In California, establishing a California Corporation is a popular business structure for business owners (referred to as “shareholders” of a California Corporation).

A separate article titled “What Liability Protection Does a California Corporation Provide?” examines the liability protection and separation of personal and business assets for shareholders, however, this article will focus solely on the tax benefits of a California Corporation.

The goal of this article is to equip business owners with the information needed to make informed decisions with respect to their tax liabilities. It is crucial to ensure that the chosen business entity aligns with tax planning goals of the business owner while adhering to California law, including the California Corporations Code, the California Business and Professions Code, and other relevant regulations.

Executive Summary: Putting the Conclusion First for Busy Business Owners

A business owner should form a California Corporation if they anticipate an immediate or future tax benefit.

Many business owners establish California Corporations exclusively for the tax benefits of operating their business using a California Corporation even if only the tax benefits are sought by the business owner, and even if they do not feel they need the benefit of the liability protections and separation of their personal assets from the debts, liabilities, obligations, and legal judgments against their business that operating as a California Corporation provides.

For many business owners, the experienced corporate attorneys at San Diego Corporate Law recommend the use of a California Corporation for the limited liability protections and tax benefits a California Corporation provides.

Choosing the right business structure for your business can be a complex task. For tailored advice that considers your specific circumstances, schedule a consultation with the experienced attorneys at San Diego Corporate Law. Our team is committed to assisting business owners in determining whether a California Corporation or another business structure best suits their needs, maximizing tax benefits while minimizing liability risks. Schedule a consultation today to ensure your business is structured for success.

Tax Benefits Overview for Business Owners

Selecting the ideal business structure to do business requires a deep understanding of tax implications. A California Corporation that opts for S Corporation status can provide substantial tax benefits, especially in relation to self-employment and payroll taxes.

Self-employed business owners are responsible for covering the full Social Security and Medicare taxes, totaling 15.3% of net profit up to the statutory cap, which is $168,600 as of 2024. Beyond this cap, they must pay 2.9% on all net profit. Additionally, there is a 0.9% Medicare tax for single taxpayers earning $200,000 or more and for married taxpayers filing jointly with incomes of $250,000 or above, added to the 2.9%.

A California Corporation offers a strategic way to minimize self-employment taxes. By providing a market-rate salary to shareholders, the salary becomes subject to payroll taxes of 15.3% up to the statutory cap ($168,600 in 2024) and 2.9% for earnings above this limit. The remaining profits can then be distributed as shareholder dividends, which are not subject to payroll or self-employment taxes (but may or may not be subject to dividend taxes depending upon the overall income of the shareholder). This approach can result in significant tax savings for shareholders who balance their salary for services as an employee with the dividends paid on their shares of stock in the California Corporation.

When do the California Corporation Tax Benefits Make Sense for a Business Owner?

Most business owners would benefit from operating as a California Corporation in California, with the exceptions being very low revenue businesses without employees and with no plans for future growth of the business.

While beyond the scope of this article, it is worth noting that pass through entities (such as a California S-Corp) are generally more tax efficient than a California Corporation for most shareholders.

Lower Net Income Businesses without Employees or Independent Contractors

If a business owner works alone, has no employees or independent contractors, is fully insured, and runs a business with an annual net income below $50,000 to $60,000 without the intention to grow the business in the future, operating as a sole proprietorship in California may be suitable for that business owner.

Lower Net Income Businesses with Employees or Independent Contractors

For business owners earning less than $50,000 to $60,000 in net income annually without plans to grow their business in the future, establishing a California Corporation is still recommended if the business owner has or plans to have employees or independent contractors at any point in time, because California Corporations offer protection to shareholders from liabilities related to their employees and independent contractors.

Higher Net Income Businesses Regardless of Liability Concerns

A business owner earning (or planning to earn) over $60,000 in net income annually should seriously consider operating as a California Corporation regardless of liability concerns because the tax savings of a California Corporation can outweigh the additional administrative costs associated with operating as a California Corporation, and these tax savings can be significant.

