In California, you can operate your business either as a sole proprietorship or as a limited liability company, but never both. A sole proprietorship is essentially a business entity owned by one person in which there is no legal distinction between the owner and the business. The owner receives all the profits and is responsible for all debts and losses. An LLC is an unincorporated association and offers limited liability to its owner, in that the owner is protected from individual liability. If you operate a small business, it’s unlikely that your choice will affect your daily operations. But before you decide on whether to open an LLC in California or not, you should consider the two key differences between sole proprietorships and LLCs: liability and taxes.
California Sole Proprietors
The great thing about running your business in California as a sole proprietor is that you can get down to business as quickly as you want, since there are no documents to file or other government procedures to deal with. If you do, however, understand that there’s no separation between your personal assets and the business. In other words, if you incur business debts, creditors may have access to your personal non-business assets as a source of repayment. And if you’re ever sued by one of your customers or clients, all of your personal assets are at stake if they obtain a court judgment against the business.
California LLC Advantages
The main advantage of operating through an LLC is that the business, including its debts, are separate from your personal assets. But keep in mind that whatever assets you contribute to the LLC are reachable by creditors, including legal judgment creditors, but at least this allows you to manage your risk. When converting your business to an LLC, you remain personally liable for all preexisting debts and contractual obligations from the sole proprietorship. You can't automatically transfer these liabilities to the California LLC you create, unless the party you have the obligation with consents to amending the agreement so that the LLC is liable. Going forward, however, all new business contracts and promissory notes can be made in the LLC's name. And depending on the nature of your business, you may need to obtain business licenses and permits for the LLC. In California, an LLC can have a single owner.
Forming an LLC
To form an LLC in California, the first thing you’ll need to do is come up with a legal name for the entity that no other registered business in the state currently uses. If you used a DBA for your sole proprietorship, you may want to consider using that as the legal name for the LLC. Alternatively, you can cancel your use of the DBA as a sole proprietor and re-register it under the LLC's name in the California county where it will use the DBA. To legally create the LLC, you must prepare articles of organization and file it with the California Secretary of State. The articles require information such as the unique business name you chose, a statement certifying that the LLC will only be used for legal business purposes, and the name and address of your California registered agent.
Federal & California Taxes
Whether you operate a sole proprietorship or decide to create the LLC, you always need to pay federal and state income taxes on your business income. Both the IRS and California impose tax on single-member LLCs in the same way they do on sole proprietors. However, if you hire employees and owe employment taxes or pay excise taxes, the LLC, not the single owner, is responsible for the payments, which is why it’s a good idea to obtain a federal employer identification number, or EIN. Forming an LLC, however, allows you to make an election to have the business income taxed as if the LLC was a corporation. Without the corporate election, you include all business income on your personal tax returns, but electing corporate tax treatment allows you to file a separate corporate tax return.
- California Secretary of State: Starting a Business – Entity Types
- California Legislative Counsel: California Corporations Code - Title 2.5: Limited Liability Companies, §17101
- California Legislative Counsel: California Corporations Code - Title 2.5: Limited Liability Companies, §17050-51
- State of California Franchise Tax Board: Limited Liability Company (LLC)
- IRS: Limited Liability Company (LLC)
- California Secretary of State: FAQ