Factors to Consider Before Starting an S Corp
Before forming an S corp, you have to consider the following factors:
- Is an S corporation the best strategy for your business?
- S corporation restrictions
- Why an LLC is the best structure for the S corp tax status
- Are S corp tax advantages right for you?
Is an S Corporation the Best Strategy for Your Business?
For help with choosing the right structure for your business, visit our Choosing a Business Structure guide.
S Corporation Restrictions
S corps have several restrictions, such as being limited to one class of stock and 100 shareholders. Read our What Is an S Corporation guide for full details.
Why an LLC Is the Best Structure for the S Corp Tax Status
As entrepreneurs, we believe that starting an LLC is the best way for forming an S corporation because any advantages of forming a corporation are negated by S corp restrictions. LLCs are also easier to maintain than corporations.
Are S Corp Tax Advantages Right for You?
You need to know if the S corp tax status versus a default LLC tax status will be better for your business. To fully understand the tax advantages of an S corp, read our LLC vs. S corp guide or check out our S corp tax savings calculator.
How to Form an S Corp
If you’re considering forming an S corp, you should know that an S corporation is a tax classification under Subchapter S of the Internal Revenue Service (IRS). S corp business owners elect this tax status for either an LLC or a corporation, since it provides tax benefits. You can form your California S corp by completing and filing Form 2553 with the IRS. In California, an S corp has a franchise tax of 1.5%.
Corporations with a C Corp IRS tax classification have double taxation (business is taxed and shareholders are taxed again on business distributions) and LLCs have pass-through taxation (all profits, credits, distributions, deductions, and losses pass directly to the owner). An S corp requires business owner(s) to have a reasonable salary based on their position and the appropriate market compensation to qualify for this type of tax classification, which results in more IRS scrutiny. Sole proprietorships and partnerships do not qualify for S corp tax status since they are informal business structures.
The following are some S corp tax advantages:
- S corps are not taxed at the business level (as opposed to C corps). S corps pass through earnings, losses, and deductions to the owner(s)
- Business owner(s) pay employment taxes and income tax on their salary
- Distributions, which are net profits (profits after operational costs, deductions, credits, income), only pay income tax on each individual owner’s income tax return within their respective tax bracket. This is where the tax savings occur since there is no employment tax paid on this portion!
S corps are required to have no more than 100 shareholders who are U.S. citizens or permanent resident aliens, among other restrictions.
There are Two Main Ways to Form an S Corp:
- By forming an LLC and electing S corp tax status from the IRS when you request your employee identification number (EIN)
- By forming a corporation and electing S corp status from the IRS
We recommend not starting a corporation with the S corp tax status because the S corp negates all of the benefits of a corporation.
Recommended: If you have an existing LLC, visit our How to Convert an LLC to S Corp guide.
Steps to Form an LLC and Elect S Corp Tax Status in California
Starting a California LLC and electing S corp tax status is easy. You can use our guides to start an LLC with the S corp status yourself, or you can hire a service provider like Collective to do it for you.
There are five basic steps to start an LLC and elect S corp status:
Step 1: Name Your LLC
Step 2: Choose a Registered Agent
Step 3: File the Articles of Organization
Step 4: Create an Operating Agreement
Step 5: Get an EIN and File Form 2553 to Elect S Corp Tax Status
Step 1: Name Your LLC
Choosing a company name is the first and most important step in starting your LLC in California.
Be sure to choose a name that complies with California naming requirements and is easily searchable by potential clients.
1. Follow the naming guidelines for a California LLC:
- Your name must include the phrase “limited liability company,” or one of its abbreviations (LLC or L.L.C.)
- Your name cannot include words that could confuse your LLC with a government agency (FBI, Treasury, State Department, etc.).
- The name cannot include the following words: bank, trust, trustee, incorporated, inc., corporation, or corp.
- The name cannot include the words “insurer” or “insurance company” or any words suggesting that it is in the business of issuing policies of insurance and assuming insurance risks.
- The name must be distinguishable from any other LLC registered with the Secretary of State. You can read more about what makes a name distinguishable on the California Secretary of State website.
You can also read the California state statute about LLC naming guidelines for more information.
2. Is the name available in California? You can use the business entity search on the California Secretary of State website to see if your desired LLC name is available.
3. Is the URL available? We recommend checking to see if your business name is available as a web domain. Even if you don't plan to create a business website today, you may want to buy the URL in order to prevent others from acquiring it.
Find a Domain Now
Step 2: Choose Your California Registered Agent
You must elect an agent for service of process, also known as a registered agent, for your California LLC.
An LLC registered agent will accept legal documents and tax notices on your LLC's behalf. You will list your registered agent when you file your LLC's Articles of Organization.
