The S Corporation

Having S corporation status provides for a few substantial benefits for a corporation. First and foremost, of course, is the goal of achieving limited liability, or mitigating the impact of personal lawsuits and other forms of debt incurred by individual shareholders, against shareholders, and protecting against these same lawsuits or adverse judgments impacting the corporation as a whole, or the rest of the shareholders as individuals. While achieving the goal of limited liability of a traditional C corporation, the S corporation also allows for the pass-through of tax benefits to individual members. This enables the S corporation to be taxed in much the same fashion as a partnership, with no company-level taxes besides franchise fees imposed by California on all entities regardless of the formation type of the company. S Corporations are subject to the same stringent organizational requirements as a C corporation, and this means that they must also establish and abide by the corporate formalities that any corporation is subject to. These corporate formalities are an absolute necessity when operating as a corporation in order to properly enjoy limited liability and to maintain the integrity of the "corporate veil."

Any income generated by an investment that a corporation invests in is known as passive income, and this income is subject to scrutiny as part of the sub-chapter S qualification of a corporation. This differs markedly from active income that is generated as a direct result of products or services rendered during the normal course of business by a corporation to its clients. In a sub-chapter S corporation, passive income is limited to 25% of revenue, and any passive income generated past this threshold for three consecutive years will subject the corporation to having its S status revoked by the IRS.

In an S Corporation, shareholders providing personal services for the corporation are employees, just like in a C corporation. Before an S Corporation is allowed to distribute any profits to owners, it must pay any owner-employees a "reasonable salary", which is subject to social security and Medicare taxes. Profits in excess of this "reasonable salary" passes through to the owners free of Social Security and Medicare taxes. An LLC passes all of its income through to the owners and it is subject to self-employment taxes on the owner's individual tax return. An owner's ability to shield excess income from Social Security and Medicare taxes is a key advantage of a highly profitable S-Corporation. An S-corporation must pay the CA Franchise Tax board either a 1.5% tax on net CA income or $800, whichever is greater.

The Limited Liability Company

The LLC form allows for an unlimited number of shareholders (known as "members") to enjoy similar tax advantages and protection from liability as a corporation, while at the same time enjoying the separate entity status that affords protection from member liability. Further, unlike the S corporation, the LLC is not subject to the traditional corporate formalities and thus enjoys a number of management and organizational flexibilities that are just not available to an S corporation. The major tax advantage of an LLC is that of the pass through taxation. The profits or losses of the company pass directly through to the members and are not subject to company-level taxation. The LLC simply files a form 1065 as a company, then lists each individual's income as taxable profit via an attachment known as a form K-1.

LLC members must pay self-employment tax on all income from the LLC. However, if the LLC incurs losses, those losses are also passed through to the members and can be deducted against other sources of income, for example W2 income. The LLC must also pay an annual minimum franchise tax of $800 which is due within 75 days after the formation of the company and every year thereafter. The annual franchise tax is greater if total reported income is greater than $250,000.