Choosing the right structure for your contractor business.
Whether initially organizing your business, assessing whether your current structure effectively meets commercial needs, or planning for succession or expansion, choosing what legal entity to use is an important decision for any contractor business.
Points to consider in determining the optimal form to adopt include liability protection, taxation considerations, growth/ liquidity potential and restrictions on the transfer of contractor licenses, among others. This article briefly addresses some key characteristics of entity forms available under California law and current Contractors State License Board (CSLB) regulations.
An individual who owns a contractor business without forming a business entity is deemed a sole proprietor with unlimited liability for all debts and obligations of the business. The individual pays personal income taxes on business income and can also be subject to self-employment taxes, but a sole proprietor is generally not subject to certain additional taxes and fees that apply to legal entities.
Although not always, a business organized as a sole proprietorship tends to have limited capability to leverage and scale significantly given the owner’s unlimited liability. Also, subject to some very limited exceptions, a CSLB contractor license issued to a specific individual (either the owner or a responsible managing employee) cannot be sold or transferred to another individual or entity.
A corporation is a legal entity that exists separate from its shareholders. Shareholders are generally not liable for the obligations of the corporation provided that the company is adequately capitalized, and entity formalities are observed (e.g., recordkeeping, periodic meetings, and separation of personal and corporate assets, etc.).
A corporation is taxed on its earnings at the corporate level and, generally, the shareholders are further taxed upon payment of any dividends or distributions. California also charges the corporate entity a minimum franchise tax regardless of earnings.
Subject to certain requirements (such as a limited number of eligible shareholders and only one class of stock), a corporation might be able to make a subchapter S election with the Internal Revenue Service and avoid federal ‘double taxation,’ although California charges the S corporation entity a franchise tax on net income in addition to the taxes paid by the S corporation shareholders.
Corporations provide flexibility for capital raising because, subject to applicable securities laws, the entity can issue additional shares and/or new classes or series of stocks with distinctive attributes (such as voting or non-voting stock, preferred stock with preferential distribution rights, etc.). Corporate shares are also generally transferable to other eligible owners subject to applicable securities laws and shareholder agreements that limit transfer.
If a corporation satisfies the various bonding, insurance and other requirements for a corporate contractor license, CSLB will issue the license to a specific corporate registration number assigned by the California Secretary of State’s office. If the registration number is changed, a new contractor license number will generally be required for the new corporation.
Also, if a corporation dissolves, merges or otherwise stops engaging in business in California, the contractor license must generally be canceled. Only under certain limited circumstances can a corporate contractor license be reassigned to a different corporate registration number or a sole proprietor’s license be reassigned to a corporation.
Limited Liability Company
A limited liability company (LLC) is a hybrid entity that affords similar liability protection to a corporation but provides the flexibility of being treated either as a ‘corporation’ or a ‘partnership’ for tax purposes. Owners of an LLC are called members and can be individuals or other entities, and the relative rights and obligations of the members are typically set out in an operating agreement. Similar to a corporation, the liability protection for an LLC depends on adequate capitalization and observation of legal entity formalities applicable to an LLC.
An LLC is not federally taxed unless it elects to be treated as a corporation. If treated as a partnership (if it has more than one member) or a disregarded entity (if it has a sole member) for tax purposes, the profits and losses generally pass through to the member(s). California charges a franchise tax for such ‘pass-through’ LLCs on a sliding scale based on income. If treated as a corporation for tax purposes, the LLC is taxed on earnings at the entity level and the members would be further taxed upon payment of any dividends or distributions.
Similar to corporations, the LLC platform provides flexibility for capital raising. Subject to applicable securities and the LLC operating agreement, the LLC can issue membership interests with varying characteristics and those membership interests can be transferred to other owners or investors.
As compared to a corporate license, the CSLB requires specific additional bonds and insurance coverage unique to LLC contractor licenses. The CSLB also restricts transfer and reassignment of contractor licenses issued to an LLC similar to the restrictions on the transfer of corporate licenses.
A partnership is an association of two or more people or entities that conduct business together as co-owners. Partnerships are most commonly either a general partnership or limited partnership and the liability profile of the two partnership types vary significantly.
In a general partnership, each partner (which can be an individual or an entity) is jointly and severally liable for all debts and obligations of the partnership. This means that each partner is liable not only for such partner’s own actions but also for every other partner’s actions.
A general partnership can be deemed to arise by law; accordingly, it’s essential that people or entities conducting business together take care to define, among other things, the scope of their joint business, how profits will be shared and the parameters for committing the enterprise to obligations. It’s highly advisable to memorialize these arrangements in a written partnership agreement. A general partnership operating in California has the option of registering with the California Secretary of State.
In a limited partnership, the general partner(s) make all business decisions on behalf of the partnership and, correspondingly, have unlimited liability for any actions of the partnerships. The limited partners (which, again, can be individuals or entities) should be passive investors who do not actively manage the business and, as a result, limit their liability to their partnership investment. If a limited partner participates in business decisions, the limited partner risks losing the liability protection and being treated as a general partner responsible for all partnership obligations.
Unlike a general partnership, which can be implied by law based on facts and circumstances, forming and maintaining a limited partnership requires registration with the California Secretary of State and some other formalities. It’s also highly advisable for a limited partnership to adopt a written partnership agreement.
Partnerships are treated as pass-through entities for tax purposes, meaning that any income from the partnership is distributed to individual or entity partners who, in turn, pay tax on the amount distributed to them on both their federal and California returns. For limited partnerships, California charges a minimum franchise tax regardless of earnings.
Similar to corporations and LLCs, a limited partnership provides some flexibility to raise capital subject to applicable securities and the partnership agreement. On the other hand, general partnerships typically face similar capital constraints as sole proprietors.
Also, similar to a corporation provided that a partnership satisfies the various bonding, insurance and other requirements for a partnership contractor license, the CSLB will issue the license to a specific general partnership or limited partnership structure. Only under certain limited circumstances can a partnership contractor license be reassigned or transferred.
In a general partnership, new partners cannot generally be added to the existing license; rather, a new license would be required for the new partnership structure. In a limited partnership, the same rules apply to the general partners of the limited partnership, but limited partners can be added or removed so long as the proper paperwork is timely submitted to the CSLB to reflect the changes.
The information above briefly touches on some of the key factors that business owners should consider in selecting the structure for a contractor business. Further consultation with an attorney and tax advisor is essential to ensure your organization optimally meets business objectives and complies with applicable legal requirements.
By Eduardo A. Carvajal, Partner, Atkinson, Andelson, Loya, Ruud & Romo