S Corp Tax Treatment in California – Guide for Freelancers
The Golden State isn’t as “golden” as it used to be, at least for those who are self-employed. Freelancers and entrepreneurs in California bear one of the heaviest tax burdens in the country, so it’s no wonder that many of them are desperately searching for ways to reduce their taxes.
If you’re a California-based freelancer, we have some good news for you: opting to be taxed as an S Corp is a one-way ticket to the tax savings town! Below, we’ll go over what it takes to get S Corp tax treatment in the state of California.
Common entities for freelancers
Are you a sole proprietor? Then you’re like most freelancers, and this means that you personally own your business and all of its assets. While this comes with some perks, you don’t have to run your business as a sole proprietorship, even if you’re only operating a small, one-owner freelance business.
The most common legal entities for freelancers are limited liability companies, also known as LLCs, and corporations. Again, even if you’re running a one-person company, you can use either of these business entities to receive additional benefits that you can’t get by functioning as a sole proprietor.
LLCs with one owner are single-member LLCs or SMLLCs
This business entity is popular amongst freelancers because it’s easy to form and operate.
In fact, you can form an SMLLC yourself, but we cover all of those important details in another article: Freelancers Guide to Filing an LLC in California – A Simple Step-by-Step Guide.
Corporations, on the other hand, are a bit more complicated to run. Yet, they’re still a great choice for freelancers.
We’re not gonna lie: whether you decide to run your business as an LLC or corporation, it’ll be a little more expensive, and a bit harder, than operating as a sole proprietor.
Here are some things you should know about forming an LLC or corporation:
1. You’ll no longer personally own your business; you’ll be a member of an LLC or a shareholder of a corporation.
This means that you’ll own and run the LLC or corporation, but the entity will own the business. And it also means that you’ll need to open a separate business bank account, which means more complicated bookkeeping. And let’s not forget that you’ll need to file a more complex tax return. But it’s all worth it. Trust us.
2. With both an LLC or a corporation, you’ll enjoy two major benefits: limited liability and the chance to use S Corp taxation.
Why are these perks such a big deal? Well, with limited liability, you avoid being held personally liable for any business-related lawsuits and debts. And, as we’ll explain below, when you opt to be taxed as an S Corp, you could save some serious money on taxes.
An introduction to S Corp taxation
S Corp taxation is a tax status, not a type of business entity.
If you’re a sole proprietor you can’t choose S Corp taxation. Instead, you must form a separate business entity in your state. Then, you can choose S Corp tax status by filing an election with the IRS (Internal Revenue Service).
If you’re in California, this means that if you form an LLC or corporation, you have the option of using S corporation status for taxation.
To understand how S Corps save you money, we need to start with the basics:
When you’re a sole proprietor, you report all of your business income on the Schedule C, Profit or Loss From Business, and you file this with your federal and state personal tax returns.
Now, let’s say that you earn $100,000 in profit as a sole proprietor in CA. You’ll pay three separate taxes on that profit:
- Federal income tax
- California income tax
- Social Security & Medicare taxes
As a sole proprietor, you have to pay all of your Social Security and Medicare taxes on your own. No employer is there to cover half of these taxes for you. And these taxes are steep!
For example, if you made $100,000 in net income, you’d pay a whopping $14,130 in Social Security & Medicare taxes. It’s no wonder that so many freelancers end up paying more in these taxes than federal and state income taxes!
How your taxes change when you’re an S Corp:
When you select S Corp taxation, all your business profits or losses “pass-through” the business to you, the business owner. Your LLC or corporation won’t pay any taxes itself. Instead, you report your business’s profits or losses on your personal tax return.
Beyond that, you won’t be a self-employed sole proprietor anymore. You’ll work as an employee of your business, so you’ll be the owner and the employee. And your business will pay you a reasonable salary.
Payroll taxes, which include Social Security and Medicare taxes, must be paid on this salary, which total of 15.3% of your wages (yup that’s the same amount as self-employment tax). You and your business split the cost. Your business pays half of these taxes, 7.65%, and you pay the other half, also 7.65%. Your half is withheld from your paycheck.
But here’s where S Corp taxation really shines: You don’t have to pay all of your business profits to yourself in the form of employee salary. Rather, you can distribute some of that profit to yourself as a shareholder distribution.
A shareholder distribution is a payment of a portion of your business’s profits made to you as a shareholder (aka the owner), not as an employee. Shareholder distributions aren’t subject to Social Security or Medicare taxes, which is major when it comes to taxes.
This means you save money on taxes because you only pay income tax on the distributions you receive. And you only pay payroll taxes on your employee wages.
Let’s say your business earns $100,000 in profit, and you take half of that as a distribution instead of as a salary payment. You’d only pay $7,650 in payroll taxes on $50,000 in employee income (rather than the $14,130 we mentioned above). That’s $6,480 in tax savings!
Here’s a chart that shows how much Social Security and Medicare tax you can save with S Corp taxation.
In this example, you’d take 40% of your profit as an employee salary, and 60% as a shareholder distribution:
Side note: Thinking about avoiding taking any employee salary? Well, sure, you wouldn’t owe any payroll taxes, but this is a big no-no. The IRS requires that S Corp shareholder-employees pay themselves a reasonable salary. What’s “reasonable”? At least what other businesses pay for similar services. By now, you might be asking if there’s any other form of taxation that can provide these kinds of savings. The simple answer, no, there isn’t. S Corp taxation is the only one.
Pro Tip: Figuring out how much salary to pay yourself can be a challenge. Check out our Freelancer’s Guide to Paying Yourself a Salary From an S Corp for a step by step guide to setting your S Corp salary.
