Choosing the correct business entity is important for the success of a business and the decision can have significant tax implications. In California, two popular options that entrepreneurs often consider are forming a California Corporation or a California S-Corp.

Both California Corporations and California S-Corps offer specific advantages including personal liability protection and credibility with customers. However, they also have unique characteristics, potential drawbacks, and distinct tax treatments.

This article will examine the differences between a California Corporation and a California S-Corp, highlighting the pros and cons of each to guide an informed decision when choosing a business structure in California.

What are California Corporations and California S-Corps?

California Corporations

California Corporations are business entities that are legally separate from their owners, who are known as shareholders. California Corporations provide a high level of personal liability protection where the California Corporation, not the shareholders, is held legally liable for business actions, business debts, liabilities, and obligations, and legal judgments against the California Corporation.

A key characteristic of a California Corporation is that it is subject to double taxation. This means the California Corporation pays taxes on its earnings, and then shareholders also pay taxes on any dividends they receive. A California Corporations subject to double taxation is often informally referred to as a C Corporation.

California S-Corps

A California S-Corp is a California Corporation that has elected S Corporation taxation with the Internal Revenue Service, which is a special type of tax election made available under Subchapter S of the Internal Revenue Code.

A California S-Corp is a pass-through entity for tax purposes, meaning the California S-Corp itself does not pay federal income taxes. Instead, the profits or losses of the California S-Corp are passed through to the California S-Corp shareholders who report it on their individual income tax returns, thereby avoiding double taxation.

Aside from Federal Income Tax Purposes and Personal Income Tax Purposes, California Corporations and California S-Corps are Very Similar

Both California Corporations and California S-Corps are business entities formed by drafting and filing of Articles of Incorporation with the California Secretary of State, both adopt corporate bylaws, and both are managed by a Board of Directors and corporate officers such as a President or Chief Executive Officer (CEO), Secretary, and Treasurer or Chief Financial Officer (CFO).

Both C Corporations and S Corporations in California must follow corporate formalities such as holding annual Board of Directors meetings, annual shareholder meetings, annually filing a Statement of Information with the California Secretary of State, and otherwise operating in compliance with the California Corporations Code and California Business and Professions Code.

Taxation of California Corporations and California S-Corp Status

Taxation is a significant factor that differentiates California Corporations and California S-Corps. As previously mentioned, one of the main distinctions lies in how these two entities are taxed at the federal level.

Taxation of a Standard California Corporation

A standard California Corporation, or C Corporation, is taxed on its earnings at the corporate level, and shareholders are also taxed on dividends received, leading to what is often termed as double taxation.

In terms of federal taxation, a California Corporation is treated as a separate tax entity that files and pays taxes on its own corporate tax return. The net income of the California Corporation is taxed at the corporate level at the rate of 21% at the time of this writing in 2024. When post-tax net income is distributed to the shareholders in the form of dividends, they are taxed again at an individual level on the personal income tax return of each shareholder. This two-tier taxing structure, where earnings are taxed first at the corporate level and then at the shareholder level, constitutes double taxation, and it is a key aspect to consider when selecting a business structure due to its potential impact on overall tax liability.

In California, California Corporations and foreign corporations are required to pay to the California Franchise Tax Board an 8.84% franchise tax on their net income, with a minimum tax of $800.

Shareholders of a California Corporation who provide services to the California Corporation may be required to pay themselves a reasonable salary from the California Corporation which is a deductible business expense for the California Corporation, but subjects that reasonable salary to both employer and employee paid payroll taxes with a total of 15.3% in FICA and Medicare taxes shared between the California Corporation and employee shareholder.

Taxation of a California S-Corp

A California S-Corp, the California S-Corp files its own corporate tax return but with its pass-through taxation status, it allows profits and losses to flow through to the personal tax returns of the shareholders. This effectively eliminates the burden of double taxation faced by California Corporations. However, it is important to note that California S-Corps are still subject to certain tax requirements in California.

In California, California S-Corps and foreign S-Corps are required to pay to the California Franchise Tax Board a 1.5% franchise tax on their net income, with a minimum tax of $800. While this may be lower than the corporate tax rate, it is a tax in additional to their personal income taxes on the net income of the California S-Corp that is paid by the California S-Corp itself.

