One of the most important business decisions a business owner will make is to choose a legal entity through which to conduct business. Often times, the decision is narrowed down to two types of entities: (1) the California S Corporation (S Corp), or the California limited liability company (LLC). Both the California S Corp and the LLC provide varying levels of personal asset protection for the business owner, varying tax advantages and disadvantages, and varying complexity in the day to day operations of the business, amongst other differences. The purpose of this article is to highlight some of the key differences when making the choice between a California LLC or a California S Corp.
Important Considerations When Choosing a Business Entity.
Owners of newly formed businesses often find sorting out the differences between the two entities to be overwhelming. However, as a general rule, when deciding whether or not to organize as a S Corp or a LLC it is usually most productive to narrow the focus on three key areas that will be important considerations for a business owner:
- Limiting potential personal liability to the owners from the liabilities associated with the business, and the requisite formalities associated with maintain such limited liability;
- Limiting potential taxes associated with the business; and
- Addressing any other special circumstances applicable or important to the owners.
Achieving the Goal of the Owners with Minimal Compromise.
However, before addressing these three issues, it is important to first determine how many owners the new entity will have (referred to as “shareholders” in the context of an S Corp, and “members” in the context of a LLC). The number of owners is very important. Determining the most important consideration where there is only owner is relatively straightforward. However, in representations involving more than one owner, each owner will often have differing objectives or areas which they feel are the key priority for the business. For example, given two owners, the first owner’s priority could be to obtain certain tax consequences above all else, while the second owner may be more concerned with flexibility with respect to ownership interests, or the allocation of the businesses’ profits and loss. In this situation, it is usually best for the attorney to take a step back, look at the overall purpose of the owner’s business, and choose the entity which would best achieve the varying goals of the owner with minimal compromises.
An Overview of the California S Corporation.
An S Corporation is a legal entity which limits the potential personal liability to the owners from the liabilities associated with the business, provided that it is properly formed and maintained.
1. S Corporation – To Limit Liability, Respecting Corporate Formalities is Essential.
With regards to proper corporate formation, unfortunately I have seen too many instances where a corporation was initially formed for a minimal cost, by a non-lawyer, using an online service (who usually misrepresent the service they are offering), or by some other means, but then once the basic milestone of receiving the stamped Articles of Incorporation from the California Secretary of State is achieved, there is never any follow through with any of the other documents that are required under California law. The end result is that the corporation is improperly formed, and right from the onset, the owners have needlessly exposed themselves to liability in the form that at some point in the future, an aggrieved party may successfully “pierce the corporate veil“. What does this mean? It means that an aggrieved party may look through the corporation to the personal assets of the owner.
With regards to proper maintenance of a corporation, a California S Corporation must observe certain corporate formalities. In comparison to a California limited liability company, it is often thought that the S Corp has more burdensome maintenance requirements than the LLC. In other words, the S Corp is the more formal entity between the two.
For example, if the S Corp is chosen as the entity, in order to afford maximum limited liability protection (and avoid the potential for a piercing action): (1) the corporation should properly notice, hold and document annual meetings of the shareholders and directors, in addition to any special meetings of the board of directors necessary to authorize and affirm certain corporate acts, (2) the corporation should timely file all required documents required under applicable law; (2) the corporation should be funded with a sufficient amount of capital, and should not be inadequately capitalized; (3) the owners should keep the corporation’s corporate minute book in order and up to date, and should sign all documents where the corporation is a party, in their capacity as an officer or authorized agent of the corporation; and (4) corporate funds should never be mingled with other personal funds of the owners.
2. S Corporation – Tax Considerations.
In general, a S Corporation does not pay federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to the shareholders pro rata in accordance with their ownership interest. The shareholders must then report the income or loss on their own individual income tax returns (this form of taxation means makes the S Corporation a type of “flow through” entity). This flow through taxation of an S Corporation is different from a C Corporation, because there is only a tax at the shareholder level. The owners in a C Corporation on the other hand experience what is called “double taxation” in that the entity is taxed separately from the shareholders. In other words, first the corporation is taxed, and then the shareholders are also taxed.
Although the S Corporation’s avoidance of double taxation in the form of pass through taxation is often viewed as one of its primary advantages, one consideration that can be viewed as a disadvantage is that there are strict eligibility requirements for S corporations.
It is also important to note that similar to a LLC, the S Corp must pay an $800 California state franchise tax for the privilege of doing business in California. However, and one big advantage of the S Corporation is that it avoids the gross receipts tax of the LLC, in which gross receipts of an LLC over $250,000 are taxed.
3. S Corporation – Other Considerations.
Eligibility Requirements of the S Corporation.
For a corporation to be eligible for S status it must adhere to fairly strict shareholder requirements. For example, a S Corporation must limit the number of permitted shareholders to 100; the shareholders must be individuals who are United States citizens or legal United States residents (this means that another corporation cannot be a shareholder in a S Corporation), or the shareholder must be a certain type of qualified trust or estate. When there is a qualified trust that is a shareholder of an S corporation, each potential current beneficiary of the trust is treated as a separate shareholder. Related shareholders, whether owning shares directly or by deemed ownership as a beneficiary of a trust, may be treated as a single shareholder pursuant to family attribution rules.
Another very important requirement is that S Corporations are limited to only one class of stock, and in that regard are less flexible with respect to special economic terms that you would often find in a limited liability company Operating Agreement.
