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Business Entity Formation: LLC vs S Corp

updated 5/24/2010

The limited liability company (LLC) and the S corporation are the 2 most common business structures formed in order to limit the business owner's liability for business debts and/or legal judgements. Whether you are starting a new business or are considering converting your current sole proprietorship or partnership, you should familiarize yourself with the similarities and differences between the LLC and S corp. The following is a general outline of the basic tax & legal considerations of doing business in the state of California as an LLC or S corp:

Business structure & legal formation:

An LLC can have one or more owners (called members) and the members appoint managers (who may or may not be members) to run the business. An S corp can have between 1 and 100 shareholders, the shareholders will appoint officers & directors to make top level management decisions.

To form an LLC in the state of California:

  1. You should draft an LLC operating agreement which does not have to be filed with the Secretary of State, but is very important since is outlines the ownership & management resposibilites of the members as well as many other important legal details.
  2. Articles of Organization (Form LLC-1) must be filed with the California Secretary of State.

To form a corporation in the state of California:

  1. Articles of Incorporation must be filed with the California Secretary of State.
  2. The legal requirements of corporate formation are more complicated than for an LLC. Among other things, you will have to appoint directors, draft corporate bylaws and issue stock.

Income tax differences:

A single member LLC is follows the same rules for Federal income tax purposes as a sole propreitorship, whereas an LLC with 2 or more members follows the same rules as a partnership for income tax purposes. The result of these rules is that the LLC income or loss is passed directly to the owner's personal income tax return (Form 1040).

An S-Corporation also passes income or loss directly to the owner's personal income tax return. However, a C-Corporation is taxed at its own level and then pays out earnings to the stockholders in the form of salaries or dividends. By default a corporation is a C-Corporation, so if you want the pass through tax advantages of an S-Corporation it is important to make a timely election with the IRS.

Passing start-up losses to owner(s):
Both LLC's and S-Corps offer the advantage of passing losses directly to the owners tax returns so the losses can offset other income. However, both of these entities are subject to basis limitations which means you can't take more of a loss than the amount of your investment. The LLC has one distinct advantage in this regard: loans taken by the LLC add to the member's basis so you can deduct losses to the extent of your cash investment plus your share of the LLC loans payable. S-Corp basis only includes funds contributed or loaned to the corporation directly from the shareholder.

Self-employment tax:
The avoidance of SE tax (social security tax) is an area where an S corp can potentially have a tax advantage since the income distributed to the shareholder(s) is not subject to SE tax. However, in practice it is not quite that simple since IRS regulations require shareholders who perform services for the corporation to pay themselves a reasonable compensation. Since this compensation must be paid as a salary using normal payroll deductions the social security tax ends up being paid on this salary anyway. You should consult your tax advisor if you are a S corp officer/shareholder to make sure you comply with these regulations.

Federal income tax reporting:

Entity
Tax form
LLC (1 member) Schedule C (Form 1040)
LLC (2 or more members) Form 1065
S corporation Form 1120S

California income tax reporting:

Entity
Tax form
LLC Form 568
S corporation Form 100S

Taxation of LLC's doing business in California:
LLC's do not pay any Federal income tax directly; the net income or loss from the businesss activities of the LLC is passed directly to the owner's Federal income tax return (Form 1040). However, California requires a minimum tax and an LLC fee in addition to the net income or loss which is also passed to the owner's California income tax return (Form 540).

California minimum tax of $800 is due each year whether the LLC has net income or not. In addition to the minimum tax there is an LLC fee due if the LLC has gross income of $250,000 or more. The determination of the LLC fee due is complex and you should consult your tax advisor re: the calculation of the fee. Also, the minimum tax and LLC fee are due in advance so you should also consult your tax advisor re: the timely payment of both in order to avoid penalties.

California LLC fee based on the gross income (less cost of goods sold), gross rents & other forms of income from California sources over $250,000:

From
To
Fee
$250,000 $499,999 $900
$500,000 $999,999 $2,500
$1,000,000 $4,999,999 $6,000
$5,000,000 and over $11,790

Taxation of S corporations doing business in California:
S corps do not pay any Federal income tax directly; the net income or loss from the businesss activities of the S corp is passed directly to the owner's Federal income tax return (Form 1040). However, California taxes the S corp 1.5% of net income from California sources in addition to the net income or loss which is also passed to the owner's California income tax return (Form 540).

California minimum tax of $800 is due each year whether the S corp net income or not (except for the corporation's first year of existence). If the tax of 1.5% of net income is less than $800, the corporation will owe $800 in tax. Also, the minimum tax is due in advance so you should also consult your tax advisor re: the timely payment in order to avoid penalties.