Shareholders of a California S-Corp who provide services to the California S-Corp may be required to pay themselves a reasonable salary from the California S-Corp which is a deductible business expense for the California S-Corp, but subjects that reasonable salary to both employer and employee paid payroll taxes with a total of 15.3% in FICA and Medicare taxes shared between the California S-Corp and employee shareholder.

Is C Corporation Double Taxation or Pass-Through to Personal Income Taxes Better?

The answer to whether standard California Corporation taxed as a C Corporation with double taxation or a California S-Corp with pass-through taxation is better largely depends on the specific circumstances of the business and its owners.

For businesses planning to reinvest profits back into the company, a standard California Corporation taxed as a C Corporation may be preferable as profits retained within the California Corporation are only subjected to the corporate tax.

However, if the business intends to distribute profits to shareholders regularly, a California S-Corp with its pass-through taxation to the personal income taxes of the shareholders might be a better choice to avoid double taxation.

Furthermore, for shareholders in higher individual tax brackets, the standard California Corporation taxed as a C Corporation could potentially result in a lower overall tax rate, even with double taxation.

It is important for each entity to conduct a thorough income tax analysis factoring in their specific business goals, profit distribution strategies, and the tax situations of the shareholders before deciding on the most suitable tax structure. A tax law advisor, such as an accountant or tax attorney, should evaluate whether an S Corporation election should be made or if C Corporation status would lead to lower tax liability.

Deductibility of Expenses of California Corporations and California S-Corp Status

Both California Corporations and California S-Corps are largely similar when it comes to the types of expenses that can be deducted from gross receipts in the calculation of taxable income. Generally, for an expense to be deductible, it must be both ordinary and necessary to the operation of the business. This includes common business expenses such as rent, salaries, utilities, office supplies, and depreciation. However, despite the similarities, there are some nuances to consider.

Deductions Specific to Standard California Corporations Taxed as C Corporations

Standard California Corporations taxed as C Corporations, being subjected to double taxation, can deduct the cost of benefits provided to employees, such as health insurance and retirement plans, at the corporate level. Shareholders of a California Corporation who are also employees can benefit from these deductions without the benefits being included in their personal income.

Deductions Specific to California S-Corps

On the other hand, in a California S-Corp, the cost of benefits provided to shareholders who own more than 2% of the shares of stock of the California S-Corp is not fully deductible at the corporate level. These benefits are typically included in the wages or salary of the shareholder-employee for income tax purposes and are only deductible on their personal income tax return to the extent allowed by individual income tax laws.

While both California Corporations and California S-Corps have a range of deductible expenses, the implications of these deductions can differ significantly between the two entities due to their respective tax structures.

Limited Liability Protection of California Corporations and California S-Corp Status

In terms of limited liability protection, both California Corporations and California S-Corps offer similar safeguards. Both California Corporations and California S-Corps provide shareholders with limited liability protection. This means that the shareholders are typically not personally responsible for the business debts, liabilities, obligations, or legal judgments against the business. The risk to shareholders is limited to the amount they have invested in the California Corporation or California S-Corp. This protection is a significant advantage of incorporating a business and a key reason why many business owners choose either a California Corporation or a California S-Corp structure.

Corporate Governance is Required to Maintain Personal Liability Protection

It is worth noting that while both California Corporations and California S-Corps provide personal liability protection to shareholders, the maintenance requirements to ensure this protection varies. Both structures are required to follow formalities such as filing an annual Statement of Information with the California Secretary of State, maintaining separate business bank accounts, and keeping detailed records of business decisions in the form of consents or meeting minutes of the Board of Directors and shareholders to preserve limited liability protections. Failure to comply with these corporate formalities could result in a court piercing the corporate veil and holding the shareholders personally liable for the business debts, liabilities, obligations, and legal judgments against the California Corporation or California S-Corp.

Limitations Specific to California S-Corps

Despite the many advantages of a California S-Corp structure, it is important to note that there are specific limitations associated with this model that do not apply to standard California Corporations taxed as C Corporations. These constraints, related to factors such as shareholder eligibility and the number of shareholders, can negatively influence both flexibility and growth potential.

