According to a IRS statistics, those who incorporate their business is 10 times less likely to be audited than those who run a business and report that income on a Schedule C form. Schedule C is for sole proprietors who report that income directly to their personal 1040 tax form.

Now, correlation does not equal causation. That is for certain. So all we can do is guess as to why this is. Is it possible that the IRS algorithm’s feel that those who report income on the Schedule C are more likely to hid income, or take inappropriate deductions? It’s possible. Also, is it harder to do these things when the Corporation must file its own tax return? That is also highly possible.

When you incorporate your San Diego small business, you will most likely elect to tax the corporation under Subchapter S. This makes it a separate entity. You must file a tax return for the Corporation, then report the results of that onto your own tax return. Most of this must be done by an accountant or CPA. It is therefore not an unreasonable assumption to believe there is less risk of abuse here, although the risk still remains.

Oh and you also get increased asset protection as well. Not a terrible side effect.

Small businesses are the IRS favorite targets. They are ripe for abuse. Unnecessary deductions, excessive deductions, hidden income here and there. Sure why not, who is counting anyways.

So as a small business you must do your best to keep a low profile from the IRS so you don’t risk being on the receiving end of an audit. According to figures from the IRS, rates of audit for Schedule C filers can reach as high as 3.68%. The rate for Corporations under Subchapter S? 0.30%.

That is amazing and quite surprising to see such low rates of audit.

So whether it’s causation or just plain old correlation, it appears that incorporating your business may lower your audit risks substantially.

A California Court of Appeals has determined that being a sole shareholder does not make you an employer. This is important for cases involving the California Family Rights Act because recovery under that act is only available from the employer. The employer in that case being the corporation. Plaintiffs argue that the shareholder should also be personally liable since he exercised control over them, and also under a theory of alter ego. The court rejected plaintiffs argument:

In this instance, where a third party seeks to hold the sole shareholder liable for the wrongdoing of the corporation, an alter ego theory is the appropriate way to determine whether the shareholder is liable.

The opinion goes on to say that in California a corporation (or other entity for that matter) is normally considered separate and apart from any shareholders, employees, officers etc. Only in very narrow circumstances will they deviate from this, and only in the interest of serving justice.

If you really like to torture yourself you can read the whole opinion here Leek-v.-Cooper

A general partnership is one of the easiest form of business to create.  In some cases two or more business owners do not want to form a more formal entity such as a corporation or limited liability company.  While a corporation or LLC provides greater protection for its owners, in some cases business owners are not ready to form such entities.

This may be due to costs, time or complexity due to the formalities attached to these entities. A general partnership can be formed as easily as agreeing verbally with another partner.  You will need to get an Employer Identification Number from the IRS in order to perform many business functions, such as opening a bank account.  The bank will usually require a written general partnership agreement as well.

If you do not have a partnership agreement, your partnership shall be governed by the California Uniform Partnership Act (scroll down to Section 16100).  But as mentioned above, you will most likely need some form of written agreement before you can even open a bank account.  How simple or complex such agreement needs to be depends on the bank, but I’ve seen an account opened with a very simple agreement before.  The UPA essentially declared general partnerships as entities separate and apart from its partners.  This determination affects titling and ownership of partnership property.  Please note, that joint and several liability of acts by other partners are still in effect, and that general partnerships do not shield your personal assets from liabilities of the business.  A very important point.

There are no mandatory filings with the Secretary of State, however partnerships may file GP-1 with the Secretary a Statement of Partnership which which can act as a supplemental grant of authority or a limitation on authority to enter into transactions on behalf of the partnership for certain partners.

There are very few situations where forming a general partnership is advisable, due to the lack of limits on liabilities which other entities provide.  Please note that while there may be a few less formalities, the law for general partnerships are still complex.

IS YOUR CORPORATION SUFFICIENTLY CAPITALIZED?

Whether or not your corporation is sufficiently capitalized is a factor that courts consider when they are determing whether or not they should apply what’s called "alter ego" liability (whereby the corporation is used as an alter ego for your personal matters).  While it isn’t clear if undercapitalization by itself is sufficient for the court to pierce the corporate veil (punch a hole in the limited liability shield of entities) you should take care to avoid adding undercapitalizing to a group of factors supporting such a finding.

WHAT CONSTITUTES ADEQUATE CAPITALIZATION?

The corporation must be capitalized in an amount that is sufficient funds for the corporation to have "independent substance" in relation to third party obligations likely to be incurred.  What this means is the initial shareholders should make a good faith effort to sufficiently capitalize the corporation with enough assets (through issuing capital shares or incurring debt) necessary to reach it’s break-even point.  As long as the estimates made at the beginning are reasonable and in good-faith, shareholders should be able to avoid alter ego liability even if those estimates turn out to be wrong.

When starting a business one of the very first questions asked is whether or not you should form a business entity.  If so, which one?  Just looking at the available entities to choose from can cause confusion to an entrepreneur.

The primary reason for choosing to form an entity is to protect your personal property from business activities.  Because an entity is recognized as a legally separate entity, typically its shareholders are not personally liable for the debts and obligations of a corporation.  Therefore, if your business falls into a negative situation, your house, your car and other assets would not be used to pay off debts.  There are exceptions of course, such as personally guaranteeing loans.

Other advantages include tax advantages, easier transfer of ownership, perpetual existence (the entity does not die when its owners do), and easier raising of capital.  Disadvantages may include double taxation in the case of some corporations, increased costs to start up and maintain the entity, and in some cases corporate formalities may be burdensome.

Which entity should you choose?  That question depends entirely on individual circumstances and should be determined on a case by case basis.  There are Corporations, California Close Corporations, both of which you can choose to treat as a C Corporation or an S Corporation where income or losses are passed through to its shareholders. There are also Limited Liability Companies and Limited Partnerships.  For some professionally licensed individuals, there are also Professional Corporations as well as Limited Liability Partnerships.

As you can see there are many entities to choose from and the decision should not be made lightly.  A business owner should always consider choosing an entity that limits liability entities, because operating as a normal partnership or sole proprietorship exposes the business owner to personal liability which is never desirable.