As a new business owner, one of your most important decisions is determining what form of ownership will best meet your business needs. Selecting the best structure for your business should be a carefully planned process that is discussed with a qualified professional such as an enrolled agent, certified public accountant, or attorney who specializes in this area. In addition, as your business grows over time, you may want to evaluate if a new form of ownership should be used to achieve better results.
A Limited Liability Company (LLC) is a hybrid entity that may have some advantages over corporations and partnerships depending on your business needs. The main advantage over a partnership is that, like the owners (shareholders) of a civil law corporation, the liability of the owners (members) of an LLC is limited to their financial investment. However, like a general partnership, members of an LLC have the right to participate in management of the LLC, unless the LLC’s articles of organization and operating agreement provide that managers will manage the LLC.
Key Features of an LLC
- May have one or more owners, and may have different classes of owners.
- May be owned by any combination of individuals or business entities.
- May not be formed under state civil law to conduct a business that requires a professional license to operate, for example, a lawyer may not form an LLC. However, there may be certain exceptions to this rule.
- Taxable as a sole proprietorship, partnership, C corporation, or S corporation.
- Taxable as a partnership can achieve both conduit tax treatment and limited liability protection under civil law.
- Taxable as a partnership does not have the ownership restrictions that apply to entities taxable as S corporations.
- If the it has a single member, it will be disregarded as separate from its owner, and will be treated as a sole proprietorship or a division of its owner, unless it elects to be taxable as a corporation.
- In general, all the owners (members) are shielded from individual liability for debts and obligations of the LLC.
- Forming and maintaining it may be simpler and faster than forming and maintaining a civil law corporation.
- Typically managed by all its members, unless the members agree to have a manager handle the LLC’s business affairs.
- Its life is perpetual in nature. However, the members may agree to a date or event of termination.
How to Form an LLC
A California LLC is formed by filing articles of organization with the California Secretary of State prior to conducting business. A foreign (out-of-state or out-of country) LLC that conducts business in California is subject to the California tax filing requirements. A foreign LLC should check with their state of origin for entity requirements.
The members must enter into a verbal or written operating agreement. A formal, written agreement is advisable. The LLC does not file the operating agreement with the Secretary of State but maintains it at the office where the LLC’s records are kept.
It may be managed by managers who are not members, if provided for in the articles of the organization. However, if managed by managers, they alone have authority to bind the LLC; members and directors have no authority in these matters. Otherwise, it is managed by its members. In this case, every member is an agent of the LLC and has the power to bind it and the right to vote on merger or dissolution. Members have the same degree of limited liability as a shareholder of a corporation. The Secretary of State will assign a 12-digit filing number and the date of organization. Keep this filing number and date for your tax records. Contact the California Secretary of State at 916.657.5448 or go to sos.ca.gov for more information.
- A separate bank account should be established for the LLC.
- If formed in California, referred to as a California LLC, will file the appropriate Articles of Organization and pay a fee to the Secretary of State prior to conducting business. When formed somewhere other than California, referred to as a foreign LLC, it can register to transact business in California by filing the appropriate Application to Register a Foreign Limited Liability Company along with an official certificate that verifies it exists in good standing with the agency where it was formed, and pay a fee to the California Secretary of State.
- LLCs are only required to file the Statement of Information biannually (every two years) with the Secretary of State. Do not issue stock, or have to hold annual meetings and keep written minutes to preserve the liability shield for its owners. An election to be classified as a corporation for tax purposes will not change these requirements.
- Most cities and counties require a business license, various permits, and/or registration to do business within their city or county limits. If you are doing business in multiple cities or counties, you may be required to have multiple licenses. Contact the business licensing department of the city and/or county directly where your business will primarily be located for specific rules and regulations. The Governor’s CalGold online database at calgold.ca.gov, the Governor’s Office of Business and Economic Development (GO-Biz) at business.ca.gov, and the California Business Portal at businessportal.ca.gov all provide links and contact information to agencies that administer and issue business licenses, permits, and registration requirements from all levels of government.
- Contact your local Chamber of Commerce or call the statewide Chamber of Commerce at 800.331.8877 for information for your area and referrals to other agencies.
- If required, register a fictitious name, also referred to as “Doing Business As” or DBA. Refer to Appendix 1 in this booklet for more information.
Tax Return Filing Guidelines
For income tax purposes, California treats the LLC and its owners, in the same manner it is treated for federal tax purposes. An LLC with a single member is classified as a sole proprietorship, while one with more than one member is classified as a partnership, unless it chooses to be classified as a corporation for income tax purposes. To be taxed as a corporation, it would file an election on a federal Form 8832, Entity Classification Election with the Internal Revenue Service.
A California LLC which has members who are not residents of California must file FTB 3832, Limited Liability Company Nonresident Members’ Consent with California Form 568, Limited Liability Return of Income. FTB 3832 is signed by the nonresident individuals and foreign entity members to show their consent to California’s jurisdiction to tax their distributive share of income attributable to California sources. The LLC must pay the tax for every nonresident member that did not sign FTB 3832.