California S-Corps are Limited to Only One Class of Shares

Unlike standard California Corporations taxed as C Corporations, which can have multiple classes of shares with varying rights and privileges, California S-Corps are limited to issuing only one class of shares. This means all shareholders in a California S-Corp have the same rights and privileges attached to their shares. The inability to have different classes of shares limits the flexibility of California S-Corps in terms of their capital structure, which may affect its ability to attract different types of investors or implement certain types of equity compensation plans.

California S-Corps are Limited to Only One Hundred Shareholders

Another limitation of California S-Corps is the restriction on the number of shareholders. California S-Corps are limited to no more than 100 shareholders. This can potentially inhibit the growth and expansion potential of the business, especially if it seeks to go public or attract a large number of investors. Standard California Corporations taxed as C Corporations, on the other hand, do not have any limitations on the number of shareholders they can have.

California S-Corps are Limited to Individuals, Estates, Certain Types of Trusts, or Certain Tax-Exempt Organizations

As a final limitation, California S-Corps can only have specific types of shareholders. These entities are limited to individuals, estates, certain types of trusts, or tax-exempt organizations as recognized by the Internal Revenue Code. Corporations, partnerships, and limited liability companies cannot be shareholders in a California S-Corp. This restriction can significantly limit the pool of potential investors for a California S-Corp, which may in turn limit its growth and expansion opportunities. In contrast, standard California Corporations taxed as C Corporations do not have such limitations on shareholder eligibility, thus providing them with a greater degree of flexibility and potential for growth.

California S-Corp Shareholders are Subject to Citizenship and Residency Requirements

Under United States federal tax law, shareholders of a California S-Corp must be U.S. citizens or permanent residents. This unique requirement excludes non-resident aliens from owning shares in a California S-Corp (because non-resident aliens may not file income tax returns in the United States, and California S-Corps pass their income tax liability to the California S-Corp shareholders), thereby limiting the pool of potential international investors. This is a crucial consideration for entrepreneurs who seek diverse and global investors for the growth and expansion of their businesses. This is also a key determination for foreign nationals seeking to expand their businesses into markets in the United States. This restriction contrasts with standard California Corporations taxed as C Corporations, which have no such citizenship or residency requirements for shareholders, thus offering them more flexibility in terms of attracting international investors or inviting foreign businesses to bring their products and services to the United States market.

Final Thoughts on Choosing Between a California Corporation and California S-Corp

In comparing California Corporations and California S-Corps, both structures offer personal liability protection and require strict compliance to corporate governance to maintain this protection. However, there are significant differences in terms of taxation, deductibility of business expenses, and limitations on shareholders.

California S-Corps, unlike California Corporations, pass income, losses, deductions, and credits through to shareholders for federal tax purposes, resulting in single-level taxation. This can help to avoid the double taxation of California Corporations.

In terms of deductibility of business expenses, both structures allow for deductions, but the specifics may vary depending on the nature of the expenses and the federal tax laws applicable to each structure.

While both structures offer limited liability protection, maintaining this involves adhering to corporate governance requirements, such as filing an annual Statement of Information and keeping detailed records of business decisions in the form of annual consents or meetings of the Board of Directors and shareholders.

Limitations on shareholders differ significantly between the two structures. California S-Corps can only have one class of shares, are limited to 100 shareholders, and have restrictions on the types of shareholders they can have, being limited to U.S. citizens or permanent residents who can only be individuals, estates, certain types of trusts, or certain tax-exempt organizations. California Corporations, in contrast, face no such limitations, offering them greater flexibility and growth potential.

Deciding between a California Corporation and a California S-Corp requires careful consideration of various factors, such as taxation, flexibility, growth potential, and compliance requirements. Entrepreneurs should carefully weigh the pros and cons of each structure to determine which one best suits their business goals and objectives. Consulting with legal and financial professionals can also help in making an informed decision that aligns with the unique needs and circumstances of the business.

Need Help Deciding Between a California Corporation and a California S-Corp? Contact San Diego Corporate Law Today for Expert Guidance and Assistance in Forming Your Business Entity!

Do not navigate the complexities of business entity formation alone. Stop second-guessing your decisions and let the experienced corporate attorneys at San Diego Corporate Law guide you. Whether you are leaning towards a California Corporation or a California S-Corp, we can help. Contact us today and start your journey to success right away!