The Golden State isn’t as “golden” as it used to be, at least for those who are self-employed. Freelancers 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 wonderful news for you: opting to be taxed as an S corporation is your ticket to the tax savings that you seek!
- What to know about companies in California
- An introduction to S corporation taxation
- A few other things you should know about S corp taxation
- Ready to get S corporation tax treatment? Here’s how!
- So many reasons to form an S corporation in California!
What to know about companies in California
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 proprietor, even if you’re only operating a small, one-owner freelance business.What are the most common entities for small businesses, including those run by freelancers? The answer is limited liability companies, also known as LLCs, and corporations. Again, even if you are running a one-person company, you can use either of these business entities to reap 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.
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, too, that you’ll need to file a more complex tax return. But it’s all worth it. Trust us.
With either an LLC or a corporation, you’ll get to enjoy two major benefits, which are limited liability and the chance to use S corporation taxation.
Why are these perks such a big deal? Well, with limited liability, you can 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 corporation, you could save big on taxes.
An introduction to S corporation taxation
This is important to know: S corporation taxation is a tax status, not a type of business entity.Sole proprietors can’t choose S corp taxation. You must first form a separate business entity in your state in order to operate your business. Then, you can choose S corp tax status by filing an election with the IRS. For those in California, this means that, if you form an LLC or corporation, you do have the option of using S corporation taxation.
To understand how this form of taxation can help you save some money, you need to start with the basics:
- When you’re a sole proprietor, you’ll need to report all of your business income on IRS Schedule C, Profit or Loss From Business, and you’ll file this with both your federal and state personal tax returns. Now, let’s say that you earn $100,000 in profit as a sole proprietor in CA, as an example. This means that you’ll pay three separate taxes on that profit: federal income tax, California income tax, and 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 will be there to cover half of these taxes for you. And these taxes are steep! To clarify, on $100,000 in net self-employment income, you’d have to pay a whopping $15,300 in Social Security & Medicare taxes. It’s no wonder that so many freelancers end up paying more in these taxes than they do federal and state income taxes!
Now let’s look at how the situation changes when you form an LLC or corporation and select S corp taxation:
- Your LLC or corporation won’t pay any taxes itself. When you select S corp taxation, all your business profits or losses “pass through” the business to you, the owner. So, you end up reporting those numbers on your personal tax return. Simple enough so far, right?
- 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 for the work that you complete. This is wage income that you have to pay tax on just like any other employee. Social Security and Medicare taxes must be paid on this salary. In the end, you and your business must each pay half of these taxes, so that you both, combined, pay the same amount that you’d pay as a sole proprietor.
- You don’t, however, have to pay all the profits your business earns to yourself in the form of employee salary. Rather, you can distribute some of that profit to yourself as a shareholder distribution. Basically, this is a payment of a portion of the business profits that are made to you as a shareholder, not as an employee. This shareholder distribution isn’t subject to Social Security or Medicare taxes. Therefore, you can save money because you’ll only owe income tax on the distributions you receive.
- The bigger the distribution, the less employment tax you’ll have to pay. Let’s say your business earned $100,000 in profit, and you decided to take half of that as a distribution instead of as a salary. You’d only have to pay $7,650 in Social Security and Medicare taxes on $50,000 in employee income (rather than the $15,300 we mentioned above). Quite a lot in 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, with the remaining 60% taken as a shareholder distribution:
|Business Income||Social Security/Medicare Tax Savings with S Corp. |
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 corporation taxation is the only one.
Side note: Thinking about avoiding taking any employee salary? Well, sure, you wouldn’t owe any employment taxes, but this isn’t allowed, as the IRS requires that S corporation shareholder-employees pay themselves a reasonable salary. What’s “reasonable”? At least what other businesses pay for similar services.
Pro Tip: Figuring out how much salary to pay yourself can be a challenge, so check out our Freelancer’s Guide to Paying Yourself a Salary From an S Corporation for some helpful information on this topic.
