2022BusinessDixon Gardner

Should I Set Up As An S-Corporation Or An LLC In California?

If you are starting a new business or interested in changing your existing business structure, a common question by business owners is which business entity should I choose? An S-Corporation (“S-Corp”) or a Limited Liability Company (“LLC”).

An S-Corp is a corporation organized under state law by filing Articles of Incorporation of a General Stock Corporation with the California Secretary of State; and this corporation has made an election with the Internal Revenue Service (“IRS”) to be taxed under Subchapter “S” of the Internal Revenue Code.  California imposes a 1.5% tax on California sourced net income to each S-Corp.  The S-Corp shareholders (i.e. the S-Corp’s owners) have to elect the directors (the agents of the shareholders) of the S-Corp each year.  The directors then appoint officers, such as the CEO, CFO, and secretary of the S-Corp each year.  The officers manage the corporation on behalf of the shareholders as the agents of the shareholder’s agents (the directors).  The bylaws of the S-Corp govern how it is to be run by and the rights of the S-Corp’s shareholders, directors, and officers.

An LLC is a limited liability company organized under state law by filing Articles of Organization of a Limited Liability Company with the California Secretary of State.  An LLC is usually treated as a partnership for taxation with the IRS and with the states.  California imposes a graduated gross revenue tax on an LLC doing business in California based on receipts (see https://www.ftb.ca.gov/file/business/types/limited-liability-company/index.html) and the $800 annual franchise tax.  The LLC members can elect to manage the LLC by themselves (called a member managed LLC) or the LLC members can elect to have the LLC managed by managers (called a manager managed LLC).  The operating agreement of the LLC governs how members and managers are to run the LLC and their rights to do so.

An LLC may also elect to be taxed as though it were an S-Corp.  This article assumes that the LLCs discussed below have not elected to be taxed as an S-Corp. However, if an LLC chooses to be taxed as an S-Corp, then the discussion for S-Corps applies to such an LLC.

First, S-Corps and LLCs have common elements, such as:

Owners Have Limited Liability To The Extent Of Their Investment:  The owners of LLCs and S-Corps have limited their liability to their investment in the equity of a LLC (called a “membership interest”) or S-Corp (called a share of common stock).

Separate Legal Entities Responsible For Their Debts.  Both are separate legal entities created by a state filing.  Under an LLC and S-Corp, their owners are not personally responsible for business debts and liabilities.  Instead, the LLC or the S-Corp, as the owner of the business, is responsible for its debts and liabilities.

Pass-Through Entities For Taxation.   As pass-through tax entities, an LLC and S-Corp pay no income taxes as an entity to the IRS but do pay a tax to the Franchise Tax Board in California: LLC pays tax on its gross revenue and a S-Corp pays tax on its net income and both pay an annual $800 franchise tax.  The owners of both the LLC and S-Corp report all income and pay income tax at the individual level for both federal and state (in addition to the foregoing taxes to the Franchise Tax Board at the entity level).  Such owners also report losses from the business reported by the LLC or S-Corp on their individual returns.

Ongoing State Compliance Requirements.  LLCs and S-Corps are subject to certain obligations imposed by the state corporation statutes and LLC statutes, such as having to appoint and maintain a registered agent for service of process, filing bi-annual reports (called a Statement of Information in California) and paying annual fees, notifying the state of certain changes such as a change of entity name, registered agent or entity type and having to qualify to do business in states outside of the formation state.

Second, The Differences between LLCs and S-Corps:

Ownership.  LLCs have no restrictions on who can own a membership interest in an LLC.  None of the IRS restrictions below apply to LLCs.  This is an advantage for members (who are the owners) of an LLC.

IRS rules restrict S corporation ownership as follows:

--S-Corps can have no more than 100 shareholders (who are the owners of the S-Corp).

--S-Corps may not have non-U.S. citizens/residents as shareholders.

--S-Corps cannot be owned by corporations, LLCs, partnerships or many trusts.

--S-Corps are not allowed to have subsidiaries.

--S-Corps cannot issue different classes of stock with different financial rights – such as giving some shareholders a preference to distributions over other shareholders or issuing preferred stock.

Governance Formalities.  Corporation laws (which S-Corps have to follow) have more mandatory requirements regarding how a corporation is to be managed than LLC laws. Therefore, S-Corps face more extensive internal formalities, such as adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.  If these formalities are not performed constantly, then an S-Corp subjects itself to having its corporate form disregarded and all of its shareholders will be liable individually as partners.  This is called “piercing the corporate veil” in legal jargon.

