What is an S Corporation?
An S Corporation is a type of tax entity that you elect at the federal tax level. To choose S Corp status, you must request it from the IRS in writing, usually by submitting Form 2553. If the IRS approves your request, your entity becomes an S Corp. But how do you set up your initial entity, the one that asks the IRS for the S Corp status? You start with your state. Your initial entity could be either an LLC or a Corporation, which you set up at the state level. Once you get all of your state paperwork in order, you can then apply for the S Corp election. And if the IRS approves your request, you become an S Corp: your business starts filing forms 1120-S and K-1s. K-1 forms will bring your business income to your personal return, and you will figure out your taxes on a personal (not corporate) level for that business income. This is what we call pass-through taxation.
Pass-through taxation helps you avoid double taxation, which is a key difference from C Corporations that face taxation at both the corporate and personal levels. Additionally, with S Corps, you will also benefit from legal protection, which safeguards your personal assets from business liabilities. S Corporations are generally used as a legal way to reduce self-employment tax (we wrote about it here) and sometimes they may help high-income earners take advantage of the Qualified Business Income (QBI) deduction (you can read about it here) and also get locked into the Pass-Through Entity tax (here is the explanation of that deduction). So, S Corps can be definitely useful. But let’s get back to the comparison of LLC and S Corporation and see potential drawbacks of an S Corp.
LLC (Limited Liability Company)
As we explained above, S Corporations operate on the federal tax level, and LLCs operate on the state level, but an LLC can decide to become an S Corp, or stay just as an LLC. An LLC is a legal entity designed to protect your personal assets from business creditors. Consider it another level of protection on top of your liability insurance. An LLC by itself has nothing to do with how your business income is taxed on Federal level (however, there are some additional costs on California level, read below). Setting up an LLC involves registering with your state, not the IRS. In California, for example, you would establish your LLC through the Secretary of State’s website.
If your situation is simple and you are a single-member LLC, you can do it yourself on the website or hire us. If your case is complicated, you have legal questions and would like to talk it over before setting up an LLC, we usually refer clients to San Diego Corporate Law. Michael and Christina have helped numerous clients with their legal questions.
Maintaining an LLC in California costs $800 annually. Yes, not cheap. Again, by itself, an LLC is not a tax entity. This $800 goes towards your legal bill: the legal separation between your business and personal assets. On federal level your LLC gets taxed just like a regular sole proprietor that files schedule C. But on California level you would attach your form 568, your LLC form. This arrangement allows you to manage your business and personal assets separately while paying taxes in a straightforward manner ( Schedule C filer).
If your LLC has two or more members, you'll file a separate partnership business tax return (Form 1065) and attach Form 568 to it. This form also confirms your LLC’s legal protection in California. So, as you can see, this LLC form is just a little appendix, for which you need to pay and file the return just to protect your legal rights.
How does an LLC relate to an S Corp?
If your LLC decides to become an S Corporation, then the LLC would have to contact the IRS by filing form 2553 asking for the S Corp status. Once the IRS grants it, you will be taxed as an S Corp, but for state legal purposes, you will still be an LLC and will still pay the minimal $800 annual fee to California for asset protection. The form for California will also be different - California SCorps file form 100 S. Once you are an S Corp, you get to have the legal protection of an LLC and the preferential tax treatment of a pass-through entity with all the perks we mentioned above: reduced self-employment tax, QBI deduction, and PTET tax deduction for high-income earners.
Differences in Fees on the California Level: LLC vs. S Corp
Regular California LLCs pay a minimum annual tax of $800 just to keep going. You can read about it here. On top of that, there is an LLC fee, which is based on the LLC’s gross receipts. Please note the difference: minimum $800 is called LLC tax, and the additional taxes you pay on gross receipts are called LLC fees. Anyway, LLC fees are based on their gross receipts, not their net profits. For instance, if your LLC has $2,000,000 in gross receipts, you would owe $6,000 in LLC fees. Yes, this is in addition to your income tax to California and IRS. You can read more about it here.
In comparison, California S Corps are taxed at a rate of 1.5% on their net profit. Net profit is different from gross receipts because (in lay terms) net profit is gross receipts minus all expenses. For example, if your S Corp generates $2,000,000 in gross receipts but has $1,900,000 of expenses, its net profit is only $100,000. This means that the tax on this income will be only $1,500 (100,000 * 0.015 = $1,500).
As we can see, both LLCs and S Corps incur additional taxes at the California level. California business owners would still have to report and be taxed on the same income on their personal income taxes. This means that California S Corps and LLCs experience some level of double taxation.
Should We All Jump Into S Corps?
With California S Corps, it makes sense to compare S Corp filing costs vs benefits you receive from being an S Corp. S-Corps can be expensive. They require some sort of bookkeeping (especially if you hit $250K in gross receipts), which means that you have to spend money on accounting software and/or hire someone to do your books. There is also a payroll requirement, and running payroll will cost you $500-600 a year. Plus a separate tax return ($900-$2,000). There is also this 1.5% tax ($800 minimum) on the California level. So, before you jump into the S Corp, I suggest you do a cost analysis and see how much you could save vs. how much you can gain if you get into an S Corp.
For single-owner members, sometimes it makes sense just to get an LLC or even go without an LLC and simply purchase good liability coverage. Generally, in California, it makes sense to get into an S-Corporation when the net profit from your business is $80,000 or more. But this number is still not a guarantee that you will benefit from electing into the S Corp. There are many other instances when running your business as an LLC or even as a sole proprietor is still more beneficial, even with high net profits from the business. We discussed some of them here. How do you know if it makes sense to jump into the S Corp? You will need a CPA to look at your financials and personal returns and give you a cost analysis: this is how much you will spend on an S Corp vs. this is how much you will gain from it. A CPA can also explain to you what are advantages and disadvantages of running an S Corp in your particular case. My firm offers this service for $250, and we call it a diagnostic fee and you can book an appointment here.
However, there are situations where forming an S Corporation is the only option. Not all professions in California are permitted to operate as LLCs. Here is a good summary of professional services that are not allowed to operate as LLCs. These professionals have two options: operate as sole proprietors/partnerships and get good comprehensive liability insurance, or establish professional corporation taxed an S-Corp.
In Summary
Selecting between an S Corporation and an LLC involves weighing various factors, including tax implications, legal protection, and your business structure. Each option has its advantages and potential drawbacks, so it’s important to carefully consider your specific needs and consult with a professional if necessary.