Forming an S Corp in California can be a great way for small business owners to stay compliant with taxes, protect against lawsuits, and keep their personal and business finances separate.
The company is set up as a corporation so it can own assets such as property, inventory, patents, or intellectual property.
There are also several tax benefits that come with the formation of this type of company. One thing to note is that you must pay personal state taxes on your share of profits from the company.
What is an S Corporation?
In the United States, a small business corporation is referred to as an S Corp. Because this type of company is considered a “pass-through entity” it means that profits and losses are counted directly against the company owners.
If the business takes in more than $50,000 per year or has at least one employee besides yourself, you will need to file as an S Corp with the Internal Revenue Service (IRS).
How to File an S Corporation in California
To get started you will need to file Form 2553 with the IRS. This is a form that informs them of your intent to have an S Corp and your request for EIN, or Employer Identification Number.
EINs are used by businesses in place of Social Security Numbers so as not to confuse matters when making payroll deposits.
Step 1: Choose a name.
The first thing you will need to do is choose a business name. This name must contain the term “corporation,” or “company,” or an abbreviation of one of these words.
You can also add additional words up to four that describe your business. It must be distinguishable from other businesses as well as inoffensive and not violate some private right.
Step 2: Appoint directors.
Any corporation must be run by at least one director. This person is responsible for the running of the company, or in your case, responsibility will fall on you.
It is a good idea to appoint other directors and also have an operating agreement that details what actions they can take on behalf of the company.
Step 3: Appoint a registered agent.
A registered agent is a person in charge of receiving legal notices on behalf of your California corporation.
They must have a physical address within California as well as a valid phone number and email address, and be available throughout regular business hours.
Step 4: Draft and file Articles of Incorporation.
You must provide certain information to the state of California when you file your Articles of Incorporation.
This includes the name and address of your registered agent as well as all directors and officers, including yourself. You will also need to include the effective date which should be soon after the filing is made.
Step 5: File a Statement of Information.
After your company is established, you will need to file a Statement of Information with the Franchise Tax Board. You will also need to file an annual Statement of Information with the Secretary of State if your company is incorporated as a non-profit. This will let the state know that a corporation has been created.
There are different fees based on the number of shareholders as well as annual sales if applicable. The fees can range from $50 to $500 depending on these factors. You can also request an extension of time in this filing.
Step 6: Apply for S corporation status with the IRS.
There are two methods you can apply for California S corporation status.
You can pay a tax of $500 when filing your Form 2553 to elect this tax status, or you can wait until the company is profitable and then file IRS Form 2553-EZ to do so at that time.
The Advantages of S Corps
- Can be owned by a single individual, not just corporations
- Has only one layer of tax so profits and losses are not distributed among multiple shareholders reducing taxes
- The company can show a loss in the first year of incorporation if there are startup costs or other expenses that must be paid. When S corporation status is attained these losses can then be used to offset other income.
- Easy to transfer shares of company between shareholder
- A shareholder can be a foreign national or corporation as long as they are eligible to do business in the United States
The Disadvantages of S Corps
- Shareholders cannot deduct losses from their personal taxes. These pass through directly to them where they will be counted against any other income they might have
- Directors must be US citizens or permanent residents. Foreign nationals cannot be made directors under California state laws related to S Corporations
- Companies cannot issue stock options as part of their compensation packages. Instead, an owner can receive dividends even if there is a loss in the company. Dividends are not subject to payroll taxes and can be up to the maximum of $280,000 that an individual is allowed to make per year.
- If you are found guilty of violating certain laws as a corporation or director, you may have to pay penalties personally.
How much does S Corp formation cost?
Between $500 and $1000 to form a corporation and another $200 or so each year to file the annual paperwork with the state.
For more S corporation information, visit: http://www.s-corp-formation.org/california-s-corporation.html
How long does it take?
One or two weeks to form the company. 1 week for articles of incorporation and another couple of days to file them with the state. Then it takes another couple of weeks to file the Statement of Information.
After this, you will need to apply for S Corp status with the IRS, which can take anywhere from a few days to several months depending on your situation.
Are taxes for LLCs and S corps the same?
No, S Corps have a flat tax rate of 15%. Up to 75% of profits can be distributed as dividends. The difference is in how losses are handled. LLCs can use these losses on their personal returns whereas this is not possible for shareholders in an S corporation.
If you think that incorporating your business in California will allow you to reduce your income tax and take more of your profits, then an S corp may be the best choice for you.
You should keep in mind that you will need to have a lot of start-up costs or at least be able to afford to pay out a large amount of money when filing the Articles of Incorporation. This can put this option out of reach for many of the smaller companies in California.
What is a reasonable salary for an S corp?
S corporation shareholders cannot receive a salary, but they can receive dividends. Dividends are counted toward the top income bracket in California which is $280,000.
This means that a shareholder who receives $50,000 in dividends will not have to pay state taxes on those dollars. Any amount over this must be paid as wages and will have to be paid state and federal taxes.
The IRS sets out a number of factors that must be considered when determining the appropriate salary for an S corp shareholder. These include:
- Ownership percentage in the company
- Additional funds are needed to run the business based on historical data
- The industry standard in his location
- His experience level and marketability
- The time he spends on the company
- How long it would take him to find a job in another field
The best way to determine what salary you should be receiving is by speaking with an accountant or your financial advisor.
They can help you decide how to save as much money on taxes as possible without putting too much strain on your company.
What is a distribution?
Distributions are payments made to shareholders who have invested money in a company. These payments allow the investor to recoup some or all of their investment in the company and maybe paid out either as cash or through stock.
The amount distributed will usually depend on how much money was initially invested by the shareholder, how well the business is doing and if there are any debts that need to be repaid or other company expenses.
Distributions can either be paid as a dividend, in which case they do not have to be declared with the IRS or as wages if it has been determined that this is a reasonable salary for the company’s shareholder.
What is pass-through taxation?
In an S Corp, the company is taxed as a normal corporation. However, tax liability passes through to the shareholders and is not paid by the corporation.
Instead of paying your taxes on what you make for yourself, you pay them based directly on what comes in from your business. Thus, there can be great tax savings depending on how much profit you make.
What is the S corp tax rate?
S Corp tax rates are the same as personal tax rates which, in California, are 8.84%.
This means that if your company is paying you a salary of $50,000 and you have no other sources of income or additional deductions, then you will only be taxed on $43,722.
Can I still use my DBA name if I elect to be an S corp?
Yes. If you elect to be taxed as an S corp you are not required to change your name or start a new company.
However, it is necessary that all shareholders agree to this decision at the time of filing.
S corp licenses and permits
S corps are not required to have any business licenses, but you may still need them depending on your industry.
Businesses requiring special permits include:
- Doctor’s offices
- Law firms
- Real estate and credit companies
The best way to find out if you need a permit is by contacting your city or county office.
They should be able to tell you what permits are required for your specific business and if any additional licenses are necessary as an S corp.
What do I need to register as an S Corp in California?
You will need the following documents when filing for an S corp license:
- The articles of incorporation
- Operating agreement if you are a limited liability company (LLC)
- By-laws if you are a limited partnership or limited liability partnership (LP/LLP)
- The certificate of status
- The annual report
- The fictitious name statement
S Corp taxation can be a great option for businesses of all sizes.
However, this article only provides basic information about the process and is not meant to serve as legal advice.
Before making any decisions with regard to your corporation’s structure it would be wise to consult with an accountant or attorney who is well-versed in the S corp tax laws.