Start a California S Corp

What is an S corp?

You should understand that an S corp is not a business structure. Rather, it’s a tax classification that either an LLC or a corporation can apply for with the IRS if it meets the criteria. We’ll outline those criteria and the steps you would need to take to file as an S corp if you decide that it’s right for your business.

If you want to form an LLC with S corp status, our S corp service can help you do just that. Plus, we offer other services to help you run and grow your business and stay in compliance with federal and California laws.

Requirements and Limitations of S Corps

Before you form an S corp in California, you need to be aware of the S corp filing requirements and limitations. Specifically, to qualify for S corporation status, an entity must:

• Be a domestic corporation or LLC (“domestic” here refers to the business having been formed within the state of California)
• Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
• Have only one class of stock
• Have no more than 100 shareholders or members (“shareholders” is the term for owners of a corporation, while “members” is the term for owners of an LLC)
• Have only allowable shareholders or members, which includes individuals, certain trusts, and estates. The shareholders may not be partnerships, corporations, or non-resident aliens. A nonresident alien is an alien who has not passed the green card test or the substantial presence test.

Not all business entities are eligible for S corp classification. However, if your business entity meets these requirements, you can apply for an S corp election.

S Corp in California Considerations

When an LLC or C corp elects to be taxed as an S corp for federal income tax purposes, most states apply state income tax in the same way. In other words, the business doesn’t pay federal or state income tax at the business level, just the individual level.

California is different, though. An S corp pays state income taxes at both the business and individual levels. Here are some other differences for S corps in California:

• S corporations in the state must pay a minimum California franchise tax every year, which is 1.5% of the corporation’s net income or $800, whichever is greater. This minimum franchise tax is due the first quarter of each accounting period regardless of whether your corporation is active, inactive, operates at a loss, or files a return for a short period (less than 12 months). California does waive the minimum tax on newly formed or qualified S corporations filing an initial return for their first taxable year if they’re registered with the California Secretary of State.
• The S corporation is allowed tax credits and net operating losses.
• The computation of tax on built-in gains and excess passive income.

Filing as an S Corp in California

To have a California S corporation, you’ll need to create either a limited liability company (LLC) or a C corporation (the default form of corporation) if you haven’t already done so. Then, you’ll file an election form with the Internal Revenue Service (IRS).

If you’re ready to learn about filing as an S corporation in California, we’ll walk you through it. First, we’ll show you how to form an LLC in California. If you’d rather form a California corporation, follow the instructions on our California corporation page. Then, in Step 7, we’ll explain how to file for S corp status as either an LLC or corporation.

Pros and Cons of Filing as an S Corp in California

While S corp classification does come with a number of tax benefits for some businesses, making this election might not be right for all business types. So, be sure to carefully weigh the various pros and cons before deciding how you want to move forward. Consult a tax professional about whether the S corp election would be best for your business.

Advantages of S Corp Status for California LLCs

The advantages of filing as an S corp for an LLC aren’t exactly the same as they are for C corporations. Let’s look at the advantages for limited liability companies first.

A traditional LLC already has pass-through taxation for federal income tax, although California does not have pass-through taxation for state income tax for S corps. So, that’s one less benefit that having an S corp would have in most states.

The benefits of S corp election for an LLC have to do with self-employment tax. This takes some explanation, but for certain LLCs, it could save a lot in taxes.

Self-Employment Tax Explained

The members of a standard LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means paying self-employment tax (Social Security and Medicare, which adds up to about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay part of them.

Dividing Salary and Profits

But when the members elect S corp status, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee. Once they do that, they only pay Social Security and Medicare taxes on their salary and not the profits they receive. Depending on factors such as how profitable your company is, the savings could add up to a lot. (Of course, the members will still pay income and all other applicable taxes on their share of the profits.) Money paid out as salary is a tax-deductible expense for the business. 

One caveat to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $1 and avoid contributing anything to Social Security and Medicare. 