A few other things you should know about S Corps
Got your attention now, haven’t we? Before you dive into signing up for S Corp taxation, here are a few other tidbits you should know:
- California does tax S Corps
Most states follow the federal IRS rules and don’t make S Corps pay income tax, but California is an exception. All California LLCs or corporations that choose S Corp taxation must pay a 1.5% state franchise tax on their net income. This is paid by the business itself, not the LLC members or corporate shareholders. Also, all LLCs and S Corps must pay a minimum franchise tax of $800 annually, except for the first year.
Your business will be required to pay these taxes in advance four times per year in the form of estimated corporate taxes. For more details, check out the Instructions for Form 100-ES.
This extra California state tax somewhat reduces the benefits of S Corp taxation in that state. Want proof? Check out these numbers: If your business made $100,000, it would pay a $1,500 franchise tax. So, if you save $8,010 by using S Corp taxation, your total savings would really only be $6,510. It’s still a substantial savings, though!
| Business Income | Social Security/Medicare Tax Savings with S Corp. Taxation | 1.5% California Franchise Tax ($800 minimum tax) | TOTAL SAVINGS |
|---|---|---|---|
| $40,000 | $3,204 | $800 | $2,404 |
| $50,000 | $4,005 | $800 | $3,205 |
| $80,000 | $6,408 | $1,200 | $5,208 |
| $100,000 | $8,010 | $1,500 | $6,510 |
| $150,000 | $11,317 | $3,000 | $8,317 |
| $200,000 | $9,596 | $4,500 | $4,096 |
Can you get around the California franchise tax by forming your LLC or corporation in another state that doesn’t have this tax? Nope!
That’s because you have to pay the CA franchise tax if your LLC or corporation is located in California (or if you earn at least 25% of your income there). Bummer!
- Restrictions on S Corp treatment
There are some restrictions on businesses that can choose S Corp tax treatment.
An LLC or a corporation may elect S Corp tax treatment only if all of the following apply:
- The corporation has no more than 100 shareholders
- None of the corporation’s shareholders are nonresident aliens (that is, noncitizens who don’t live in the United States)
- The corporation has only one class of stock (for example, there can’t be preferred stock that gives some shareholders special rights)
- None of the corporation’s shareholders are members of other corporations or partnerships
Fortunately, these restrictions don’t affect the vast majority of freelancers.
- Pass-through tax treatment
When you opt for S Corp taxation, your LLC or corporation is a pass-through entity for tax purposes. Meaning: the profits, losses, deductions, and tax credits of the business are passed through to the owners’ individual tax returns.
So, if the business has a profit, the owners will pay income tax on their ownership share on their individual returns.
What if the business incurs a loss? Likewise, it’s shared among the owners, who may deduct the loss from other income on their individual returns (this is subject to certain limitations so it’s best to check with a tax professional).
Even though pass-through entities don’t pay taxes, they still have to file tax returns with the IRS.
But these forms aren’t used to pay taxes. Instead, they’re informational returns that report the entity’s income, deductions, profits, losses, and tax credits for the taxable year. You must file an information return on IRS Form 1120S, U.S. Income Tax Return for an S Corporation
by March 15 every year.
Also, Form 1120S includes a separate part called Schedule K-1, which reports each owner’s share of the business’s income or loss. Your S Corp must complete a K-1 for every owner.
Then, each owner reports, their share of the company’s net profit or loss (shown on Schedule K-1) on their personal tax return
In California, you also file Form 100S: California S Corporation Franchise or Income Tax Return with the California Franchise Tax Board by March 15. What’s this? It’s the state tax return for your LLC or corporation, similar to IRS Form 1120S. And it includes its own version of the K-1 form.
- Management of your business
We can’t stress this enough: S Corp taxation is only a tax status; it doesn’t mean anything when it comes to how you manage your business. Instead, how you manage your business is governed by California law.
If you form a California LLC, the state’s LLC law governs how you manage it. The same goes for a corporation, which is governed by the state’s corporation law.
Many freelancers prefer forming an LLC because the legal formalities for operating one are simpler than a corporation.
How to get S Corp tax treatment in California
Obtaining S Corp tax treatment for your business is pretty straightforward.
Step 1: Form a business entity
The first thing you need to do is form a California LLC or corporation. This involves filing articles with the California Secretary of State and paying the necessary filing fees.
In addition to filing the right forms, there are other steps involved when establishing your business. You can learn all about them by reading The Ultimate Guide to Starting a Business In California.
Step 2: File a subchapter S election
Next, your LLC or corporation must file IRS Form 2553, Election by a Small Business Corporation.
To receive S Corp tax treatment for the current year, you need to file the form within 75 days of the filing or registration date on your articles of incorporation or LLC articles of organization.
Was your LLC or corporation formed last year or before that? You have to file the Form 2553 by March 15 for your election to take effect this year. If you file your election too late, it won’t go into effect until the following year, unless the IRS grants you relief for the late filing.
Step 3: California recognition of S Corp status
You don’t need to file an S Corp election in California to obtain the state’s recognition of your S Corp tax status. Just file the federal Form 2553 with the IRS.
If you elect S Corp treatment for an LLC, the Franchise Tax Board will assign an ID number when they request your first estimated tax payment, annual tax payment, or tax return.
Pro tip: Don’t want to go it alone? Collective can give you the guidance, support, and advice that you need to start an S Corp. Our experts even help you take care of the accounting and tax side of your business, so you can run your business stress-free.
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.