How to Form an S Corporation in California
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An S-corp election is a process that alters your federal tax status. S-corp election is filed with the Internal Revenue Service (IRS). Although businesses that elect this status are often referred to as S-corps, the election actually has no effect upon your entity type (an LLC, for example, can elect to be taxed as an S-corp, but it will still be an LLC).
S-corp election changes the way your business is taxed. For certain businesses, this can be a positive step, saving your company money each year. The savings, however, are not guaranteed, and not all companies will benefit. A tax professional should be consulted before making an S-corp election.
Who Can Apply for S-Corp Status?
Not every California company will be eligible for S-corp status. The IRS lays out very specific requirements for which companies are eligible. It should be noted that eligibility must be maintained throughout the life of your business. If your company meets the S-corp requirements one year but fails to meet them at a later date, then your status will be revoked.
IRS S-Corp Requirements:
Your company must:
- Be a domestic entity
- Have allowable shareholders or members
- Have no more than 100 shareholders or members
- Offer only one class of stock
- Not be an ineligible corporation, such as financial institutions, insurance companies, or domestic international sales corporations
What Are Allowable Shareholders/Members?
Not all shareholders or members are considered “allowable” for S-corp election. All of your California corporation shareholders or LLC members must be: individuals, certain trusts or estates.
Partnerships, corporations and non-resident aliens cannot be shareholders or members of an S-corporation.
Pros and Cons of S-Corp Elections
As stated before, S-corp election will change the tax status of your company. While this election is not permanent, once elected it cannot be changed for at least one fiscal year. We advise that you meet first with a competent tax specialist to determine whether the election makes sense for your company.
S-corps in California are in a different boat. In most states, S-corps, like LLCs, are not taxed at the entity level. California state law, however, circumvents this and taxes S-corps as it does any other business. Thus S-corps must pay either 1.5% of the company’s net income or $800 each year, whichever is greater.
In spite of this, an S-corp allocation allows many businesses to save money by paying shareholders/members a reasonable salary and then classifying the remaining profits as distributions, which are typically taxed at a lower rate than self-employment taxes.
As noted previously, S-corps in California are still required to pay the state Franchise Tax, which is an entity-level tax, somewhat negating the normal benefit of electing for S-corp status.
S-corps are required by the IRS to adhere to formal administrative standards:
- Regular director and shareholder meetings
- Records maintenance
- Adopted bylaws
- Financial records maintenance
LLC, by contrast, have no such corporate formalities.
In addition, S-corps are required to pay shareholders/members who work for the company competitive salaries. If an S-corp is underpaying a shareholder/member in order to allocate higher distributions (which are taxed at a lower rate), the IRS will audit your S-corp and “reclassify” your distributions as wages. This will result in you owing more money to the IRS.
How to Apply for an S-Corp Election
The Form to File: Form 2553 Election by a Small Business Corporation
IRS Filing Instructions: Form 2553 Instructions
To apply for an S-corp election, you must submit a Form 2553 to the IRS. You will need an Employer Identification Number (EIN), which is also issued by the IRS. If you don’t have one, you can learn how to get an EIN for your California business.
The Form 2553 must be submitted no more than two months and fifteen days after the beginning of your tax year. If you submit the application after this point, your S-corp election will not apply to your current fiscal year.
Applications should be sent to:
Department of the Treasury
Ogden, UT 84201
Acceptance or Rejection
Applicants will be notified by the IRS generally within 60 days after it has filed Form 2553. The IRS will inform you whether your application has been accepted or rejected.
If you have not received a response from the IRS within 60 days after filing, you should contact the IRS at 1-800-829-4933.