Tax Difference between LLC and S-Corp in California

The two most common types of business entities new owners look into setting up are LLC’s (Limited Liability Company) and S-Corps. Both of these entity types have legal and tax ramifications that any new business owner should be aware of. To understand how each of these business structures work, we need to break down their ownership structure, legal requirements, and tax implications.

Read on to learn more about:

• How to file an S-Election or S-Corp conversion in California
• Are S-Corps worth it in California?
• What is the Tax Rate on S-Corporations in California?
• Do S-Corps Require Payroll in California?
• What tax forms must S-Corporations file in California?
• How much might you save with an S-Corp in California?

California S-Corporations Sub Chapter S Conversions

Most small business owners and 1099 income earners we meet want to know the answer to one question:

Is it worth it to convert to an S-Corp in California?

This question arises because most freelancers and small business owners have heard that an S-Corp can help reduce self employment and medicare taxes.

But California is a different beast because it has implemented what's called the California Franchise Tax Board tax which creates some nuance for S-Corporations.

How are Sole Props & S-Corps Taxed?

Simply stated, every Sole Proprietorship will pay social security and medicare taxes on their net profits, at least up to the social security limits.

Medicare and Social Security Taxes are often called "Self Employment Taxes", and they add up to 15.3%.

LLC’s

Sole-Proprietor

Before we dive into the nuances of operating your own LLC, it is important to first understand how sole-proprietorships are treated from a business structure and tax perspective. After all, if you are operating an LLC as a single owner, the Federal government still considers you to be a sole-proprietor.

In most states, if you start a business today without any legal formalities, you are automatically considered a sole-proprietor. This means that you have unlimited personal liability with any legal matters related to your business. Establishing an LLC, however, serves as a quick fix for single business owners looking to mitigate that unlimited personal liability, and limit it to whatever assets are under your business.

LLC Structure

An LLC is a partnership business entity that limits the owners’ (Members) liability to whatever their stake is in the business. LLC’s are formed by filing an Articles of Organization with the state, and annual filing fees are generally similar to whatever the state charges for corporate annual filing fees. You do not have to be the resident of the state in which you form your LLC, however, if you do this, you will need to have a registered agent in the state you form your business.

An LLC is governed through an Operating agreement, which should spell out in detail how Members will allocate ownership, profits, and losses. Although it is common practice to have profits and losses distributed equally to ownership percentages, this is not required when operating an LLC. Still, without an operating agreement, your LLC will be subject to the default provisions of its governing state.

LLC Tax

In the tax world, LLCs are what we call pass-through entities. This means that the profits are not taxed at the entity level, and rather, the income made by the company is passed-through to the owners and taxed at their individual income tax brackets.

Single-member LLC owners report the income from their LLC on Schedule C (Profits and Loss from Business) or form 1040 (Individual Income Tax Return). It is important to check your state’s requirements for LLC tax filings, but most single-member LLC owners must file a business state income tax return along with their individual income tax return for the state.

For example, if you are a California single-member LLC Owner, you will have at least 3 tax returns to file.

1. Form 1040 - Individual Income Tax Return (Federal)
2. Form 540 – Individual Income Tax Return (State)
3. Form 568 – LLC Tax Return (State)

LLCs with multiple members must file form 1065 to report their income to the federal government. When form 1065 is prepared, the individual member’s share of income is reported on a Schedule K-1. Unlike the single member LLC where the owner’s share of business income is reported on Schedule C, multi-member LLC owners report their share of income on Part II of Schedule E (Income or Loss from Partnerships and S-Corporations).

Contrary to popular belief, LLCs are not inherently large tax saving entities. Members of LLCs who are not considered Limited Partners (someone who simply invests in the business and has no contributions to the active operations of the company) are subject to both income tax and self-employment tax on their earnings. If a Limited Partner receives guaranteed payments from the business, however, these payments would also be subject to self-employment taxes.

S-Corporation

S-Corporation Structure

Despite its name, s-corps are not actually a legal business entity. Rather, they are a tax election made by a corporation to be treated as a pass-through entity for tax purposes. Owners of C-Corporations generally like this since it allows them to bypass the burden of double taxation that is carried along with a C-corp. It is important to note, however, that other entity types (such as LLCs) can also elect for S-Corp status. Generally, this is done through filing form 2553.

Unlike the LLC, where ownership requirements are less strict, the ownership requirements of an s-corporation have more rules to follow. For example, they are limited to 100 members that must be US citizens or residents (certain trusts and estates may also qualify). There are also more corporate formalities to follow, such as issuing stock (limited to common stock), electing officers, holding regular board of director meetings, and ensuring that the distribution of profits and losses are proportional to ownership percentages.

