and even then, it happens only in extreme cases. You can easily avoid it by respecting the boundaries of your personal and business lives by opening a separate LLC checking account, getting a federal employer identification number, keeping separate accounting books for your LLC, and funding your LLC adequately enough to be able to meet foreseeable expenses.

    TIP
    Planning on running a socially conscious business? A variation on LLCs, called the low-profit limited liability company, or L3C, might be for you. For details, see the “Emerging Business Structures for Socially Conscious, Mission-Driven Businesses” section later in this chapter.

    LLC Taxation

    Like a sole proprietorship or partnership, an LLC is not a separate tax entity from its owners; instead, it’s what the IRS calls a “pass-through entity.” This means the LLC itself does not pay income taxes; instead, income passes through the business to each LLC owner, who pays taxes on the share of profit (or deducts the share of losses) on an income tax return (for the feds, using Form 1040 with Schedule E attached). A multiowned LLC, like a partnership, does have to file Form 1065—an “informational return”—to let the government know how much the business earned or lost that year. LLC owners don’t pay tax with this return.

    LLC members can choose to have the company taxed like a corporation rather than as a pass-through entity. In fact, partnerships now have this option as well. (See IRS Form 8832, Entity Classification Election, on the IRS website.)

    You might wonder why LLC owners would choose to be taxed as a corporation—after all, pass-through taxation is one of the most popular features of an LLC. The answer is that, because of the income-splitting strategy of corporations (discussed in “Corporate Taxation,” below), LLC members can sometimes come out ahead by having their business taxed as a separate entity at corporate tax rates.

    For example, if the owners of an LLC become successful enough to keep some profits in the business at the end of the year (or regularly need to keep significant profits in the business for upcoming expenses), paying tax at corporate tax rates can save them money. That’s because federal income tax rates for corporations start lower than the rates for individuals. For this reason, many LLCs start out being taxed like partnerships, and when they make enough profit to justify keeping some in the business (rather than doling it out as salaries and bonuses), they choose corporate-style taxation.

    LLCs face significant taxes and fees at the state level. They owe a minimum annual tax of $800, which is due in the first quarter of operations, whether or not you’re making a profit. Additional fees might be charged.

    (LLC taxes and fees are discussed in more detail in Chapter 9.)

    LLCs Versus S Corporations

    Before LLCs came along, the only way all owners of a business could get limited personal liability was to form a corporation. Problem was, many entrepreneurs didn’t want the hassle and expense of incorporating, not to mention the headache of dealing with corporate taxation. An easier option was to form a special type of corporation known as an S corporation, which is like a regular corporation (a C corporation) in most respects, except t hat business profits pass through to the owner (like in a sole proprietorship or partnership), rather than being taxed to the corporation at corporate tax rates. In other words, S corporations offered the limited liability of a corporation with the pass- through taxation of a sole proprietorship or partnership.

    For a long time, this was an okay compromise for small to medium-sized businesses, though they still had to deal with the requirements of running an S corporation (discussed in more detail below).

    Now, however, LLCs offer a better option for many entrepreneurs. LLCs are similar to S corporations in that they combine limited personal liability with pass-through tax status. But LLCs are not bound by the many regulations that govern S corporations.

    Here’s a quick rundown of the major areas of difference between S corporations and LLCs (corporations, including S corporations, are explained in more detail in the next section):

