Proper Entity Choice for a Small Business in California (S Corp and LLC)

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Reason for Incorporation:

Business owners are personally liable for the debts of the business or a legal judgment against the business if the business is not incorporated.  There are three primary forms of business incorporation: the C Corporation (C Corp), the S Corporation (S Corp) and the Limited Liability Company (LLC).  Incorporation of a business into one of the three above entities will limit the owner’s personal liability for the business’ debts and judgments.

Pass Through Taxation:

The C Corp entity choice results in two layers of taxation.  The C Corp is a separate taxpayer and will pay taxes on the income of the business which is the first layer of taxation.  The shareholders are then taxed on their receipt of the business’ distribution of the income to the shareholders which is the second layer of taxation.

The S Corp and LLC structures avoid the double layer of taxation and are known as “pass through” entities.  The S Corp and LLC income is not reported on the business’ tax return; rather the income passes through to the business owners and is taxed on the owners’ personal tax returns.

Differences Between S Corps and LLCs: 

Both the S Corp and LLC provide the limitation of liabilities of a separate entity while not incurring a double layer of taxation.  However, important differences between S Corps and LLCs exist which must be analyzed prior to choosing the appropriate entity form for a given business.  The primary difference between the S Corp and the LLC are detailed below.

Business Formation and Management:

The formation and management of an LLC is extremely simple.  The formation of an LLC only requires the filing of its Articles of Incorporation with the California Secretary of State.  An operating agreement should be drafted outlining the management of the LLC and the duties and rights of the business’ owners (the LLC members).

An S Corp requires Articles of Incorporation to be filed with the California Secretary of State similar to the LLC.  However, the S Corp also requires the more extensive formalities of the appointment of a board of directors, the drafting of corporate bylaws and the issuance of corporate stock.  The S Corp must also hold director and shareholder meetings, keep minutes of the meetings, and file annual reports.

Business Owners:

The owners of an S Corp (shareholders) must be U.S. citizens or permanent residents and the S Corp may not have more than 100 shareholders.  These limitations do not apply to the LLC so the LLC may be the appropriate entity choice where an owner is not a U.S. citizen or permanent resident or a large number of owners is desired.  It is also important to note that the LLC has a limited life and may end upon the death or bankruptcy of a member while the S Corp can continue for an unlimited duration.

Profit Sharing:

The members of an LLC may assign the business profits and losses disproportionately amongst the members if that is provided in the operating agreement.  The S Corp is required to allocate income and losses proportionately amongst its shareholders.  The flexibility of the LLC is especially beneficial when one owner is dedicating personal efforts toward the business while other owners may remain in a more passive role.

Self-Employment Taxes:

The earnings of both the S Corp and the LLC are taxed in their entirety to the owners whether or not the earnings are actually distributed to the owners.  Some amount of the earnings may remain in the S Corp or LLC to provide for business expansion.  The entire amount of the earnings of the LLC is subject to self-employment tax regardless of whether the earnings are distributed to the owners or retained in the business.

The S Corp owners must only pay self-employment tax on their salaries and the remaining earnings may be retained in the business or distributed to the shareholders without incurring self-employment tax.  The IRS requires the S Corp shareholders who work for the business to pay themselves “reasonable compensation” to avoid abuse of this distinction between the S Corp and the LLC.  The S Corp’s ability to avoid paying self-employment taxes on all of its income is significant given the fact that the self-employment tax rate is 15.3% (but one-half may be deducted as an expense).  This distinction from the LLC may result in the conclusion that the S Corp is the appropriate entity form for a given business.

California Taxes:

S Corps and LLCs are taxed differently at the state level.  California taxes S Corps at a 1.5% rate on net income with a minimum tax of $800 due each year.  California requires LLCs to pay an $800 franchise tax plus an additional fee on gross income over $250,000.

Real Estate Investment:

The LLC should most likely be chosen as the entity of incorporation where the purpose of the business is real estate investment.  The members of an LLC can add the amount of the mortgage to their basis in their computation of loss, a benefit not available to S Corp shareholders.

Conversion to C Corp:

The S Corp is easily converted to a C Corp with the filing of a single form with the IRS.  The conversion of the LLC to a C Corp is far more involved as all of the corporate formalities would be required to be put into place.  The ability to convert to a C Corp may be important if the business is seeking venture capital.  Most venture capital firms invest in C Corp entities rather than S Corps or LLCs.

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