California Business Entity Forms and Types, Which Choice is Best For Your Business?

The following questions are designed to help you decide whether a Subchapter S corporation or a limited liability company (LLC) or another entity &ndash such as a sole proprietorship, C corporation or limited partnership &ndash is best for your business.

  1. If you are a sole owner (or you and your spouse are the sole owners), sole proprietorship may be the way to go: the tax advantages are usually better than with a corporation or LLC, and you avoid the cost and administrative time of establishing and maintaining a separate entity. (You also have to pay the State an $800 annual minimum tax for the privilege of having an LLC or corporation.) Although with a sole proprietorship your personal assets are not protected from litigation, often sufficient protection can be provided through insurance. Still, there are other considerations.

    Will there be other owners or investors besides you (and your spouse)? If so, you almost certainly want to form an LLC or corporation. Otherwise you have a general partnership and you are personally liable for any contracts your partner enters or acts your partner takes with respect to the business. In addition, a Subchapter S corporation may well be better than a partnership in terms of the self-employment tax that must be paid. (More about this later.)

    Will forming a business entity give you more credibility with potential (or current) customers, vendors or business partners? If so, forming a business entity may be worthwhile.

    Is your business in a field where high-stakes litigation is possible? The more likely this prospect is, the more reason to form a business entity &ndash if only for peace of mind.

  2. Do you expect the company to provide extensive benefits (health insurance, etc.)? Do you need to carry large amounts of revenue from one year to the next, for example, for research and development?

    If so, a "C" corporation should be considered. If you can set salaries and bonuses so that there is no profit, a "C" corporation may be best, since certain fringe benefits are tax deductible but are not counted as income for employees. Employer payments for health insurance premiums and other medical expenses is deducted as a business expense, but isn't included in employees' gross income. Employer payments for the following are treated the same way: (a) employees' life insurance benefits; (b) accident and disability benefits; (c) death benefits; and (d) supplementary unemployment benefits; (e) employee parking expenses and employer-provided transit passes (up to certain limits); (f) child care; (g) meals and travel lodging.

    Although salaries and bonuses can often be set to minimize profits, if a C Corporation has profits there is double taxation. (Passive investors will often insist that there be profits.) More specifically, the "C" corporation pays taxes on its profits and the owners pay taxes on their salaries and any dividends. With Subchapter S corporations and LLC’s, the profits and losses flow through to the owners in proportion to their percentages of ownership.

  3. If you are licensed under the California Business & Professions Code or under the California Chiropractic Act or the California Osteopathic Act, you cannot form an LLC to practice those licensed services. (Corp. Code Section 17375.) This group includes doctors, lawyers, accountants, licensed contractors, etc.

  4. Non-resident aliens may not be owners of a Subchapter S corporation (although they may be beneficiaries of a small business trust that CAN be an owner of a Subchapter S). For this purpose, the IRS definition is used: basically, a non-resident alien is any non-citizen or legal permanent resident who has not been physically present in the United States on at least:

    • 31 days during the current year, and
    • 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:
      • All the days he/she was present in the current year, and
      • 1/3 of the days he/she was present in the first year before the current year, and
      • 1/6 of the days he/she was present in the second year before the current year. (26 U.S.C. Section 7701(b)(3).).

    Persons who meet the SPT will be taxed primarily the same as legal permanent residents and citizens, which may include withholding of FICA from employment compensation.

  5. Will the entity initially have any investors that are not individuals (corporations, LLC's, etc.)? In the future, is the entity likely to have investors that are not individuals? If so, how far in the future? (Subchapter S corporations can only have individuals and certain trusts as owners.) If you will be having entities as investors on startup or soon after, then an LLC is the only option for preserving profit/loss pass-throughs.

  6. Will the entity eventually have more than 75 shareholders, counting a husband and wife as a single shareholder? A Subchapter S corporation cannot have more than 75 owners; an LLC can.

  7. If you expect to have paper losses during the first year (or beyond), multiple your anticipated percentage of ownership in the company by the total of those paper losses. Does this amount exceed the value of items (cash, equipment, IP, etc.) that you personally will be contributing to the company? If so, by how much? (With a Subchapter S, you can only deduct losses up to the amount of your investment; with LLC's you can deduct all losses.)

