When establishing a corporation in California, one of the key decisions you will have to make is whether to structure your business as a California C Corporation (C-Corp) or a California S Corporation (S-Corp) for corporate income tax purposes.
Though both offer the benefit of limiting the personal liability of their owners, they differ in terms of tax advantages and ownership restrictions.
This article aims to dissect the differences between California C-Corps and California S-Corps, providing you with essential insights to make an informed decision on the legal entity for your California-based business venture.
Introduction to California Corporations
A California Corporation is a legal entity separate from its owners, known as shareholders, which are established to conduct business in a corporate structure.
California Corporations are created under the California Corporations Code and, because they are considered separate business entities, they have their own rights, privileges, and liabilities distinct from the individuals who form them.
Just like other legal business entities, California Corporations have the ability to enter contracts, borrow and lend money, initiate legal proceedings, hire employees, own assets, and fulfill tax obligations. One of the most significant advantages of a corporation is that it shields its shareholders from personal liability for the debts, obligations, and legal judgments incurred by the California Corporation.
What is the Difference Between a C-Corp and an S-Corp in California?
In California, businesses looking to incorporate have typically two options: forming a California C-Corp or an S-Corp. Both types of California Corporations offer certain advantages and come with their own sets of rules, benefits, and potential drawbacks.
The fundamental differences between C Corporations and S Corporations in California lie in taxation, ownership restrictions, and shareholder rights.
Initial Formation of a California C-Corp vs a California S-Corp
The process of initially forming a C Corporation and an S Corporation in California is largely the same, with a key distinction in tax status election.
For both types, the process begins with choosing a unique business name compliant with California rules. Then, the Articles of Incorporation must be filed with the California Secretary of State, setting out the basic information about the California Corporation, such as the company name, purpose, number of shares authorized for issuance, and details about the registered agent.
After the corporation is formed, both S and C Corporations are required to appoint a board of directors, hold an initial board of directors meeting, and issue shares to shareholders. Additionally, both types of corporations must file a Statement of Information with the California Secretary of State within 90 days of filing the Articles of Incorporation, and pay the associated filing fee.
The key difference between forming a C-Corp and an S-Corp in California comes with establishing S-Corp status after the formation process. For a California Corporation to establish S-Corp status and be considered a California S-Corp, it must file Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service. This form is used to elect taxation under Subchapter S of the Internal Revenue Code for federal tax purposes.
The election of S-Corp status must be made by all shareholders, and it must be made within two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year for which it wants S-Corp status to take effect.
In contrast, a California C-Corp does not need to make this election because it is considered a C-Corp for tax purposes by default.
Taxation of a California C-Corp vs S-Corp
Understanding the different tax implications for California C-Corps and California S-Corps is vital for making an informed decision about which corporate tax structure will be best for your business.
The differences between the corporate tax structure can significantly impact the net income and the monetary benefits shareholders may receive from the California Corporation.
This section will cover the tax obligations, benefits, and potential drawbacks associated with each type of corporation, providing a clearer picture of what each may mean for your business.
Income Tax for a California C-Corp
Double taxation is a significant tax implication that affects California C-Corp. This term refers to the way corporate profits are taxed twice, which is once at the corporate level and then again at the individual shareholder level.
Federal Corporate Income Taxes for California C-Corps
A California C-Corp is subject to federal corporate income tax, which is a flat rate of 21% since the corporate tax reforms in 2017 and at the time of this writing. This obligation to pay corporate taxes is levied on the earnings of the California C-Corp before they are distributed to shareholders. The process of preparing and filing taxes for a California C-Corp involves several steps.
First, the California C-Corp must calculate its gross income, which includes all income from all sources, including sales, services, interest, rent, capital gains, or any other form of income. From this gross income, the corporation can then subtract the cost of sales, operating expenses, and other deductions to arrive at the taxable income.
Next, the corporation must prepare and file its corporate tax return using Internal Revenue Service Form 1120, U.S. Corporation Income Tax Return. Form 1120 is a comprehensive form that requires detailed financial information, including income, gains, losses, deductions, credits, and tax liability.
California Corporate Income Taxes for California C-Corps
In addition to facing federal taxes, a California C-Corp is also subject to California state taxes. The California Franchise Tax Board imposes a flat corporate income tax rate of the greater of $800 or 8.84% on all net income earned within the state.
The corporation must prepare and file California Franchise Tax Board Form 100, California Corporation Franchise or Income Tax Return, which is the state equivalent of Internal Revenue Service Form 1120. This form requires comprehensive financial information about the corporation, including income, gains, losses, deductions, credits, and tax liability. Like with the federal returns, it is important to ensure all information on the form is accurate and complete.
Federal and California Taxation of Dividends of a California C-Corp
When a California C-Corp declares dividends to shareholders to share post-tax net profits, these dividends are subject to taxation at both the federal and California levels.
Federal Taxation of Corporate Dividends
On the federal level, dividends are taxed at the personal income tax rate of the California C-Corp shareholders if the dividends are classified as ordinary dividends. However, most dividends paid by C-Corps are deemed qualified dividends, and these are taxed at a lower rate.
As of the date of this writing, the tax rates for qualified dividends are 0%, 15%, or 20%, depending on the personal income tax rates and filing status of the shareholder.
California Taxation of Corporate Dividends
In California, dividends are considered part of the personal income taxes of each shareholder. Just like with federal taxes, California taxes dividends on the personal tax returns, at the personal income tax rates, of the shareholder. The tax rates in California are progressive, ranging from 1% to 13.3% depending on the income of the shareholder.
