In California, establishing a California S-Corp is the most popular business structure for business owners (referred to as “shareholders” of a California S-Corp) in California.

A California S-Corp is a California Corporation making an S Corporation election in accordance with the Internal Revenue Code; S Corporations avoid double taxation and pay federal income tax on net business income at the shareholder level.

A separate article titled “What Liability Protection Does a California S-Corp 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 S-Corp.

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 S-Corp if they anticipate an immediate or future tax benefit.

Many business owners establish California S-Corps exclusively for the tax benefits of operating their business using a California S-Corp 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 S-Corp provides.

For many business owners, the experienced corporate attorneys at San Diego Corporate Law recommend the use of a California S-Corp for the limited liability protections and tax benefits a California S-Corp 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 S-Corp 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 S-Corp 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 S-Corp 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 distributions, which are not subject to payroll or self-employment taxes. This approach can result in significant tax savings for shareholders who balance their salary for services as an employee with the distributions on their shares of stock based upon ownership of their California S-Corp.

When do the California S-Corp Tax Benefits Make Sense for a Business Owner?

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

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 shareholder.

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 S-Corp is still recommended if the business owner has or plans to have employees or independent contractors at any point in time, because California S-Corps 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 S-Corp regardless of liability concerns because the tax savings of a California S-Corp can outweigh the additional administrative costs associated with operating as a California S-Corp, 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 S-Corp. 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 S-Corp versus forming the California S-Corp as a part of starting their business.

Tax Benefit Details for Business Owners

The organizational structure of a California S-Corp may offer a significant reduction in tax liability for shareholders. By understanding the tax benefits of California S-Corps 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 S-Corp 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 S-Corp 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 S-Corp may be diminished.

This section examines tax concerns for shareholders, helping them assess whether establishing a California S-Corp 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 S-Corps

A California S-Corp 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 S-Corps offer a potential reduction in FICA tax liability by distributing a portion of business profits to shareholders as distributions rather than wages. However, shareholders actively participating in the daily operations of the California S-Corp 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 S-Corp.

Shareholders may receive distributions from any profits beyond their reasonable salary exempt from FICA taxes. This allows shareholders in California S-Corps 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 distribution through shares of stock in the California S-Corp.

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 S-Corp.

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 S-Corp 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 distributions not subject to the FICA tax.

Based upon the examples above, a California S-Corp that pays a $50,000 fair market salary to a shareholder as an employee could save that shareholder up to $14,706 per year 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.

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 business 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 S-Corps

A California S-Corp 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 S-Corps 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 S-Corp.

Shareholders must receive a reasonable salary, but any additional profits can be paid as distributions to the shareholder not subject to Medicare taxes. This allows shareholders with California S-Corps 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 distributions from the California S-Corp.

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 S-Corp.

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 S-Corp can bifurcate its income to pay a reasonable salary to a shareholder as an employee, which is subject to the Medicare tax, while distributing the remaining income to the shareholder not subject to the Medicare tax.

Based upon the examples above, a California S-Corp 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 S-Corps

While the Additional Medicare tax applies to wages, including wages earned by shareholders involved in the day-to-day operations of a California S-Corp, 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.

Deductibility of Health Insurance Premiums and Other Fringe Benefits

Deducting health insurance premiums and other fringe benefits for shareholders is another consideration in tax planning when selecting a business entity for a California business. This section will detail the tax implications and advantages of providing health insurance and other fringe benefits to shareholders and employees. By grasping these deductions, one can engage in more strategic financial planning, significantly affecting overall tax liabilities.

Deductibility of Health Insurance Premiums and Other Fringe Benefits for Sole Proprietors and General Partners

For sole proprietors and general partners of general partnerships, the ability to deduct health insurance premiums and other fringe benefits can offer a tax advantage. Sole proprietors can deduct the health insurance premiums they pay for themselves as an above-the-line deduction, thereby reducing their adjusted gross income.

This deduction is available even if the sole proprietorship does not show a profit, though it cannot surpass the net profit of the business. It is important to remember that these deductions do not reduce Medicare or Social Security taxes. For general partners in general partnerships, similar provisions apply if the premiums are paid by the general partnership and classified as guaranteed payments.

These deductions not only reduce taxable income but also serve as incentives within the tax code, encouraging smaller business structures to offer health-related benefits.

Deductibility of Health Insurance Premiums and Other Fringe Benefits for California S-Corps

For California S-Corps, understanding the deductibility of health insurance premiums and other fringe benefits for shareholders is important to creating an effective tax strategy.

Shareholders who own more than 2% of the California S-Corp can deduct health insurance premiums and other fringe benefits for their benefit paid on their behalf by the California S-Corp, however, these premiums are treated as compensation to the shareholders and are reported as such on their W-2 forms, underlining their inclusion in taxable income.

Proper handling of these deductions ensures that the California S-Corp remains compliant with tax regulations.

Deductibility of Health Insurance Premiums and Other Fringe Benefits Conclusion

Grasping these deductions is crucial for selecting the right business structure and optimizing tax responsibilities. For sole proprietorships, general partnerships, and California S-Corps, health insurance premiums can qualify as business expenses. However, shareholders of California S-Corps must include these premiums and other fringe benefits in their income tax calculations, although they are exempt from FICA and Medicare tax liabilities.

Additional Costs to Operating as a California S-Corp

California Franchise Tax Board Minimum Annual Franchise Tax

California S-Corps 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 1.5% 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 S-Corps far exceeds the California minimum franchise tax requirement.

Other Administrative Costs to Operate a California S-Corp

Operating a California S-Corp involves additional administrative costs beyond the minimum annual franchise tax compared to sole proprietorships and general partnerships.

For example, a California S-Corp 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 S-Corps, 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 S-Corps will require payroll services even if the shareholder is the only employee of the California S-Corp, 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 S-Corps.

The additional financial obligations of a California S-Corp 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 S-Corp.

Conclusions About Tax Benefits

The additional costs associated with operation as a California S-Corp 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 S-Corps.

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 S-Corp.

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 S-Corp.

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 S-Corp, 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 S-Corp, a tax savings of $122,856.

Thus, for lower net income, say $50,000 or below, a California S-Corp 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 S-Corp 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 S-Corp, resulting in the shareholder keeping more of the net income earned after taxes.

The experienced corporate attorneys at San Diego Corporate Law are available to assist with the analysis of net income versus administrative expense budgeting when deciding whether or not a shareholder should form a California S-Corp or choose another business structure such as a limited liability company for a California business. Limited liability companies are popular choices, but without consulting a tax professional, there may be surprise taxes when it is time to file an income tax return.

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 S-Corp 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 S-Corp 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 S-Corp formed as a part of starting the business.