One of the most important business decisions a business owner will make is to choose a legal entity through which to conduct business. Often times, the decision is narrowed down to two types of entities: (1) the California S Corporation (S Corp), or the California limited liability company (LLC). Both the California S Corp and the LLC provide varying levels of personal asset protection for the business owner, varying tax advantages and disadvantages, and varying complexity in the day to day operations of the business, amongst other differences. The purpose of this article is to highlight some of the key differences when making the choice between a California LLC or a California S Corp. Incfile vs ZenBusiness
Important Considerations When Choosing a Business Entity.
Owners of newly formed businesses often find sorting out the differences between the two entities to be overwhelming. However, as a general rule, when deciding whether or not to organize as a S Corp or a LLC it is usually most productive to narrow the focus on three key areas that will be important considerations for a business owner:
- Limiting potential personal liability to the owners from the liabilities associated with the business, and the requisite formalities associated with maintain such limited liability;
- Limiting potential taxes associated with the business; and
- Addressing any other special circumstances applicable or important to the owners.
Achieving the Goal of the Owners with Minimal Compromise.
However, before addressing these three issues, it is important to first determine how many owners the new entity will have (referred to as “shareholders” in the context of an S Corp, and “members” in the context of a LLC). The number of owners is very important. Determining the most important consideration where there is only owner is relatively straightforward. However, in representations involving more than one owner, each owner will often have differing objectives or areas which they feel are the key priority for the business. For example, given two owners, the first owner’s priority could be to obtain certain tax consequences above all else, while the second owner may be more concerned with flexibility with respect to ownership interests, or the allocation of the businesses’ profits and loss. In this situation, it is usually best for the attorney to take a step back, look at the overall purpose of the owner’s business, and choose the entity which would best achieve the varying goals of the owner with minimal compromises.
An Overview of the California S Corporation.
An S Corporation is a legal entity which limits the potential personal liability to the owners from the liabilities associated with the business, provided that it is properly formed and maintained.
1. S Corporation – To Limit Liability, Respecting Corporate Formalities is Essential.
With regards to proper corporate formation, unfortunately I have seen too many instances where a corporation was initially formed for a minimal cost, by a non-lawyer, using an online service (who usually misrepresent the service they are offering), or by some other means, but then once the basic milestone of receiving the stamped Articles of Incorporation from the California Secretary of State is achieved, there is never any follow through with any of the other documents that are required under California law. The end result is that the corporation is improperly formed, and right from the onset, the owners have needlessly exposed themselves to liability in the form that at some point in the future, an aggrieved party may successfully “pierce the corporate veil“. What does this mean? It means that an aggrieved party may look through the corporation to the personal assets of the owner.
With regards to proper maintenance of a corporation, a California S Corporation must observe certain corporate formalities. In comparison to a California limited liability company, it is often thought that the S Corp has more burdensome maintenance requirements than the LLC. In other words, the S Corp is the more formal entity between the two.
For example, if the S Corp is chosen as the entity, in order to afford maximum limited liability protection (and avoid the potential for a piercing action): (1) the corporation should properly notice, hold and document annual meetings of the shareholders and directors, in addition to any special meetings of the board of directors necessary to authorize and affirm certain corporate acts, (2) the corporation should timely file all required documents required under applicable law; (2) the corporation should be funded with a sufficient amount of capital, and should not be inadequately capitalized; (3) the owners should keep the corporation’s corporate minute book in order and up to date, and should sign all documents where the corporation is a party, in their capacity as an officer or authorized agent of the corporation; and (4) corporate funds should never be mingled with other personal funds of the owners.
2. S Corporation – Tax Considerations.
In general, a S Corporation does not pay federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to the shareholders pro rata in accordance with their ownership interest. The shareholders must then report the income or loss on their own individual income tax returns (this form of taxation means makes the S Corporation a type of “flow through” entity). This flow through taxation of an S Corporation is different from a C Corporation, because there is only a tax at the shareholder level. The owners in a C Corporation on the other hand experience what is called “double taxation” in that the entity is taxed separately from the shareholders. In other words, first the corporation is taxed, and then the shareholders are also taxed.
Although the S Corporation’s avoidance of double taxation in the form of pass through taxation is often viewed as one of its primary advantages, one consideration that can be viewed as a disadvantage is that there are strict eligibility requirements for S corporations.
It is also important to note that similar to a LLC, the S Corp must pay an $800 California state franchise tax for the privilege of doing business in California. However, and one big advantage of the S Corporation is that it avoids the gross receipts tax of the LLC, in which gross receipts of an LLC over $250,000 are taxed.
3. S Corporation – Other Considerations.
Eligibility Requirements of the S Corporation.
For a corporation to be eligible for S status it must adhere to fairly strict shareholder requirements. For example, a S Corporation must limit the number of permitted shareholders to 100; the shareholders must be individuals who are United States citizens or legal United States residents (this means that another corporation cannot be a shareholder in a S Corporation), or the shareholder must be a certain type of qualified trust or estate. When there is a qualified trust that is a shareholder of an S corporation, each potential current beneficiary of the trust is treated as a separate shareholder. Related shareholders, whether owning shares directly or by deemed ownership as a beneficiary of a trust, may be treated as a single shareholder pursuant to family attribution rules.
Another very important requirement is that S Corporations are limited to only one class of stock, an