No, an LLC cannot own an S-Corp in California (or any other state, for that matter!). However, is there a business entity or other business structure small business owners may use to mimic the flexibility and tax savings that would result if limited liability companies were an LLC was permitted S Corporation shareholder?

This article will not only explore the requirements and limitations of the Internal Revenue Code, the rules of the Internal Revenue Service, and California law to explain why a California LLC is not a permitted California S Corporation shareholder, but also try to find a business entity or business structure that mimics as closely as possible the business structure that would result if limited liability companies were a permitted S Corporation shareholder.

Introducing the California LLC and California S-Corp

What is a California LLC?

A California Limited Liability Company (LLC) is a legal business entity that provides its owners, known as LLC members, with limited liability and the potential for tax savings. In California, an LLC can be either a Single-Member LLC or a Multi-Member LLC. All California LLCs are pass-through entities by default but may make an S-Corp election for S-Corp tax status or corporation status for federal tax purposes.

California Single-Member LLC

A Single-Member LLC in California is owned and operated by one LLC member. By default, a California Single-Member LLC is a disregarded entity for federal tax purposes, which is essentially sole proprietorship taxation and all business income is subject to self-employment tax. However, a California Single-Member LLC may elect a corporation tax status, such as S-Corp status to be taxed as an S-Corp or elect to pay income tax as a C Corporation, which avoids self-employment taxes in favor of payroll taxes on business income.

California Multi-Member LLC

On the other hand, a Multi-Member LLC in California is an LLC owned by more than one member. By default, a California Multi-Member LLC is treated as a partnership for federal tax purposes, with all business income subject to self-employment tax. However, a California Multi-Member LLC may also elect a corporation tax status, such as S-Corp status to be taxed as an S-Corp or elect to pay income tax as a C Corporation, which avoids self-employment taxes in favor of payroll taxes on business income.

California LLC Fee

All California LLCs are subject to an $800 annual franchise tax paid to the California Franchise Tax Board, however, California LLCs using default tax classifications are also subject to the California LLC Fee also paid to the California Franchise Tax Board.

The California LLC Fee is based on the total annual income of the LLC. The LLC Fee starts at $900 for LLCs with an annual income between $250,000 and $499,999 and can go up to $11,790 for those with an income of $5 million or more.

Member-Managed California LLCs

Independent of the number of members, a California LLC may elect to be managed by all of its members. When member-managed, all members of the California LLC participate equally in the day-to-day running of the business. Every member has a say in business decisions and operations.

California Manager-Managed LLC

A California LLC may also be manager-managed, with one or more managers appointed by the members to handle the daily operations and make business decisions. This structure can be beneficial when some members prefer to be passive investors, or when there is a need for a more centralized decision-making process.

What is a California S-Corp?

A California S Corporation (S-Corp) is a special type of California Corporation that elects to be taxed in accordance with Subchapter S of the Internal Revenue Code by drafting and filing Internal Revenue Service Form 2553 to avail itself to the tax savings of a small business corporation with S-Corp status.

Federal and California Income Taxation of California S Corporations

The S Corporation status allows for pass-through taxation, meaning the S Corporation itself does not pay federal income tax on corporate income. Instead, the net corporate income, losses, deductions, and credits are passed through to the shareholders, who are personally responsible for reporting the corporate income on their personal tax returns at individual income tax rates.

California S-Corps are subject to a 1.5% franchise tax on net income against an $800 annual minimum paid to the California Franchise Tax Board.

Management of California S Corporations

California S Corporations are managed by a board of directors, who are elected by the shareholders. The board makes high-level decisions and appoints officers to handle the day-to-day operations. This structure differs from an LLC, which can either be member-managed or manager-managed.

While Not Permitted, How Might California LLC Ownership of a California S-Corp Operate if it Were Permitted?

If the Internal Revenue Code and California Corporations Code allowed LLC ownership of California S Corporations, which to be clear is not permissible, the operating agreement would play a significant role in determining the management and governance of the California S Corporation.

Voting as S Corporation Shareholders

For instance, if LLC ownership of a California S Corporation was permitted, in a California LLC managed by one or more managers, the managers would likely have the power to make the voting decisions about the California S Corporation within the power of California S Corporation shareholders, including appointing its board of directors. In a member-managed California LLC, those decisions left to the California S Corporation shareholders would be made by a vote of the members.

Taxation with LLC as Shareholder of S Corporation

If a California S Corporation was permitted to be owned by a multi-member California LLC, the net corporate income, losses, deductions, and credits would first pass through to the California LLC.

The California LLC would then allocate these tax items to its members according to the terms of the operating agreement of the California LLC. Each member would then report their respective share of the California LLC income on their personal tax returns.

It is worth noting, however, that because members of a California LLC pay self-employment taxes on their share of the California LLC income, the tax savings delivered by S Corporation status do not include self-employment tax in favor of payroll taxes on the reasonable salary paid to employee shareholders.

