S Corporations are a popular choice among entrepreneurs due to their key advantage: avoiding double taxation. At the federal level, S Corporations operate as pass-through entities. This means that the income of the company is shown directly on the personal income tax of the shareholders, which helps avoid corporate tax. However, a common misconception is that the pass-through taxation automatically applies to all states in the USA, which is definitely not true.
California presents a unique landscape for entrepreneurs, with S Corp regulations that diverge significantly from federal guidelines and those of other states. It imposes both a franchise tax and a net income tax on the company itself. Although you might understand federal S Corp benefits, you still need to know that California has its own significant layers of taxation and compliance. Moreover, it is essential to know California S Corporation rules because not knowing them may surprise you when setting up the business. It can also result in higher costs and specific compliance hurdles for the company.
The primary purpose of this article is to demystify California S Corporation compliance requirements and taxes. This article explains the difference between federal and California S Corporation taxes. By the end of this article, you will have a complete understanding of the potential pitfalls and the methods to avoid them. Forming an S Corp in California can be made easy if you stay connected till the end.
Federal vs. California S Corporation: The Basics
S Corporations are treated very differently at the federal level than at the state level in California. The Internal Revenue Service (IRS) treats S Corps as pass-through entities at the federal level. This implies that the company itself is not required to pay federal corporate income tax; rather, the income, credits, and deductions pass through to shareholders and are shown on their individual tax returns. The problem of double taxation is eliminated with this structure, as the profits are only taxed at the individual level.
In contrast to federal tax regulations, California takes a different approach, imposing individual and corporate taxes. While an S Corporation in California qualifies for pass-through status for federal purposes, its profits will be taxed at both the individual and corporate levels in the state. This means that S Corporations are not purely pass-through entities at the state level in California.
Furthermore, after the first year of establishment, every S Corp needs to pay an S Corporation franchise tax in California, a minimum of $800 annually. This tax is due even if the business has no profit or operates at a loss. California S Corporations can also pay 1.5% net income tax, which works in conjunction with the minimum tax.
Key California-Specific Compliance Requirements
Running an S Corporation in California involves various other compliance requirements than just paying taxes. Businesses should comply with these regulations to avoid fines and penalties.
1. Annual Statement of Information (Form SI-550)
The first major requirement for California S Corporations is filing the Annual Statement of Information (Form SI-550). This needs to be filed with the California Secretary of State to update the corporate records of the company. It should be filed within 90 days of incorporation and then every two years thereafter. Late filing of the Form SI-550 may result in a fine of $250.
2. California S Corporation Franchise or Income Tax Return (Form 100S)
Another important form for the S Corps in California is the Form 100S. It needs to be filed by the 15th day of the third month after the end of the taxable year. This due date is typically March 15 for calendar-year corporations. This is a mandatory form that must be filed, even if the S Corp has no income.
3. Estimated Tax Payments (Form 100-ES)
If the estimated tax due in California exceeds $500, then the company is required to submit quarterly estimated tax payments (Form 100-ES). The quarterly estimated payments need to be paid within deadlines, which generally fall in April, June, September, and December.
4. Corporate Formalities
In addition to paying taxes, S Corporations are also responsible for other ongoing obligations. Every S Corp in California should understand the importance of maintaining corporate formalities such as holding annual shareholder/director meetings, keeping minutes, and opening separate bank accounts for business finances. Taking these corporate formalities seriously helps preserve liability protection, which is extremely crucial in California.
5. Reasonable Compensation for Shareholder-Employees
Just like the IRS, California scrutinizes reasonable compensation for shareholder-employees. A reasonable salary is important for tax planning, as distributions are not subject to self-employment tax, but a salary is. It is a key strategy for the S Corps to optimize taxes and minimize self-employment tax on distributions. However, it is also a common audit trigger if not handled correctly.
How California S Corp Taxes Compare to Federal and Other States
California S Corporations experience a total contrast in taxes at the federal and state levels. They enjoy pure pass-through taxation with no corporate income tax at the federal level. Shareholders only pay taxes on their share of profits and avoid self-employment tax.
While many states follow federal pass-through taxation, California doesn’t offer pass-through treatment and imposes a corporate income tax on businesses. This makes California one of the most significant exceptions and strictest jurisdictions in the USA. Some other states also have similar entity-level taxes and other unique fees. The difference matters when entrepreneurs compare different entity types, like a California S Corp vs an LLC.
The core federal benefits still exist as S Corporations avoid federal-level double taxation on dividends and reduce self-employment taxes on distributions. But the state-level taxes in California can reduce these benefits up to a certain extent. This means that the savings aren’t as substantial as they might be in a state with no entity-level tax.
Qualified Business Income (QBI) Deduction
The Qualified Business Income (QBI) Deduction is a significant benefit for S Corporations. Self-employed individuals and owners of pass-through entities are eligible to deduct up to 20% of their qualified business income. This can greatly reduce the overall tax burden on businesses. The Qualified Business Income (QBI) Deduction is a federal tax deduction. It offers federal tax benefits for California S Corporation owners, but does not apply to their state income taxes.
Potential Pitfalls and How to Avoid Them
1. Underpayment Penalties
A major issue seen with companies is underestimating their taxes. It is of great importance to make a correct estimate of the taxes to be safe from underpayment penalties. The best way to avoid these penalties is to work with a CPA who can calculate projections accurately and pay on time.
2. Failure to File/Pay
Another potential pitfall can be not filing forms or paying taxes on time. If you do not file the Form 100S or fail to pay the franchise tax, it may lead to suspension of corporate powers by the Franchise Tax Board (FTB). Therefore, it is wise to file the essential forms and pay taxes before deadlines.
3. Disregarding Corporate Formalities
Disregarding corporate formalities can prove to be highly lethal for the business. If you mix personal and business funds, fail to maintain accurate records, and do not attend required meetings, courts may pierce the corporate veil. This can expose the personal assets of shareholders to business debts. To preserve limited protection, keep personal and business records separate and maintain meticulous records.
4. Incorrect Reasonable Compensation
Incorrect reasonable compensation can be very harmful to the business. It may increase the risk of IRS/FTB audits if the salary is deemed too low compared to industry standards. To avoid getting involved in such cases, provide reasonable compensation to your workers.
Is a California S Corporation Right for You?
A California S Corporation business structure offers numerous advantages, such as limited liability, potential federal tax savings, and business credibility. However, its entity-level tax, increased compliance, reasonable compensation scrutiny, and limitations on shareholders may reduce the benefits significantly.
A business owner should consider various factors when deciding on an S Corp in California. These factors include profitability, growth plans, number of shareholders, administrative capacity, and other factors. These factors can help you assess if an S Corp is the optimal structure with the specific rules in California. If you are planning to establish an S Corp, then you should consider consulting a professional service provider. Contact IncParadise today to get help with S Corp incorporation.
