Let’s Rewind: What is a Business Structure?

First things first, it’s important to understand what we’re talking about here.

In the initial stages of your business, every business owner(s) has to decide how he/she wants to structure the business.

Forming a business structure, or entity, will provide separation between you (the business owner) and the business itself, in case of any civil legal ramifications.

Read: lawsuit!

Additionally, your business structure and elected tax status will affect several things throughout the business, most notably the tax return you file and which deductions you can take.

Ok. What are the differences between LLC vs. S-corp?

Let’s start with the definitions of each.

An LLC, which stands for “limited liability company,” is a business structure that protects the personal assets of the business’s owner(s).

An S corporation, also referred to as an S-corp, is a tax election that lets the IRS know your business needs to be taxed as an S Corporation. It is not a business entity like an LLC, sole proprietorship, partnership, or corporation.

Instead, it’s a way of determining how the business will be taxed.

To become an S-corp, your business first must register as a C corporation or LLC.

Yes, your business can be structured as an LLC and taxed as an S corporation.

And while both operating options provide liability protection for the business owner(s), they have several key differences when it comes to tax implications, benefit eligibility, profit sharing allocation rules, administrative requirements… *takes a breath* and operational ease when making decisions.

In layman terms, operating as an LLC or electing an S corp can have far-reaching implications for many avenues of your business.

So, between a California LLC and S corp, which one is best?

Both the LLC and the elected S corp status are the most common choices for small businesses in California.

The one you choose is going to depend on your unique business situation, and the benefits that are most important to you as the owner(s).

Let’s take a deeper look.

California LLC vs. S-corp: Liability Protection

When it comes to protecting yourself as an individual from the business itself, both options protect the owner(s) from the action of the company, in cases of debt or lawsuits. They just do it in different ways.

Neither shields the owner from criminal or personal tort liability. This is an important note to remember.

When it comes to personal lawsuits, it is possible for creditors to go after your shares if you are structured as a corporation in California.

Some states offer protection from this (called charging order protection); however, California is not one of them.

However, as an LLC, your personal assets are protected.

Additionally, if you’re a general partner in a California LLC that is taxed as a partnership, you will be responsible for all of the company’s debt.

While owners in an LLC only have limited liability in the company’s debt – hence the name! – up to the amount of capital they’ve invested in the business.

California LLC vs. S-corp: Owner Preferences

When it comes to the administration of your business, things can change quite a bit depending on whether you structure as an LLC or elect as an S corp.

For starters, structuring as an LLC is usually easier to manage than an S corp.

An S corp comes with greater reporting requirements and additional legal and filing obligations.

This makes sense when you think about the employment options available to you as an S corp.

When operating as an S corp, you can hire yourself as an employee in the business and receive wages and fringe benefits. In this case, you’ll be filing taxes on behalf of the business (business return), and as a shareholder (recipient of the profit and losses).

Alternatively, members of an LLC can’t work for their business or classify themselves as employees.

Last but not least, transferring ownership in an S corp is as simple as transferring stocks by buying, selling, gifting or inheriting.

However, with an LLC, admitting or removing a new member requires change in the operating agreement and approval by the voting membership, both which require careful planning.

California LLC vs. S-corp: Tax Implications

Ok, let’s get into the juicy stuff – tax implications!

While an S corp is oftentimes more complex to manage, it can bring huge tax savings depending on the revenue of your business.

One of the biggest benefits with the S corp is that profit is not subject to employment tax, which can save you about 14.2% in taxes as an owner.

An LLC that is used for trade or business, classified as a sole proprietorship or partnership, is subject to the 14.2% self-employment tax.

That’s a huge savings depending on how much you make each year.

In other tax implications, S corporations are required by the IRS to allocate profit and losses every year to the shareholder. Profit and losses must be assigned on a per-share basis.

Whereas with an LLC taxed as a partnership, you have more flexibility. A financial arrangement can be setup which allows special allocations which don’t necessary correspond with the actual percentage of ownership.

Last but not least, another major difference is the S corp 1.5% franchise tax and the LLC fee.

The 1.5% corporate tax is based on the net taxable income, while CA LLC fee is calculated at the gross income level.

Let’s take for example a business that has a $200K taxable income and $4M gross receipts.

As a California LLC, the business will pay $800 minimum franchise tax plus a $6000 annual fee, for a total of $6800 / year. 

As an S corp, you only pay 1.5% of $200,000, or $3000 / year.

Another big savings!

Ok. What’s the Verdict?

The decision to operate as an LLC or S corp is not a decision to take lightly.

As demonstrated in this article, structuring your business in a less optimal way can have a damaging impact to your bottom line.

While an LLC is much easier to manage, the S corp can bring significant tax savings to businesses that meet a certain income threshold. 

Our advice?

We strongly recommend seeking out the help of an accountant to help you form the best decision. 

Making the right entity choice requires collective accounting, tax, and legal expertise.

Structuring your business in the most optimal way from the beginning can save you thousands and thousands of dollars down the road.

Here at Basta & Company, we’re happy to help you however we can. You can send us an email with your questions, or book a complimentary call with one of our accountants.

We’re here to help.