Disadvantages of S Corp Status for California LLCs

Having an LLC with S corp status can have some drawbacks over a traditional LLC:

More Filing Requirements 

As we listed above, S corps must adhere to more regulations than a standard LLC or C corporation. An S corp can have no more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. A traditional LLC doesn’t have these limitations.

More IRS Scrutiny

Because of the above restrictions and the requirements about paying yourself a “reasonable salary,” the IRS tends to monitor LLCs filing as S corps more closely. That could mean a greater chance of being audited, even if you follow the law to the letter. In fact, S corp owners may want to observe many of the same formalities that C corporations do (such as regular meetings and extensive record keeping), even if they’re not legally required to.

Additional Accounting and Bookkeeping

Having an LLC that files as an S corporation generally means more paperwork. If you don’t already have to do payroll for your business, being an owner-employee means that you’ll have to do so. Your taxes will be more complex, as well.

With these added complications, you’re likely to have higher administrative costs. You may find that you need an accountant, bookkeeper, and/or a payroll service or software.

Advantages of S Corp Status for California Corporations

If you have a C corporation (the default form of corporation), filing as an S corp does have its advantages:

Pass-Through Taxation

One big disadvantage for traditional corporations is “double taxation.” When the corporation makes money, the IRS taxes those profits on the corporate level. But when those profits are ‌distributed to the individual business owner (shareholder) as dividends, they’re taxed a second time on the shareholder’s personal income tax return.

But when a C corporation qualifies to be an S corp, those profits are only federally taxed at the individual level. The business itself doesn’t pay income tax on them. This is called “pass-through taxation,” and it’s how sole proprietorships and general partnerships are taxed.

As mentioned earlier, in California, pass-through taxation for an S corp applies only to federal income taxes, not state income taxes. Your business still must pay state income taxes at both the corporate and shareholder levels.

We need to add here that, since the 2017 Tax Cuts and Jobs Act, the corporate tax rate has been lowered to a flat 21%. So, the disadvantages of double taxation aren’t as severe now as they were. 

Writing Off Losses

Just as business profits pass through to the owners of an S corp, so do the losses. Unlike the shareholders of a C corporation, S corp owners can write off the company’s losses on their personal income statements. 

This can help offset their income from other sources and can be helpful if the corporation loses money in the first couple of years. Still, make sure you’re aware of ​​the IRS’s shareholder loss limitations.

Qualified Business Income Deduction

Under the Tax Cuts and Jobs Act, some S corp owners may be able to deduct up to 20% of their qualified business income. This deduction isn’t available to C corporation shareholders.

Qualified business income (QBI) is basically your share of the company’s profits, or, as the IRS puts it, “QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.” The IRS website has a detailed explanation as to what is and is not included in QBI. There’s an income threshold that, if exceeded, may reduce your QBI (see the IRS website for details).  

Disadvantages of S Corp Status for California C Corporations

S corp status also has its downsides:

Limited Number of Shareholders

As we said, an S corp can’t have more than 100 shareholders, while a C corporation has no such restriction. That limitation could be an issue later if the corporation expands and goes public.

Limited Types of Shareholders

All S corp shareholders must be U.S. citizens, or certain trusts or estates. That could limit your ability to expand internationally. You also can’t have partnerships or corporations as shareholders. C corporations don’t have these limitations.

One Class of Stock

One way corporations attract investors is to offer preferred stock. That’s fine for C corporations, but the IRS doesn’t allow it for S corps.

More IRS Scrutiny

Because of the extra restrictions S corps have, the IRS watches them more closely to see if they’re in compliance. In other words, your corporation is more likely to get audited.

We can’t stress enough how important it is to have tax guidance about your specific situation from a qualified tax professional. An accountant with S corp experience should be able to make sure you stay in compliance with the IRS, but they may also be able to help you find additional tax savings.

S Corp California: How We Can Help

Forming a business can be complicated, but we’re here to make it as easy for you as possible.

When you’re ready to take the leap, we can help you form a California LLC with an S corporation designation and provide you with valuable support for all of your business needs moving forward.