Q: I am in the state of California and I have a sole proprietorship. I’d like to switch it to an S-corp, but I understand that I need to make it an LLC first. Is that something you can help me with?
Sole proprietorship is common in California. That probably doesn’t come as a shock to anyone, considering that all you have to do to become a sole proprietor in California—or in any state—is sell something. Do a little freelance writing? Mow lawns? Sell vintage clothes online? Unless you’ve filed paperwork with the California Secretary of State to start a business entity, you’re a sole proprietor.
Sole proprietors don’t have to file any paperwork or pay any fees to the California Secretary of State. They don’t need to open a separate business bank account or pay corporate taxes. Sole proprietorship is low maintenance, for sure, but it comes with a major catch: sole proprietors have no liability protection. When your business is sued, so are you. And your personal assets are all fair game.
Another catch? A sole proprietor can’t become an S-Corp. At least not directly. Let us explain.
Why Sole Proprietors Can’t Become S-Corps
An S-Corporation is not a business entity like a California LLC or corporation—you can’t “form” one by filing paperwork with the California Secretary of State. An S-Corp is a tax designation that you apply for with the IRS. Only LLCs or corporations are allowed to apply for S-Corp status. No sole proprietor S-Corps allowed. So if a sole proprietor wants to apply for the S-Corp tax election, they’ll first need to form an LLC or a corporation.
New to the buzzy world of S-Corps? Check out our guide to understanding S-Corps.
Forming a California LLC or Corporation
As our client noted in their question, the only way for a sole proprietor to get S-Corp tax status is for it to form a business entity. You can actually apply for S-Corp status with either an LLC or a corporation. But most business owners opt to form an LLC when they want an S-Corp. This is because S-Corps have several restrictions that negate the benefits of incorporating in California, including a limit on the number of shareholders a corporation can have and a requirement to pay the $800 franchise tax.
So for most sole proprietors, forming an LLC is the best route to S-Corp status. Forming an LLC also has the added benefit of providing limited liability, which means that if your business is sued, your personal assets typically won’t be up for grabs.
To start a California LLC, you’ll need to:
- Pick a name for your business
- Appoint a California registered agent
- File Articles of Organization and an Initial Statement of Information
If you need a registered agent or an expert to help file your paperwork, we can do that!
There are several other steps you’ll want to take to get organized, like drafting an operating agreement or bylaws and opening a business bank account. But once the California Secretary of State processes your formation paperwork, you’ll be ready to apply for S-Corp status with the IRS.
Applying for S-Corp Status
If you have a California LLC, you can move on to the next step: applying for S-Corp status. To do so, you’ll file Form 2553 with the IRS. You should first check the IRS’s due dates to make sure you’re in the right window. If you want to make the S-Corp election for the following tax year, you can file anytime. But if you want to make the election for the current tax year, you must apply within the first 2 months and 15 days of your tax year.
Once you complete the form, you can send it to the IRS. Where you send it depends where your business address is located. But California LLCs will send the form to the following address:
Department of the Treasury
Internal Revenue Service
Ogden, UT 84201
If you miss the 90s, you can also fax your form to 855-214-7520.
How your California S-Corp Will be Taxed
Like a sole proprietorship, S-Corps receive pass-through taxation. This means that the business itself doesn’t pay any corporate tax rate. Rather, profits pass through to the LLC’s owners (called members), who then report the income on their personal tax returns.
Unlike the way an LLC is taxed federally by default, S-Corps can make distributions. These distributions are not subject to employment taxes. Distributions don’t include normal compensation, which is required for anyone providing services to the business. Compensation is subject to employment taxes.
California Franchise Tax for S-Corps
One of the worst parts about starting an LLC in California is the Franchise Tax. At $800 minimum, it’s one of the highest business taxes on the country. And there’s really no way around it. Fail to pay and your business will be suspended by the California Franchise Tax Board. Thankfully, California is waiving the Franchise Tax for the first taxable year for LLCs formed between January 1st, 2021 and December 31, 2023.
How much is the California Franchise Tax?
Though it’ll be waived your first year, you’ll eventually have to pay the California Franchise Tax. To pay it, you’ll file California S Corporation Franchise or Income Tax Return (Form 100S).
For an S-Corp, the rate will be whichever number is higher: $800 or 1.5% of your net income. Never been good at math? We get it. Basically, you’ll have to pay at least $800. If you make a lot of money, you might have to pay more.