What are the tax implications in California between an LLC and a Corporation?

Naomi Kokubo

Naomi Kokubo

by Naomi Kokubo, Editor of Founders Space

It’s probably best to understand the difference between LLC, S Corporation and C Corporation first before we can sort out the tax implications between LLC and Corporation.

There are two legal business entities that relate to this question.  One is LLC (limited liability company) and the other is C Corporation (traditional corporation).  S Corporation is an election by limited liability companies or traditional corporations to be taxed as such.  In other words, both limited liability companies and traditional corporations can choose to be taxed as S Corporation.

And here’s an excerpt from “3 minutes version” that summarizes the differences, which might be helpful to you:

LLC

First, there are no tax advantages (or disadvantages) to forming an LLC. In fact, forming an LLC won’t change a thing for Federal income tax purposes. Single-owner LLCs are taxed just like sole proprietorships, and multiple-owner LLCs are taxed just like partnerships.

You should, however, be aware that forming an LLC might subject your business to additional state taxes. Certain states (California for instance) subject LLCs to “franchise taxes” in addition to a typical income tax.

S-Corp

S-Corporations have the ability to provide some tax savings as a result of the fact that profits from an S-Corp are not subject to Self-Employment Tax. However, before you’re allowed to distribute any profits, you are required to pay any owner-employees a “reasonable salary.” This salary will be subject to social security and Medicare taxes (which total the same amount as the Self-Employment Tax). As such, the tax savings only take effect once the business has a pretty sizable income.

Also, you should be aware that S-corporations are significantly more complicated from a tax and legal standpoint than LLCs. So if you form an S-corp, know that you’re going to be spending a great many more billable hours with your accountant/attorney.

C-Corp

Unlike most other business structures, C-corporations are taxable entities. This means that the corporation itself is taxed on its income (as opposed to other structures which simply pass the income along to the owner(s), who are then taxed on it).

If you don’t plan to distribute all of the profits from your business, you might benefit from forming a C-corp and utilizing a strategy known as “income splitting.” The idea is to split the business’s income so that part of it is taxable to the corporation and part of it is taxable to the corporation’s owner(s), thus putting them each in a lower tax bracket than they’d be in if either one was earning all of the income.

The big disadvantage to C-corp taxation is that distributions of profits (known as “dividends”) are subject to double taxation. In other words, the corporation is taxed once on its income, and then the shareholders are taxed upon any dividends they receive.

Also, like S-corporations, C-corporations are more complicated from an accounting/tax/legal standpoint than sole proprietorships, partnerships, or LLCs. As such, C-corp owners tend to incur fairly high legal and accounting costs.

Regarding the tax differences between LLC and S Corp, BusinessKnowHow offers the following information:

From S-Corporation, Taxation section

Pass through: Profits and losses pass through the corp and reported to the individual tax return of shareholder (same as partnership and LLC)

Self-Employment Tax Break: Profits of the S-Corp which pass through to the shareholders are not subject to self-employment tax (Social Security and Medicare which is approximately 15%). Rather, self-employment is only taxed on the portion classified as a “reasonable salary”. LLCs and sole-proprietorships must pay self-employment tax on all income. The ability to minimize self-employment tax is deemed to be one of the greatest benefits of a s-corporation.

Corporate Losses: losses in the corporation can be deducted from the individual tax returns of the shareholder thereby allowing them to offset other sources of income such as their W-2 income.

Franchise Tax: Franchise Tax is waived your first year. LLC on the other hand, must pay franchise tax its first year. S-Corp must pay the CA Franchise Tax board either a 1.5% tax on net CA income or $800, whichever is greater.

Distribution of Profits and Losses: No special allocation of profit and losses for shareholders. Corporate profits and losses must be split up proportionately to the percentage of shares owned by each shareholder. LLC’s on the otherhand allow for flexibility as to how they split their profits and losses.

From LLC, Taxation section

Pass through: Profits and losses pass through the LLC and reported to the individual tax return of shareholder (same as partnership and Corps).

