In the realm of business formation, aspiring entrepreneurs often grapple with the choice between forming a California Limited Liability Company (California LLC) or a California S-Corp (California S-Corp). This decision is particularly crucial in the State of California, where the business climate, regulations, and tax structure are unique.

In this article, we will review the pros and cons of each business structure, exploring factors such as liability protection, tax implications, and administrative requirements to provide the knowledge necessary to make an informed decision about whether a California LLC or a California S-Corp is the better fit for a business entity in California.

What are California S-Corps and California LLCs?

Before getting into the comparative analysis between California S-Corps and California LLCs, it is essential to first understand what these business entities represent. Both serve as legal entities that offer personal liability protection for business owners, but they differ in terms of tax benefits, ownership rules, and operational flexibility.

In the following sections, we will provide a quick introduction to each business entity, explaining their defining characteristics and operational nuances. Understanding these fundamentals will allow a more thorough evaluation of these business entities before evaluating which business structure aligns best with what types of business objectives and industries.

What is a California S-Corp?

A California S-Corp is a special type of California Corporation that elects treatment as an S Corporation, which name is drawn from Subchapter S of the Internal Revenue Code. This S Corporation designation allows the California Corporation to avoid double taxation—a common issue with traditional California Corporations.

In a California S-Corp, income, losses, deductions, and credits pass through to shareholders for state and federal income tax purposes. Shareholders then report this income and loss on their personal tax returns, to pay federal income tax as individual income tax rates. This allows California S-Corps to avoid the double taxation that traditional California Corporations face. A detailed discussion of California S-Corp taxation may be found in this article we previously published.

California S-Corps are subject to certain restrictions, including a maximum of 100 shareholders, all of whom must be U.S. citizens or residents, and only one class of stock can be issued. California S-Corps combine the personal liability protection of a California Corporation with the income tax benefits of a California Sole Proprietorship or California General Partnership while not exposing the employee-shareholders of the California S-Corp to self-employment taxes.

What is a California LLC?

A California LLC is a business entity that combines elements of a California General Partnership, California Limited Partnership, and corporate structures such as California Corporations and California S-Corps. California LLC owners, referred to as members, receive personal liability protection comparable to shareholders of California Corporations and California S-Corps.

In terms of state and federal income taxation, California LLCs with one member may elect tax treatment of a California Sole Proprietor (known as being disregarded for tax purposes), California Corporation, or make an S Corporation election to be taxed as a California S-Corp. California LLCs with more than one member may elect tax treatment of a California General Partnership (partnership taxation), California Corporation (traditional corporation), or make an S Corporation election to be taxed as a California S-Corp (S Corporation taxation). A California LLC is subject to the same restrictions on ownership for S Corporations presented above. A detailed discussion of California LLC taxation may be found in this article we previously published.

Other than when California LLC members elect to be taxed as traditional California Corporations, the California LLC members enjoy pass-through taxation where profits and losses pass directly to the members, who report them on their personal tax returns, thus avoiding double taxation.

The structure of a California LLC is more flexible than a California S-Corp, with fewer restrictions on ownership (unless an election to be taxed as an S Corporation is made) and less rigorous administrative requirements. This makes them a popular choice for small businesses and small business owners seeking personal liability protection without the complexities of a corporate structure, but as we will discuss, this flexibility can come with some unintended negative consequences at times.

LLCs and S-Corps in California: Tax Benefits

Understanding the tax implications of operating as a California S-Corp or California LLC is critical to determining the most beneficial business structure for a business. Each entity has a distinct tax structure that can significantly affect the net business income of the business within.

In this section, we will discuss the key differences of how California LLCs and California S-Corps are taxed (without getting into an entire dissertation on taxation) to shed light on how these structures can impact the business net income and growth potential of a business.

Capital Gains Taxation Differences Between California LLCs and California S-Corps

When it comes to capital gains taxation, California LLCs and California S-Corps are treated differently under the federal and state tax laws. Both of these business structures offer their own unique sets of advantages and disadvantages that can significantly influence business decisions and the overall financial health of a business.

Capital Gains Taxation of California S-Corps

In the case of a California S-Corp, capital gains taxation for a shareholder selling their shares of stock can be quite complex and is contingent on whether the shares of stock were held for more or less than a year. If held for more than a year, the capital gains are considered long-term and are taxed at the applicable long-term capital gains tax rates. However, if those shares were held for less than a year, the gains are considered short-term and taxed as ordinary income.

