California LLC vs. S Corp: Key Differences for Owners

Key Takeaways

• Both LLCs and S Corporations in California offer liability protection but differ in compliance requirements and tax treatment.
• LLCs offer operational flexibility and simpler formation, ideal for businesses wanting fewer formalities.
• S Corps provide potential tax savings by splitting income between salary and distributions.
• California imposes unique taxes on LLCs based on gross receipts, which may affect your choice.
• Your decision should also factor in ownership structure, industry type, and long-term business goals.

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.

Industry and Investor Considerations

The right structure for your business in California can also depend on your industry and whether you seek outside investment. For example, startups aiming to raise venture capital often lean toward forming corporations—specifically C corps—but if you're leaning toward an S corporation, know that this structure supports a more standardized equity system that appeals to certain investors. On the other hand, service-based professionals, such as consultants, therapists, or solo practitioners, may prefer LLCs for their flexibility and simpler management requirements.

If you plan to grow quickly, attract investors, or eventually offer stock options, you may need to factor in whether the corporate structure better supports those goals.

Tax Implications

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.

California State Taxes for LLCs and S Corporations

While both LLCs and S corporations benefit from pass-through taxation at the federal level, California imposes additional tax burdens that can impact your choice.

LLCs:

• Must pay an $800 annual franchise tax, regardless of income.
• Must also pay a gross receipts fee if annual revenue exceeds $250,000:
  • $900 for $250,000–$499,999
  • $2,500 for $500,000–$999,999
  • $6,000 for $1M–$4,999,999
  • $11,790 for $5M+

S Corporations:

• Pay the same $800 annual minimum franchise tax.
• Must also pay a 1.5% tax on net income earned in California (even if no income is distributed).
• Shareholders still pay personal income tax on distributions.

The gross receipts fee for LLCs can disproportionately affect high-revenue, low-margin businesses, making the S corporation structure more appealing from a tax-efficiency standpoint in some cases.

Owner Preferences

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 communicate with 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 entities, as well as a professional CPA.

Formation and Ongoing Requirements in California

Understanding the setup and maintenance obligations in California is essential when comparing an LLC vs S Corp.

LLC Formation and Requirements:

• File Articles of Organization with the Secretary of State (Form LLC-1).
• Create an Operating Agreement (not required by the state but strongly recommended).
• File a Statement of Information (Form LLC-12) within 90 days and every two years thereafter.
• Pay the $800 annual tax and applicable gross receipts fee.
• No formal meeting or minute-taking obligations.

S Corporation Formation and Requirements:

• Incorporate by filing Articles of Incorporation (Form ARTS-GS).
• Elect S corp status with the IRS by filing Form 2553 within 75 days of incorporation or the start of the tax year.
• Adopt bylaws and issue stock to shareholders.
• File Statement of Information (Form SI-550) and pay the $800 annual tax and 1.5% income tax.
• Must hold regular shareholder and board meetings with documented minutes.

S corporations require more ongoing compliance, such as maintaining corporate formalities, issuing stock, and maintaining detailed records. LLCs offer more relaxed operational rules, which can be a major advantage for small businesses or sole-member entities.

Pros and Cons Summary Table: LLC vs S Corp in California

Frequently Asked Questions

1. Is it better to form an LLC or S Corp in California? 

It depends on your business goals. LLCs offer flexibility and ease, while S corps can offer tax savings for owners who take a reasonable salary and dividends.

2. Do both LLCs and S Corps pay the $800 franchise tax in California? 

Yes, both must pay the annual $800 franchise tax to the state of California, regardless of profitability.

3. Can a California LLC be taxed as an S Corp? 

Yes. An LLC can elect S corporation tax treatment by filing Form 2553 with the IRS, which may offer tax benefits while maintaining LLC flexibility.

4. Are LLCs or S Corps easier to maintain? 

LLCs are generally easier to maintain, with fewer administrative requirements like meetings and minutes compared to S corporations.

5. What’s the main reason a business would choose an S Corp over an LLC? 

Primarily for potential tax savings. S corp owners can take a salary and receive dividends, which may reduce overall self-employment taxes.

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