March 2009

How To Choose Between the California S – Corporation and California C – Corporation

Introduction.

In the simplest terms, the only real difference between a California S- Corporation (S - Corp) and a California C- corporation (C – Corp) is a tax election. Every California corporation is initially formed as a C - Corp. It is only after the articles of incorporation have been filed, the bylaws enacted, shares issued, and the initial shareholders hold the First Meeting of the Shareholders that a newly formed California C - Corp can elect to be treated as an S - Corporation. (e.g. can choose to file IRS Form 2553, electing to be treated as an S- Corporation so the income, or losses, of the corporation pass directly through to the shareholders' (owners') individual 1040 tax returns. The S-Election must be made and filed within approximately 75 days of incorporating, or the corporation will remain a C- Corp until the following year when the shareholders will have their next opportunity to file IRS Form 2553 S-Election.

Once the corporation is formed, In fact, an S- Corp is merely a C - Corp that within 75 days of formation has made a 2553 tax election to be treated as an S- Corp for tax purposes.

California C - Corporation.

Let there be no misunderstanding, every corporation is initially formed as a C - Corp. Unlike the S - Corp and the LLC in which the profits pass through to the individual owners, a C – Corp is a completely separate taxable entity. A C - Corp must file IRS Form 1120 and pay federal taxes on its net profits (after all expenses, including salaries and bonuses) at 15% on the first 50,000 in net income or retained earnings, and at 25% on any additional net income, or retained earnings for reinvestment into the business. If the after tax profits are to be paid out to the shareholders in the form of dividends, then the individual shareholders will be required to pay the capital gains tax rate (10% or 15%) on those dividends. Thus the notion of "double taxation." It is, however, slightly misleading because a good CPA can often use the favorable corporate tax rate to the benefit of his or her client (unless the corporation is a personal service corporation). A personal service corporation is almost always best off electing S tax treatment because a personal service corporation is subject to a flat tax of 35% regardless of income. A personal service corporation is any corporation:

1. Whose primary business is providing a personal service, such as accounting, medical treatment, dentistry, consulting, engineering, veterinary services, legal services, etc.); and
2. Whose shareholder-employees perform more than 20% of the personal services provided by the corporation; and
3. Whose shareholder-employees own more than 10% of the outstanding stock.

California S- Corporation (S - Corp).

A California corporation that has elected S tax treatment by filing IRS Form 2553 is commonly referred to as an S - Corp. An S- Corp is merely a C- Corp that has made a federal IRS 2553 tax election to be treated as a sole proprietorship or partnership for tax purposes. When a corporation elects to be treated as an S- Corp, all income and losses are "passed-through" to the individual shareholders, who then report their pro-rata share of the corporation's income, or losses, on their individual tax returns. The S - Corp itself does not pay any income tax, but an S - Corp with more than one shareholder (owner) still must file an informational tax return like a partnership or LLC, to report each shareholder's portion of the corporate income. Attorneys and other qualified tax specialists often recommend that their clients form a Subchapter S - Corp, and while this is most often the right choice occasionally such an election may cost the client a lot more in tax dollars.

Advantages To Electing "S" Corporation Status.

There are several major federal income tax advantages to making the IRS 2553 federal S-Election, including:

1. Single Level Tax. Corporate profits and losses are passed through to the shareholders (owners) of the corporation thus eliminating the potential for the "double taxation" faced by C- Corps;
2. Net Losses Can Be Deducted On Personal Income Tax Returns. While the losses of a C- Corp can only offset the corporation's earnings, the net operating losses of a S - Corp can be passed through to the individual shareholders and deducted on their individual tax returns in the year the loss occurs;
3. Minimization of Self-Employment Tax and FICA. With an S - Corp, the shareholders can minimize both self-employment and FICA taxes by creating a balance between a reasonable salary and dividends. Dividends (the corporate profits distributed to the shareholders) are not subject to either self-employment tax or FICA; and
4. A Personal Service S - Corp is not subject to the flat 35% income tax rate. With an S -Corp, the corporate profits and losses are passed through to the shareholder-employees who will pay ordinary personal income tax.