S-Corporation Tax

When a corporation elects to be an s-corporation for tax purposes, they are electing to be taxed as a pass-through entity, or a partnership. S-corps report their annual income through filing form 1120S. Similarly, to other partnership entities, the income passed through to the owners of an s-corp is reported on a Schedule K-1, which is then reported on their individual tax return through Schedule E of form 1040. 

There is a major difference to note between reporting income from your Schedule K-1 when it comes from an LLC as a general partner, as opposed to when it comes from an s-corp. Both K-1’s are reported in Part II of Schedule E, however, LLC income for a general partner is placed under the column listed as “Non-passive Income from Schedule K-1”, whereas s-corp income is placed under the column listed as “Passive Income from Schedule K-1”. 

This means that the net income reported from your s-corp is not subject to self-employment taxes. 

S-Corporation = No self-employment taxes?

This statement is a bit of an oversimplification. To understand what the exact tax implications of an s-corp are, we have to define a few terms first.

Self-Employment Tax

Self-employment taxes are simply the Social Security and Medicare taxes paid by a person who is self-employed. When you are the employee of a company, you must pay FICA (Social Security + Medicare) from your wages, which is done through the form of withholdings on your paycheck. You are responsible for paying half of this total tax liability, and your employer is responsible for paying the other half. As a self-employed individual, however, you are responsible for paying this full amount (15.3%). It is a rather steep amount that hits many new business owners by surprise, but there is some upside to it when you consider that you deduct half of these taxes in calculating your taxable income.

Salary/Wages

Your salary is how much you are paid as an employee of a company through the form of wages. When you are under payroll, in addition to having FICA deductions, you will also have deductions for Federal and State income taxes. These Federal and State income tax deductions are then reported on your tax return, reducing your total tax liability. If these income tax deductions exceed your total tax liability for the year, you will receive a refund after filing your tax return. Your wages, FICA deductions, and Federal and State income tax deductions are all reported on form W2 at the end of the year. 

Distributions

Distributions are direct withdrawals/payments from the business to the individual owner. They primarily take place through the form of cash or property. These distributions are technically not subject to tax (unless your distributions exceed your total basis in the business) since owners of pass-through entities are taxed on their share of income, regardless if it was actually received or not. 

S-Corporation Owners must pay themselves a fair and reasonable salary

As the owner of an s-corporation, you are required to pay yourself a fair and reasonable salary. The IRS has given very vague guidance as to what this amount would actually be. Industry standards, geographical standards, as well as a thorough analysis of your business must be performed in order to determine what this amount would be. 

When s-corporation owners pay themselves a salary, they will pay FICA through two mediums. First, their paycheck will have these amounts withheld. Second, they will pay the other half of these payroll taxes through the business. These payroll taxes are deductible as a business expense when filing form 1120s.

As you can see, while s-corps owners don’t pay self-employment taxes directly, they do still incur these FICA payments through their salary. 

LLC vs S-Corporation example:

To illustrate the differences between these two entities, it would be best for us to look at a side-by-side example with similar income. Note, we are making a strong generalized assumption in this example, where we have determined that $50,000 of salary is fair and reasonable for a business owner of a company that makes a net of $150,000 in the year. Whether or not this is applicable to your business will be determined on many factors, and it is strongly advised you speak with a professional before assuming your salary is reasonable by IRS standards.

INSERT EXAMPLE HERE

From this example, it is clear that the s-corporation is a much more strategic entity choice than the LLC if your goal is to maximize tax savings. The key factor here comes down to self-employment taxes. 

Not shown in the example above is the payroll taxes we have to consider when paying the owner $50,000 of salary. As we discussed earlier, payroll taxes and self-employment taxes essentially cover the same liability. Even if we consider an extra $7,650 of taxes on our s-corp salary ($50,000 x 15.3%), the s-corp owners still ends up paying a total of $34,518 ($26,868+$7,650) of taxes for the year, as compared to the LLC owner paying $44,892.

Closing Remarks

It’s easy to look at the example above and assume that the s-corp is the best strategy for small business owners to take when looking to minimize their tax liability. For many business owners, this is likely the case, but you want to make sure that this does truly apply to you. For certain business owners, such as those in the startup stages still incurring net losses, limited partners of partnership entities like the LLC, or even certain C-Corporation owners, there may be income, stock, and distribution scenarios where the s-corp might not make most sense. Income level, while being an important, is likely not as crucial of a factor as some would think.

At Asnani CPA, we have seen owners with net income substantially lower than the example above still benefit from electing s-corp status. Similarly, we have seen certain scenarios with s-corp owners who are high income earners navigate their salary requirements in a way that mitigates any tax benefits from this entity type. 

Your entity choice matters, and you don’t want to start a business by just guessing which one suits your needs the best. Take the time to speak with a professional, and analyze which one will be the best for you. Otherwise, you might be leaving a lot of money on the table.