Who Can't Form an LLC

Some California businesses that need state licenses aren't allowed to become LLCs. The Secretary of State has never put out an official list of which businesses can and can't form LLCs, but they have made rulings on specific jobs. If your work requires a state license, you should check with the Secretary of State or talk to an experienced tax accountant before setting up a California LLC. If a company becomes an LLC when it's not supposed to, it can lose many of its legal protections.

Contractors are one exception — the Contractor State License Board will issue licenses to LLCs. But there's a big requirement: the company has to either carry $1 million in liability insurance or have $500,000 in cash on hand. Because of this, probably only bigger contracting companies will operate as LLCs.

Who Can't Be an S Corporation

S corporations have stricter rules about who can own them. All shareholders must be U.S. citizens or residents — no foreign ownership. Shareholders have to be individuals or estates (with limited exceptions). All shareholders must have exactly the same rights to distributions and liquidation proceeds. There are other restrictions too, so check with your tax accountant.

Why an LLC Might Be Better

More Flexibility with Money

LLCs offer flexibility when dividing profits, losses, and deductions. With S corporations, profits and losses (after owners' salaries) must be split based on stock ownership. For example, if 4 people each own 25% of the corporation, profit or loss must be split 1/4 to each (though salaries can differ).

With an LLC, owners can divide profits and losses however they agree. Example: 4 partners each own 25%, but one contributed all the equipment. That partner can deduct the depreciation, and the remaining profit or loss gets split 4 ways.

Simpler Taxes for Single Owners

If you're the only owner of an LLC, it's treated as a disregarded entity for tax purposes. Income and expenses go on your personal return — no separate business return needed. Married couples count as a single owner for this purpose.

Better Loss Deductions

Both LLCs and S corporations let losses flow through to owners' personal returns if the owner has enough basis (what you've invested). LLC members can include their share of company debt in basis, so they can claim more losses. S corporation shareholders generally can't include company debt in basis, except for money they personally loaned to the company.

For example, if you're personally liable for the company's credit line with a bank, that doesn't increase your basis as an S corporation shareholder, which might limit how much loss you can deduct right away.

Why an S Corporation Might Be Better

Potential Social Security Tax Savings

S corporation owners might reduce Social Security taxes by taking a reasonable salary and the rest of the profit as distributions. You can only do this with an S corporation. In an LLC, all profits paid to an active member are subject to self-employment tax. Note: this tax benefit is often discussed for removal and could change in tight budget times.

Lower Fees for Higher‑Revenue Businesses

In addition to California's $800 annual minimum tax, LLCs with sales over $250,000 pay an extra annual fee (unless taxed as corporations):

• $900 for sales over $250,000

• $2,500 for sales over $500,000

• $6,000 for sales over $1,000,000

• $11,790 for sales of $5,000,000 or more

You have to pay this fee even if your company loses money. S corporations don't pay a gross receipts fee. Instead, they pay the higher of $800 or 1.5% of taxable income.

A Big Reason to Avoid S Corporations

If your company makes a profit, owners must take salaries. Payroll must run regularly and total a reasonable annual amount. If you don't take a reasonable salary, you're more likely to be audited. A payroll service can handle the filings, but you must follow the rules.

Other Things to Keep in Mind

You can create an LLC and choose to be taxed as an S corporation. Legally you stay an LLC — this is a private agreement with the IRS, and California recognizes it too.

If a company has more than one owner, take the time to create a written agreement before doing business. It should cover how profits and losses are shared, what happens if more money is needed, what happens if an owner becomes disabled, dies, or wants to leave, and other important issues.

Whether you pick an LLC or an S corporation, your business should carry substantial insurance coverage. Many other factors will influence your choice. This information is meant to help you understand common issues and start the conversation with your CPA and attorney.