  8. Will the entity be receiving more than 25% of its income from passive investments? The IRS can terminate a corporation’s S status if its income from passive investments is more than 25% of its total income for more than three years in a row. This makes a Subchapter S corporation unattractive for real-estate businesses. (Passive income is income from dividends, interest, royalties, rent payments, annuities, etc. – as opposed to income directly generated by your labor.)

  9. With a Subchapter S corporation, each owner has the same percentage of ownership, voting power, and profits and losses. With an LLC someone can have, for example, 25% of the ownership (meaning 25% of the proceeds if the LLC is sold), 10% of the voting power and 5% of the profits and losses. (It is possible to control voting in a corporation with a voting trust, though it can be complicated.)

  10. Do you want to offer a stock option plan to employees? Only a corporation can set up an Incentive Stock Option Plan ("ISOP") where the employee does NOT pay taxes at the time the option is exercised but only when the employee sells the stock. Still, even a corporation can only offer an ISOP to employees and not to outsiders. Also, an LLC (as well as a corporation) can offer options/warrants, although the employee is taxed at the time he/she exercises the option on the difference ("spread") between the amount the employee paid for the stock (the exercise price) and the value of the stock at that time. An LLC (as well as a corporation) can also use a profit-sharing ("Phantom Stock") plan. Still, if you want to offer an ISOP, you need a corporation.

  11. Are you planning to allow anyone to purchase ownership by providing future services or giving a promissory note? With a corporation, an agreement to provide future services cannot be used to purchase stock. If a promissory note is used to purchase stock, the note must be adequately secured by collateral other than the stock itself, unless it is given pursuant to a stock purchase plan or a stock option plan. (California Corp. Code Sections 409(a).) An LLC has no such restrictions. (California Corp. Code Section 17200(a).)

  12. Also, a Subchapter S corporation can only have one class of stock. Differences in voting rights are not considered different classes for purposes of S status. On the other hand, debt that is convertible to stock and stock with different distribution rights ARE considered different classes of stock. Straight debt is not considered a second class of stock so long as the borrower cannot alter the due date and the interest payments are not contingent on profits or on the borrower’s discretion. (Deferred compensation is not considered a different class of stock, though.)

  13. Does your tax advisor feel that, based on your personal tax situation, an Subchapter S corporation or an LLC would be better for you? (Though the two are taxes similarly, they are not taxed quite the same.)

  14. Corporations do not have to pay the California $800 minimum franchise tax during their first year. RTC §23153(f)(1). LLC’s do. (A Subchapter S still has to pay 1.5% of any profits it has during the first year.)

  15. Will the entity have large revenues compared with profits? (LLC’s pay an extra California tax based on revenues; Subchapter S corporations pay an extra California tax based on profits.)

    Tax on LLC Total Income (in addition to the $800 minimum per year)

    $250,000 up to $500,000 $900 0.36% at $250,000; 0.24% at $375,000
    $500,000 up to $1 million $2,500 0.5% at $500,000; 0.333% at $750,000
    $1 million up to $5 million $6,000 0.6% at $1 million; 0.2% at $3 million
    $5 million or more $11,790 0.2358% at $5 million
    Average at midpoint (first three levels): 0.2576%

    As you can see, the average LLC tax percentage is approximately 1/4 of one percent of revenues. In California, the Subchapter S tax rate is 1.5% of profits. (In contrast, the maximum rate that California taxes a C corporation is 8.84% of profits -- and there are federal taxes as well.) Up to $5 million income, using the average at midpoint, if profits are less than 17.17% of income, a Subchapter S is better; if profits are more than 17.17% of income, an LLC is better. (profit% x 1.5% = 0.2576%). After one reaches $786,000 in profits, the LLC is better. Of course, compensation and bonuses may be set so that there is no profit.

  16. If the new entity will have enough revenue to make it worthwhile, there is a way to deal with the LLC tax while still retaining some of the advantages of an LLC over a Subchapter S corporation. (These advantages are that owners can be entities &ndash versus individuals -- and non-resident aliens and that each owner may have a different percentage of profits/losses, voting power and ownership; however, losses with a limited partnership are limited to the amount invested by that partner, unlike the complete deductibility of losses with an LLC.) Assuming you expect the entity to have annual income in excess of $500,000, one can create a limited partnership with an LLC (or corporation) as the general partner holding a 1% interest. (You want an entity as the general partner because the general partner has unlimited liability for the partnership.) Only the general partner has any management rights. (As a result, each owner often owns a piece of both entities, but it does not have to be that way.) Since a limited partnership is not subject to the LLC income tax, the savings may outweigh the cost of setting up a second entity, filing two tax returns each year and paying the minimum $800 minimum tax for both entities.

