As with most business decisions, the decision regarding which legal entity is best suited for your San Diego business depends on a variety of important factors. Most San Diego business owners interested in the benefits of a formal business organization without the burden of the double taxation that accompanies the C Corporation, turn to either the California Limited Liability Company (LLC) or the S Corporation. Both offer owners protection from unlimited liability and both offer pass through taxation (no double taxation). The question then becomes which is better, the S Corporation or the LLC. The decision is best made with the guidance of a San Diego business entity lawyer and a tax professional. However, with fewer restrictions on the allocation of ownership and profit interests and greater management flexibility, the LLC seems to be the better option although this doesn’t mean it is the better option for every business.
The most significant benefit of the S Corporation is the ability to limit self employment taxes (social security and Medicare taxes). The benefit is available to stockholder/employees who minimize their salary (subject to self employment taxes) and then distribute excess profits as dividends (not subject to self employment taxes). In certain circumstances, this can be a valuable tool. For example, assume an S Corporation is owned entirely by two stockholder/employees (each owning 50% of the stock). The corporation’s profits for the last taxable year were $200,000 of which each salaried stockholder received $50,000 in wages. Each owner would pay self-employment taxes on $50,000 and each would receive a dividend for $50,000 free from self-employment taxes. Based on the current social security and Medicare rates, each owner would save $7,650. However, this benefit is limited by two important factors. First, the IRS requires that salaries paid to owner/employees of corporations be reasonable. There is no guarantee that the IRS will accept the $50,000 incomes in this example, and it has recently become more aggressive in ensuring that stockholder/employee salaries are not too low. It may instead consider the dividend distributions to be wages subject to self-employment taxes. Second, most of the self employment tax is the social security portion which is currently capped when wages reach $106,000. This means that stockholder/employees who earn an annual salary above $106,000 only save 2.9% percent (the Medicare portion) for all dividends paid above their salary.
California LLCs are also subject to a gross receipts tax. The tax is relatively small when compared to the revenues that trigger the tax. The gross receipts tax is $900 for gross receipts between $250,000 and $499,999, $6,000 on for gross receipts above $1,000,000, and $11,790 for gross receipts in excess of $5 million. Profitable businesses will barely notice this tax. For unprofitable businesses or for businesses with a very low profit margin, the gross receipts tax can be problematic since the tax is on gross revenue and not on profits.
For the stockholders in the above example, the tax savings seem to make sense. In fact, tax savings no matter how small always make sense. Nonetheless, the S Corporation suffers from several statutory limitations and lack many of the benefits LLCs offer. First, the S Corporation cannot be owned by another corporation or LLC; it cannot be owned by a foreign person; it cannot have more than 100 shareholders; it cannot issue different classes of stock; and it must distribute profits in equal proportion to ownership interests. While one owner in the example above could pay himself a higher salary for taking on greater responsibility, he would still have to take 50% of the dividends distributed. All distributions must be made simultaneously and on a pro rata basis. If one of the owners above preferred to purchase his interest in the S-Corporation directly from his existing LLC, he couldn’t. The LLC suffers from none of these limitations. The LLC members are free to allocate profits however they like, make contributions however they like and are able manage the company with the greatest flexibility.
LLCs also offer benefits when it comes to the tax consequences of most transactions and events: An LLC is permitted to adjust its basis in its assets to correspond to the step-up in basis obtained by the heir or purchaser upon the death of an LLC member or the sale of a membership interest (a section 754 election which is unavailable to S Corporations). In addition, LLCs generally do not recognize a gain on assets distributed to its members. S Corporations must recognize the gain upon distribution of assets to its stockholders.
Finally, under California’s corporation law S Corporations are required to follow certain corporate formalities including holding annual shareholder and director meetings, conducting annual elections of officers and documenting the procedures. While it is always advisable to maintain formal procedures for the operation of any business entity, LLCs are not required to do so under California law. This reduces the risk that an LLC’s official standing will be challenged. It is easier to pierce the corporate veil where S Corporations fail to maintain corporate formalities.
None of this means that businesses should blindly opt for the LLC. Consideration of the above issues is helpful in making the determination but it remains advisable to consult with an attorney and a CPA before making a final decision.