A California S-Corp is a special type of corporation that combines the limited liability benefits of a traditional corporation with the income tax advantages of a partnership or sole proprietorship without the same self-employment tax liabilities of partnerships or sole proprietorships.

Despite carrying certain eligibility requirements and formation procedures, many business owners find the unique blend of benefits offered by a California S-Corp the best option.

This article aims to provide an understanding of California S-Corps, the process of setting one up, its pros and cons, and how it may fit into your business plans.

Understanding the Concept of a California S-Corp

First, Understand Traditional Corporations

To understand the concept of a California S-Corp, it is beneficial to first grasp the fundamentals of a traditional corporation. A corporation is a legal entity separate from its owners, providing them with limited liability protection. This means that the personal assets of shareholders are not at risk in the event of a financial failure or legal judgment against the business.

How a California S-Corp is Different

A California S-Corp, named after Subchapter S of the Internal Revenue Code, allows the income, deductions, and credits of the corporation to pass through directly to its shareholders for federal tax purposes, and this is recognized for California tax purposes as well. This avoids the issue of double taxation that typically occurs in a traditional corporation, where the net profits are taxed at both the corporate level and taxed a second time at the shareholder level after dividends are declared and paid to shareholders.

Benefits of a California S-Corp for a Small Business

Operating as a California S-Corp can offer small businesses several benefits:

Limited Liability Protection of a California S-Corp

As with a traditional corporation, a California S-Corp provides its shareholders with limited liability protection. This means that shareholders are typically not personally liable for the debts, liabilities, and obligations of the business, which protects the personal assets of shareholders from being used to satisfy business debts.

Tax Benefits of a California S-Corp

Bear in mind that while the following tax benefits can be significant, they should be considered in conjunction with other factors, such as legal requirements and business goals. Always consult with a tax professional or advisor for personalized advice.

Pass-through Taxation of a California S-Corp

A distinguishing feature of California S-Corps is the pass-through taxation structure. This allows the income or losses of the California S-Corp to pass through directly to the individual income tax returns of the shareholders, thereby avoiding the double taxation experienced by traditional corporations.

Employment Tax Savings for Business Owners

Shareholders of a California S-Corp can save on self-employment and employment taxes. Only the salary paid to a shareholder as an employee is subject to employment tax while the remaining income paid as a distribution on the shares of stock is not subject to self-employment or employment taxes.

Franchise Tax Exemption for the First Year of a California S-Corp

California S-Corps may be exempt from the annual minimum franchise tax in their first year, offering a cost-saving advantage for start-up businesses.

No Corporate Alternative Minimum Tax (AMT) for California S-Corps

California S-Corps are not subject to the Alternative Minimum Tax (AMT), a tax system separate from the standard tax that aims to prevent corporations from avoiding their fair share of taxes.

Ability to Write off Start-Up Losses of a California S-Corp

In the early years, businesses often incur losses. For a California S-Corp, these losses can be deducted from the individual tax returns of shareholders to offset shareholder income from other sources.

Credibility

Operating as a California S-Corp can lend credibility to the business. Customers, vendors, and competitors may perceive the business as more legitimate or established because it is a corporation, which can help in building trust and credibility in the marketplace.

Comparing Employment Tax Liabilities of a California S-Corp to Other Forms of Doing Business

California S-Corps can potentially reduce self-employment and employment tax liabilities compared to sole proprietorships (or sole member LLCs that do not elect corporate tax treatment) and entities taxed as partnerships (such as multi-member LLCs that do not elect corporate tax treatment).

Self-Employment Tax for Sole Proprietors, Partnerships, and LLCs

In sole proprietorships and partnerships, all business income is subject to both income tax and self-employment tax. This means the owners must pay not only California and federal income taxes on the entire net income of the business but an additional 15.3% self-employment tax (up to the statutory maximum) annually. This means that sole proprietors and partners in partnership could pay close to $20,000 per year in self-employment taxes alone!

Self-Employment Tax for California S-Corps

In a California S-Corp, only the salary paid to the shareholder-employees is subject to employment tax. Any remaining income after paying salary can be distributed to the owner as distributions on the shares of stock in the California S-Corp, which distributions are not subject to self-employment tax. This effectively bifurcates the income of a shareholder into two income streams: salary (subject to employment tax) and distributions (not subject to self-employment tax).