Starting a New Business Without Certainty of Future Performance

Shareholders planning to start small and grow their business over time should carefully consider the administrative challenges of initially operating as a sole proprietor or general partnership with plans to later convert to a California Corporation. It is best to schedule a consultation with an experienced corporate attorney for advice on the challenges for converting a thriving business from a sole proprietorship or general partnership to a California Corporation versus forming the California Corporation as a part of starting their business.

Tax Benefit Details for Business Owners

The organizational structure of a California Corporation may offer a significant reduction in tax liability for shareholders. By understanding the tax benefits of California Corporations compared to the taxation of sole proprietorships and general partnerships, business owners can make more informed decisions when selecting a business entity for their business.

The tax benefits of a California Corporation are influenced by several factors: the net income of the business before distributing funds to shareholders, additional income earned by the shareholders, and their overall tax strategy.

Certain tax situations can diminish the usual benefits of forming a California Corporation from a tax perspective. This is especially true when the net income of the business before compensation to the shareholder owner is relatively low or when other income of the shareholder owner already meets the FICA cap. In such cases, the tax advantages of a California Corporation may be diminished.

This section examines tax concerns for shareholders, helping them assess whether establishing a California Corporation aligns with their financial objectives and tax efficiency strategies.

FICA Tax Liability

The FICA tax is a mandatory payroll tax in the United States that funds Social Security. Both employees and employers share the responsibility of paying FICA taxes.

The FICA tax is directly deducted from the wages or salaries of employees at a rate of 6.2% of their gross income. Employers must match this contribution with an additional 6.2%, resulting in a total contribution of 12.4% per employee.

For self-employed individuals, such as sole proprietors and general partners in general partnerships, the FICA tax is calculated differently. Instead of being based on wages or salaries, it is assessed at 12.4% of the net income attributed to the self-employed person (whether a sole proprietor or general partner) from their business.

The FICA tax is applied solely to income or net income up to a specified limit, which is annually adjusted for inflation. As of 2024, this cap is set at the first $168,600 earned.

FICA Tax Liability for Sole Proprietors and General Partners

Sole proprietors and general partners in general partnerships shoulder the entire FICA tax burden on the net income of a California business, each up to their individual FICA cap. Unlike employees who split this tax with their employers, self-employed business owners must cover both the employer and employee portions, resulting in a total FICA rate of 12.4% for sole proprietors and general partners in general partnerships.

The following are some examples of FICA tax liability for a business owner with various net income:

$50,000 net income x 12.4% = $6,200 FICA tax liability

$150,000 net income x 12.4% = $18,600 FICA tax liability

$300,000 net income x 12.4% = $20,906 FICA tax liability (limited by $168,600 FICA cap for 2024)

FICA Tax Liability for Shareholders of California Corporations

A California Corporation modifies the approach to handling FICA tax liability for its shareholders. Unlike sole proprietors or general partners of general partnerships, who pay FICA taxes on their entire net income, California Corporations offer a potential reduction in FICA tax liability by distributing a portion of business profits to shareholders as dividends rather than wages. However, shareholders actively participating in the daily operations of the California Corporation must still receive reasonable compensation which is subject to FICA taxes. This reasonable salary is taxed at the 12.4% FICA rate up to the annual wage base limit, with a 6.2% contribution deducted from the wages of the shareholder as an employee and a matching 6.2% paid by the California Corporation.

Shareholders may receive stock dividends from any profits beyond their reasonable salary, and these dividends are exempt from FICA taxes (although they may be subject to dividend taxation or income taxation). This allows shareholders in California Corporations to strategically organize their income to reduce FICA tax liabilities as long as they adhere to Internal Revenue Service guidelines for determining reasonable compensation.

Here is an example of FICA tax liability for a shareholder earning a minimum fair market value salary as determined by Internal Revenue Service guidelines:

$50,000 salary x 12.4% = $6,200 FICA tax liability.

This applies regardless of whether the shareholder also receives $100,000, $250,000, or any other amount as a dividend through shares of stock in the California Corporation.

