Taxes are an important consideration when deciding how and when to form a business. For small businesses or businesses with only one owner, taxes matter. They do not want to form a corporation where double taxation rules apply, but they also do not want the liability that flows from a sole proprietorship or partnership. An S corporation is a solution. But understanding the qualifications, responsibilities, and purpose of forming an S corporation in California will be the ultimate key to success.

At Duvel Law, APC., our business law attorney in Orange County can review all your options when determining business structure and business formation. We can help you throughout the entire process so that planning is strategic and operations are managed well. Contact us at (714) 542-5100 to schedule a Free Consultation today.

What is an S Corporation?

An S corporation, or S corp, is a special tax status available to corporations and limited liability companies (LLCs). S corps are typically smaller businesses. Many S corps only have one owner. 

Both C corporations and LLCs can apply via the Internal Revenue Service (IRS) for S corp status. S corp status allows C corporations and LLCs to maintain limited liability provided by their original business structures but adds the additional benefit of a tax structure meant for partnerships. 

Like a partnership, an S corp is a pass-through entity for tax purposes. Its income, losses, deductions, and credits are passed to the owners–shareholders (if the business is formed as a corporation) and members (if the business is formed as an LLC). The respective owners-shareholders or members report their income, losses, deductions, and credits in their personal tax returns and are then taxed at the individual rate. The S corporation itself doesn't pay any federal corporate taxes.

While the S corp status is attractive because it avoids double taxation, not all corporations or LLCs qualify for it. To be eligible, these companies must meet specific criteria.

Qualifications for S Corp Status

To qualify as an S corporation, a business must meet specific eligibility criteria set by the IRS. The corporation or LLC must:

  • ​​Be a domestic corporation
  • Have only allowable shareholders (which can be individuals, certain trusts, and estates but not partnerships, corporations, or non-resident alien shareholders)
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)

If your organization meets these criteria, you can apply for S corporation status by filing IRS Form 2553.

C Corporations vs. S Corporations

A C corporation is the standard form of incorporation under IRS rules. The main differences between S and C corps are:

  • C corps pay taxes on profits at an entity level and shareholders also pay individual taxes on the profits they receive. S corporation status avoids this double taxation. 
  • C corps can have an unlimited number of shareholders
  • C corps can accept foreign investment
  • C corps can have more than one class of stock 

If your business meets the eligibility criteria to elect for S corp status, you should first consider the pros and cons of doing so. 

Advantages of an S Corp in California

There are many advantages to an S corp, and that's why many business owners of corporations and LLCs apply for this special status. A few of the larger advantages are described below.

  • Double taxation avoidance. When a business becomes an S corp, it doesn't pay federal taxes on its profits at the entity level. Instead, profits and losses are passed on to the shareholders who are then taxed at the individual rate. This avoids the double taxation that C corps pay. 
  • Potential tax advantages for the owners. S corporation status may also reduce the personal tax liability of shareholders or members. S corp shareholders are commonly also its employees, especially in the case of single owner S corps. These shareholder-employees can be paid both via a salary and distributions, the latter of which is not subject to self-employment tax. Business losses may also be used to offset personal income from other sources. 
  • Limited liability. As an incorporated entity, an S corp has a separate legal identity from its shareholders, protecting their personal assets from the corporation's creditors in the event it goes bankrupt or faces a lawsuit. 

Not all eligible companies will benefit the same from an S corp structure. These factors should be balanced against the potential disadvantages. 

Disadvantages of an S Corp in California

The disadvantages of an S corp are distinct from the disadvantages of most other business structures. It is important to understand these disadvantages before applying for S corp status.

  • Restrictions on shareholders. S corp status may not suit a business with high growth potential, given its limits on the number and types of shareholders it can have. For example, S corps cannot go public via a share offering. 
  • Higher formation and running costs. Setting up and running a corporation is complex and highly regulated, costing more time and money than a partnership or LLC. S corps also attract additional annual filing fees and taxes in some states. 
  • Attract close scrutiny from the IRS. The IRS closely monitors S corps to ensure they're operating properly and income is correctly classified as a distribution or salary. S corps typically seek expert financial and legal advice on how to manage this and ensure compliance. 

Before electing S corp status, you should speak with a corporate lawyer in Orange County who can advise you whether it's a suitable option for your business. 

Contact a Business Law Attorney in Orange County Today 

Your business may qualify for S corp status, and as such, it can benefit from the advantages that flow from maintaining that status. To make sure your business qualifies or to make sure you form a business using the proper business structure, speak to our corporate attorney in Orange County today. Contact Duvel Law, APC. either by filling out the online form or calling us at (714) 542-5100 to schedule a Free Consultation and to learn more about strategic business formation and smart business operations today.