California Multi-Member LLC S Corp Twist

Sounds like a drink, doesn’t it? “Oh man, I was up all night pounding Cali Twists.”

The previous mothership structure, where the MMLLC pays fees for services to the baby S Corps, works well in most states. It still works in California as a structure, but the tax expense, namely the California LLC fee, makes it egregious. Shocking, right?

Every California LLC, single-member or multi-member, pays the $800 annual tax plus an LLC fee once its total income from California sources reaches $250,000 (Cal. Rev. & Tax. Code 17941 and 17942). Total income is essentially gross receipts before expenses. Read that again. Before expenses. If you take in $1,000,000 and have $950,000 in expenses, you still pay the LLC fee computed on the $1,000,000.

The fee is “banded,” as we say, since it is not a straight percentage. The bands are set by statute and have not changed in years-

Sidebar: Franchise Tax or LLC Fee? People use the terms interchangeably, including us on a bad day, but California has three related charges-

• Annual LLC tax. Generally $800 for California LLCs taxed as partnerships or disregarded entities (Cal. Rev. & Tax. Code 17941).
• Corporate franchise tax. California S Corps generally pay 1.5% of net income, while C Corps generally pay 8.84%, with an $800 minimum, first-year exceptions aside (Cal. Rev. & Tax. Code 23153 and 23802).
• LLC fee. A separate charge on LLCs taxed as partnerships or disregarded entities, computed on total income from California sources using the bands above (Cal. Rev. & Tax. Code 17942).

An LLC with $1,000,000 of California revenue generally pays $800 of annual LLC tax plus a $6,000 LLC fee. Elect S Corp status, and the LLC fee goes away. The entity instead pays California’s corporate franchise tax, which could be just $800 if taxable income is nominal. That is the entire point of the Cali Twist.

What makes matters worse is that if the baby S Corps receiving the fees are California S Corps, each also pays California’s 1.5% franchise tax on its net income, with an $800 minimum (Cal. Rev. & Tax. Code 23802(b)). So the same dollar can be hit twice: once as part of the mothership’s total income for the LLC fee, and again as profit in the baby S Corp. Yuck. Super yuck!

California S Corporation Election

What can be done? Simple! We elect the MMLLC to be taxed as an S Corp. Hang in there on this one!

The graphic above is eerily similar to the previous one… except S Corp replaces MMLLC. The MMLLC is now taxed as an S Corp, and Fred, Velma and Shaggy remain the owners as shareholders. An LLC taxed as a corporation is out of the LLC fee system entirely and pays California’s corporate franchise tax instead. After paying fees for services to the baby S Corps, the mothership S Corp has very little taxable income, say $1,000. California computes its franchise tax at 1.5% of $1,000 or $800, whichever is higher. So $800. Unavoidable, but a lot better than $6,000.

The mothership S Corp generally would not pay salaries to its shareholders. The professional services are performed through each owner’s baby S Corp under the services agreements, and each owner’s role at the mothership is governance. That is the same paper we described in the fee for service section, and it is what makes a zero salary at the mothership defensible. In addition, distributions theoretically should be $0, since the cash is leaving as fees to the baby S Corps. There might be some goofiness if the mothership has depreciating assets, loans or some other transaction that causes net income to be something other than $1,000 and distributions to be something other than $0 (we discuss this in another section, and again below). The important takeaway here is the elimination of the California LLC fee.

Remember the tradeoff we mentioned in another section. Once the mothership is an S Corp, it follows the S Corp rules, including the single class of stock restriction, so the fee for service agreements carry even more weight.

The baby S Corps owned separately by Fred, Velma and Shaggy carry on as normal. They pay their own expenses, pay salaries, provide distributions and so on. Fred, Velma and Shaggy each get two K-1s, one from the mothership S Corp and another from their respective baby S Corp. This is exactly the same as the previous schematic in terms of K-1s.

Sidebar: Other States, Other Tax Headaches. The Cali Twist is mostly a California play. Other states have their own creative ways to tax businesses, including Washington’s B&O tax, New Mexico’s gross receipts tax and Oregon’s Corporate Activity Tax. In some states, both the mothership’s revenue and the baby S Corps’ fees can be taxed, creating two layers of taxable receipts. Lovely! We explore this madness in our State and Local Taxes discussion under Things to Work Through With Multiple Entities section. Nice things cost money.

Loan Basis in an S Corporation

This is a relatively common issue, and when it pops up it can be brutal. In a multi-member LLC taxed as a partnership, the partnership’s debts increase the partners’ basis (IRC Section 752), and a personal guarantee can affect how that debt basis is allocated among the partners. In a simple way, extra basis lets you take more distributions from the business without creating a “distributions in excess of basis” situation, which creates a capital gain.

If we are in California and want to dodge the egregious LLC fee, we S Corp elect the mothership. But in an S Corp, a guarantee creates no basis at all. Only a loan made directly by the shareholder to the S Corp creates debt basis (Treas. Reg. 1.1366-2(a)(2)). Huh? At the risk of belaboring this too much, consider the following-

• You buy a piece of equipment for $100,000, with a loan in the business name that you personally guarantee.
• You deduct 100% of the purchase price using bonus depreciation.
• You had $100,000 of cash revenue and a $100,000 deduction, leaving $0 of net business income after expenses. Nice!
• But you have $100,000 in the business checking account, and like most business owners, you sort of kind of would like to spend it.

In an MMLLC taxed as a partnership, the loan already increased your basis, so you could distribute the $100,000 without creating a capital gain. In an MMLLC taxed as an S corporation, the $100,000 distribution could exceed your stock basis and create capital gains tax. Your stock basis didn’t change during the year, since the business had $0 of income. So, December 31’s basis equals January 1’s basis, but you have a bunch of cash earned from revenue, and depreciation reduced your income to $0. Depreciation is a cashless expense. Good and bad, right? No taxable income, good. No access to the cash through a tax-free distribution if you don’t have enough stock basis, bad.

Here is the scorecard-

The fix is in how the money goes in, so it can come back out. Distributions from an S Corp are tested against stock basis only, not debt basis (IRC Section 1368). So the cleaner routes are-

• Shareholders contribute capital. If your lender will lend to the shareholders personally and the shareholders contribute the money to the S Corp, the contribution increases stock basis and supports a tax-free distribution later.
• Shareholders lend to the S Corp. The company can then repay the loan out of that $100,000 of cash. A repayment is a return of principal, not a distribution, and it is tax-free as long as the loss deductions haven’t eaten the debt basis.

With multiple shareholders, contributions and the distributions that follow must be coordinated with everyone’s ownership and basis, since one shareholder’s extra basis doesn’t buy preferential distributions. Speak to your lender before doing any of this! If your lender can give the shareholders the cash to lend or contribute to the S Corp and still retain a lien on the equipment, that might be the preferred route.

This is not a showstopper per se, and we definitely geeked out a bit. And here is the subtle part we haven’t highlighted until now. The distribution version of this problem is worst when the mothership is sending cash out as distributions, like the original version where the S Corps owned the mothership. When the cash leaves as fees for services, the distribution problem mostly goes away. But it can show up in a different costume. If the mothership pays out the $100,000 as fees and still deducts $100,000 of bonus depreciation, it has a $100,000 loss, and an S Corp shareholder can only deduct losses up to their stock and debt basis (IRC Section 1366(d)). Without basis, that loss gets suspended. Either way, debt-financed equipment in an S Corp mothership deserves a conversation before you buy it.

Again, our apologies for getting into the weeds on this. WCG CPAs & Advisors can always review your unique situation to help avoid this trap.