A few other things you should know about S corp taxation
Got your attention now, haven’t we? Before you dive into signing up for S corp taxation, though, here are a few other tidbits you should know about:
1. California does tax S corporationsMost states follow the federal IRS rules and don’t make S corporations pay any 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 corporation shareholders. Also, all LLCs and S corporations must pay a minimum $800 franchise tax 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 in California made $100,000 in net income, it would have to pay a $1,500 franchise tax. So, if you’re saving $8,010 by using S corp taxation, your total savings would really only be $6,510. Still substantial savings, though, compared to what you’d otherwise pay!
|Business Income||Social Security/Medicare Tax Savings with S Corp. Taxation||1.5% California Franchise Tax ($800 minimum tax)||TOTAL SAVINGS|
Can you get around the California franchise tax by forming your LLC or corporation in another state that doesn’t have this tax (like, Nevada, for example)? Nope! That’s because you’ll have to pay the CA franchise tax if your LLC or corporation is located in California or you earn at least 25% of your income there. Bummer!
2. Restrictions on S corporation treatmentThere are some restrictions on businesses that can choose S corporation tax treatment, which is intended to be used by smaller businesses.
An LLC or a corporation may elect S corporation 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. Phew!
3. Pass-through tax treatment
When you opt for S corp taxation, your LLC or corporation will be 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, at their individual income tax rates. Clear? Great!
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, subject to certain limitations.
Now, even though pass-through entities pay no taxes, they still have to file tax returns with the IRS. But these forms aren’t used to pay taxes. Instead, they’re only informational returns that inform the IRS of the entity’s income, deductions, profits, losses, and tax credits for the year. You must file an information return on IRS Form 1120S, U.S. Income Tax Return for an S Corporation.
Also, Form 1120S includes a separate part called Schedule K-1. This is completed for each owner of the pass-through business, and it’s used to report the owner’s individual share of the business’s income or loss. Every owner reports, on his or her individual tax return (Form 1040), the owner’s share of the company’s net profit or loss, as shown on Schedule K-1. So, Schedule K-1 is a bit like a W-2 form for a pass-through business owner (W-2 is the form used to report employee income to the IRS).
We’re not quite done yet. If you’re in California, you have to also file Form 100S with the CA Franchise Tax Board by March 15. What’s this? Well, 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.
4. Management of your businessWe can’t stress this enough: S corporation 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 will 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 for a corporation.
Ready to get S corporation tax treatment? Here’s how!
Obtaining S corporation tax treatment for your business is pretty straightforward, thankfully.
Step 1: Form a business entity
The first thing you’ll need to do is form either 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, to get S corporation tax treatment, your LLC or corporation must file IRS Form 2553, Election by a Small Business Corporation.
For this election to be effective for the current year, file the form within 75 days after you form your LLC or corporation—meaning, within 75 days of the filing or registration date on your articles of incorporation or LLC articles of organization with the California Secretary of State.
Was your LLC or corporation formed last year or even before that? You have to file the form by March 15 for your election to take effect this year.
If you file your election too late, it won’t be effective until the following year, unless the IRS grants you relief for the late filing. The IRS routinely grants relief for late Form 2553 filing. You can get relief and elect S corp status within 3 years and 75 days from the date you originally intended the election to be effective. Check out Instructions to Form 2553 for details on how to request relief for a late S corporation election.
Step 3: California recognition of S corporation status
You don’t need to file an S corporation election in California to obtain the state’s recognition of your business’s S corporation tax status. Just file the federal Form 2553 with the IRS.
If you elect S corporation treatment for an LLC, the Franchise Tax Board will assign an ID number upon request of your first estimated tax payment, first tax payment, or the first tax return.
Pro tip: Don’t want to go it alone? Thanks to online platforms like Hyke, you can get the guidance, support, and advice that you need when you are ready to form and maintain your business. Our experts will even help you take care of important aspects of your accounting and taxes so you’ll never skip a beat. So easy!
So many reasons to form an S corporation in California!
Sure, it can be tough—and expensive—to run a business of your own as a freelancer in California. But thanks to some smart strategies, like establishing S corporation taxation for your business, you can save some much-needed cash that you can use to continue growing your company and doing what you enjoy most!
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.