S Corp vs LLC in California

Deciding on an S corp vs LLC in California is the most important decision that you can make with respect to structuring your business.

Both corporate structures provide personal asset protection of varying levels for the business owner, tax advantages and disadvantages, and complexities with respect to the day to day operations of running the business.

LLC Definition

An LLC, at its core, is a default business structure that has similarities to a sole-proprietorship and a partnership.

With respect to formation in California, the owners are required to file Articles of Organization, agree on important business points that are to be outlined in an Operating Agreement, and file a Statement of Information, also known as an SOI, with the California Secretary of State.

According to the IRS, an LLC is structured “to provide the [owner or owners with] limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.”

As a pass-through entity for tax purposes, profits and losses pass through the business to the LLC owners, which are known as members. Like partnerships, the members report the profits and losses on their personal federal tax returns.

If there are multiple members, the LLC is taxed as partnership and is therefore required to report income/loss on an IRS Form 1065. Per partnership tax rules, members will receive an annual Form K-1 that reports the member’s distributive share of income or loss, and it is also reported on the member’s personal income tax return.

S Corp Fundamentals

An S corp is an entity that limits an owner’s personal liability from liabilities that are associated with the company, provided that the S corp is formed and maintained correctly.

First, the business must have a corporate charter filed in its headquartered state before it can be S corp consideration. Per the IRS, S corps are “separate and apart from those who own it.” This allows for an owner, or a shareholder, to have limited responsibility with respect to the financial liability of the corporation.

What to Focus On

In general, when making a determination about whether to organize as an S corp or as an LLC, it is most productive to focus, for purposes of organization, on three key areas:

  • How to limit possible personal liability from the liabilities of the business and any associated formalities required with maintaining limited liability.
  • How to limit potential tax matters associated with the business.
  • How to address other special circumstances that may exist or will come up that are applicable to the circumstances or important to the principals of the business.

How to Choose Your Company’s Business Structure

To choose correctly, you should first answer six basic questions:

  • How do you make or plan to make your money?
  • Who will own the company now and in the future?
  • Who will now and in the future run the company?
  • What are the current and expected gross revenues?
  • What are the current and projected net revenues?
  • What is the structure for splitting the profits if there is more than one owner?

How to Achieve the Goal of the Owners with Little or No Compromise

First, determine how many owners your new entity will have (note that for S corps they are referred to as “shareholders” and for LLCs they are referred to as “members”). Making this determination when there is only one owner is very straightforward.

However, with business structures that involve more than one owner, each owner may have different objectives or areas that they feel are the priority or priorities of the business.

For instance, take two owners wherein the first owner’s priority is to obtain certain tax benefits before discussing anything else, while the second owner is more concerned with ownership flexibility or the appropriation of the businesses’ profits and loss.

To properly address this issue, it is probably best for the lawyer organizing the business to take a step back, look at the overarching goal of the business, and choose the business structure that best suits the varying goals of the owners while having minimal compromises.

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