In contrast, LLCs are not required to follow these same formalities as long as the LLC’s operating agreement states this is the case, such as no annual meetings are required. Managers or members --who act as the officers/directors of the LLC -- are permitted to authorize LLC transactions without a resolution and any meeting.  That said, an LLC needs to adopt an operating agreement, issue membership interest to members, and document all major company decisions (such as selling all its assets, merging with another LLC, filing bankruptcy, or dissolving).  These are some of the reasons that LLCs often have less management costs than an S-Corp.

Management Differences. Owners of an LLC can choose to have themselves as members manage the LLC or appoint managers to manage the LLC.  When members manage an LLC, the LLC is much like a partnership (or a sole proprietorship if there is only one member).  If run by managers, the LLC more closely resembles a corporation as its owners (LLC members) are not involved in managing the business of the LLC; and, the LLC managers manage the LLC business like corporate officers do.  An LLC is better for a small business where the owners of the business are its managers since this usually results in the LLC having less management costs than an S-Corp.

S-Corps have directors and officers.  Every year, the shareholders of an S-Corp must elect its board of directors.  The board of directors of the S-Corp oversees corporate affairs and handles major decisions but not daily operations of the S-Corp.  The directors appoint officers who manage the S-Corp’s daily business affairs.  A S-Corp shareholder may be a director or an officer of the S-Corp.

            Transfer Of Ownership. S-Corporation stock is freely transferable.  However, S-Corp status may be lost if one of the S-Corp shareholders decides to violate IRS ownership restrictions and transfer shares to an illegal owner of S-Corps. Such a transfer converts the S-Corp into a regular C-Corporation that is subject to taxation at the corporate level for both state and federal income tax.  This is a disadvantage to an S-Corp since LLCs have no such restriction.

Common stock in an S-Corp may be freely transferred without triggering adverse tax consequences.  In contrast, the transfer of more than a 50 percent interest in an LLC may trigger its termination unless the operating agreement accounts for the continued life of the LLC after such a transfer.

An LLC membership’s interest usually is not freely transferable and usually requires the approval from other members before a transfer may be made.  These other members usually have the right of first refusal to buy the selling members’ interest in the LLC.  Members may decide not to have this restriction in their operating agreement if they choose.  This flexibility over ownership is an advantage to LLCs since S-Corps prevent certain owners from acquiring common stock in an S-Corp.

Accounting and Tax Issues. An S-Corp usually does not have to use the accrual method of accounting for income taxes and can use cash accounting for its income tax reporting unless the S-Corp has inventory.  An LLC usually may use the cash method, but IRS restrictions may apply.

An S-Corp does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred unlike an LLC that is taxed as a partnership.  However, these rules permit LLC members to adjust their cost basis when LLC membership interests are transferred just as regular partnerships (which are not LLCs) do.

S-Corp shareholders cannot increase their cost basis in their common stock in an S-Corp when it borrows money.  In contrast, an LLC member’s cost basis in his membership interest increases when the LLC borrows money.  This difference means the tax on distributions from an S-Corp and an LLC will differ and the tax on S-Corp distributions will usually be higher than for an LLC.

An S-Corp requires more record keeping from an accountant than an LLC to keep track of the accumulated adjustments account, cost basis in stock, and taxability of distributions.

The IRS exercises more scrutiny over an S-Corp because it has more opportunities to characterize income than an LLC to avoid taxes.

Self-Employment Taxes.  S-Corps may have preferable self-employment taxes compared to the LLC if the S-Corp shareholder can be treated as an employee of the S-Corp and paid a reasonable salary.  Corporate earnings after payment of the salary may be able to be treated as unearned income that is not subject to self-employment taxes.

Allocation Of Profits And Losses.  S-Corps’ shareholders receive their profits and losses based on their percentage of ownership (e.g. a 50% shareholder receives 50% of the profits and losses).  LLC members may allocate profits and losses as they choose (e.g. a member with a 50% ownership interest could be entitled to 90% of the profits and losses).  Another issue with S-Corps is that they may generate a profit or gain and not distribute it to shareholders.  This will trigger income tax on this profit or gain even though the S-Corp shareholder did not receive a distribution to pay this income tax.  This tax makes it difficult for S-Corps to reinvest profits in their business since the S-Corp has to pay this tax on a transaction that did not provide any cash to the S-Corp to pay the tax.


            An LLC usually provides more flexibility and less cost to run than an S-Corp in most of the elements identified above.  This is why the LLC has grown to be the more popular business structure to use in owning a business.  That said, a detailed analysis of your business goals, current operations, tax position, and funding sources is important to perform before setting up a legal entity to own your business.  This article is intended to guide you in starting this analysis.  Contact Madison Law, APC for further information on how to set up a business entity for you and to choose a business entity for its financial situation.

Dixon Gardner, Esq.



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