For a long time, small business owners elected to operate their business as an S corporation (S corp) due to the many tax advantages. An S corp carries limited liability for owners and no double taxation at the federal level. However, recent changes under the Tax Cuts and Jobs Act (TCJA) of 2017 dampened the appeal of an S corp election.
So as a business owner, and especially one in California, what is your best option when incorporating your California business: an LLC or an S Corp?
What’s in this article?
LLC vs. S Corp: What are they?
At the end of the day, your business structure is largely directed by the nature of the business and the vision the owner has for the future. It is a crucial decision, as the structure type significantly affects important issues throughout the business’s life. Under the Small Business Job Protection Act of 1996, a number of basic corporate tax law modifications were made. As a result, LLCs and S corp structures surged to the forefront.
California LLC vs. S Corp: What is a Limited Liability Company?
A limited liability company (LLC) is an entity structure whereby the owners are not personally liable for the company’s debts or liabilities. They are hybrids that combine the qualities of a corporation with those of a partnership or sole proprietorship.
LLCs are formed under state regulations. The owner, called a “member,” is required to file articles of organization with the state of operation. Many states do not have restrictions on LLC ownership; therefore, anyone can be a member including individuals, corporations, foreigners and foreign entities, and even other LLCs. However, some entities are prohibited from LLC membership, such as banks and insurance companies.
Notably, LLCs do not pay taxes themselves. Rather, profits and losses are passed through to the owner’s personal tax returns. Also, members’ wages are classified as operating expenses and are thereby deducted from the company’s profits.
California LLC vs. S Corp: What is an S Corporation?
An S Corporation (S corp) is a type of corporation that satisfies specific Internal Revenue Code (IRC) requirements. The guidelines allow a corporation with 100 shareholders or less the ability to incorporate while being taxed as a partnership. Corporations are required to have a board of directors and corporate officers. The board oversees management and is in charge of major decisions. Most significantly, an S corp passes income directly through to the shareholders and avoids double taxation.
In order to elect S corp status, the company must:
- Be a domestic corporation,
- Have only one class of stock,
- Have no more than 100 shareholders, and
- Have only “allowable shareholders, including individuals, certain trusts and estates. Shareholders cannot include partnerships, corporations and nonresident shareholders.”
Furthermore, certain businesses are restricted from S corp classification. Those businesses include financial institutions, insurance companies and domestic international sales companies.
What are the Pros and Cons of an LLC?
Primarily, business owners decide to register as an LLC due to the limited liability for members. This means members are not personally liable for business debts and lawsuits.
Another pro is that there are fewer reporting and recordkeeping requirements than corporations. Also, an LLC avoids double taxation that C corporations are subject to.
While an LLC is an attractive option, there are disadvantages to consider. Depending on state law, an LLC may be dissolved upon the death or bankruptcy of a member. (Compare this to a corporation which can exist in perpetuity.) Furthermore, an LLC is not always a logical choice when the owner’s principal objective is to become a publicly-traded company.
Additionally, there are high self-employment taxes at the federal level, and a regulated professional field, such as a medical practice, cannot register as an LLC.
What are the Pros and Cons of an S Corp?
Generally, the central reason a business elects S corp status is to gain limited liability and the ability to pass corporate income, losses and deductions and credits through to shareholders. This allows S corps to avoid double taxation of corporate income – at the corporate level and again when it is distributed to shareholders. Rather, the tax items pass through to the shareholders’ personal returns and they pay tax at their individual income tax rates.
Operating as an S corp also establishes credibility with potential customers, employees, suppliers and investors by demonstrating a formal commitment to the company. Other advantages include the transfer of interests without adverse tax consequences, capacity to adjust property basis and compliance with complex accounting rules.
The shareholders of an S corp can become company employees, earn salaries and receive corporate tax-free dividends if the distribution does not exceed their stock basis. In the event the dividends do exceed the tax basis, the excess is taxed as capital gains. Furthermore, classifying the distributions as salary or dividends may help the owner reduce liability for self-employment tax while generating business-expense and wages-paid deductions.