  17. Will you be receiving substantial profit pass-throughs?

    With an LLC, each owner who a) is empowered to sign contracts on behalf of an LLC (which includes managing members and members of LLC’s that are member-managed) or b) spends more than 500 hours in a year on the LLC’s business probably has to pay the self-employment tax on ALL money that he/she receives that is in addition to his/her compensation as an employee (where withholding is already being done). The self-employment tax is equivalent to withholding for employees for Social Security and MediCare, but includes both the employer and employee portions; currently this is currently 15.3%.

    While it is possible to try to avoid this by designating someone as the manager who is not a member (e.g., an affiliated corporation), that still does not help members who work more than 500 hours in a year on the LLC’s business.

    There is an exception if the income arises from real estate rentals. For example, if your business is solely involved in real estate leasing, the rental income generated estate would not be subject to the self-employment tax in an LLC. (In contrast, income from the rental of personal property would be taxable.)

    In contrast to an LLC, if you are a shareholder of a Subchapter S corporation you do not have to pay the self-employment tax on profits that pass through to you as a shareholder. Of course, if you’re an employee of the Subchapter S corporation, you must pay the withholding tax on money you receive as compensation for services. (You MUST take a "reasonable" amount of salary – within the salary ranges for that position in that industry in that geographic location – as compensation if you are working for the corporation.) One negative side to this is that the amount that can be contributed to a retirement plan is based only on the money you receive as salary and not on the money you receive as profit pass-through.

    As a result, unless you are going to be having entities as investors immediately or in the reasonably near-term future (which would require an LLC), the self-employment tax generally will frequently mean that a Subchapter S corporation is best.

  18. Conversion from an LLC to a corporation is not a problem from a tax perspective. (You still have the fees to handle the conversion, of course.) Going from a corporation to an LLC will be a taxable event IF the value of the corporation has appreciated since its formation.

  19. Is the entity being formed for the purpose of investing in real estate, with more than one owner (counting a husband and wife as one owner)? If so, taking title as tenants in common may be appropriate. (Tenancy in common is not a legal entity, but a way for multiple people to own real estate.) Tenancy in common (TIC) allows owners to be able to buy and sell their individual interests freely as part of 1031 exchanges. TIC without more is risky, since the TIC owners are deemed to be part of a general partnership. As a result, each owner’s assets are fully at risk for whatever liability that the other TIC owners create or that arises from the real estate. For individuals, the safest approach is to form a corporation or LLC and then have that entity take TIC ownership.

Comparison of "Pass-through" Entities

(all pay $800/year minimum tax in California)

Subchapter S Corporation

Limited Liability Company

Limited Partnership

Can be formed to practice a licensed profession? Yes No No
Non-resident aliens can be owners? No Yes Yes
Entities allowed as owners (as well as individuals)? No Yes Yes
Paper losses deductible beyond investment amount? No Yes Yes
Can more than 25% of income be from passive investments? No Yes Yes
Different types of ownership allowed? No: only one class of stock allowed (although voting rights can be different) Yes Yes, but limited partners can have no say in management.
Stock option plans allowed? Yes, all allowed, including ISOP Only NSOP and Phantom Stock allowed Only NSOP and Phantom Stock allowed
Additional taxes for California entities 1.5% of profits ~0.25% of revenues none
Must pay $800 California minimum tax during first year? No, but still must pay 1.5% of profits Yes Yes
Self-employment tax Not paid on any profit pass-throughs, although a reasonable salary must be paid on work for the corporation. Paid on all profit pass-throughs received, at least if owner has contract-signing authority (is a managing member or LLC is member-managed); also probably paid if owner without contract authority spends more than 500 hours in a year on the LLC’s business. For limited partners, not paid on profit pass-throughs. General partners, if individuals, must pay self-employment tax on the profit pass-throughs.