S Corps v. LLCs for the Small Business Owner: Which Entity to Choose?

Most small business entrepreneurs in California confront the question of whether to form California S corporation (“S corp”) or a California limited liability company (“LLC”) when they begin the process of forming a business entity.  

A California S corp is a pass-through entity, meaning that the business profits pass through the owner, as with a sole proprietorship or partnership.  However, there are some restrictions and tax considerations, as more fully detailed in our previous blog post here.

A California LLC is also a pass-through entity, such that business taxes are paid on the individual owner’s income tax return.  Today, solo business owners can form an LLC; there is no need to have at least two members.  The LLC can be manager-managed in the case of passive investors, allowing for any manager to legally bind the LLC; or member-managed in the case of active members, allowing any member to legally bind the LLC.  Similar to corporations, LLC owners are not personally liable for the LLC, with the exception of a some limited circumstances, which include but are not limited to:

• Personal guarantees on a loan to an LLC;
• Overdue taxes, in which case the IRS or California Franchise Tax Board may go after personal assets of LLC owner(s);
• Negligent or intentional acts (“torts”);
• Breach of fiduciary duty, which requires more than just an honest mistake or poor judgment and is usually reserved for serious indiscretions like fraud; and/or
• Absence of a boundary between the LLC and owners, allowing courts to “pierce the corporate veil.”

First, it is relatively easy to form an LLC in California, but there are some startup cost concerns.  There is a minimum annual franchise tax of $800, due shortly after starting an LLC.  Conversely, with S corporations, as with all other California corporations, the minimum annual franchise tax of $800 is not due until after the first year of business.  So, from the outset, small business entrepreneurs must consider whether they have the funds to pay this minimum annual franchise tax at the time of incorporation.  

Second, entrepreneurs must also consider long-term cost concerns.  While forming an S corp may be cheaper at the outset, forming an S corp, or any corporation for that matter, can be more expensive in the long run due to compliance with increased level of corporate formalities and the requisite filings.  For example, an owner of a corporation will have to file a Statement of Domestic Stock Corporation 90 days after filing Articles of Incorporation, and then every year of business thereafter.

Finally, there are some small business entrepreneurs that simply may not operate as an LLC in California.  California Corporations Code section 17375, states that an LLC may not render "professional services," as defined in sections 13401(a) and 13401.3 (the “Moscone-Knox Professional Corp Act”).  California Corporations Code § 13401(a) defines a professional as one who provides any type of professional service that may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act.  So, professionals such as accountants, lawyers, doctors, etc.  may not form an LLC.  Those individuals are eligible to incorporate their businesses as S corps or professional corporations.

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Smith Shapourian & Mignano, LLP is available to answer any questions or concerns you may have regarding incorporating your S corp or LLC in California.  Feel free contact us to learn more.

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.