Other than when a shareholder of a California S-Corp sells their shares in the California S-Corp, all other income of a California S-Corp will be treated as ordinary income, even when the California S-Corp sells assets it has held for greater than one year. This means that when a California S-Corp sells assets that might otherwise qualify for treatment as capital gains, the shareholder owners personal tax returns will pay state and federal taxes on these company profits as ordinary income at personal income tax rates, which are generally significantly higher than capital gains tax rates.

Capital Gains Taxation of California LLCs

In the case of a California LLC, capital gains taxation for a member selling their membership interest can be quite complex and is contingent on whether the membership interest was held for more or less than a year. If held for more than a year, the capital gains are considered long-term and are taxed at the applicable long-term capital gains tax rates. However, if that membership interest was held for less than a year, the gains are considered short-term and taxed as ordinary income.

For a California LLC electing taxation as an S Corporation or a traditional corporation, other than when a member of the California LLC sells their membership interest in the California LLC, all other income of the California LLC taxed as an S Corporation or traditional corporation will be treated as ordinary income, even when the California LLC sells assets it has held for greater than one year. This means that when a California LLC taxed as an S Corporation sells assets that might otherwise qualify for treatment as capital gains, the personal tax returns of the members will pay state and federal taxes on these company profits as ordinary income at personal income tax rates, which are generally significantly higher than capital gains tax rates. For a California LLC taxed as a traditional corporation, the California LLC would pay income tax on the company profit at the prevailing corporate income tax rate before members received distributions of dividends of the post-tax company income and paid taxes on those dividends on the personal income tax returns of the members, which double taxation would generally be significantly higher than capital gains tax rates.

For a California LLC disregarded for tax purposes or taxed as a partnership, both of which are pass through taxation directly to the members, the members would be able to claim capital gains tax status for the company profits, which would generally provide a significant tax savings.

Conclusions About Capital Gains Taxation between LLCs and S Corporations in California

When access to capital gains taxation is advisable, such as when a business entity will hold appreciating assets such as real estate, intellectual property, or investments, a California LLC disregarded for tax purposes or taxed as a partnership would provide superior tax treatment when selling assets compared to a California S-Corp, California Corporation, or a California LLC taxed as an S Corporation or traditional corporation.

Self-Employment Tax and Payroll Tax Differences Between California LLCs and California S-Corps

This section discusses the distinctive treatment of self-employment taxes and payroll taxes for California LLCs and California S-Corps. This is a crucial consideration as self-employment taxes and payroll taxes can significantly impact not only the business net income, but also the personal income of the business owner. Understanding the differences between self-employment taxes and payroll taxes between limited liability companies and S-Corps in California can help guide the choice of the best business structure.

Understanding Payroll Taxes

Payroll taxes are taxes that employers are required to withhold from the salaries and wages of employees to fund Social Security and Medicare. Employers also pay matching payroll taxes on the salaries and wages paid to employees which are not withheld from employees.

At the time of this writing, the 2024 Social Security tax rate is 6.2% for the employer and 6.2% for the employee, or 12.4% total on the first $168,600 paid to each employee, the Medicare tax rate is 1.45% each for the employee and employer, or 2.9% total, bringing the total combined payroll taxes of employers to employees to 15.3% on the first $168,600 and 2.9% for Medicare on any amount in excess of $168,600. There is a 0.9% additional Medicare tax when an employee earns over $200,000.

Understanding Self-Employment Taxes

Self-employment taxes are Social Security and Medicare taxes for individuals who work for themselves. At the time of this writing in 2024, a self-employed individual pays 12.4% for Social Security and 2.9% for Medicare, a total of 15.3% on the first $168,600 a self-employed individual earns. In addition, a self-employed individual will pay 2.9% for Medicare on any amount in excess of $168,600. There is a 0.9% additional Medicare tax when a self-employed individual earns over $200,000.