Many business owners choose to hire a registered agent service. Many of these services will form your LLC for a small fee and include the first year of registered agent services for free.
Hire a professional service provider like Collective for all your S corporation needs, including:
- S corp formation or to convert an existing business
- Registered agent services and obtaining an EIN
- Managing your monthly accounting (payroll, bookkeeping)
- Personalized service with a back office team
- Keeping your business compliant with regulatory obligations
- Helping you find potential business tax savings, and more.
Connect with Collective to learn more!
Step 3: File the California LLC Articles of Organization
The California LLC Articles of Organization is used to officially register an LLC.
OPTION 1: File Online With the California Secretary of State
- OR -
OPTION 2: File Form LLC-1 by Mail or in Person
State Filing Cost: $70, payable to the Secretary of State (Nonrefundable)
Secretary of State
Business Entities Filings
P.O. Box 944260
Sacramento, CA 94244-2600
Secretary of State
1500 11th St.
Sacramento, CA 95814
Step 4: Create an LLC Operating Agreement
An LLC operating agreement is a legal document that outlines the ownership and member duties of your LLC.
For more information, read our California LLC Operating Agreement guide.
Our operating agreement tool is a free resource for business owners.
Step 5: Get an EIN and Complete Form 2553 on the IRS Website
An EIN is a number that is used by the US Internal Revenue Service (IRS) to identify and tax businesses. It is essentially a Social Security number for a business.
EINs are free when you apply directly with the IRS.
Elect S Corp Tax Status
During the online EIN application, the IRS will provide a link to Form 2553, the Election By a Small Business form.
Visit our Form 2553 Instructions guide for detailed help with completing the form.
This is the form to elect S corp tax status for your LLC:
Start an S Corp FAQ
What is an S corp?
An S corporation (S corp) is a tax classification for which an LLC or a corporation can apply.
Is an S corp an LLC?
No. An S corp is a tax designation for which an LLC or a corporation can elect. LLCs and corporations are formal business structures.
How do you form an S corp?
You can form an S corp by filing Form 2553 with the Internal Revenue Service (IRS).
What are the requirements for an S corp?
S corps must meet four requirements:
- They can have no more than 100 shareholders.
- All shareholders must be private individuals (not other business entities).
- Shareholders cannot be nonresident aliens.
- The business may only issue one class of stock-this means all members must have the same distribution amount.
What are the benefits of an S corp?
Owners of S corps are considered employees of their company and can save thousands of dollars on self-employment taxes as a result.
Are taxes for LLCs and S corps the same?
No. The default taxes for an LLC and taxes for an S corp are not the same.
With an S corp, owners pay personal income tax and self-employment tax on a predetermined salary. They may then withdraw any remaining profits from the business as a “distribution,” which isn’t subject to self-employment tax.
With an LLC, all company profits pass through to the owners’ personal tax returns, and then the owners must pay personal income tax and self-employment tax on the entire amount.
Both LLCs and S corps benefit from a provision in the Tax Cuts and Jobs Act of 2017 that allows qualifying owners of pass-through entities to deduct 20% of qualified business income (QBI) from their tax returns. However, for S corps, the deduction doesn’t apply to profits paid out as wages.
What is a reasonable salary for an S corp?
Unlike the default LLC business structure, in which owners must pay self-employment tax on all of the company’s profits, owners of S corps are considered employees of the business and only have to pay self-employment tax on a salary they receive. Any other money they take from the company’s profits in the form of disbursements isn’t subject to self-employment tax.
S corp owners are required to earn a “reasonable” salary, which basically means a fair market rate based on the individual’s qualifications as well as their duties and responsibilities at the company. The purpose of this requirement is to prevent S corp owners from paying themselves an artificially low salary in order to pay less self-employment tax.
What is a distribution?
A distribution is a dividend that a shareholder/owner can take from the business profits that remain after a company pays all of its employee salaries. Shareholders must pay personal income tax on distributions, but distributions aren’t subject to self-employment tax.
What is pass-through taxation?
Pass-through taxation is a system of taxation that generally applies to sole proprietorships, partnerships, LLCs, and S corps. In this system, the profits or losses of the business are not taxed at the business level. Instead, they pass through to the owners’ personal tax returns and are taxed at each owners’ personal income tax rate.
What is the S corp tax rate?
There’s no corporate tax rate for S corps. Instead, owners of S corps pay personal income tax on the company’s profits. This rate depends on each owner’s personal income tax bracket.
Can I still use my DBA name if I elect to be an S corp?
LLCs and corporations that operate under a “doing business as” (DBA) name can choose the S corp election.