Single Member LLC
Although California tax law requires an LLC to have the same tax classification for both state and federal tax purposes, filing requirements differ. For federal tax purposes, there is no separate reporting requirement for the disregarded single member LLC (SMLLC). Reporting the activities of the disregarded SMLLC on the single-member’s federal income tax return is sufficient. However, for California tax purposes, disregarded SMLLCs that are organized or doing business in California, or are registered with the California Secretary of State are required to:
File California Form 568 and also include:
- Single Member LLC Information and Consent section on Side 3.
- Schedule IW, Limited Liability Company (LLC) Income Worksheet.
- Schedule B and Schedule K when any item of income, profit, gain, or distribution is $3 million or more.
- $800 annual tax.
- Fee, if applicable.
The disregarded SMLLC is not required to issue a Schedule K-1 to a single-member.
The disregarded SMLLC’s tax return, Form 568, is due by the 15th day of the 4th month after the close of the tax year. If the disregarded SMLLC files its tax return under the automatic six-month extension, then the due date is the 15th day of the 10th month after the close of the tax year. The disregarded SMLLC will use the same tax year as its single-member. Generally, individuals adopt a calendar year as their tax year, so the due date for the disregarded SMLLC is often April 15 and the extended due date is October 15.
The due date for the $800 annual tax is the same as the original due date for the tax return, not the extended due date. For many disregarded SMLLCs this means the $800 annual tax is due April 15.
FTB 3537, Payment for Automatic Extension is used to pay the disregarded SMLLC’s tax and fee by the original due date of the disregarded SMLLC’s tax return.
If the disregarded SMLLC’s only member is a nonresident who has not signed the Single Member LLC Information and Consent on Side 3 of the Form 568, then the disregarded SMLLC is required to complete Schedule T, located on Side 4 of the Form 568 and pay the tax on behalf of its single owner. Payment is due by the original due date of the disregarded SMLLC’s tax return. Use FTB 3537 to make this payment.
The fee is based on the total income from all sources derived from or attributable to California. It is determined as follows:
If Total Income is:
- $250,000-$499,999 – the fee is: $900
- $500,000-$999,999 – the fee is: $2,500
- $1,000,000-$4,999,999 – the fee is: $6,000
- $5,000,000 or more – the fee is: $11,790
The fee is generally considered an ordinary and necessary expense paid or incurred in carrying on the trade or business. The fee is deductible on the LLC’s Form 568, Schedule B, on the Other Deductions line.
The estimated fee is due by the 15th day of the 6th month of the taxable year. The due date for the estimated fee is often June 15. Use FTB 3536, Estimated Fee for LLCs, to make the estimated LLC fee payment.
The person who owns a disregarded SMLLC that operates a trade or business may be subject to the tax on net earnings from self-employment in the same manner as a sole proprietorship and responsible to make quarterly estimated tax payments. For more information, refer to IRS Publication 3402, Taxation of Limited Liability Companies, and California Form 540-ES, Instructions for Estimated Taxes for Individuals for more information.
Estimated Tax for an SMLLC
- California taxes are pay-as-you go.
- The due date for the $800 annual tax is the same as the original due date for the LLC tax return, not the extended due date. For many disregarded SMLLCs this means the $800 annual tax is due April 15.
- Estimated tax installment payments for the individual SMLLC are due and payable on April 15, June 15, September 15 of the taxable year, and January 15 of the following taxable year.
- Individuals complete California Form 540-ES, Estimated Tax for Individuals to report their estimated taxes.
- An individual who is the single member of the LLC will include all sources of business and personal income, such as wage and investment income, when determining estimated tax payments.
- Generally, you must make estimated tax payments if you expect to owe at least $500 ($250 if married/RDP filing separately) in tax for the current year (after subtracting withholding and credits) and you expect your withholding and credits to be less than the smaller of: 1). 90 percent of the tax shown on your current tax return; or 2). 100 percent of the tax shown on your prior year tax return including Alternative Minimum Tax (AMT).
Withholding for an SMLLC
If the SMLLC pays a California nonresident for services they performed for the business while they were in California, generally, the SMLLC must withhold 7 percent on all payments that exceed $1,500 in a calendar year.
If you backup withhold for the Internal Revenue Service, you must also backup withhold for the Franchise Tax Board on California source income. Backup withholding applies to California residents and nonresidents who do not provide a taxpayer identification number or do not certify exemption from backup withholding when required.
For more information about withholding, refer to FTB PUB 1017, Resident and Nonresident Withholding Guidelines.
LLC Classified as Partnership
Known as the “default rule,” Treasury Regulation Section 301.77013(f)(2), provides that an LLC with at least two members is classified as a partnership for federal tax purposes. If with two or more members chooses the default rule of partnership classification for federal purposes, it must follow the federal partners and partnerships rules found in Internal Revenue Code (IRC) Subchapter K (IRC Sections 701-777), to which California conforms through Revenue and Taxation Code Section 17851. The partnership rules give the multiple-member LLC a significant amount of flexibility to vary their respective shares of the members’ income. The multiple-member LLC will also be in a position to make the tax elections at the entity level, rather than the member level. Such elections may include selecting a tax year, adopting accounting and depreciation methods, and to amortize organizational costs. For more information, refer to IRS Publication 541, Partnerships.
The multiple-member LLC will file as a partnership for federal tax purposes (unless it makes an affirmative election to be classified as a corporation for federal tax purposes) using IRS Form 1065,