A limited liability company (LLC) is a business entity that combines the limited liability of a corporation with the flexible management and default pass-through taxation of a partnership or sole proprietorship. Owners, called members, are generally not personally liable for the LLC’s debts, and by default its profits and losses flow through to the members’ tax returns. In California, LLCs are governed by the California Revised Uniform Limited Liability Company Act and owe an annual franchise tax and, above certain revenue levels, an additional fee.
The LLC is one of the most popular structures for small businesses, real estate holdings and family ventures because it is relatively simple to form and run. It is not the right choice for every business, however. Here is how LLCs work, what they cost to maintain in California and when another entity may fit better.
Limited Liability: The Core Feature
An LLC is a legal entity separate from its members. As a general rule, if the business owes money or is sued, only the LLC’s assets are at risk; creditors usually cannot reach a member’s house, car or personal accounts. This sets the LLC apart from sole proprietorships and general partnerships, where owners are personally responsible for business debts.
The protection has limits. Members remain liable for their own wrongful acts and any personal guarantees they sign, and courts can disregard the LLC under the alter ego doctrine if members commingle funds, undercapitalize the business or use it to commit fraud. California law provides that an LLC’s failure to hold meetings or observe formalities is not, by itself, a reason to hold members personally liable, which is one practical advantage over a corporation.
Flexible Structure and Management
An LLC can have one member or many, and members can be individuals, corporations or other entities. It can be:
- Member-managed, where the members run the business directly, or
- Manager-managed, where one or more designated managers, who may or may not be members, run the business.
The rules for voting, profit sharing, capital contributions, transfers of interests and what happens when a member leaves are set by the operating agreement. California does not require the operating agreement to be filed, and it can technically be oral, but a written agreement is strongly advisable. Without one, default statutory rules apply, and they may not match what the members expect. Our shareholder and owner agreements page covers similar issues for corporations.
How LLCs Are Taxed
By default, the IRS treats a single-member LLC as a “disregarded entity,” taxed like a sole proprietorship, and a multi-member LLC as a partnership. Profits and losses pass through to the members, who report them on their own returns, avoiding the entity-level tax that applies to C corporations. Members actively involved in the business generally owe self-employment tax on their share of earnings.
An LLC can instead elect to be taxed as a C corporation or, if eligible, as an S corporation. An S corporation election can sometimes reduce self-employment taxes for owners who take a reasonable salary, but it comes with eligibility limits and payroll obligations. See our article on understanding S corporations.
California-specific costs
- Annual LLC tax. California LLCs, and out-of-state LLCs doing business in California, generally owe an annual minimum franchise tax, currently $800, regardless of profit. A temporary first-year exemption that applied to some newly formed LLCs has expired.
- LLC fee. LLCs with California gross receipts above a threshold also owe an annual fee that increases with revenue.
- Statement of Information. California LLCs must file a Statement of Information with the Secretary of State every two years, and within 90 days of formation.
How to Form an LLC in California
- Choose a name that is distinguishable from existing entities and includes “LLC” or “Limited Liability Company.”
- Appoint an agent for service of process.
- File Articles of Organization with the California Secretary of State.
- Adopt a written operating agreement.
- Obtain an EIN from the IRS, open a business bank account and register for applicable state and local tax accounts, permits and licenses.
- File the initial Statement of Information.
Federal beneficial ownership reporting under the Corporate Transparency Act has changed significantly since it took effect, and current federal rules exempt most U.S.-formed companies. Confirm current requirements before forming an entity.
When an LLC May Not Be the Right Choice
- Venture-backed startups. Most venture capital funds invest in C corporations, often Delaware corporations, and stock options and preferred stock are designed for corporations. An LLC planning to raise venture capital will usually need to convert.
- QSBS planning. The qualified small business stock exclusion under Section 1202 applies only to stock in a C corporation, not LLC interests. See our article on the QSBS exclusion.
- Licensed professions. California generally does not allow LLCs to provide services that require certain state professional licenses, such as legal, medical and accounting services. Those businesses typically use a professional corporation or, for some professions, a limited liability partnership.
- Transferability. Transfers of LLC interests are usually restricted by the operating agreement, which can make bringing in new owners more complex than issuing stock.
Keeping the LLC in Good Standing
Like a corporation, an LLC continues to exist, and to owe taxes and fees, until it is formally dissolved. Keep business and personal finances separate, sign contracts in the LLC’s name, file the Statement of Information and tax returns on time, and keep the operating agreement current as the business changes.
The Takeaway
An LLC offers limited liability, flexible management and pass-through taxation with fewer formalities than a corporation, making it a strong fit for many small businesses and holding companies. In California, factor in the annual franchise tax and LLC fee, and consider whether venture funding, QSBS or a licensed profession points toward a corporation instead.
Frequently Asked Questions
What is the main advantage of an LLC?
An LLC gives its owners limited liability for business debts while allowing flexible management and, by default, pass-through taxation. It also requires fewer formalities than a corporation.
How much does an LLC cost per year in California?
California LLCs generally owe an annual minimum franchise tax, currently $800, plus an additional LLC fee if California gross receipts exceed a threshold. They also file a Statement of Information every two years.
Is an LLC or a corporation better for a startup?
It depends on the plan. An LLC often suits small businesses and holding companies, while startups planning to raise venture capital or grant stock options usually form, or convert to, a C corporation.
Does an LLC need an operating agreement in California?
California does not require an operating agreement to be filed, but a written agreement is strongly advisable. Without one, default statutory rules govern voting, profit sharing and member exits.
How Sutter Law Can Help
Sutter Law helps California business owners choose an entity, form LLCs and corporations, draft operating agreements and convert entities as their plans change through our business formation practice. Contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