    • Ownership restrictions. An S corporation is limited to 75 shareholders, all of whom must be U.S. citizens or residents. And even if an S corporation initially meets the U.S. citizen or resident requirement, its shareholders can’t sell shares to another company (like a corporation or an LLC) or a foreign citizen, on pain of losing S corporation tax status. In an LLC, any person or entity can become a member—a U.S. citizen, a citizen of a foreign country, or another LLC, corporation, or limited partnership.
    • Allocation of profits and losses. Shareholders of an S corporation must allocate profits according to the percentage of stock each owner has. For example, a 25% owner has to receive 25% of the profits (or losses), even if the owners want a different division. Owners of an LLC, on the other hand, can distribute profits (and the tax burden that goes with them) however they see fit, without regard to each member’s ownership share in the company. For instance, a member of an LLC who owns 25% of the business can receive 50% of the profits if the other members agree (subject to a few IRS rules).
    • Corporate meeting and record-keeping rules. In order for S corporation shareholders to keep their limited liability protection, they have to follow the corporate rules—issuing stock, electing officers, holding regular board of directors’ and shareholders’ meetings, keeping corporate minutes of all meetings, and following the mandatory rules found in the corporation code. By contrast, LLC owners don’t need to jump through most of these legal hoops.
    • Tax treatment of losses. S corporation shareholders are at a disadvantage if their company goes into substantial debt—for instance, if it borrows money to open the business or buy real estate. That’s because an S corporation’s business debt cannot be passed along to its shareholders unless they have personally cosigned and guaranteed the debt. LLC owners, on the other hand, normally can reap the tax benefits of any business debt, cosigned or not. This can translate into a nice tax break for owners of LLCs that carry debt.

    Forming an LLC

    To form an LLC, you must file Articles of Organization with the California Secretary of State (www.sos.ca.gov). You should also execute an operating agreement, which governs the internal workings of your LLC. Be aware that an LLC might not be as cheap to start as a partnership or sole proprietorship. While the filing fee itself isn’t terribly expensive ($70 as of 2021), the California Franchise Tax Board requires that you pay a minimum annual LLC tax of $800 when you start your LLC.

    Many brand-new business owners aren’t in a position to pay this kind of money right out of the starting gate, so they start out as partnerships until they bring in enough income to cover these costs. Since California lowered its corporate start-up fees in 2000, some entrepreneurs are tempted to start out as corporations, which are now cheaper to start than LLCs. But the added expense of running a corporation (legal and accounting fees, for example) will almost always make a corporation more expensive to run than an LLC.

    CAUTION
    Some LLCs must comply with securities laws. LLCs that have owners who do not actively participate in the business might have to register their membership interests as securities or, more likely, qualify for an exemption to the registration requirements. For information about federal securities laws related to small business, visit the Securities and Exchange Commission’s website at www.sec.gov/smallbusiness.

    RESOURCE
    For more on LLCs. The Nolo website includes a comprehensive package to form an LLC online. You can also learn more from Nolo’s books on LLCs, including: Form Your Own Limited Liability Company, by Anthony Mancuso (which has detailed information, step-by-step instructions, and forms for creating an LLC); Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies, also by Anthony Mancuso; and Nolo’s Guide to Single-Member LLCs, by David M. Steingold.

    Corporations

    For many, the term “corporation” conjures up the image of a massive industrial empire more akin to a nation-state than a small business. In fact, a corporation doesn’t have to be huge, and most aren’t. Stripped to its essentials, a corporation is simply a legal structure that imposes legal and tax rules on its owners (also called shareholders). A corporation can be as large as Microsoft or, in many cases, as small as one person.

    One fundamental legal characteristic of a corporation is that it’s a separate legal entity from its owners. If you’ve already read this chapter’s sections on sole proprietorships and partnerships, you’ll recognize that this is a major difference between those types of unincorporated businesses and corporations. Another important corporate feature is that shareholders are normally protected from personal liability for business debts. Finally, the corporation itself—not just the shareholders—is subject to income tax.

    CAUTION
    Publicly traded corporations area different ball game. This section discusses privately held corporations owned by a small group of people who are actively involved in running the business. These corporations are much easier to manage than public corporations, whose shares are sold to the public. Any corporation that sells its stock to the general public is heavily regulated by state and federal securities laws. But corporations that sell shares, without advertising, to only a select group of people who meet state requirements are often exempt from many of these securities laws. If you plan to sell shares of a corporation to the general public, you should consult a lawyer.

    Limited Personal Liability

    Owners of a corporation are generally not personally liable for the corporation’s debts. (Some exceptions to this rule are discussed below.) Limited personal liability is a major reason why owners have traditionally chosen to incorporate their businesses: to protect themselves from legal and financial liability in case their business flounders or loses an expensive lawsuit and can’t pay its debts. In those situations, creditors can take all of the corporation’s assets (including the shareholders’ investments), but they usually can’t get at the personal assets of the shareholders.