Self-Employment Tax: LLC members must pay self-employment tax on all income from the LLC.

LLC Losses: losses in the LLC can be deducted from the individual tax returns of the member thereby allowing them to offset other sources of income such as their W-2 income.

Franchise Tax: Must pay first year minimum annual tax of $800, and is due 75 days after formation and every year thereafter. Annual franchise tax is greater if total reported income is greater than $250,000. See http://www.ftb.ca.gov/forms/06_forms/06_3522.pdf.

Distribution of Profits and Losses: It is flexible since an LLC allows you to decide what share of the LLC profits and losses each owner will receive.

About the California specific tax issue, here’s an excerpt from Wikipedia on S Corporation:

S-corporations pay a franchise tax of 1.5% of net income in the state of California (minimum $800). This is one factor to be taken into consideration when choosing between a limited liability company and an S-corporation in California. On highly profitable enterprises, the LLC franchise tax fees, which are based on gross revenues (minimum $800), may be lower than the 1.5% net income tax. Conversely, on high gross revenue, low profit-margin businesses, the LLC franchise tax fees may exceed the S corp net income tax.

You may also want to read up on Tax Differences Between LLC and S Corporation and another article at PowerHomeBiz.  You may find this excerpt from PowerHomeBiz article helpful:

A major factor that differentiates an S corporation from an LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self-employed and, as such, must pay a “self-employment tax” of 15.3% which goes toward social security and Medicare. The entire net income of the business is subject to self-employment tax.*
In an S corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings. Case in point:

Mary owns a print shop. In keeping with the industry standard, Mary decides that a reasonable salary for a print shop manager is $35,000 and pays herself accordingly. Mary’s total earnings for the year are $60,000: $35,000 paid in salary and the remaining $25,000 paid as a distribution from the S corp. Mary’s total employment tax is $5,355 (15.3% of $35,000).

If Mary were the owner of an LLC, she would have to pay employment tax on the entire $60,000, equaling $9,180. But as an S corporation, she realizes savings of $3,825 in employment tax.

One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions—but this would be an incorrect assumption. In practice, the IRS is careful to notice whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary.

Still, while the potential employment tax savings may make the S corporation an attractive structure for your business, bear in mind that you would then have to deal with all the paperwork associated with payroll tax. The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year–on time, or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with this; and if you expect to incur losses or otherwise experience a cash flow crunch during the year that would hinder you from paying the payroll tax when due, this could present a problem.

Owners of LLCs pay their self-employment tax once a year on April 15 when income taxes are normally due. Income tax filings are also relatively easy for the owners of an LLC: A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.
There is no one, magical entity that works for everyone. A CPA or a specialized tax attorney can assist you in choosing the right structure for your business. The important thing is to consider the operational, legal and tax aspects of each structure as they apply to your unique situation.

* The self-employment tax rate for 2009 consists of two parts: 15.3% for social security and 2.9% for Medicare. In 2009, only the first $106,800 of total net income is subject to the social security portion of the tax. All of the the total net income is subject to the Medicare portion of the tax.

*For those who prefer the tax treatment of an S corp but like the simplicity of an LLC, there is an alternative worth considering: Forming an LLC that is taxed as an S corp. An LLC may make a special election with the IRS to be taxed as an S corp. This election is made on IRS Form 2553 and must be filed with the IRS before the 16th day of the third month of the tax year in which the election is to take effect.

An LLC that is taxed as an S corp is still a limited liability company from a legal standpoint (subject to the laws governing limited liability companies in the state of formation); however, for tax purposes it is treated as an S corp.

A word of caution: Certain nuances of S corp taxation can be confusing to some LLC owners, especially do-it-yourselfers and/or those who prepare their own tax returns; for example, an LLC owner might easily make the mistake of referring to an IRS publication that addresses LLCs when, in fact, such a publication would not apply to an LLC that is taxed as an S corp–and such an error could lead to negative tax consequences. It is therefore highly recommended that you consult a CPA or other qualified tax professional for advice and/or assistance.