As a result, the overall tax liability can be significantly reduced, sometimes a reduction of well over $10,000 every year, providing a key advantage of the California S-Corp over sole proprietorships, partnerships, and LLCs (other than LLCs electing to be taxed as S Corporations).

Annual Governance Requirements for a California S-Corp

Operating a California S-Corp involves several legal obligations to maintain the status and benefits of the corporation.

Annual Statement of Information for a California S-Corp

California S-Corps are required to file an annual Statement of Information with the California Secretary of State. This report includes information about the corporation, its principal executive office, and its officers and directors. The annual Statement of Information filing must be accompanied by a $25 payment to the California Secretary of State.

Board Meetings for a California S-Corp

S-Corps must hold and document annual meetings of the board of directors. Meeting minutes should be recorded and stored as they serve as a legal record of corporate activities.

Shareholder Meetings for a California S-Corp

California law requires S-Corps to hold and document an annual meeting of shareholders. At this meeting, shareholders elect the board of directors and vote on other significant matters.

Tax Filings for a California S-Corp

California S-Corps must file an informational federal income tax return on Internal Revenue Service Form 1120S and the corresponding California income tax return is filed on California Franchise Tax Board Form 100S annually.

Maintaining Corporate Records for a California S-Corp

S-Corps should maintain comprehensive corporate records, including articles of incorporation, bylaws, shareholder and director meeting minutes, copies of all filed statements of information, and a shareholder register.

Business Licenses and Permits for California S-Corps

Depending on the nature of the business, a California S-Corp may need to obtain various federal, state, and municipal licenses and permits, such as a local business license.

Understanding the Role of Shareholders in a California S-Corp

Shareholders play a critical role in a California S-Corp, serving as its owners. They have the power to elect the board of directors and make decisions on significant company matters. Understanding the rights and responsibilities of shareholders is essential for managing a successful California S-Corp.

Shareholder Rights in a California S-Corp

Shareholders have several rights in a California S-Corp, including the right to vote on major corporate decisions, the right to receive dividends, and the right to inspect corporate books and records.

Shareholder Voting in a California S-Corp

Each shareholder of a California S-Corp generally has one vote per share. Major decisions, such as amending bylaws or approving a merger, typically require a majority vote of the shareholders.

Shareholder Agreements for a California S-Corp

Shareholders in a California S-Corp often enter into a shareholder agreement, such as a Buy-Sell Agreement. These contracts govern the relationships among shareholders and with the California S-Corp, often setting out their respective rights and obligations, the management of the company, the distribution of net profits, and the sale of shares.

Shareholder Restrictions in a California S-Corp

A California S-Corp has specific restrictions concerning its shareholders.

Limitation on Number of Shareholders of a California S-Corp

An S-Corp in California can have no more than 100 shareholders. The purpose of this restriction is to maintain the “small business” nature of S-Corporations and to prevent them from becoming excessively large. It is crucial to keep track of the total number of shareholders in a California S-Corp, as exceeding the 100 shareholders limit can lead to the company losing its S Corporation status, which would remove the tax benefits associated with this type of taxation.

Citizenship Requirements for Shareholders of a California S-Corp

In order to be a shareholder in a California S-Corp, an individual must be a U.S. citizen or a permanent resident. This requirement originates from the Internal Revenue Code and is aimed at ensuring that the tax benefits of an S Corporation are exclusively accessible to those who contribute to the U.S. tax base.

Non-resident aliens, corporations, partnerships, LLCs, and certain trusts are generally prohibited from being shareholders in an S-Corp. It is important for a California S-Corp to carefully vet potential shareholders to maintain compliance with these citizenship requirements, as failing to do so could result in the loss of the S-Corp status and its associated benefits and tax treatment.

In certain circumstances, one S-Corp may wholly own another S-Corp.

Single Class of Stock

California S-Corps can only have one class of stock, although they can have both voting and non-voting shares. This simplicity can be advantageous but may limit the flexibility in profit distribution.

California S-Corp: Management and Control

In a California S-Corp, the management and control typically rest with the board of directors, as elected by the shareholders. The board of directors is responsible for making major business decisions and setting strategic direction. The Board of Directors appoints officers who handle the day-to-day operations of the business.

Shareholders, while owners of the California S-Corp, do not typically involve themselves in daily business operations, but do have the power to elect and remove directors. This structure provides a clear separation between ownership and management, allowing for robust corporate governance. However, in smaller California S-Corps, it is not uncommon for shareholders to also serve as directors and officers.