Management and Control of the S Corporation.
The three key categories concerning management and control in an S Corporation are the (i) Directors, (ii) Officers, and (iii) Shareholders. Corporations are managed by a Board of Directors, who appoint officers to run the day-to-day business operations of the corporation. The Officers (including a President, Secretary, and Treasurer) are considered agents for the corporation, and are granted with authority to bind the corporation. Shareholders (in other words, the owners) elect the Board of Directors, but have no right to participate in the day-to-day management of the corporation, unless elected as a director, or appointed as an officer. In a typical small business S Corporation, it is not uncommon to for a single individual Shareholder/owner to also serve as both an Officer and/or a Director (in addition to their ownership role as a shareholder).
Transfer Issues in a S Corporation.
In the context of a S corporation, ownership is evidenced by stock certificates, which must be issued to each owner as part of the corporate formation. Usually, significant changes in ownership in a corporation are memorialized in a Stock Purchase Agreement, Asset Purchase Agreement, or occasionally, other forms of acquisition or transfer documents. Whenever stock (sometimes referred to as shares) are transferred, it is always very important to thoroughly review the corporate documents to determine if the shares are bound any Shareholder Agreement (also sometimes referred to as a Buy-Sell Agreement) which may place limitations on transferability.
An Overview of the California Limited Liability Company.
Similar to the California S Corporation, a California limited liability company is a legal entity which affords its owners protection from potential personal liability associated with the business, but again with the proviso that such entity is properly formed and maintained.
1. LLC – Relaxed Requirements Compared to S-Corporation, But Don’t Get Too Relaxed.
With regard to formation, to form a California limited liability company, the owners must file Articles of Organization (as opposed to the Articles of Incorporation filed for a corporation), agree on key business points to be outlined in a company Operating Agreement, file a Statement of Information with the California Secretary of State, amongst various other requirements which are beyond the scope of this article. Unfortunately, too many times I have seen LLC company kits in my office where the Articles of Organization for the LLC were filed and then, not much else happened after that. In such cases, typically, the membership certificates are not issued, no Statement of Information was ever filed, and an inadequate “plain vanilla” (although the online service that sold it bills it as “custom”) Operating Agreement lies in the company kit, unsigned and untouched. The situation is compounded further when several years after formation a disagreement amongst owners arises about distributions or allocations, and the key business terms (that were to become a formal Operating Agreement) are instead buried in roughly outlined emails. Needless to say, this is not something you should let happen with your business.
With regard to maintenance, a California limited liability company is often thought of as having relaxed requirements with respect to formalities in comparison to a S Corp. Although meetings are not required, we suggest that the owner(s) still properly notice, hold and document meetings of the members to bolster the personal limited liability protection.
2. LLC – Tax Considerations.
For federal income tax purposes, by default, an LLC is treated by as a flow-through entity. This means, that if there is only one member in the LLC, the LLC is treated as a flow through entity for tax purposes, and profits and losses would be reported on Schedule C of the owner’s individual income tax return. In the event there are multiple members, the default rule is that the LLC is taxed as partnership, which is required to report income and loss on IRS Form 1065. Under partnership tax treatment, each member of the LLC annually receives a Form K-1 reporting the member’s distributive share of the LLC’s income or loss that is then reported on the member’s individual income tax return. It is important to note that an LLC may elect to be taxed in other ways that are beyond the scope of this article.
Similar to the S Corporation, a California LLC must pay the $800 California state franchise tax. However, one significant disadvantage for a business operating as an LLC is that it must pay an additional California tax on gross receipts over $250,000. This is an annual tax, and its effect can be seen in the table below:
California “Total Income”
$250,000 or more, but less than $500,000
$500,000 or more, but less than $1,000,000
$1,000,000 or more, but less than $5,000,000
$5,000,000 or more
In other words, depending on income, a California business operating as an LLC could be subject to an additional $11,790 tax which is not taxable to a S Corporation.
3. S Corporation – Other Considerations.
In comparison to the S Corporation, the LLC is a more flexible entity, both in terms of who can be an owner, and the structuring of economic sharing arrangements between the members. For example, a LLC would be implicated where two partners desired to be equal owners but have a disproportionate allocation of profits and losses.
Management and Control.
As compared to a S Corporation, a California LLC is a much more flexible with respect to management and control issues. In comparison to the Officer, Directors, and Shareholders who each play separate roles in a S Corporation, an a LLC, management and control lies either with the members (in a so called “member-managed LLC”) or with the managers (in a so called “manager-managed LLC”). The key difference is that in a member managed LLC, each member is authorized as an agent to bind the LLC by virtue of membership, whereas in a manager managed LLC, there is a centralized management committee in the form of the managing members.
Similar to the S corporation, transferability of a member’s interest can be accomplished easily so long as it is not precluded in the Operating Agreement or some other legal document such as a Membership Buy/Sell Agreement. Before the transfer of any LLC Membership Interest, one should always consult the provisions of the LLC Operating Agreement to check for any transfer restrictions.
What Entity Should I Choose For My California Business?
In any new business, it is important to always keep the three key areas in mind, namely: (i) limited liability and the formalities required to maintain it; (ii) the tax consequences; and (iii) special circumstances applicable to the owners. There is no “one size fits all” legal entity, and the choice must be made with careful deliberation about the long term ramifications.