With the adjusted tax rates under the TCJA, S corp owners may be eligible for the qualified business deduction (QBI), which can be equal to as much as 20% of the QBI.
Changes under the TCJA have made S corp status less appealing. The TCJA lessened the concern of double taxation by instituting a 21% flat income tax rate applied to C corporations (C corp). Compare that to the top individual income tax rate of 37%.
One primary disadvantage of electing S corp status is the increased Internal Revenue Service (IRS) scrutiny. In particular, the IRS is on the lookout for S corps that pay shareholder-employees unreasonably low salaries to avoid paying employment taxes and then make distributions that are not subject to those taxes. Noncompliance issues such as mistakes in election, consent, notification, stock ownership or filing requirements can lead to the termination of an S corp. However, quickly resolving the errors helps avoid any negative consequences.
Additionally, an S corp necessitates extra time and money. For example, in several states owners pay annual report fees, a franchise tax and other miscellaneous fees. However, the charges are often minimal and can be deducted as cost of doing business.
How do I file for an LLC in California?
Forming an LLC in California calls for registration with the California Secretary of State. The Secretary of State is the one who defines the rules and fees.
To file as an LLC in California, follow these 8 steps:
1. Choose a Name
California law states that a business name cannot be similar enough to another name that it sparks confusion among consumers. Also, it cannot mislead the public. You are able to search names currently on file in the state by going to the Business Search tool run by the Secretary of State. In addition, while not required, you are able to complete a Name Availability Inquiry Letter and/or a Name Reservation Request Form.
Furthermore, all California LLCs must end with “Limited Liability Company,” “LLC,” or “L.L.C.” The word “Limited” can be abbreviated as “Ltd.” and “Company” can be shortened to “Co.” Additionally, the name cannot contain any of the following: “bank,” “trustee,” “incorporated,” “inc.,” “corporation,” “corp,” “insurer” or “insurance company.”
2. Select a Registered Agent in California
Every LLC in the state is required to have a registered agent. A registered agent is an individual or company that accepts legal and official documents on your business’s behalf. If you are filing in California, the agent must be a California resident with a physical address in the state.
3. Obtain California Business Permits
Essentially every business in California requires a business license. The most basic license in California is called a general business license or business tax certificate (in some areas). Cities and counties are responsible for issuing the licenses. If you are operating in more than one location, your business requires multiple licenses.
Businesses that sell or lease merchandise must obtain a seller’s permit from the California Department of Tax and Fee Administration. Additionally, if you are doing business under a name other than the legal one, you must file for a fictitious business/ “doing business as” name.
For more information, review the information provided by the Governor’s Office of Business and Economic Development.
4. File Articles of Organization
You are required to file articles of organization with the state. In California, the LLC articles of organization must include:
- LLC name
- Address of the LLC California office
- Registered agent information
- Management structure (member-managed or manager-managed)
- Name and signature of the organizer filling out the form (typically is, but does not need to be, a member or manager of the LLC)
Domestic LLCs – meaning those based in and organized under California laws – must fill out Form LLC-1. On the other hand, foreign LLCs – those formed under laws of another state but are seeking to do business in California – must fill out Form LLC-5.
5. Draft an LLC Operating Agreement
An LLC operating agreement is not required by the state but is highly recommended. The agreement should include the following details:
- Purpose of the LLC, including offered products or services
- Names and address of all members
- Financial contributions of each member
- Each member’s ownership interest and division of profits and losses
- Procedures for admitting new members
- Procedures for electing a manager if the LLC is manager-managed
- Meeting schedule and procedures
- Dissolution procedures
6. File a Statement of Information
You must file a Statement of Information within 90 days of formation and every two years after. The Statement ensures that all company information on file with the state is up-to-date and accurate.
7. Comply with Tax Obligations
Both domestic and foreign California LLCs are required to pay four main types of taxes: 1) annual franchise tax, 2) gross receipts tax based on total revenue, 3) personal state income taxes on share of LLC profits (for members only), and 4) employer share of payroll taxes.
