California LLC Vs S Corp: Everything You Need to Know
California LLC vs. S Corp is one of the most important choices you need to make if you're forming a new business in California.3 min read
California LLC vs. S Corp is one of the most important choices you need to make if you're forming a new business in California. They both have advantages and disadvantages in terms of paying taxes, and the day-to-day operations will vary in complexity. Owners may find the research involved in this decision overwhelming at times. There are three areas, though, that you should focus on when making that important choice.
- Limiting Personal Liability
- Limiting Tax Obligations
- Addressing Issues Important to the Owners
First of all, decide how many owners the new business will have. In an LLC, owners are referred to as “members” while owners of an S corporation are “shareholders.” Of course, if there's only one owner, this will be easy. But if there are multiple owners, each may have their own preferences and goals for the business.
Personal Liability Protection
Both corporations and LLCs have an edge over sole proprietorships and partnerships regarding personal liability, because they both offer protection. Owners of LLCs and corporations have business assets and personal assets kept separate, so none of the owners are responsible for the company's debts. Personal assets are also protected from lawsuits the business may incur.
Both LLCs and corporations are “pass-through” entities with regard to taxes. In this way, any profits and losses from the business activities are reported on the owners' personal income tax returns, in proportion to their ownership in the business. An S corporation provides significant advantages when it comes to taxes, however. It allows owners to be paid a salary that is separate from distributions they may receive from company profits, also called dividends.
LLCs are taxed the same as sole proprietorships and partnerships; owners must pay self-employment tax on all profits, which is similar to a W2 employee's social security and Medicare withholdings. S corporation owners, however, only need to pay self-employment tax on their salary. Dividends are taxed differently. This can save a lot of money at tax time. The only catch is that the IRS requires these owners to be paid a “reasonable salary,” so it doesn't appear to the IRS that you are trying to cheat the system.
California has additional rules for LLCs operating within the state. An additional tax must be paid on the business's gross receipts over $250,000. Therefore, businesses over a certain size need to take this into consideration.
Much of the decision between LLCs and S corporations comes down to personal preferences of the owners. An LLC provides more flexibility and simplifies the administrative process.
In order for a business to maintain status as an S corporation and limit its owners' liability effectively, there are several rules that must be followed, including:
- Owners must be U.S. citizens or permanent residents.
- There may not be more than 100 owners, or shareholders.
- It can only have one class of stock.
- S corporations must hold regular meetings for shareholders and a board of directors.
- All documents, such as annual reports and meeting minutes, must be documented and filed with proper authorities as mandated.
- Personal assets should never be co-mingled with business accounts.
LLCs have more relaxed requirements when it comes to administrative formalities. For example, Meetings are not required, though owners should still hold occasional meetings to provide communication between members/managers and keep documentation. Any losses the business incurs may be used as a deduction on members' personal income taxes, offsetting income they may receive from other sources. Also, there is flexibility with regard to members' share of ownership. Members can decide among themselves how they wish to divide the ownership in terms of distributing profits and losses; in an S corporation it must be distributed evenly according to company shares.
The amount of work involved to maintain an S corporation may tip the scales in your decision, also. Although there may be significant tax savings from separating salary from dividends on company profits, this also involves handling payroll taxes and the paperwork that requires. Payroll tax must be paid throughout the year at regular intervals, and if the company is short on cash for some reason, you might be penalized for late payments.
Before making this important decision, you'll want to consult with an attorney who is familiar with all forms of business entity, as well as a professional CPA.
If you need more information or help with California LLC vs. S Corp, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.