Personal Liability Protection with LLC as Shareholder of S Corporation

In terms of personal liability protection, if a California LLC was permitted to own a California S Corporation, the members of the LLC would still enjoy limited liability for the debts and obligations of the California S-Corp because the California LLC, not its members, would be the shareholder of the California S-Corp.

Flexible Income Distribution with LLC as Shareholder of S Corporation

Finally, this hypothetical ownership structure could potentially provide flexibility in terms of income distribution.

In a California S-Corp, all income and losses must be allocated pro rata to the shareholders, meaning strictly based on their proportion of shares. However, if a California S-Corp were permitted to be owned by a California LLC, the allocation of income and losses could be more flexible because California LLCs are not subject to the same allocation restrictions as California S-Corps.

The California LLC could potentially allocate the income and losses from the California S-Corp to its members in a manner that differs from the proportionate ownership interests of the members in the California LLC, assuming the operating agreement provided for such flexibility.

Keep in Mind, This is All Hypothetical

However, it must be emphasized again that under current laws, an LLC cannot own an S-Corp in California or any other state.

What are the Permissible Shareholders of a California S-Corp?

In California, the permissible shareholders of an S-Corp are restricted. All shareholders must be individuals (i.e., natural persons), another S-Corp that wholly owns the California S-Corp (a Qualified Subchapter S Subsidiary, or QSub), certain trusts, or estates.

Restrictions on Ownership of S Corporations

Corporations, partnerships, and LLCs are not permitted to be shareholders of an S-Corp in California. Also, there is a limit on the number of shareholders, which is set at 100. Moreover, all shareholders must be citizens or permanent residents of the United States, and California S-Corps can only have one class of stock.

With an understanding of the types of entities that can and cannot own shares in a California S-Corp, we may examine how ownership by individuals, Qualified Subchapter S Subsidiaries (QSubs), certain trusts, and estates work in the context of a California S-Corp.

Each type of ownership presents its unique characteristics, advantages, and considerations. By understanding these nuances, one can make informed decisions on the best structure for their specific needs and circumstances.

California S-Corps Owned by One or More Individuals

Taxation of California S-Corps Owned by One or More Individuals

When a California S-Corp is owned by one or more individuals, each shareholder is subject to individual taxation on their proportion of the profits and losses of the California S-Corp. This means that income, deductions, losses, and credits pass through the corporation to the individual shareholder(s), who then report these items on their personal tax return. This pass-through taxation can be an advantage because it avoids the double taxation commonly associated with traditional corporations.

In addition, the profits of a California S-Corp are not subject to self-employment taxes. Instead of self-employment tax, the reasonable salary paid to each owner is subject to standard payroll taxes.

Management of California S-Corps Owned by One or More Individuals

The management of the S-Corp involves a board of directors appointed by the shareholders. The board makes high-level decisions and appoints officers to handle day-to-day operations.

The individual shareholders have a say in the corporation’s affairs based on their proportion of ownership. They can influence the corporation’s direction and strategy, but they are not involved in the daily operations unless they are also appointed as officers.

Liability Protection of California S-Corps Owned by One or More Individuals

The liability of individual shareholders is limited to their investment in the corporation. In other words, personal assets of shareholders are not at risk in case of the company’s debts or liabilities.

California Subchapter S Subsidiary (QSub) Ownership

Taxation of California S-Corps Owned by Another S-Corp

When a California S-Corp is owned by another S-Corp, this is often referred to as a Qualified Subchapter S Subsidiary, or QSub, ownership structure. The parent S-Corp wholly owns the QSub, and for tax purposes, the QSub is treated as a disregarded entity. This means that the QSub’s assets, income, deductions, and credits are treated as those of the parent S-Corp, which reports them on its tax return. Essentially, the QSub’s financial activity is consolidated into the parent S-Corp’s tax return.

Management of California S-Corps Owned by Another S-Corp

The parent S-Corp appoints the board of directors for the QSub, who in turn manage the subsidiary. The QSub operates as a separate legal entity, with its own officers and employees. It can engage in business operations and enter into contracts in its own name.

Liability Protection of California S-Corps Owned by Another S-Corp

In terms of liability, the parent S-Corp’s liabilities are generally limited to the assets it has invested in the QSub. The debts and liabilities of the QSub do not typically extend to the parent S-Corp, protecting its assets from any financial distress the QSub might experience.

One important consideration for QSub ownership is that the QSub cannot have its own shareholders. All shares are owned by the parent S-Corp. Similarly, the QSub is limited to having only one class of stock, reflecting the restriction that applies to its parent S-Corp.

If the QSub is sold or otherwise transferred, the transaction is treated as a sale or transfer of the underlying assets of the QSub for tax purposes. This means that the parent S-Corp will report any gain or loss on its tax return.