    EXAMPLE: Tim and Chris publish Tropics Tripping, a monthly travel magazine with a focus on Latin America. They form their business as a corporation to protect their personal assets in case their magazine fails. Business is great for a few years, but subscriptions and advertising revenue drop when political unrest in several Latin American countries suddenly restricts travel to that area. Hoping the situation will turn itself around, Tim and Chris forge ahead—and go deeper into debt as it proves impossible to pay printing and other bills on time. Finally, when their printer won’t do any more print runs on credit, Tim and Chris are forced to call it quits. Tropics Tripping’s debts total $250,000, while business assets are valued at only $90,000—leaving a $160,000 debt to creditors. Thankfully for Tim and Chris, they won’t have to use their personal assets to pay the $160,000, because as owners of a corporation, they’re shielded from personal liability.

    Forming a corporation to shield yourself from personal liability for business obligations provides good, but not complete, protection for your personal assets. Here are the principal areas in which corporation owners still face personal liability:

    • Personal guarantees. If you give a personal guarantee on a loan to the corporation, then you are personally liable for the repayment of that loan. Because banks and other lenders often require a personal guarantee, this is a good reason to be a conservative borrower. Of course, if the owners don’t make personal guarantees, only the corporation—not the shareholders—is liable for the debt.
    • Taxes. The IRS or the California Franchise Tax Board can go after the personal assets of corporate owners for overdue corporate tax debts, particularly overdue payroll taxes. Owners of small corporations who have an active hand in managing the business, rather than passive shareholders, are more likely to face this consequence.
    • Negligent or intentional acts. A corporate owner whose intentional or negligent (careless) actions end up hurting someone can’t hide behind the corporate barrier to escape personal liability. Shareholders are personally responsible for wrongs they commit personally and directly—such as attacking a customer or leaving a floor wet in a store—that cause injury.
    • Breach of fiduciary duty. Corporate owners have a legal duty to act in the best interest of the company and its shareholders. This legal obligation is called a “fiduciary duty,” or sometimes a “duty of care.” An owner who violates this duty can be held personally liable for damages that result from those actions (or inactions). Fortunately for corporate owners, run-of-the-mill mistakes or lapses in judgment usually aren’t considered breaches of the duty of care. Typically, only serious indiscretions are a breach of duty. For example, if a corporate officer has falsified financial data to seal a deal with a client, that officer might be personally liable for damages that result from that breach of duty to the company.
    • Blurring the boundaries between the corporation and its owners. When corporate owners ignore corporate formalities and treat the corporation like an unincorporated business, a court can ignore the existence of the corporation (in legal slang, it can “pierce the corporate veil”) and rule that the owners are personally liable for business debts and liabilities. To avoid losing liability protection, it’s important for corporate owners to keep the legal boundary between the corporation and its owners clear. Owners need to scrupulously respect corporate formalities by holding shareholders’ and directors’ meetings, keeping attentive minutes, issuing stock certificates, and keeping corporate accounts strictly separate from personal funds.

    Bear in mind that although limited personal liability can prevent you from losing your home, car, bank account, and other assets, it won’t protect you from losing your investment in your business.

    A business can quickly get wiped out if a customer, employee, or supplier wins a lawsuit against the business and it has to be liquidated to cover the debt. In short, even if you incorporate to protect your personal assets, you should purchase appropriate insurance to protect your business assets. (Insurance is discussed in Chapter 8.) But remember, insurance won’t help if you simply can’t pay your normal business debts.

    Corporate Taxation

    The words “corporate taxes” raise a lot of fear and loathing in the business world. Fortunately, the reality of corporate taxation is usually less depressing than its reputation. Here are the basics—think of it as Corporate Tax Lite. If you decide to incorporate you’ll likely want to consult an account or a small business lawyer who can fill you in on the fine points. (See Chapter 17 for information on finding and hiring a lawyer.)