Disadvantages To Electing "S" Corporation Status.

Despite the many advantages listed above, an S- Corp (excluding personal service corporations) cannot avail itself of the following benefits afforded to C- Corp:

1. A C - Corp may exclude up to 50% of the gain on the sale of "qualified small business stock;"
2. The shareholders of a C- Corp may avail themselves of tax-free fringe benefits such as health and accident insurance, while the S – Corp is prohibited from deducting the costs of such fringe benefits provided to shareholder-employees who own more than 2% of the outstanding shares;
3. The C - Corp can have more than 100 shareholders, while an S corporation must have less than 100 shareholders;
4. The C - Corp can be owned by other corporations, non-resident aliens, LLCs, and other S - Corps, while an S - Corp can only be owned by individuals, estates, and certain qualified trusts;
5. The shareholder-employees of a C - Corp are scrutinized less by the IRS, while those same shareholder-employees of an S- Corp are scrutinized to ensure they receive a "reasonable salary" before any non-wage distributions (dividends) may be made to them; and
6. Unlike a C - Corp that can deduct and carry forward all losses, an S - Corp shareholder may not deduct corporate losses that exceed his or her "basis" in the corporate stock, which equals the amount of the shareholder's investment in the corporation plus or minus a few adjustments.

Personal Service Corporation.

For personal service corporations, the single most critical tax planning issue is not whether to make the 2553 S-Election (almost invariably a personal service corporation should elect S - status, but establishing the right balance between the shareholder-employee's salary (reported wages on the W-2) and corporate dividends ("distribution of profits."). Unlike salaries, the distribution of profits is not subject to the FICA taxes, unemployment taxes, workers compensation insurance (if applicable), or any other employment related expenses. Problem is if you elect S – status and you do not pay a reasonable salary to the shareholder-employees who provide services to, or on behalf of, the corporation, you cannot take advantage of the favorable tax treatment afforded to dividends.

When a C - Corp May Be Better.

In short, a C - Corp is often the better choice when: (1) One or more of the shareholders are not U.S. citizens, or are resident aliens; (2) the corporation envisions having more than 100 shareholders; (3) the corporation requires, or can benefit from, different classes of stock; (4) the corporation is a publicly traded company; or (5) the corporation is not a personal service corporation and its earnings are such that a qualified CPA has determined that the C - Corp offers beneficial tax treatment. This may be the case if the individual shareholders are in the upper income tax brackets because high income shareholders who have elected S status will find they are required to pay income tax on their share of an S - Corp's profits whether or not they take the money out of the corporate account. Consequently, if a corporation is not a personal service corporation and the shareholders are in the higher income tax brackets, the shareholders of that corporation may be better off remaining a C- corporation.

Conclusion.

Once an S election is made, it applies for all succeeding years unless and until the shareholders of the corporation unanimously agree to terminate the election, or the election is involuntary revoked because the corporation ceases to satisfy the eligibility requirements for S status (e.g., the S corp's stock is acquired by a nonqualified shareholder such as a corporation, or non-resident alien.). Corporate shareholders preferring pass through taxation because the individual shareholders are not in the top income brackets, the corporation is a personal service corporation, or because the shareholders expect initial business losses and desire to take such business losses on their individual tax returns to offset other income earned, should unanimously elect S corporation status. Fortunately, if you make the 2553 S-Election and later decide there are more tax advantages to being a C – Corp, the shareholders can vote to terminate the S-Election and convert back to C - Corp status.

If you would like to have Los Angeles, California business law attorney, Melissa Marsh, help you incorporate your business or form a California S Corporation, call 818-849-5206 or E-mail Your Request.

• S - Corporation or LLC?
• Is a Nevada Corporation Right For You?
• Is a California LLC or Living Trust Better For Asset Protection?

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California business lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves individuals and businesses throughout Los Angeles County, including: West Hollywood, Miracle Mile, Beverly Hills, Century City, Santa Monica, Burbank, North Hollywood, Valley Village, Toluca Lake, Studio City, Sherman Oaks, Van Nuys, Encino, and Woodland Hills.

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