When establishing a business in California, the business structure decision between forming a Limited Liability Company (LLC) or an S Corporation (S-Corp) can have significant implications for your operations, taxation, and overall success. Both entity types offer distinct advantages and limitations.

This article will provide an in-depth comparison of LLCs and S-Corps in California, detailing key aspects such as formation requirements, taxation rules, and management structure, to equip entrepreneurs with the necessary information to make an informed choice.

LLC vs S-Corp Definitions in California

What is a California LLC?

An LLC, or Limited Liability Company, is a type of business entity in California that offers its owners, known as members, limited personal liability for debts, liabilities, obligations, and legal judgments against the company. A California LLC benefits from flexibility in management and operations, and it does not require a board of directors or annual meetings.

What is a California S-Corp?

An S Corp, or S Corporation, is a special type of corporation in California that decides to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes. This allows S-Corps to avoid double taxation on corporate income. S-Corps are regulated and required to follow more rigid rules than LLCs, including the necessity for a board of directors and annual meetings. However, they offer certain tax advantages that can be beneficial for specific business scenarios.

LLC vs S-Corp Restrictions on Ownership in California

Who May Own a California LLC?

In California, there are very few restrictions on who may own an LLC. Any individuals, partnerships, other LLCs, or corporations, both domestic and foreign, can own a California LLC. There is no limit on the number of members an LLC can have, and it can also have just one member. Moreover, members of California LLCs are not required to be U.S. citizens or permanent residents. However, certain professionals are prohibited from forming LLCs for their practices in California and must use a California Professional Corporation instead.

Who May Own a California S-Corp?

Ownership of a California S-Corp is subject to certain restrictions. S-Corps can have up to 100 shareholders, and these shareholders must be U.S. citizens or residents. Non-resident aliens cannot own shares in an S-Corp. Moreover, ownership is restricted to individuals, certain trusts, and estates. Other corporations, partnerships, or LLCs cannot own shares in a California S-Corp. Additionally, all shareholders must agree to have the business taxed as an S-Corp. It’s also important to note that an S-Corp can only have one class of stock, which limits the flexibility in distributing profits and losses among owners.

LLC vs S-Corp Formation Process in California

How is a California LLC Formed?

Forming a California LLC involves several key steps.

Choosing a Name for a California LLC

First, you must choose a suitable and unique name for your LLC, ensuring it ends with ‘Limited Liability Company’, ‘LLC’, or ‘L.L.C’. California law prohibits LLC names that may confuse your LLC with a government agency, and certain words may require additional paperwork or a licensed professional to be part of your LLC. Once a name is chosen, you should verify its availability.

Appointing a Registered Agent for a California LLC

Next, you must appoint a registered agent for service of process in California. This can be an individual resident or a business entity authorized to do business in California.

File Articles of Organization for a California LLC

Afterward, you will need to file the Articles of Organization with the California Secretary of State and pay the required filing fee. This document includes information such as the name of your LLC, its purpose, information about the registered agent, and whether it will be member-managed or manager-managed.

Creating an Operating Agreement for a California LLC

Post filing, you should create an operating agreement, which, although not legally required to be in writing in California, is crucial for defining the operating procedures of your LLC and helps protect its limited liability status.

Obtain an Employer Identification Number from the Internal Revenue Service

Finally, you need to obtain an Employer Identification Number (EIN) from the IRS, even if you don’t plan to have employees. This number is required for tax purposes.

Statement of Information Filing for a California LLC

To stay in good standing, California LLCs are also required to file a Statement of Information with the Secretary of State within 90 days of filing the Articles of Organization, and every two years thereafter.

How is a California S-Corp Formed?

Forming a California S-Corp also involves multiple important steps.

Choosing a Name for a California S-Corp

Like an LLC, your S-Corp will need a unique name, usually ending with “Corporation”, “Incorporated”, or “Inc.” but such corporate designation is not strictly required for a California S-Corp. Similar constraints apply regarding potential confusion with government agencies and required additional paperwork for certain words. After selecting a name, its availability should be confirmed.

Appointing a Registered Agent for a California S-Corp

An individual resident or a business entity authorized to operate in California will need to be appointed as a registered agent for your S-Corp.

File Articles of Incorporation for a California S-Corp

The next step is filing the Articles of Incorporation with the California Secretary of State and paying the associated fee. This document includes details like the name, purpose, information about the registered agent, and details about the shares of stock the corporation is authorized to issue.

Create Corporate Bylaws for a California S-Corp

After filing, your corporation should create corporate bylaws to define the operating rules for the California S-Corp.

Appoint Directors and Hold the First Board Meeting for a California S-Corp

Directors need to be appointed, after which the first board meeting should be held. In that meeting, bylaws are adopted, officers are appointed, and stock is issued as well as several other initial approvals.

Obtain an Employer Identification Number from the Internal Revenue Service

Similar to an LLC, an Employer Identification Number (EIN) from the IRS is needed.