Payroll Taxes for a California S-Corp and its Shareholder-Employees

In the context of a California S-Corp, there are specific rules regarding payroll taxes for shareholder-employees. As per the Internal Revenue Service regulations, shareholder-employees are required to pay themselves a reasonable salary in the form of wages for their services. These wages are reported on federal Form W-2 and subject to payroll taxes which include federal income tax, state income tax, Social Security, and Medicare, and are a deductible expense to the California S-Corp, reducing its net business profit.

The California S-Corp reports the net business profit (which is reduced by wages to its employees, including its shareholder-employees) on the federal Form 1120S and issues a Schedule K-1 to each shareholder to report their share of the business profit. The shareholders of the California S-Corp report their wages from Form W-2 and their share of the business net profit of the California S-Corp from Schedule K-1 on their individual tax return. The wages are subject to payroll taxes while their share of business profit is not subject to self-employment tax or payroll taxes, providing a potential tax-saving opportunity.

It is worth noting that the Internal Revenue Service scrutinizes the reasonable salary rule closely. If the Internal Revenue Service determines that the salary or wages of a shareholder-employee is below fair market value or otherwise artificially low to evade payroll taxes, the Internal Revenue Service can reclassify K-1 net business income as salary and wages and assess back taxes, penalties, and interest. Therefore, it is prudent for California S-Corp shareholder-employees to ensure that their salary is commensurate with their roles, responsibilities, and industry standards.

The California S-Corp itself is also responsible for paying the employer portion of the payroll taxes while the shareholder-employee pays the employee contributions. Careful planning, sound legal advice, and proper tax advice can allow S-Corp shareholder-employees to minimize their payroll taxes while ensuring compliance with federal and state tax laws.

Payroll Taxes for a California LLC taxed as an S Corporation or Traditional Corporation for its Member-Employees

For a California LLC that chooses to be taxed as an S Corporation or a traditional corporation, the treatment of payroll taxes for its member-employees mirrors that of a California S-Corp. The member-employees are required to receive a reasonable salary for their services, which is reported on Form W-2 and subject to payroll taxes. The California LLC taxed as an S Corporation or traditional corporation can deduct these wages, reducing its net business profit.

While wages are subject to payroll taxes, the share of the business net profit is not subject to self-employment tax or payroll taxes. However, the reasonable salary rule applies, and member-employees must ensure that their wages align with market rates to avoid repercussions from the Internal Revenue Service. The California LLC is also responsible for the employer portion of the payroll taxes. With the right planning and advice, member-employees of an LLC taxed as an S Corporation or traditional corporation can optimize their tax liabilities.

Self-Employment Taxes for a California LLC Disregarded for Tax Purposes or taxed as a Partnership

For a California LLC disregarded for tax purposes or taxed as a partnership, the self-employment tax rules are different. Each member of the LLC reports their share of the business net profit on their individual tax return. This net income is subject to self-employment tax, which as discussed above, is 15.3% for Social Security and Medicare on the first $168,600 of self-employment income, 2.9% for Medicare on any amount in excess of $168,600, and an additional Medicare tax of 0.9% when self-employment income exceeds $200,000.

Unlike a California S-Corp or California LLC taxed as an S Corporation or traditional corporation where only the salary portion of income is subject to payroll taxes, in a California LLC disregarded for tax purposes or taxed as a partnership, the entire share of the business net profit allocated to a member is subject to self-employment taxes. This can result in higher overall tax liabilities when compared to an S-Corp.

Conclusions About Self-Employment Taxes and Payroll Taxes between LLCs and S Corporations in California

Assuming an allocated business net profit of $100,000 to a member of a California LLC disregarded for tax purposes or taxed as a partnership, the California LLC member would be liable for $15,300 in self-employment taxes in addition to state and federal income taxes.

Assuming that same $100,000 in a California S-Corp or California LLC taxed as an S-Corporation, if the shareholder-employee or member-employee was paid a $50,000 annual salary and received a Schedule K-1 for the remaining $50,000, the California S-Corp or California LLC taxed as an S Corporation and shareholder-employee or member-employee would only pay a combined $7,650 in payroll taxes in addition to the shareholder-employee and member-employee state and federal income taxes, which income taxes would be approximately the same.

Therefore, when capital gains taxation is not a consideration, a California S-Corp or California LLC taxed as an S Corporation can provide significant employment tax savings compared to a California LLC disregarded for tax purposes or taxed as a partnership.

