Small businesses play such a huge role in the Californian economy, with 48.8% of the private workforce being employed by them in this state. Many of these businesses are limited liability companies (LLCs), which compose the largest group of registered business entities across the country. LLCs are also able to elect a tax classification called ‘S corp’ status, which is often confused for a business structure, despite not being one.
S corps (or S corporations) are an Internal Revenue Service (IRS) tax designation that LLCs and corporations can file to become as long as they meet specific requirements. Despite the 1.5% franchise tax that California levies against businesses that choose this tax status, LLCs stand to gain significantly from this switch as a result of the additional tax advantages it offers. This article will explore these benefits as well as the requirements to elect this status.
Before Electing This Status
Before rushing ahead and deciding to elect S corp status for your business it is worth considering a number of preliminary questions. Firstly, whether this is truly the best tactic for your particular company depends on, among other factors, the amount of profit your business generates.
As long as the business produces enough revenue to be able to pay its members a ‘reasonable salary’ and annual distributions in excess of $10,000, the S corp tax option is an excellent choice for LLCs. Furthermore, this more accurately describes small businesses that reasonably expect themselves to be churning out such significant profit so there is no need to attract investors.
Contrastingly, businesses that rely on attracting investment and venture capital might be better suited to form as a corporation. This is even more true in cases where a large proportion of the profit will be carried over from one tax year to the next, as this business structure’s carryover profits are taxed at a far lower rate than that of LLCs.
It is better for your business to form as a corporation, it is recommended not to elect S corp status (despite it being an option available to you), as the nature of the corporation business entity will inherently preclude most of the benefits of electing to be taxed as an S corp.
Benefits of S Corps
It is more common for small businesses to file their taxes under the default provisions for LLCs since they do not produce a sufficient enough amount of profit to gain any benefit from S corp tax status.
That said, where businesses do generate enough profit, S corp tax status can prove incredibly advantageous. Under this designation, members of the LLC can expect to save nearly 17% of the income they receive from distributions. This is because, as long as they are paid a ‘reasonable salary’ (with regard to their position and industry), only this income stream is subject to both employment and income taxes.
Copyright: TRUiC
Furthermore, the distributions produced by S corps only have income tax levied against them in the personal tax returns of each member, pursuant to their tax bracket. As such, this portion saves greatly in tax since it is not required to pay employment tax on distributions in S corps.
In addition to this, it provides all these benefits while also retaining the advantages of passthrough taxation that LLCs demonstrate. Namely, the profits that S corps generate will not be taxed at a business level (unlike corporations), because they ‘pass through’ to the owners in the form of their income, which are then subject to personal income and employment taxes.
While S Corps in California are liable to pay a 1.5% franchise tax (or $800 minimum), due to the incredible tax savings this IRS designation can produce, it is more than worth electing where businesses are earning enough profit to make it viable.
Closing Remarks
Although this article has focused on the tax benefits of forming an s corp in california, this tax designation of course benefits from all the advantages inherent to LLCs too. These include the passthrough tax savings, as well as the credibility this structure provides. For a more in-depth look at all these benefits, feel free to refer to TRUiC’s resource on the topic.