This approach requires planning and documentation, as non-compliance with reasonable compensation standards could lead to the reclassification of distributions as wages, incurring additional FICA tax liabilities and penalties. Nonetheless, a $50,000 salary can be considered reasonable according to Internal Revenue Service standards, regardless of the total net income of the California Corporation.

FICA Tax Liability Conclusion

When comparing FICA tax liability, sole proprietors and general partners of general partnerships are taxed on the total net income of their business. In contrast, a California Corporation can divide its income into that which is paid to a shareholder as salary subject to the FICA tax and distributions paid to the shareholder as dividends not subject to the FICA tax.

Based upon the examples above, a California Corporation that pays a $50,000 fair market salary to a shareholder as an employee could save that shareholder up to $14,706 per year in self-employment taxes based on the 2024 FICA tax cap of $168,600 compared that same net income being paid to a California sole proprietor or general partner (but the overall tax savings will vary based upon the income of the shareholder).

Medicare Tax Liability

The Medicare tax is a mandatory payroll tax in the United States, supporting the federal Medicare insurance program. Responsibility for paying these taxes is shared between employees and employers.

For employees, the Medicare tax is deducted directly from their wages or salaries at a rate of 1.45% of their gross income. Employers must also contribute an additional 1.45% on behalf of the employee, resulting in a total contribution of 2.9% per employee.

For self-employed individuals, including sole proprietors and general partners in general partnerships, the Medicare tax is calculated not on wages or salaries, but rather as 2.9% of the net income of the business attributed to the shareholder owner.

Unlike the FICA tax, which is imposed only on income up to a certain threshold, the Medicare tax has no cap on the amount owed by an employee, sole proprietor, or general partner.

Medicare Tax Liability for Sole Proprietors and General Partners

As sole proprietors or general partners of a general partnership, these business owners shoulder the entire Medicare tax burden on their net income. Unlike employees who share this responsibility with their employers, self-employed business owners must cover both the employer and employee portions of the tax, resulting in a total Medicare tax rate of 2.9%.

The following are some examples of Medicare tax liability for a business owner with various net income:

$50,000 net income x 2.9% = $1,450 Medicare tax liability

$150,000 net income x 2.9% = $4,350 Medicare tax liability

$300,000 net income x 2.9% = $8,700 Medicare tax liability

Medicare Tax Liability for California Corporations

A California Corporation changes how Medicare tax obligations are managed for its shareholders. Unlike sole proprietors or general partners of a general partnership who pay Medicare taxes on their entire net income, California Corporations offer a way to potentially reduce Medicare tax liability by classifying a portion of business profits as distributions on shares of stock instead of wages. Shareholders actively engaged in the daily operations of the business must still receive reasonable compensation, which is subject to Medicare taxes. The Medicare tax responsibility is split, with a 1.45% contribution from the wages of the shareholder as an employee and a matching 1.45% paid by the California Corporation.

Shareholders must receive a reasonable salary, but any additional profits can be paid as dividends to the shareholder not subject to Medicare taxes. This allows shareholders with California Corporations to strategically manage their income and reduce Medicare tax liabilities. It is essential, however, to adhere strictly to Internal Revenue Service guidelines when determining reasonable compensation.

Here is an example of Medicare tax liability for a shareholder earning a minimum fair market value salary as determined by the Internal Revenue Service:

$50,000 salary x 2.9% = $1,450 Medicare tax liability.

This applies regardless of whether the shareholder receives $100,000, $250,000, or any other amount as dividends from the California Corporation.

This approach requires planning and documentation, as non-compliance with reasonable compensation standards may lead to distributions being reclassified as wages, resulting in additional Medicare tax liabilities and penalties. Nonetheless, a $50,000 salary can be considered reasonable under Internal Revenue Service standards, regardless of the total net income of the California Corporation.