California Annual Taxation of Business Income Differences Between California LLCs and California S-Corps

One of the significant differences between a California LLC and a California S-Corp is the manner in which they are subjected to annual taxation, which may be drastically different depending upon both the business net income and business gross revenue.

California Annual Taxation of a California S-Corp

A California S Corporation is subject to an annual minimum franchise tax of $800, an amount which must be paid regardless of the business gross revenue or business net income. The California S-Corp is subject to the annual minimum franchise tax of $800 even if the California S-Corp is inactive or otherwise does not operate during the tax year. In addition to the minimum franchise tax, a California S-Corp is also taxed on 1.5% of its business net profit. This tax is based on the net income of the California S-Corp.

It is worth noting that the 1.5% tax does not apply if the 1.5% tax on business net profit is less than the $800 minimum franchise tax. In such case, the S Corporation only pays the $800 minimum franchise tax. However, if the 1.5% tax on the business net profit exceeds $800, then the S Corporation is required to pay the 1.5% tax on its net profit, not the minimum franchise tax.

California Annual Taxation of a California LLC Taxed as an S Corporation

A California LLC that elects to be taxed as an S Corporation follows the same annual taxation rules as a California S-Corp. This means it is subject to the annual minimum franchise tax of $800, regardless of its business gross revenue or business net income. This minimum tax applies even if the LLC is inactive or not operating during the tax year. In addition to the minimum franchise tax, a California LLC taxed as an S Corporation is also subjected to a 1.5% tax on its business net profit. However, if the 1.5% tax is less than the minimum franchise tax, the LLC only pays the $800 minimum. Conversely, if the 1.5% tax on its net profit exceeds $800, the LLC is obliged to pay the 1.5% tax on its net profit.

California Annual Taxation of a California LLC Disregarded for Tax Purposes or Taxed as a Partnership

A California LLC disregarded for tax purposes or taxed as a partnership follows a distinct set of rules for annual taxation.

Unlike a California S-Corp or California LLC taxed as an S Corporation, a California LLC that is disregarded for tax purposes or taxed as a partnership is not subject to a 1.5% tax on its business net income. However, a California LLC disregarded for tax purposes or taxed as a partnership is subject to an annual franchise tax of $800 regardless of the business gross revenue or business net income. This $800 is a mandatory fee that needs to be paid each year to the California Franchise Tax Board even if the California LLC is inactive or does not operate during the tax year.

In addition to the $800 annual franchise tax, a California LLC disregarded for tax purposes or taxed as a partnership is also subject to the California LLC Fee. The California LLC Fee is based on the business gross revenues and not on the business net income. The fee ranges from $0 to $11,790, depending on the total gross revenues of the California LLC disregarded for tax purposes or taxed as a partnership.

For example, a California LLC disregarded for tax purposes or taxed as a partnership with business gross revenues between $250,000 to $499,999 pays a fee of $900 in addition to the $800 franchise tax, between $500,000 to $999,999 pays $2,500 in addition to the $800 franchise tax, between $1,000,000 to $4,999,999 pays $6,000 in additional to the $800 annual franchise tax, and an LLC with gross revenues equal or exceeding $5,000,000 pays $11,790 in addition to the $800 franchise tax.

The California LLC Fee can make a California LLC disregarded for tax purposes or taxed as a partnership more expensive to operate than a California S-Corp or a California LLC taxed as an S Corporation if the gross revenues of the LLC are high enough. This can be especially damaging to the financial health of a California LLC disregarded for tax purposes or taxed as a partnership if business gross revenues are high and business expenses are correspondingly high, as it is possible to pay a up to $12,590 per year in franchise tax and the California LLC Fee if a California LLC disregarded for tax purposes or taxed as a partnership does not operate profitably despite business gross revenues greater than or equal to $5,000,000 annually.

Conclusions About California Annual Taxation between LLCs and S Corporations in California

Choosing the proper tax structure for your business in California can significantly influence your annual tax liabilities. While both California S-Corps and California LLCs taxed as S Corporations are subject to the annual minimum franchise tax of $800 and a progressive 1.5% tax on net profit, California LLCs disregarded for tax purposes or taxed as a partnership are subject to an $800 franchise tax and an additional California LLC Fee determined by gross revenues, potentially leading to higher total taxation.