Dividends are not a cost of doing business for a California C-Corp and thus are not deductible from the corporate income tax of the California C-Corp. Hence, dividends are essentially taxed twice: first, the California C-Corp must pay taxes at the corporate level when the income is earned, and second, the shareholders must pay federal taxes and pay personal income taxes at the shareholder level in California when the dividends are received. This phenomenon is referred to as double taxation.
Taxation of California S-Corps
An S-Corp in California is subject to unique taxation rules that differentiate it from the double taxation of a California C-Corp and generally provide tax benefits to small business owners. While a California S-Corp itself is not taxed on its income, the income passes through to the shareholders (similar to a limited liability company under partnership tax treatment), then shareholders pay taxes for the net profit of the California S-Corp on their personal tax returns, thus avoiding the double taxation found in California C Corporations, which is generally a lower tax liability for small business owners.
Federal Income Taxation of California S-Corps
On the federal level, a California S Corp is considered a pass-through entity for tax purposes. This means the corporation itself is not subject to federal income tax. Instead, the income, losses, deductions, and credits of the California S-Corp flow through to the California S-Corp shareholders, who pay taxes on these items on their personal income tax returns.
The calculation of the federal income tax of a California S-Corp begins with determining its net income. The California S-Corp takes its total revenue and subtracts the costs of goods sold and other allowable business expenses, such as salaries, office rent, supplies, and business travel expenses. The result is the net qualified business income.
The net business income of a California S-Corp is not subject to double taxation but instead may be distributed among the shareholders based on their percentage ownership of the California S-Corp. Each shareholder then pays taxes on their share of the business income on their personal income tax return at their individual income tax rates.
A California S-Corp reports its income, deductions, and credits to the Internal Revenue Service using Form 1120S, U.S. Income Tax Return for an S Corporation. This form is not used to calculate tax liability, but rather to report the financial activity of the California S-Corp so that the Internal Revenue Service can ensure the shareholders are reporting their income correctly.
Each shareholder of a California S-Corp receives a Schedule K-1 to Internal Revenue Service Form 1120S, which details their share of the corporation’s income, deductions, and credits. The shareholders use this form to complete their individual tax returns.
California State Income Taxation of California S-Corps
In California, an S-Corp is also treated as a pass-through entity for state income tax purposes, similar to the federal tax treatment. However, California imposes a franchise tax on S Corporations at a flat rate of 1.5% of the net income of the California S Corporation, with a minimum tax of $800. Note that even if the corporation has a loss for the year, it must still pay the minimum franchise tax of $800.
In addition to the franchise tax, the net income of a California S-Corp passes through to the shareholders, who pay taxes on their share of the income on their personal income tax return at their individual tax rates. The pass-through of income is reported to the shareholders on the same Schedule K-1 to Internal Revenue Service Form 1120S used for federal tax purposes.
California S-Corps must file a California S Corporation Franchise or Income Tax Return on California Franchise Tax Board Form 100S annually.
Federal and California Taxation of Dividends of a California S-Corp
California S-Corps do not pay dividends due to their unique pass-through entity status.
California S-Corps distribute profits directly to their shareholders because shareholders are already taxed on their distributive share of the net profit of the California S-Corp. These distributions are not classified as dividends but rather as a share of the profits of the California S Corporation.
This different treatment is part of the attraction of the S Corporation structure, as it avoids the double taxation experienced by California C-Corps and their shareholders when it comes to dividends.
Shareholder Limitations for California C-Corp vs S-Corp
For both S and C Corporations, defining who may or may not be a shareholder is a significant factor. It is essential to understand the specific limitations each type of corporation poses in terms of its shareholder structure. These constraints can affect the flexibility, growth potential, and even the tax status of a California Corporation, hence needing careful consideration in the business planning process.
Who May Be a Shareholder of a California C-Corp?
A California C-Corp has a broad range of options when it comes to shareholders.
There are no restrictions on the type or number of shareholders a California C-Corp can have. This means that individuals, other corporations, trusts, and foreign entities are all eligible to be shareholders.
Moreover, a California C-Corp may have an unlimited number of shareholders, making it an appealing choice for companies that plan to go public or need to raise substantial capital.
This flexibility in shareholder structure allows California C-Corps to attract investment on a large scale, which can be crucial for growth and expansion.
Who May Be a Shareholder of a California S-Corp?
A California S Corporation, unlike a California C Corporation, has stricter limitations when it comes to shareholders.
Limit of 100 Shareholders in California S Corporations
Pursuant to Subchapter S of the Internal Revenue Code, a California S Corporation is limited to a maximum of 100 shareholders.
Citizenship and Residency of California S Corporation Shareholders
In order to qualify as shareholders in a California S-Corp, all individuals must meet certain criteria, such as being U.S. citizens or permanent residents. Estates, certain trusts, or certain exempt organizations may also be shareholders in a California S-Corp.
Foreign investors, partnerships, LLCs, and corporations cannot hold shares in a California S-Corp due to these specific legal restrictions and regulations. This requirement ensures that the shareholders of a California S-Corp file taxes in the United States of America, which is important because the shareholders of a California S-Corp pay the tax on the net income of the corporation on their personal tax returns, in contrast to the double taxation of a California C-Corp.
California S Corporations Are Limited to One Class of Stock
California S-Corps can only have one class of stock. This means all shareholders have the same voting rights and receive an equal share of dividends, proportional to their ownership.
Choosing the Right Business Structure
If you are still unsure about whether a California C Corporation or a California S Corporation is the right choice for your business, do not hesitate to seek expert advice.
At San Diego Corporate Law, our experienced corporate attorneys can guide you through this crucial decision-making process. We can help analyze your unique business situation, answer any questions you may have, and provide insights into the potential tax implications and legal considerations of each business structure.
Contact us today to schedule a consultation, and let us ensure that your business starts off on the right foot.
