What are the reasons to choose an S-Corporation for your new California business?  Why do you need an experienced business attorney to guide you through the process of starting your new company?  What is the difference between all of the corporate entity options for your new company, and why might an S-Corporation be the best alternative for your new venture? The Watkins Firm provides sound business counsel informed by our almost four decades of service to the San Diego and California business communities.

Key Takeaways About the Reasons to Choose an S Corporation for Your California Business:

• Selecting the right legal structure is one of the earliest and most consequential decisions a business owner will make. The choice affects taxation, liability protection, governance, and long-term strategy.
• One of the primary reasons to choose an S Corporation involves how the profits generated for its owners are treated for tax purposes.
• While the potential tax benefits are attractive, S Corporations also come with several important statutory limitations. These eligibility requirements are strict and must be maintained to preserve the election.
• The option to make an S Corporation election should always be evaluated within the broader context of your business plan.

The Importance of Selecting the Right Business Entity

Selecting the right legal structure is one of the earliest and most consequential decisions a business owner will make. The choice affects taxation, liability protection, governance, and long-term strategy. When evaluating reasons to choose an S Corporation, California business owners are usually focused on tax efficiency—but the analysis should go deeper than that.

An S Corporation is not a separate type of entity under California corporate law. It is a tax election made with the Internal Revenue Service after forming your new corporate entity. The election changes how income is taxed, while the company remains a corporation for liability and governance purposes.

Tax Advantages of an S Corporation

One of the primary reasons to choose an S Corporation involves how the profits generated for its owners are treated for tax purposes. A traditional C Corporation is subject to “double taxation,” that means corporate profits are taxed at the corporate level and then that income is “taxed again” when distributed to its owner/shareholders as dividends (income).

By contrast, an S Corporation is generally considered to be a pass-through entity for federal tax purposes. Corporate income flows through to shareholders and is reported on their individual tax returns. The corporation itself typically does not pay federal income tax or corporate tax. In California, S Corporation income is taxed at the rate of 1.5% (much lower than C Corporation business taxes). There is also a minimum franchise tax of $800 for the State of California, due in the first accounting quarter of each fiscal year. The franchise fee is owed whether your company is profitable or incurring losses.

From a planning perspective, this structure can offer advantages such as:

• Avoidance of double taxation on distributed profits
• Potential self-employment tax savings through reasonable salary and distributions
• Allocation of income and loss directly to shareholders
• Opportunity to offset other income with business losses (subject to limitations)

For many closely held California businesses, especially those who intend to generate a profit, these features are central reasons to choose the S Corporation election. However, income (compensation) must be structured carefully. The IRS and the California Franchise Tax Board (FTB) require the company’s owners (shareholder-employees) to receive “reasonable compensation” before taking distributions. Improper allocations or lower than reasonable “compensation” can trigger scrutiny and penalties.  You will need to consult with a tax attorney to discuss your unique situation and the right elections based on your circumstances, and how business will be conducted.

Structural and Governance and Compliance Considerations

While the potential tax benefits are attractive, S Corporations also come with several important statutory limitations. These eligibility requirements are strict and must be maintained to preserve the election.

An S Corporation must:

• Be a domestic corporation
• Have no more than 100 shareholders
• Issue only one class of stock
• Limit shareholders to individuals, certain trusts, and specific qualifying entities

If these requirements are violated, the S election can be terminated. In addition, California imposes its own minimum franchise tax and compliance obligations.

Corporate formalities must also be respected. Corporate governance and compliance including annual meetings and minutes, appropriate accounting and recordkeeping, and maintenance of the corporate veil (separation between personal and business finances) must be preserved in order to maintain the liability protections of your S Corporation. Failure to observe these formalities can weaken or eliminate the protections of the corporate veil, and expose an S Corporation’s owners to extensive legal, financial, and tax liabilities.

What to Know About Timing and Election Requirements

To secure S Corporation status, the election must be filed with the IRS within the first two months and fifteen days of the tax year in which the election is to take effect. The failure to take the S Corporation election in a timely manner either eliminates the option altogether, or results in a “late election.” Late elections may be possible under specific circumstances and legal provisions, but they require careful documentation.

California business owners should also understand that the S election is not automatically renewed each year; once properly made and maintained, it continues unless revoked or terminated. Ongoing compliance is the critical factor.

Comparing S Corporations to C Corporations and LLCs

When assessing reasons to choose an S Corporation, it is essential to compare it to other common structures. Each has advantages and disadvantages depending on the business model, growth strategy, and ownership structure.

For example:

• A C Corporation may be preferable for a company who intends to initially or eventually seek venture capital or plans to retain significant earnings.
• An LLC offers flexible management and pass-through taxation without corporate formalities, but may not provide the same payroll tax planning opportunities.
• An S Corporation often balances necessary corporate liability protections with potential tax advantages for active shareholders (owners).

Professional practices, including healthcare and medical businesses, often face additional regulatory considerations. In California, certain licensed professionals should operate through a California Professional Corporation. In some structures, a Management Services Organization (MSO) may be deployed alongside a professional entity to improve the business efficiency and profitability of a healthcare organization, while clearly separating the provision of healthcare from day-to-day business and tax considerations.

The Short and Long-Term Strategy of an S Corporation

The option to make an S Corporation election should always be evaluated within the broader context of your business plan. What are your short and long term objectives? Will you seek outside investors? Do you plan to reinvest profits or distribute them? Are there multiple owners with differing financial goals? What is your projected level of income?