Therefore, business entities expecting high gross revenues but also high expenses may find operating as an S-Corp or an LLC taxed as an S Corporation more tax efficient. However, each business situation is unique, and what business entity may work best for one business may not work for another business.

LLCs and S-Corps in California: Management Structures

Management structure plays a pivotal role in the growth trajectory, decision-making processes, and operational efficiencies of a business entity. As we compare the management structures of California LLCs and California S-Corps, we will highlight the key differences, delve into the flexibility and rigidity of each structure, and examine how these structures can impact the business operations, governance, and overall performance.

Management Structure of a California S-Corp

California S-Corps, adhere to a traditional corporate structure with a set hierarchy and distinct roles for overseeing and managing the business operations. This structure typically includes a board of directors, officers, and shareholders, each having specific roles and responsibilities.

In this section, we examine the management structure of a California S-Corp, exploring the roles of the board of directors, officers, and shareholders and how this rigid structure could impact the fluidity of operations and overall business performance.

The Management Role of the Shareholders of a California S-Corp

The shareholders of a California S-Corp play a crucial role in the overall management and governance of the California S-Corp. Shareholders are the owners of the California S-Corp, holding equity shares that denote their ownership. Their management role is primarily exercised through their voting rights, which are used to make key business decisions and elect the board of directors.

The board of directors, elected by the shareholders, is accountable to the shareholders and is responsible for leading the California S-Corp in a way that aligns with shareholder interests.

Shareholders also have the right to vote on major company decisions, such as mergers, acquisitions, or dissolution. They are entitled to receive a portion of the business net profits in the form of distributions, pro rata based on the percentage of their ownership.

In addition, shareholders have the right to access certain company information, including annual reports and financial statements, allowing them to maintain oversight of the performance and direction of the California S-Corp.

While shareholders do not participate in the day-to-day operations of the California S-Corp, their role in governance, board selection, and major decision making is crucial to the successful operation of a California S-Corp.

The Management Role of the Board of Directors of a California S-Corp

The board of directors of a California S-Corp holds a central role in the governance and strategic oversight of the California S-Corp. Comprised of individuals elected by the shareholders, the board of directors is vested with considerable authority in shaping the direction of the California S-Corp and making substantial business decisions.

As the governing body, the board of directors carries the fiduciary responsibility of acting in the best interests of the California S-Corp and its shareholders. This includes making decisions about major corporate actions such as mergers and acquisitions, capital increases, and executive compensation.

One of their key roles is to set the strategic direction of the California S-Corp. The board of directors does this by evaluating and approving the long-term strategies of the California S-Corp, ensuring they align with the mission of the California S-Corp and the interests of the shareholders. The board of directors also monitors the performance of the California S-Corp against these strategic goals, taking corrective action as needed.

The board of directors also plays a critical role in risk management. The board of directors is responsible for identifying, managing and mitigating, significant risks to the California S-Corp. The board of directors oversees the implementation of adequate internal control systems and often establishes dedicated committees such as an audit committee to provide additional oversight on specific areas of risk.

Furthermore, the board of directors is responsible for selecting, evaluating, and if necessary, replacing the CEO or other high-ranking officers. They determine executive compensation and assess the performance of top management.

In a California S-Corp, the board of directors is also responsible for ensuring the compliance with laws and regulations and maintaining high standards of corporate governance and ethical conduct.

In summary, the board of directors in a California S-Corp plays a multifaceted role in corporate governance, strategic direction, risk management, and executive oversight, ensuring the long-term viability and success of the California S-Corp.

The Management Role of the Corporate Officers of a California S-Corp

Corporate officers of a California S-Corp hold executive positions and are responsible for the day-to-day management and operations of the corporation. These officers must include the Chief Executive Officer (CEO), Chief Financial Officer (CFO), and the Secretary, though additional officer roles may exist depending on the needs of the California S-Corp.

The CEO is primarily responsible for making major corporate decisions and is the main point of communication between the board of directors and the rest of the California S-Corp.

The CFO, on the other hand, oversees the financial actions and decisions of the California S-Corp, managing finances, budgeting, financial planning, and risk management in addition to financial reporting to the board of directors and shareholders.

The Secretary is often responsible for maintaining corporate records and compliance with state and federal laws. They ensure that the records of the California S-Corp are accurately kept and that corporate meetings, such as shareholder meetings and meetings of the board of directors, are properly organized and executed.