California S-Corps Owned by Certain Trusts

California S-Corps can be owned by specific types of trusts, namely, Qualified Subchapter S Trusts (QSSTs), Electing Small Business Trusts (ESBTs), and certain grantor trusts.

Qualified Subchapter S Trusts (QSSTs)

A QSST is a special kind of trust that can own shares of stock in California S Corporations.

For a trust to qualify as a QSST, it must meet several requirements. It must have only one income beneficiary who is a U.S. citizen or permanent resident, all income of the trust must be distributed to that beneficiary, and the income beneficiary must have the right to distribute trust property.

The income of the S-Corp passes through to the income beneficiary who reports it on their personal tax return, avoiding double taxation.

However, the QSST’s beneficiary must make an election to treat the trust as a QSST.

Electing Small Business Trusts (ESBTs)

An ESBT is another type of trust that can own shares in an S-Corp. Unlike a QSST, an ESBT can have multiple beneficiaries, and they need not be individuals but can be other trusts or estates.

ESBTs are unique because they pay tax on S-Corp income at the trust level, rather than passing it through to the beneficiaries. This means the corporate income of California S Corporations is taxed once at the trust level, and then again when distributed to the beneficiaries.

It is important to note that the trustee of the ESBT must make an election to have the trust treated as an ESBT.

Grantor Trusts

Certain types of grantor trusts can also own S-Corp stock. In this setup, the grantor (the person who establishes the trust) is treated as the owner of the S-Corp shares for income tax purposes, regardless of the identity of the beneficiaries.

Any corporate income, deductions, losses, and credits pass through the trust to the grantor, who reports them on their personal tax return. This results in a single level of taxation, similar to individual ownership or a QSST.

California S-Corps Owned by an Estate

An estate can also be a shareholder of a California S-Corp. When an individual shareholder passes away, their shares may be transferred to their estate. This occurs when the will or estate plan of the deceased shareholder dictates that their California S-Corp shares should be part of their estate, or if the deceased shareholder dies intestate (without a will) and their shares are allocated to the estate by the probate court.

Taxation of California S-Corps Owned by an Estate

The ownership of the S-Corp in California by an estate has certain tax implications. The income, losses, deductions, and credits of the S-Corp pass through to the estate and are reported on the income tax return of the estate. This avoids double taxation that would occur if the corporation itself was taxed and then the beneficiaries were taxed again upon distribution of income.

Management of California S-Corps Owned by an Estate

The executor or personal representative of the estate then takes on the responsibility of managing the S-Corp shares. They act on behalf of the estate, which involves managing the shares, receiving dividends, and voting on shareholder matters.

Duration of Estate Ownership of S-Corp in California

Once the estate is closed and the assets (including the shares of stock of the S-Corp in California) are distributed to the beneficiaries, the beneficiaries become the new shareholders of the S-Corp. Their tax responsibilities then mirror those of any other California S-Corp shareholder, with the corporate income, losses, deductions, and credits passing through to their personal tax returns.

Ownership of the S-Corp by an estate is temporary and ends when the estate is closed.

Which Permissible Shareholders of a California S-Corp Most Closely Mimics California LLC Ownership of a California S-Corp?

To mirror the characteristics of California LLC ownership within the confines of California S-Corp regulations, the closest entity would be a trust.

Trusts, specifically grantor trusts, are permissible shareholders in a California S-Corp. A grantor trust can have aspects of pass-through taxation similar to an LLC with default income tax treatment, where the income, deductions, and credits of the California S-Corp flow directly to the owners.

However, trusts are subject to different regulations and legal requirements than LLCs. Thus, while they can mimic some benefits of LLC ownership, they are not an exact match and should be utilized after careful consideration and consultation with a legal advisor. Ultimately, the choice between LLCs and S Corporations ownership structures should be based on the specific needs and goals of the business owner.

California S-Corps have a wide range of permissible shareholders, including individuals, certain trusts, estates, and even other S Corporations. Each type of shareholder carries its own unique tax implications and considerations.

It is important to understand the various options and their implications before making a decision. With proper guidance, business owners can select the most suitable shareholder type to maximize their tax benefits and achieve their desired goals for their California S-Corp.

By exploring the various permissible shareholders of a California S-Corp, business owners can make informed decisions about their ownership structure and plan for long-term success. With proper planning and guidance, an S-Corp can provide significant tax advantages while protecting assets and promoting growth.

Seeking professional advice is highly recommended to ensure all factors are considered and the most advantageous decision is made for the business, and careful evaluation and consultation with professionals is essential when determining the best ownership structure for a California S-Corp.

Finding the Best California S-Corp Ownership Structure

Contact San Diego Corporate Law today for a comprehensive consultation. Our highly qualified attorneys are experts in California S-Corp ownership structures and are ready to guide you toward the most beneficial decisions for your business. Navigate the complexities of S-Corp regulations with confidence, knowing you are backed by the best in the field. Do not leave the future of your business to chance; reach out to us now and let us help you map out your path to success.