Regardless of the size and complexity of the California S-Corp, it is vital to maintain clear records of corporate decisions and to comply with all state regulations regarding corporate governance.

Role of Shareholders in a California S-Corp

In a California S-Corp, shareholders are the owners of the company, holding equity interest represented by shares. While they typically do not participate in day-to-day operations, they hold significant power by electing the board of directors who make strategic decisions for the company.

Shareholders have the right to vote on major corporate actions like mergers, acquisitions, or liquidation of assets. They can also approve or decline significant changes to bylaws or the articles of incorporation. The voting power of each shareholder is directly proportional to the number of shares they own. Additionally, shareholders have the right to receive distributions, which must be made pro rata (proportionate) to their equity interest in the S-Corp.

Another key right pertains to the inspection of books and records of the corporation, which ensures transparency and accountability.

Role of Directors in a California S-Corp

In a California S Corporation, the Board of Directors plays a pivotal role in overseeing the overall direction and making strategic decisions.

Providing a Long-Term Strategy for California S-Corps

Typically elected by shareholders, the board is responsible for both setting the long-term strategy of the California S-Corp as well as ensuring such strategy is executed.

Providing for Day-to-Day Operations for California S-Corps

On a day-to-day level, the Board of Directors is tasked with appointing officers, like the CEO, CFO, and Secretary, who handle the daily operations of the business. The Board of Directors also guides and monitors the performance of the appointed officers to safeguard the interests of the shareholders.

Meeting Statutory and Ethical Requirements for a S Corporation in California

The Board of Directors is responsible for ensuring that the California S-Corp meets all its statutory and ethical obligations, including abiding by federal, state, and municipal regulations, maintaining accurate records of corporate decisions, and ensuring transparency in all operations.

Fiduciary Duties in an S Corporation in California

In discharging their responsibilities, the Board of Directors is guided by fiduciary duties of care, loyalty, and good faith towards the California S-Corp and its shareholders. These duties require the Board of Directors to act in the best interest of the S Corporation, avoid conflicts of interest, and uphold the utmost standard of care and diligence in their decision-making process.

Removal by Shareholders of a California S-Corp

It is also important to note that while the Board of Directors exercises significant power within the S-Corp, they are accountable to the shareholders who have the right to elect and remove directors. This dual role of authority and accountability helps maintain a robust corporate governance structure in a California S-Corp.

Role of Officers in a California S-Corp

In a California S-Corporation, the officers hold key executive roles and are responsible for the daily operation of the business.

Appointed by the board of directors, typical officer positions include the Chief Executive Officer (CEO), Chief Financial Officer (CFO), and the Secretary. A brief description of each of these officer roles is described below.

Chief Executive Officer of a California S-Corp

The CEO is the highest-ranking officer and is responsible for making vital business decisions, establishing corporate policies, and setting the strategic direction in alignment with the vision of the Board of Directors.

The CEO usually also acts as the main public-facing representative of the California S Corporation, but this is not always the case.

Chief Financial Officer of a California S-Corp

The CFO of a California S-Corp oversees the financial operations, including budget management, financial planning, and financial reporting.

The CFO is instrumental in making financial decisions and strategies that contribute to the financial health and growth of the California S-Corp.

Secretary of a California S-Corp

The Secretary of a California S-Corp has the responsibility of maintaining corporate records and compliance with regulatory requirements.

The Secretary also handles the logistics of board and shareholder meetings, including setting agendas, taking minutes, and ensuring that the corporate actions are in line with its bylaws and legal obligations.

Officer Accountability to the Board of Directors of a California S-Corp

While officers of a California S-Corp are entrusted with significant responsibility, they are accountable to the board of directors.

The actions of officers must align with the strategic direction set by the Board of Directors, and officers must uphold fiduciary duties of care, loyalty, and good faith to the corporation and its shareholders.

Failure of officers to fulfill their responsibilities can lead to their removal by the Board of Directors.

Let San Diego Corporate Law Form Your California S-Corp

At San Diego Corporate Law, we specialize in guiding businesses through the complexities of forming and running an S Corporation in California. Our expert team of experienced corporate attorneys can navigate you through every step of the process. Whether it is forming a California S-Corp, fulfilling statutory requirements, establishing corporate governance, or ensuring ongoing regulatory compliance, we have you covered. Do not navigate the complexities of S-Corporation formation alone. Contact us today and let us lay the foundation for your business success.