    The first thing you need to know is that how you’ll be treated for tax purposes will depend on whether you operate as a regular corporation (called a C corporation) or have elected S corporation status. An S corporation is the same as a C corporation in most respects, but when it comes to taxes, C and S corporations are very different animals. A regular, or C, corporation must pay its own taxes, while an S corporation is treated like a partnership for tax purposes and doesn’t pay any income taxes itself. Like partnership profits, S corporation profits (and losses) pass through to the shareholders, who report them on their individual returns. (In this respect, S corporations are very similar to LLCs, which also offer limited liability along with partnership-style tax treatment.) These two types of corporations are explained in more detail below.

    Fringes and Perks

    Corporations can deduct many fringe benefits as business expenses, just as they do with employee salaries. If a corporation pays for benefits such as health and disability insurance for its employees and owner/employees, the cost can usually be deducted from the corporate income, reducing a possible tax bill. (There’s one main exception: Benefits given to an owner/employee of an S corporation who owns 2% or more of the stock can’t be deducted as business expenses.)

    As a general rule, owners of sole proprietorships, partnerships, and LLCs can deduct the cost of providing these benefits for employees, but not for themselves. (These owners can, however, deduct a portion of their medical insurance premiums, though it’s technically a deduction for the individuals, not a business expense.)

    The owner’s ability to deduct the cost of fringe benefits for themselves might make incorporating a wise choice. But it’s less likely to be a winning strategy for a capital-poor start-up that can’t afford to underwrite a benefits package.

     

    C Corporations

    As a separate tax entity, a regular corporation must file and pay state and federal income taxes on its own tax return, much like an individual does. After deductions like employee compensation, fringe benefits, and other reasonable and necessary business expenses have been subtracted from its earnings, a corporation pays tax on whatever profit remains.

    In small corporations, in which all of the owners of the business are also employees, all of the corporation’s profits are often paid out in tax-deductible salaries and fringe benefits—leaving no corporate profit and thus no corporate taxes due. (The owner and employees must, of course, pay tax on their salaries on their individual returns.)

    The Tax Cuts and Jobs Act made major, sweeping simplifications to corporate tax rates, replacing eight tiers of rates (ranging from 15% to 39%) with just one: 21% for all corporations. The significantly lower rate, plus the simpler structure, could make C corporations more attractive to even very small businesses.

    Double Taxation
    Double taxation is a vexing issue faced by large corporations with shareholders who aren’t active employees. Unlike salaries and bonuses, dividends paid to shareholders cannot be deducted as business expenses from corporate earnings. Because they’re not deducted, amounts paid as dividends are included in the total corporate profit and taxed. And when the shareholder receives the dividend, it is taxed at the shareholder’s individual tax rate as part of personal income. As you can see, any money paid out as a dividend gets taxed twice: once at the corporate level and once at the individual level.

    You can avoid double taxation simply by not paying dividends. This is usually easy if all shareholders are employees, but probably more difficult if some share-holders are passive investors anxious for a reasonable return on their investment.

    S Corporations

    Unlike a regular C corporation, an S corporation does not pay taxes itself. Profits pass through to the owners, who pay taxes on income as if the business were a sole proprietorship, a partnership, or an LLC. Yet the business is still a corporation, giving its owners protection from personal liability for business debts, just like share-holders of C corporations and owners of LLCs.

    Forming and Running a Corporation

    In addition to tax complexity, major drawbacks to forming a corporation—either a C or an S type—are time and expense. To incorporate, you must file Articles of Incorporation with California’s Secretary of State, along with a filing fee of $100. (The minimum annual state tax of $800 is not due in the first business year for corporations.) You will have to file a Statement by Domestic Stock Corporation every year, beginning within 90 days of filing your Articles of Incorporation. (These requirements are covered in detail in Chapter 7.) And if you decide to sell shares of the corporation to the public—as opposed to keeping them in the hands of a relatively small number of owners—you’ll have to comply with lots of complex federal and state securities laws.

    CAUTION
    Corporations must comply with securities laws. Corporations must either register their shares with the Securities and Exchange Commission or qualify for an exemption to securities registration requirements. For information about small business exemptions to federal securities laws, visit the Securities and Exchange Commission’s website at www.sec.gov/smallbusiness.

    RESOURCE
    More on running corporations. For more information on the many complexities of running a corporation, read The Corporate Records Handbook: Meetings, Minutes & Resolutions, by Anthony Mancuso (Nolo).


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