Each of these corporate officers plays a vital role in managing the California S-Corp and ensuring its success. The corporate officers report directly to the board of directors and are held accountable for their performance and adherence to the strategic direction of the California S-Corp. In essence, while the board of directors is responsible for strategic oversight, it is the corporate officers who implement this strategy and manage the daily operations of the California S-Corp.

Management Structure of a California LLC

Management Structure of a California Limited Liability Company (LLC)

A California LLC has a flexible management structure. Members may choose to manage the California LLC themselves or appoint a manager or a team of managers for this purpose. This flexibility allows the management structure of a California LLC to adapt to the needs of the business, making it a popular choice for many entrepreneurs and small business owners.

In the following sections, we examine both member-managed and manager-managed management structures of LLCs in California, detailing their roles, responsibilities, and the impact they have on the daily operations and strategic direction of the California LLC.

California LLC in which All Members Manage

In a member-managed California LLC, all members actively participate in the daily operations and decision-making processes of the business. This management structure is common in small businesses where the owners prefer to have direct control over business operations. Each member has the authority to make decisions on behalf of the California LLC, enter into contracts, and has a responsibility towards the operational tasks. It is important to note that in this structure, all members share the fiduciary duty to act in the best interest of the California LLC. While this approach fosters a democratic atmosphere with shared responsibility, it may also lead to conflicts if members disagree on certain issues. Therefore, clear communication and decision-making protocols set forth in a written operating agreement are essential in a member-managed California LLC.

California LLC with One Manager

In a manager-managed California LLC, the members appoint a single manager to handle the day-to-day operations and make decisions on behalf of the California LLC. This management structure is often adopted by larger California LLCs or when the members do not wish to be involved in regular operations or when the members prefer to take a more passive role. The appointed manager, who may or may not be a member of the California LLC, holds the authority to enter into contracts, hire and fire employees, and manage all administrative tasks. All significant decisions pertaining to the strategic direction and financial management of the organization are typically under the purview of the manager. However, certain major decisions, like amendments to the operating agreement or decisions on mergers and acquisitions, may still require the approval of the members. The manager also bears a fiduciary responsibility to act in the best interest of the California LLC. The delineation of roles and responsibilities in this structure allows for a clear division of labor, though it places a significant level of trust and power in the hands of the appointed manager.

California LLC with More than One Manager

In a California LLC managed by more than one manager, the structure is similar to that of a single-manager California LLC, but with multiple managers holding managerial responsibilities. These managers collectively oversee the daily operations and strategic direction of the California LLC, dividing the management tasks among themselves. As with a single-manager California LLC, these managers have the authority to enter into contracts, manage administrative tasks, and make significant business decisions. However, the degree of their individual authority can vary based on the specifications in the operating agreement. As with all other management structures, each manager holds a fiduciary duty to act in the best interest of the California LLC. This approach provides the benefits of shared responsibility and expertise, but it requires clear communication and a well-structured operating agreement to prevent potential conflicts and ensure smooth operation.

Conclusion About Management Structures of California S-Corps and California LLCs

In summation, the management structures of California S-Corps have a more rigid, hierarchical structure, with defined roles. On the other hand, California LLCs offer greater flexibility in their management structures, with the option for member management or appointment of one or multiple managers. This flexibility can adapt to various business needs and preferences, allowing for more hands-on involvement from the members or delegation of managerial responsibilities. However, such flexibility also brings the potential for conflicts, especially in a member-managed California LLC where each member has decision-making authority. Therefore, while the flexibility of California LLCs can be beneficial, it often necessitates clear communication protocols and a comprehensive operating agreement to manage potential disagreements and ensure effective governance.

Need Help Deciding Between a California LLC and California S-Corp? Contact San Diego Corporate Law Today!

If you are still unsure about whether a California LLC or California S-Corp best suits your business needs, do not hesitate to reach out. At San Diego Corporate Law, our experienced attorneys are ready to guide you through every step of your decision-making process. With our in-depth knowledge and expertise, we can help you understand the implications of each choice for your business situation. Contact us today to set up a consultation and take the guesswork out of your corporate structure decision. Your successful business future starts with a single step. Let us walk you through it!