Considering the idea of forming an S corporation in California? While you may be able to save lots of money on payroll taxes with an S corporation, you do need a good handle on three, specific to California S corporation issues: The California entities eligible for Subchapter S status, the way the California LLC franchise tax hits LLCs and S corporation, and how converting from an LLC to an S corporation affects state-level payroll taxes.
Both LLCs and Corporations Eligible California Entities
Here’s the first thing to know about setting up an S corporation in California. Two California entities are able to make the election.
- A California corporation, for example, may elect to be treated according to the Subchapter S corporation accounting rules (as long as it meets the eligibility requirements).
- And a California limited liability company, or LLC, may also elect to be treated according to the Subchapter S corporation accounting rules.
A couple of related notes, too: First, if you make the federal election to be treated as an S corporation, the state of California recognizes the federal election. In other words, you file one election with the Internal Revenue Service and the California Franchise Tax Board accepts that paperwork.
RELATED: Advantages of S Corporations
A second thing to know about Sub S election is that not every LLC or corporation can elect. An entity needs to have only U.S. citizens or permanent residents as owners. The entity needs to have a single class of stock (that treats owners the same with regard to distributions of profit). And there’s a limit on the number owners. (An S corporation can’t have more than a hundred shareholders.)
California Annual LLC Franchise Tax Hits S Corps
Here’s another thing to consider if you’re setting up an S corporation in California: The dreaded annual LLC franchise hits both limited liability companies and S corporations. In other words, you don’t avoid the annual LLC franchise tax by electing S corp status.
Note: The amount of the California annual LLC franchise varies depending on the size of the business, but even the smallest businesses and investments trigger a minimum $800 per year tax.
California S Corp Shareholder-employees Hit by Payroll Taxes
As a generalization, small businesses convert to an S corporation because an S corporation saves payroll taxes.
A business operated as an LLC would by default be treated as a sole proprietorship or partnership, for example. And the business profits in either case would be subject to Social Security and Medicare taxes. Roughly speaking, these employment taxes run 15% on the first $110,000 and 3% on amounts above that limit.
An S corporation election, however, means that only that portion of the profit that’s specifically labeled “wages” gets subjected to these Social Security and Medicare taxes. Usually that saves money.
Unfortunately, California assesses state-level payroll taxes on these new “wages.” These state level taxes include a 6% unemployment tax and a .1% employment training tax on the first $7,000 of wages and also a 1.2% disability insurance tax on roughly the first $93,000 of wages.
A California S corporation, therefore, doesn’t save as much payroll tax as a business owner hopes. Yes, the S corporation should save federal payroll taxes to the extent that not all of the business’s profits are subject to Social Security and Medicare taxes. But the S corporation will probably trigger additional state-level payroll taxes.
Recommended Books on S Corporation
- How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners
- Taxation of S Corporations in a Nutshell (In a Nutshell (West Publishing))
- Practical Guide to S Corporations (6th Edition)
- LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- S Corporation ESOPs, 3rd Ed.