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San Diego Corporate Law: Pros and Cons of Making an “S Corp” Selection

One of the questions that is often asked by entrepreneurs is, “Should my corporation be a ‘C Corporation’ or an ‘S Corporation’”? Here is some basic information on the difference and the pros and cons of making the S-Corporation selection.

San Diego Corporate Law: C-Corporation vs. S-Corporation

All California corporations begin as California C-Corporations. The only thing that converts a California C-Corporation into a California S-Corporation is a form that is filed with the Internal Revenue Service that elects for the corporation the taxation status of an S-Corporation. The form is IRS Form 2553, Election by a Small Business Corporation. See here.

In the simplest terms, S-Corporation election allows the corporation to avoid federal taxation on the corporation’s profits. Those profits are passed through to the individual owners and the owners are then taxed on the corporate earnings on their personal IRS form 1040 tax returns as though such earnings were individual income. This is why an S-Corporation is called a “pass-through tax entity.” Importantly, corporate LOSSES are also passed through to the individual owners which, under the various IRS regulations, might offset other personal taxable income.

If there is no election by a corporation to be treated as an S-Corporation, then the corporation remains, for all purposes, a C-Corporation and the corporation must pay federal taxes on any corporate income. Note, however, the election as an S-Corporation does NOT eliminate California corporate tax obligations. Both California C-Corporations and S-Corporations owe California corporate taxes to the California Franchise Tax Board (with the minimum tax being $800 per year).

San Diego Corporate Law: Advantages to S-Corporation Election

There are three major federal income tax advantages of making an S-Election:

  • Corporate earnings are passed through to the owners thus avoiding “double taxation”
  • Corporate losses can be used to offset other personal income
  • S-Corporation net profits are not subject to self-employment taxes (as they are LLC or partnership forms).

San Diego Corporate Law: Disadvantages of S-Election

However, because of the many rules established by the Internal Revenue Service, there are some serious disadvantages to making an S-Election. These include:

  • S-Corporations are limited to fewer than 100 shareholders
  • S-Corporations must be domestically formed corporations
  • S-Corporations cannot deduct as business expenses certain tax-free fringe benefits such as health and accident insurance for employees above certain ownership thresholds
  • S-Corporations cannot have certain types of shareholders such as non-resident aliens, LLCs, other corporations, etc.
  • No carry-forward losses that exceed an S-Corporation’s shareholder’s “basis” in the corporate stock

San Diego Corporate Law: Personal Service Corporations

California allows a large number of professionals, such as doctors, nurses, veterinarians, and the like to form personal service corporations. These begin as C-Corporations but they are almost invariably converted to S-Status so that the professionals can minimize their self-employment taxes. As noted, the net profits of a California professional S-Corp are not subject to self-employment taxes. The key, however, is to strike the right balance. The profession must pay him or herself a “reasonable” salary for his or her level and skill as a member of the profession. Beyond that level, the net profit can be distributed free of self-employment taxes. Failure to strike that balance will bring IRS scrutiny with the IRS potentially treating all income as salary.

San Diego Business Law: Call San Diego Corporate Law Today

For further information, contact corporate attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard has been named a “Rising Star” for 2015, 2016, and 2017 by Mr. Leonard can help with the annual maintenance requirements and with any other business-related legal matter. Contact Mr. Leonard by email or by calling (858) 483-9200.

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