Medicare Tax Liability Conclusion

When examining Medicare tax liability, sole proprietors and general partners of general partnerships are taxed on the entire net income of their business. In contrast, a California Corporation can split its income to pay a reasonable salary to a shareholder as an employee, which is subject to the Medicare tax, while distributing the remaining post-corporate tax income to the shareholder as a dividend not subject to the Medicare tax.

Based upon the examples above, a California Corporation that pays a $50,000 fair market salary to a shareholder as an employee could save that shareholder $2,900 per year based on a $150,000 annual income or $7,250 per year based on a $300,000 annual income compared to the Medicare tax liability for a California sole proprietor or general partner of a general partnership.

Additional Medicare Liability

The Additional Medicare Tax, introduced under the Affordable Care Act, targets high-income earners with increased taxation. Unlike the standard Medicare tax, this additional levy applies only to individuals and couples who surpass specific income thresholds. Specifically, it imposes a 0.9% tax rate on wages and self-employment income exceeding these limits, affecting only the income that surpasses the threshold.

The threshold for the Additional Medicare Tax is $200,000 for single taxpayers, $250,000 for married couples filing jointly, and $125,000 for married individuals filing separately.

Additional Medicare Tax Liability for Sole Proprietors and General Partners

As sole proprietors and general partners in general partnerships, individuals bear the full burden of the Additional Medicare tax obligation on their entire net income in excess of the thresholds.

The following are some examples of Additional Medicare tax liability for a single business owner with various net income:

$50,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$150,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$300,000 net income x 0.9% = $900 Additional Medicare tax liability ($100,000 above threshold)

The following are some examples of Additional Medicare tax liability for a married business owner filing jointly with various net income:

$50,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$150,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$300,000 net income x 0.9% = $450 Additional Medicare tax liability ($50,000 above threshold)

The following are some examples of Additional Medicare tax liability for a married business owner filing separately with various net income:

$50,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$150,000 net income x 0.9% = $225 Additional Medicare tax liability ($25,000 above threshold)

$300,000 net income x 0.9% = $1,575 Additional Medicare tax liability ($175,000 above threshold)

Additional Medicare Tax Liability for California Corporations

While the Additional Medicare tax applies to wages, including wages earned by shareholders involved in the day-to-day operations of a California Corporation, the fair market value wages required by the Internal Revenue Service are unlikely to come close to the thresholds for the Additional Medicare tax, regardless of marital status or tax filing status, with proper tax planning as follows:

$50,000 salary x 0.9% = $0 Additional Medicare tax liability (below threshold)

Additional Medicare Tax Liability Conclusion

While not as large as the FICA and Medicare tax examples at the net income rates used as examples above, the Additional Medicare tax is not nominal and can become quite large for the owners of businesses with high net income.

Additional Costs to Operating as a California Corporation

Federal Taxation of California Corporations

California Corporations must pay federal income tax on their net income. This net income is calculated after wages are paid to employees, including shareholder employees, but prior to the distribution of net profit to shareholders as dividends. This means that the amount available to be paid as dividends to shareholders is after the payment of federal and state income tax.

As of the date of this writing in 2024, the federal income tax rate for a California Corporation is 21% of the net profit. This income taxation at the corporate level together with the taxes shareholders pay on dividends, is referred to as double taxation of C Corporations (C-Corps).

California Franchise Tax Board Minimum Annual Franchise Tax

California Corporations must pay the minimum annual franchise tax mandated by the California Franchise Tax Board. The minimum franchise tax is the greater amount between an annual $800 or 8.82% of net income.

Sole proprietorships and general partnerships are exempt from franchise taxation in California, allowing them to bypass the annual minimum tax. This exemption provides a slight financial benefit; however, the tax efficiency of California Corporations far exceeds the California minimum franchise tax requirement.

Other Administrative Costs to Operate a California Corporation

Operating a California Corporation involves additional administrative costs beyond federal taxes and the minimum annual franchise tax compared to sole proprietorships and general partnerships.

For example, a California Corporation will have expenses related to maintaining state and federal compliance for keeping its FinCEN Beneficial Ownership Information Report up to date, filing an annual statement of information, and the drafting of meeting minutes for its annual meetings of shareholders and its board of directors that sole proprietorships and unregistered general partnerships do not require.