8. Consider Federal Requirements
Be diligent about complying with federal laws as well. For example, LLCs with employees and LLCs taxed as corporations are required to apply for an employer identification number (EIN). Also, LLC members must pay self-employment taxes to cover social security and Medicare obligations. If the LLC has employees, the business withholds social security and Medicare taxes from employees and pays the employer share instead.
How do I file for an S Corp in California?
To operate as an S corp in California, complete the following 10 steps:
1. Choose a Corporate Name
Your corporation’s name cannot be the same or similar to an existing name on file with the California Secretary of State. It may, but is not required to, include the words “Corporation,” “Incorporated” or “Limited.” Furthermore, it cannot be misleading to the public.
Like an LLC, you can submit a Name Availability Inquiry Letter and/or a Name Reservation Request Form to the Secretary of State. There is also the Business Search database to determine what is and is not available.
2. File Articles of Incorporation
You are legally responsible to file Articles of Incorporation-General Stock (Form ARTS-GS) with the California Secretary of State. The Articles must include:
- Corporation’s name
- Corporation’s address
- Name and address of a registered agent
- Number of shares the corporation is authorized to issue
3. Appoint a Registered Agent
Every S corp must hire a registered agent. The registered agent accepts legal documents on behalf of the corporation. The agent must reside in California, have a physical address in California, and have filed a Registered Corporate Agent for Service of Process Certificate (Form 1505).
4. Establish a Corporate Records Book
It is important to develop a central records book which contains important papers. This includes minutes from director and shareholder meetings, stock certificates and stock certificate stubs.
5. Prepare Corporate Bylaws
Bylaws establish the basic ground rules for operating the corporation. They are not required by the state, but they do help you: 1) establish your operating rules, and 2) show banks, creditors, the IRS and others that the corporation is legitimate and credible.
6. Appoint Initial Corporate Directors
The incorporator, also known as the individual who signed the articles – appoints the initial corporate directors who will serve until the first annual meeting of shareholders. The incorporator fills out an Incorporator’s Statement to list the names and addresses of the initial directors. Again, this is not filed with the state but essential for legitimizing your business.
7. Issue Stock
Issue stock to your shareholders. A share of the stock is classified as a security under state and federal securities laws that regulate the offer and sale of corporate stock. However, the federal and state governments exempt most small corporations from this law.
8. Comply with California Tax Obligations
All California corporations, as well as those out of state corporations doing business in California, must pay California taxes to the California Franchise Tax Board (FTB).
The annual minimum tax starts at $800 during the first quarter of each accounting period whether the corporation is active, operates at a loss or does not do any business. For brand new corporations, the tax is determined on the income for the first year and subject to estimate requirements. For all following years, the minimum tax is $800.
Additionally, S corps with income which exceeds a certain threshold must pay another fee based on their total annual income.
9. Comply with Other Tax Requirements
In addition to state regulations, you are expected to comply with federal corporation guidelines.
- You must obtain a federal employer identification number through the IRS.
- If a corporation elects S corp status for tax purposes, it must file Form 2553 Election by a Small Business Corporation. It must be submitted within two months and 15 days following the corporation’s first tax year.
- Certain businesses necessitate business licenses. Visit here for information specific to California.
10. File Statement of Information
Every corporation in California is required to file a Statement of Information with the Secretary of State within 90 days of filing the Articles of Incorporation and every year thereafter. Both domestic and foreign California corporations must file Form SI-550.
LLC vs. S Corp: How do I know what the best option is for my California business?
At the end of the day the decision is yours. You know the nature of your business and where you want it to go. LLCs are easier and less expensive to set up. They are simpler to maintain and remain compliant with the laws. However, an S corp is more logical for a business seeking substantial outside financing or if it intends to go public one day. Changing business structure is a doable option, but it often comes with tax penalties.
You do not have to navigate the stress and complexities of establishing your business on your own. Due to the types of entities and variance between states, it is difficult to figure out the best option all on your own. That is where we come in. Our accounting firm is here to help you structure your California business to best meet your personal and professional goals. Contact us today!
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.