Note: Before making any business decisions based on information on this site, it is your responsibility to check with your counsel or professionals familiar with your situation.

Tip: Consider using a filing service such as Legal Zoom where they file all the documents with the state, get your record book, and more.

Comments & Advice:
  1. Ethan Stone Ethan Stone says:

    This answer assumes a single-member LLC. A single-member LLC is, indeed, a “disregarded entity” for federal and California income tax purposes, so that there are truly no income tax implications to forming one. If the LLC has two or more members, however, it is no longer disregarded entirely. It must elect to be treated as a partnership, an s-corporation or a c-corporation. Typically, people forming multiple member LLCs elect partnership treatment. This generally means that tax items will be passed through to the LLC's members. But the pass through isn't complete and can get very complicated. It also isn't transparent. The LLC has to prepare and file federal and California “information” tax returns and send “Schedule K-1″s to its members (telling them what they need to include on their own tax returns).

    It should be noted that the potential complication of the pass-through in an LLC that elects to be treated as a partnership is not all bad. It can allow more complex financing structures, in which different investors have varying economic rights and get varying tax pass-throughs. An LLC that elects to be treated as a partnership allows much more flexibility in this regard than an s-corporation because the s-corporation rules allow only one class of stock, which makes it difficult or impossible to vary the rights of equity investors.

    It's also worth noting that the pass-through treatment of both LLCs often make them unattractive to institutional investors, such as venture capital funds, because of the tax implications for the funds' investors. There are workarounds for these problems, but they can discourage investment by making it more complicated. Institutional investors are, generally speaking, ineligible to invest in s-corporations.

  2. Vishal says:

    Naomi, thanks for an insightful article. But this doesn’t focuses much on C-corporations. I’m too keen to learn more about c-corporations, their legal compliances round the year, and the tax implications on the corporation and its founders/shareholders.

    If a startup starts with a C-corporation so that it can issue equity while raising funds, and if its founders/shareholders do not extract substantial income out of it in the form of dividend issued to themselves, and thus allow the profits to get reinvested into the business for further growth, and one day the founders and its investors decide to exit, then, will their capital gain that their sale of the business generates be taxed?

    I’ll be greatly thankful to you if you can write up an article on “Lifecycle of a C-corporation”, that educates a fresh new entrepreneur with legal compliances, expenses, tips on reducing legal expenses and the best practices and tips on managing a c-corporation.

    I just now googled and found this :
    http://www.taxschool.illinois.edu/merch/2011ccorpwebinar.html

    It discusses about a webinar addressing the following issues :

    Formation considerations including contributions of property and services, transfer of liabilities, basis and depreciation of contributed property

    Taxable income computation issues such as tax years and accounting methods, controlled groups, PSCs, special deductions and AMT

    Distributions, redemptions

    Dissolution and liquidation

    Penalty taxes

    Purchase and sale of a business; taxable and nontaxable transactions

    Corporate divisions

    Change of ownership – survival of tax attributes

    ==========

    An article shedding light on these issues will be of great value for new budding entrepreneurs!
    Thanks in advance.
    Regards,
    Vishal.

  3. vivian says:

    Great Article, simple, clear and up to the point.

    I have a question about single member LLC. what if the income source during a tax year is a mix of c2c income and w2 income?

    let’s say 10k income come from corp to corp contract and 20k income come from w2 (without beneift). so when you say: the LLC members must pay self-employment tax on all income from the LLC. that means need to pay self employment tax on 10k corp to corp income only? since w2 income already deduct the tax of social security and medicare?

    so what would be the tax benefit here for the single member LLC? for the 10k income, I assume you can claim some expenses to reduce the net income amount? from this perspective, once I have a single member LLC, I should NOT take W2 contract since I can’t claim any expenses in this case to reduce the net income?

  4. As a licensed insurance agent, I have been advised that in California I cannot file for LLC status. That if one’s endeavor requires a professional license from a government entity they must file as a corporation. Is this true? Also, I am a one person operation at this time, but expect to hire additonal agents, (licensed), and one clerical person next year. What are the implications?

    Thanks
    TSR

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