Entity selection is not simply based on a tax decision, or short-term objectives for the current year. Choosing the right corporate entity will affect everything from profitability to succession planning, compensation strategies, audit risk, and exit opportunities. Changing structures later can involve cost, complexity, and unintended tax consequences.

Before making an S Corporation election, business owners should work with the experienced business formation attorneys at the Watkins Firm, as well as proven tax advisors who understand California corporate law, federal tax requirements, and industry-specific regulations. A well-conceived business plan at the outset often prevents costly restructuring and needless additional tax exposure now and in the future.

An S Corporation can provide meaningful advantages for the right business under the right circumstances. The key is disciplined analysis and informed decision-making. This is why it is so important to work with the experienced business formation attorneys at Watkins Firm. Draw on our 40+ years of experience serving the business, science and tech, real estate, and medical / healthcare communities here in San Diego and across California. When evaluated strategically, the structure becomes more than a tax label—it becomes part of a deliberate plan to protect the company and support sustainable growth.

If you are thinking about an S Corporation your new California business the Watkins Firm can help.  We have served the San Diego business and healthcare communities for more than 40 years.  What are the advantages of an S Corporation versus a C Corporation or LLC?  If you are in a medical practice or healthcare business you will want to give consideration to a California Professional Corporation and/or a Management Service Organization or MSO.

Pro-Tip: “You’re giving birth to a living creature that’s been recognized by the United States Supreme Court. And so what it means is birth is what we call capitalizing. And so you have these corporate documents and you have to decide on how much ownership will be and who owns what. Then you decide about what potential ownership there are. Reserve shares, I mean other ways in which people can own it. And then you capitalize it. Either you capitalize it with cash or you capitalize it with goodwill or a combination or a property.

But how you capitalize it can determine whether or not it’s a real company or you have all those protections of corporate veil and creditors and you’re personally shielded. So how you start it is very important. And thinking about it, we’ll send you on the right path to avoiding all kinds of pitfalls and trouble.

You need to carefully tailor the company documents, if you choose a corporation, and not all corporations are the same. If you choose a limited liability company, if you choose a partnership, a limited liability partnership, there’s all types of different variations. And then you can get into the nitty gritty based on your profession and all the regs and all the professional license requirements and all of the, depending on the kind of company, their resale license and permits.

There’s all kinds of little things that your old business lawyer knows about <laugh> and can tell you about from the get go. As opposed to you finding out after you’ve made a few mistakes, and your in an expensive dispute or lawsuit.

And let’s talk about the corporate veil for a minute. Because the whole reason to have an entity is to separate you the person from the legal person of the business.

That’s a big one. I mean, especially if you’re going to be doing some big business, you’re going to have big liability or you could personally not have big liability. And also you can have an entity that can be sold at a substantial profit.  It’s an asset that can appreciate (or depreciate). You can have an entity that can be sold in whole or bring in investors. If you do everything right, you get to do all these things. If you get a big opportunity and you didn’t set your company up correctly, then you can’t have your friend or a larger company with an extra (several) million dollars decide to invest or buy the company.

You’ve got to rewrite everything and restructure everything and hope you didn’t make any mistakes. And all of a sudden that opportunity doesn’t look so like such a good deal to the investor or company interested in acquisition. And that person or entity who’s got the investment money will say, ‘well, this isn’t professional, it’s not organized, it’s not valuable, and they’re not really serious about doing business.’ And you’ll miss it all because you didn’t pay attention in the beginning when you formed a company.” – Dan Watkins, Founding Partner

We invite you to review our Podcast Episode 2 – Starting a Business as well as the strong recommendations of our clients and contact the Watkins Firm or call 858-535-1511 for a complimentary consultation today. Draw on the 40+ Years of experience of our experienced corporate formation attorneys at the Watkins Firm and get your company started and moving forward more quickly and profitably.  We will help you to avoid the pitfalls that disrupt other businesses and build a solid business foundation for the future.

Meet Daniel Watkins:

Daniel W. Watkins is a true people person who sincerely listens. He cares deeply about what others are going through.  Dan enjoys digging into the facts and finding creative solutions to problems.  He contributes his insights candidly and constructively.

Dan’s interest in people make him deeply invested in every relationship and his exuberant personality makes him a true litigator. Dan fights for his clients with a fierce and calculated commitment.

Dan has practiced in the areas of business, medical practices and healthcare business, high tech/science, real estate and employment defense law since 1987. He is a trusted litigation strategist and true trial attorney with over 50 jury and bench trials to his credit. Dan has successfully represented both large companies and individuals and achieved substantial victories in well-publicized trials throughout California and the U.S.

He is experienced in business and corporate formation and administration, as well as all forms of alternative dispute resolution, including binding arbitration and mediation.

THE ROAD TO BECOMING A BUSINESS LAWYER AND LITIGATOR

Dan has almost 40 years of experience working with, for and against some of the largest insurance companies in the country. He has successfully tried and litigated cases in the areas of Healthcare Compliance, Commercial Litigation, Unfair Business Practices, Fraud, Breach of Contract, Battery, Premises Liability, Product Defect, Medical Malpractice, Discrimination, Sexual Harassment, Construction Defect, as well as Unfair Competition, Defamation, and Trade Secrets.

In December 2003, Dan commenced litigation against Health South Surgery Centers-West, Inc and its’ subsidiaries, exposing the company’s extensive mismanagement and misconduct of its’ surgery centers. Dan has also been asked by some of California’s largest municipalities and corporations to conduct legally required investigations into matters involving alleged employment discrimination and harassment.