File Form 2553 for a California S-Corp

To gain S-Corp status, Form 2553 must be filed with the IRS. This is the “Election by a Small Business Corporation” form and all shareholders must sign it.

Statement of Information Filing for a California S-Corp

Lastly, like an LLC, an S-Corp must file a Statement of Information within 90 days of filing the Articles of Incorporation, and annually thereafter.

LLC vs S-Corp Personal Liability Protections in California

What are the Personal Liability Protections of a California LLC?

Personal Liability Protection for California LLCs Generally

A California LLC provides robust personal liability protection for its members. In essence, members are not personally responsible for debts, liabilities, obligations, and legal judgments against a California LLC. This means that in the event of a lawsuit or bankruptcy, the personal assets of the members are typically shielded from creditors.

However, this protection is not absolute and members can still be held personally liable in certain circumstances, for instance, if they provide a personal guaranty for a loan for the business, commit fraud or illegal acts, or fail to adequately separate personal and business finances.

Charging Order Protection for California LLCs

A charging order is a legal tool that creditors of a member of a California LLC can use to obtain access to the debtor-member’s interest in the LLC. Essentially, it allows the creditor to intercept any distributions that would otherwise be allocated to the debtor-member from the LLC.

However, the charging order does not grant the creditor the right to intervene in the management affairs of the LLC or to force the LLC to make distributions. This means that while the creditor can potentially acquire the financial interests of a debtor member, they do not gain control over the voting or management rights of the debtor member within the LLC. This limitation is the essence of the charging order protection characteristic of LLCs in California.

Hence, while the California LLC structure provides a significant degree of personal asset protection, it’s also crucial for members to maintain proper business operations and financial practices.

What are the Personal Liability Protections of a California S-Corp?

Personal Liability Protection for California S-Corps Generally

A California S-Corp also offers substantial personal liability protection for its shareholders. Much like an LLC, shareholders of a California S-Corp are generally not personally liable for debts, liabilities, obligations, or legal judgments against a California S-Corp. The personal assets of shareholders are protected in the event of lawsuits or bankruptcy, meaning creditors typically cannot reach personal assets of shareholders to satisfy the debts of the California S-Corp.

However, it should be noted that this protection is not absolute. Shareholders could be held personally responsible in certain situations, such as when they provide a personal guaranty for a business loan, engage in fraudulent or illegal activities, or fail to adequately separate personal and business finances. This highlights the importance of maintaining proper business practices and financial operations within the S-Corp structure.

No Charging Order Protection for California S-Corps

Unlike an LLC, a California S-Corp does not offer charging order protection for its shareholders. This means that if a shareholder of a California S-Corp becomes a debtor in a case, their creditors may potentially acquire not only their financial interests in the corporation but also their voting and management rights.

This can lead to creditors exercising control over the affairs of the corporation, which is a situation that members of an LLC are generally protected against due to the charging order protection feature. Therefore, while both an LLC and an S-Corp provide personal liability protection, the charging order protection is unique to the LLC structure.

LLC vs S-Corp Management in California

How is a California LLC Managed?

A California LLC can be managed in one of two ways: member-managed or manager-managed.

Member-Managed LLCs in California

In a member-managed LLC, all members participate in the day-to-day operations and decision-making of the business. Each member acts as an agent of the LLC and has the authority to bind the LLC to business agreements.

Manager-Managed LLCs in California

On the other hand, in a manager-managed LLC, the members appoint one or more managers to handle the daily operations and make decisions on behalf of the LLC. The managers can be selected from the existing members, or they can be outside individuals or entities. The members in a manager-managed LLC typically do not participate in the daily business operations unless specified otherwise in the operating agreement. In either case, an operating agreement outlining the management structure and operating procedures must be in place to provide clear guidance for the LLC’s operations.

How is a California S-Corp Managed?

A California S-Corporation (S-Corp) operates under a more formal management structure compared to an LLC.

California S-Corp Board of Directors

It is managed by a board of directors who are elected by the shareholders of the corporation. The board is responsible for the overall governance and strategic decision-making of the corporation.

California S-Corp Officers

Day-to-day operations, however, are typically overseen by officers (such as a CEO, CFO, Secretary, etc.) who are appointed by the board. These officers hold a fiduciary duty to act in the best interest of the corporation.

California S-Corp Shareholders

Shareholders, meanwhile, have limited involvement in the daily operations of the S-Corp, but they hold the power to elect and remove directors. Similar to an LLC operating agreement, the bylaws of an S-Corp should define the roles and responsibilities of directors and officers, and guide the governance of the corporation.

LLC vs S-Corp Taxation in California

How is a California LLC Taxed?

A California Limited Liability Company (LLC) has a flexible taxation structure.

Income Tax for a Single-Member California LLC Disregarded for Tax Purposes by Default

By default, a single-member LLC is treated as a “disregarded entity” for tax purposes, meaning the income and expenses of the California LLC are reported on the personal tax returns of the owners, much like a sole proprietorship, including having to pay self-employment taxes like a sole proprietorship.

