Forming a California Corporation Online

Federal taxation

A C corporation is its own tax entity. It pays taxes on its earnings, while shareholders only pay taxes on what they receive from the corporation. However, if the corporation gives out dividends to shareholders, these dividends get taxed again on shareholders’ personal returns. This scenario, where profits are taxed twice, is known as “double taxation.”

In contrast, an S corporation operates differently. While it does file a K-1 tax return if there’s more than one shareholder, it doesn’t pay corporate taxes. Instead, each shareholder reports their share of the profits (or losses) on their personal tax returns and pays tax based on their individual rate. This structure bypasses the “double taxation” issue seen with C corps.

Furthermore, S corps offers an added benefit if the company faces losses. S corp shareholders can use their share of these losses to offset other income. But they can’t deduct losses beyond the value of their investment in the company, with a few tweaks. 

One important note: Only up to 25% of an S corp’s total income can come from passive sources.

California taxation

While most states usually align with the federal stance on S corporations, there are notable variances in state treatments:

• Non-recognition states: Some states don’t acknowledge the S corporation status. While the corporation might enjoy federal tax benefits as an S corporation, it’s treated and taxed as a C corporation on the state level.
• Double tax states: Certain states impose taxes on the S corporation’s earnings and the shareholders’ shares. This results in a ‘double taxation’ somewhat reminiscent of a C corporation distributing its profits as dividends.
• Partial tax states: Some states only tax a fraction of their income even while recognizing the S corporation.
• Other variations: There’s a spectrum of ways states can tax S corporations, with many unique nuances to consider.

If you’re considering forming an S corporation in California, you must get clear insights first. It’s essential to know precisely how California deals with S corporations. Consultation with a tax advisor or contact the California income tax agency can guide you on any specific forms or taxes relevant to S corporations in the state.

Compensation of officers

The IRS mandates that S corporation owner-employees receive wages. These wages must reflect a “reasonable amount” for their work. This ensures owner-employees can’t sidestep payroll taxes by not paying themselves. Even if the corporation isn’t profitable, these salaries are still subject to payroll taxes.

Employee benefits

Both C and S corporations can offer employee benefits that are deductible for the corporation and tax-free for employees. However, some of these tax-free benefits are limited for S corporation shareholders owning more than 2% of the stock.

Capital accumulation

C corporations often build capital more efficiently than S corporations, given the generally lower corporate tax rate and the absence of double taxation on retained profits. While S corporations might save more by not sharing profits with shareholders, it’s problematic. Some owners are taxed on this “phantom income” – money they haven’t received.

Stock/ownership

All S corporation shareholders must be U.S. citizens or residents. On the other hand, C corporations can offer various stock classes, whereas S corporations can only have one, though voting rights can vary.

Business activity

S corporations are not allowed to operate certain businesses, including banks, Subchapter L-taxed insurance companies, Domestic International Sales Corporations (DISC), and specific affiliated corporate groups.

Corporation size

C corporations provide greater flexibility than S corporations, making them ideal for large, publicly traded companies with many shareholders.

Fiscal year

C corporations can choose their fiscal year-end, but S corporations must end on December 31. If a C corp switches to an S corp, it must adopt the December 31 date. Once set, an S corp is not allowed to change from this year-end, even if its status changes.

Accounting method

C corporations with gross receipts over $5 million must use the accrual accounting method. Meanwhile, only S corporations with inventory are required to adopt this method.

Conversion from C corp to S corp

After its formation, a C corporation can convert to an S corporation by filing Form 2553 with the IRS. Some states also require an S election form. If an S corp changes to a C corp, it must wait five years before switching back to an S corp.

Conversion of an S corp back to a C corp

An S corporation can switch to a C corporation by submitting a request to the IRS. Once changed, the C corp must adhere to a December 31 fiscal year and can’t revert to an S corp for five years. This limits certain tax-saving strategies. Often, starting a new C corporation is more advantageous than converting.

Entity

C and S corporations are individual legal entities under the law.

Creation

Both are initially formed as C corporations by filing Articles or a Certificate of Incorporation with a state.

Life

Both continue indefinitely, even after the death of the owners.

Makeup

C and S corporations have a similar organizational structure. At the core are the shareholders, who own the company and are vested in its success. They elect a board of directors responsible for making overarching decisions and setting the corporation’s strategic direction. The board of directors appoints officers to handle the day-to-day operations and ensure the company runs smoothly. This hierarchical structure provides that while the shareholders have a say in the corporation’s direction, a dedicated team makes the daily decisions and drives the company forward.

Liability protection

Both offer limited liability, protecting shareholders from the corporation’s debts.

Ownership

Ownership changes through the selling of the corporation’s stock.

Capital

Both can garner additional funds by selling more stock.

Employee benefits

Both C and S corporations can offer a range of employee benefits that enhance staff retention and satisfaction and provide tax advantages. These benefits can be tax-deductible for the corporation and tax-free for the employees. Common offerings include Retirement Plans, Medical Plans, Life Insurance, Childcare, and Education Plans. However, there’s a caveat for S corporations: owners who possess more than 2% of the company’s stock might find that the tax-free status of some of these benefits is not as generous as it would be in a C corporation.

Taxation

All shareholders pay personal income tax on salaries, dividends, and distributed earnings.

Ongoing administration

Compliance is critical for both C and S corporations. They are required to follow state mandates concerning corporate organization and operation. This includes adopting bylaws, issuing and tracking stock, and maintaining detailed records of shareholder interactions. Regular meetings of both shareholders and the board of directors must be held, and meticulous minutes of these meetings should be recorded. Additionally, all necessary state and federal reports must be prepared and filed punctually.

Adhering to these procedures is not just a formality; it’s imperative for the corporation’s legal protection. Any lapses or inconsistencies might lead to legal challenges where courts could pierce the corporate veil, making the primary stakeholders personally liable for the corporation’s obligations.