When starting or restructuring a business in California, choice of legal entity is a critical decision that impacts taxation, management, and overall operations. The most common options include partnerships (both general or limited), limited liability companies (“LLCs”), and corporations (C-corporations or S-corporations).  For the most part, California conforms with the U.S. federal income tax treatment of these entities but some differences do exist.

S corporations (including LLCs electing S corporation treatment) offer a powerful tool for owners to optimize their tax obligations, particularly when it comes to employment taxes. By electing S corporation status, business owners can potentially reduce their exposure to self-employment taxes through careful income allocation between salaries and distributions. 

Partnerships (including limited liability companies taxed as partnerships) are creatures of contract that offer flexible mechanisms for providing equity-based compensation to employees, managers, and service providers. Two primary forms of partnership interests used for this purpose are capital interests and profits interests. Rev. Proc. 93-27 defines a profits interest as a partnership interest other than a capital interest.  

Both are forms of equity that allow partnerships to incentivize key individuals by aligning their interests with the entity's long-term success.