Income Tax for a Multi-Member California LLC Taxed as a Partnership by Default

On the other hand, a multi-member LLC is treated as a partnership for tax purposes by default, and the LLC must file a U.S. Return of Partnership Income form (Form 1065), issuing individual Schedule K-1 forms to each member reporting their share of the company profits or losses of the California LLC, including having to pay self-employment taxes.

Income Tax for a California LLC Taxed as a Corporation or S Corporation by Election

However, a California LLC also has the flexibility to elect to be taxed as a corporation or an S Corporation by filing the appropriate forms with the IRS. While electing to pay corporate income tax eliminates the need to pay LLC self-employment taxes, it does put the same restrictions on ownership as a California S-Corp.

California Franchise Taxation for a California LLC

It should be noted that LLCs in California are subject to an annual minimum franchise tax of $800, regardless of income. These tax implications underscore the importance of understanding and appropriately planning for the tax obligations of an LLC.

California LLC Fee if Disregarded for Tax Purposes or Taxed as a Partnership

If a California LLC is disregarded for tax purposes or is taxed as a partnership, it is subject to the California LLC Fee, an additional fee based on its total income from all sources reportable to California. This fee is due if the total income of the California LLC equals or exceeds $250,000. The fee schedule is as follows:

• An LLC with a total income of $250,000 to $499,999 pays a fee of $900.
• An LLC with a total income of $500,000 to $999,999 pays a fee of $2,500.
• An LLC with a total income of $1,000,000 to $4,999,999 pays a fee of $6,000.
• An LLC with a total income of $5,000,000 or more pays a fee of $11,790.

This fee is in addition to the $800 minimum franchise tax and is due on the original return filing date, regardless of any extensions. Failure to pay this fee will result in penalties and interest.

California LLCs electing to be taxed as corporations or S Corporations are not subject to the California LLC Fee, which is one of the many tax benefits of such an election.

Self-Employment Tax for a California LLC

Members of California limited liability companies are generally considered self-employed. As a result, they are not subject to withholding, but they are required to pay self-employment tax on their share of the business’s income. This self-employment tax is comprised of both Social Security and Medicare taxes. However, if a California LLC hires employees or elects to be taxed as a C-Corp or S-Corp, there are additional employment tax responsibilities.

Employment Taxes for a California LLC Taxed as a C-Corp or S-Corp

If an LLC chooses to be taxed as a corporation or S Corporation, it is subject to employment taxes similar to those of traditional corporations and must pay a reasonable salary to LLC owners. This tax classification means that the LLC will need to withhold income taxes and payroll taxes such as Social Security and Medicare taxes, and pay unemployment tax on wages paid to employees. However, the tax classification provides an advantage because only salaries (and not company profits) are subject to employment taxes. Therefore, if you operate an LLC taxed as an S-Corp, and you pay yourself a “reasonable salary,” any additional profits paid as dividends are not subject to self-employment tax. This can result in significant tax savings.

How is a California S-Corp Taxed?

A California S-Corp operates under a specific tax structure that potentially provides several tax benefits by electing to be taxed as an S Corporation.

Income Tax for a California S-Corp

Unlike a traditional corporation, corporations taxed as S Corporations are pass-through tax entities, which means that profits and losses are passed directly through the business to the shareholders. These individuals then report the profits and losses of the S Corporations on their personal tax returns. S Corporations avoid the double taxation of corporate income, where corporate income is taxed at both the corporate level and again on the personal tax returns of the shareholders.

California Franchise Taxation for a California S-Corp

S-Corporations in California are subjected to the greater of a minimum franchise tax of $800 or a .5% tax on the net income annually, even if the business is not active or generates no income.

Self-Employment Tax for a California S-Corp

Owners of a California S-Corp are not subject to self-employment taxes.

Employment Taxes for a California for a California S-Corp

Owners of a California S-Corp who also work in their business are considered employees. They are required to pay themselves reasonable compensation for their services in the form of a salary, upon which employment taxes must be paid. These employment taxes, which the S-Corp withholds and remits to the IRS, include federal income tax, Social Security, and Medicare taxes. The S-Corp also pays the employer’s portion of Social Security, Medicare, and unemployment (FUTA) taxes. While this might seem burdensome, it also means that any remaining profits after salary is paid can be distributed to the owners on their shares of stock, and those distributions are not subject to employment or self-employment tax liability and can result in significant tax savings.

LLC vs S-Corp Making the Best Decision for Your California Business

At the end of the day, the business structure choice between a California LLC and a California S-Corp depends on several factors, including your business goals, income, and tax situation. The decision between LLCs and S-Corps is an important decision that can have lasting impacts on your business, so it is essential to get it right.

The corporate attorneys at San Diego Corporate Law are ready to assist you in the critical decision-making process when deciding between LLCs and S-Corps. Get a thorough understanding of your unique business needs and potential tax implications. Contact San Diego Corporate Law today for a comprehensive consultation so you can make the best decision for your California business with their expert advice and guidance.