For both general partnerships and California Corporations, additional administrative costs for bookkeeping, legal consultation to ensure adherence to corporate governance requirements, and tax preparation are likely higher than equivalent costs for a sole proprietorship.

Sole proprietorships and general partnerships without employees will generally not incur payroll costs, but California Corporations will require payroll services even if the shareholder is the only employee of the California Corporation, which is an added expense. However, sole proprietorships and general partnerships with employees will incur equivalent payroll costs that are comparable to those of California Corporations.

The additional financial obligations of a California Corporation can add up to a few thousand dollars per year depending upon the costs of tax preparation and payroll services, but these costs are often outweighed by the tax benefits provided by a California Corporation.

Conclusions About Tax Benefits

The additional costs associated with operation as a California Corporation vary but are generally a few thousand dollars per year compared to a sole proprietorship or general partnership that does not pay an annual franchise tax to the California Franchise Tax Board and does not have employees requiring payroll. In addition, sole proprietorships may enjoy lower tax preparation costs than general partnerships or California Corporations.

However, depending upon the net income of the business, these additional expenses may be paid for by the FICA, Medicare, and Additional Medicare tax savings possible with a California Corporation.

For $50,000 of allocated net income, a California sole proprietor or general partner would expect to pay $7,650 in self-employment taxes ($6,200 FICA + $1,450 Medicare), equivalent to that which would be paid by a shareholder of a California Corporation.

For $150,000 of allocated net income, a California sole proprietor or general partner would expect to pay $22,950 in self-employment taxes ($18,600 FICA + $4,350 Medicare), compared to $7,650 in payroll taxes (employee and employer contributions combined of ($6,200 FICA + $1,450 Medicare) for a $50,000 salary from a California Corporation, a tax savings of $15,300.

For $300,000 of allocated net income, a California sole proprietor or general partner would expect to pay $30,506 in self-employment taxes ($20,906 FICA + $8,700 Medicare + $900 Additional Medicare), compared to $7,650 in payroll taxes (employee and employer contributions combined of ($6,200 FICA + $1,450 Medicare) for a $50,000 salary from a California Corporation, a tax savings of $122,856.

Thus, for lower net income, say $50,000 or below, a California Corporation will likely cost more in additional administrative expenses than the tax savings realized.

At around $60,000 of net income per year, the tax savings versus additional expense of operating a California business as a California Corporation starts to break even depending on the costs of the additional expenses incurred.

Above the $60,000 of net income per year, the tax savings begins to exceed the additional expense of operating a California business as a California Corporation, resulting in the shareholder keeping more of the net income earned after taxes.

However, while a California Corporation is generally more tax efficient than a sole proprietorship or general partnership, when a California S-Corp is available for use, a California S-Corp will usually be more tax efficient than a California Corporation.

The experienced corporate attorneys at San Diego Corporate Law are available to assist with the analysis of business income less business expenses for net taxable income and business taxes versus administrative expense budgeting when deciding whether or not a business owners should form a California Corporation, California S-Corp, or choose from the other available business entities for a California business to minimize the bill when it is time to pay tax and calculate tax credit and tax breaks both for federal and state taxes..

Establishing a Business Structure for Anticipated Growth

Establishing a business structure conducive to anticipated growth involves selecting a formation that not only accommodates current operations but also facilitates future expansion.

For shareholders foreseeing growth of their business, choosing to start as a California Corporation is advantageous because it allows these shareholders to establish their business once, avoiding the establishment of a business as a sole proprietorship or general partnership for a year or two before facing the need to establish the business a second time to after net income grows and the self-employment tax burden becomes expensive.

Additionally, even when net income remains lower, the California Corporation is still valuable to a shareholder because it provides legal protection by separating personal assets from business liabilities, a critical consideration for risk management.

If within the means of such a shareholder, the recommendation is to start with a California Corporation formed as a part of starting the business.