Choosing your business entity in California is not a one-size-fits-all decision. The entity you select—whether a limited liability company, an S-corporation, or a C-corporation—will determine how much you pay in taxes at both the federal and California state levels, what compliance burdens you shoulder, how attractive your company appears to investors, and what your exit strategy looks like when you eventually sell or transfer the business. This guide provides California-specific analysis with real numbers, comparing what each structure actually costs at different profit levels and what trade-offs you’re making with each choice.

Why Entity Choice Matters More in California Than Almost Anywhere Else

California is not a tax-friendly state for business entities. Unlike states that impose no income tax or offer minimal franchise fees, California imposes entity-level taxes and fees that make the math materially different from a federal-only analysis. An LLC in Wyoming or Delaware faces no state income tax and minimal annual fees. That same LLC organized in California—or merely “doing business” in California—faces an $800 annual minimum tax plus a tiered gross receipts fee that can reach $11,790 for high-revenue businesses.

This California layer changes the calculus. A business owner who reads generic “LLC vs S-Corp vs C-Corp” advice online is often getting federal-only analysis that ignores the California Franchise Tax Board. The optimal entity choice for a Texas business might be completely wrong for a California one. Throughout this guide, the focus is on the combined federal and California tax picture, because that’s what actually hits your bank account.

Understanding the Three Entity Types

The California LLC

A limited liability company formed under the California Revised Uniform Limited Liability Company Act (Corporations Code section 17701.01 and following) is a hybrid entity. It provides the liability protection of a corporation while allowing the tax treatment flexibility of a partnership. The LLC itself is not a tax classification—it’s a legal structure. For federal tax purposes, a single-member LLC defaults to disregarded entity status (meaning the IRS ignores it and taxes the owner directly), while a multi-member LLC defaults to partnership treatment (the LLC files an informational return but does not pay entity-level federal tax).

The LLC structure offers maximum flexibility in allocating profits, losses, and distributions among members. Through the operating agreement, members can create allocation schemes that bear no relationship to ownership percentages—something not possible with corporations. This flexibility makes LLCs attractive for real estate ventures, family businesses, and situations where capital contributions and labor contributions differ among owners.

The S-Corporation

An S-corporation is not a type of entity under California law. Rather, it’s a tax election. You form either a regular corporation under California law or, alternatively, you form an LLC and elect to have it taxed as a corporation and then make the S-election. The S-election is made by filing Form 2553 with the IRS, which causes the corporation to be treated as a pass-through entity for federal purposes. Income passes through to shareholders and is taxed on their individual returns, avoiding the double taxation that plagues C-corporations.

California respects the federal S-election but imposes its own twist: a 1.5 percent tax on net income at the entity level, with an $800 minimum. This means California S-corporations pay more entity-level tax than their federal pass-through status would suggest, but significantly less than C-corporations.

The S-corporation structure comes with rigid requirements. The entity can have no more than 100 shareholders. All shareholders must be U.S. citizens or resident aliens—no foreign shareholders permitted. Only individuals, certain trusts, and estates can be shareholders, meaning venture capital funds (which are typically LLCs or limited partnerships) cannot invest in S-corporations. The entity can have only one class of stock, though voting right differences are permitted. These restrictions make S-corporations unsuitable for companies seeking institutional investment or those with international ownership structures.

The C-Corporation

A C-corporation is the default corporate form. It’s a separate taxpaying entity at both federal and California levels. The corporation pays tax on its income, and when profits are distributed to shareholders as dividends, those shareholders pay tax again on the distribution. This double taxation is the defining characteristic of C-corporations and the reason many small business owners avoid them.

However, C-corporations offer advantages that justify the double tax burden in specific circumstances. They provide unlimited flexibility in capital structure—multiple classes of stock with different economic and voting rights, which is essential for venture capital financing. They have no restrictions on shareholder identity, meaning foreign investors, corporations, and partnerships can all be shareholders. Most importantly for startups with substantial exit potential, C-corporation stock can qualify for the Qualified Small Business Stock exclusion under Internal Revenue Code section 1202, which can eliminate federal capital gains tax entirely on up to $10 million in gain.

Tax Comparison: Federal Level

Federal Taxation of LLCs

When taxed in default mode, an LLC’s income flows through to its owners. For a single-member LLC, all net income appears on the owner’s Schedule C (or Schedule E if it’s rental income, or Schedule F if it’s farm income). The owner pays ordinary income tax on this profit based on their marginal tax rate, which can reach 37 percent at the highest federal bracket.

The more painful federal cost for LLC owners is self-employment tax. Net income from a trade or business is subject to self-employment tax at 15.3 percent—comprising 12.4 percent for Social Security (up to the annual wage base, which is $176,100 for 2025) and 2.9 percent for Medicare. Additionally, net earnings above $200,000 for single filers trigger an additional 0.9 percent Medicare tax. This self-employment tax applies to the entire net profit of the business, not just what the owner withdraws.

Consider an LLC with $150,000 in net profit. The owner pays self-employment tax on roughly 92.35 percent of that amount (Schedule SE adjusts for the employer-equivalent portion), resulting in approximately $21,194 in self-employment tax alone, before a single dollar of income tax. This self-employment tax burden is one of the primary reasons business owners seek alternatives to default LLC taxation.

On the positive side, LLC owners with qualified business income can claim the 20 percent pass-through deduction under Section 199A. This deduction reduces the taxable portion of qualified business income by 20 percent, though it phases out for specified service trades or businesses once taxable income exceeds threshold amounts (which are inflation-adjusted annually). At $150,000 of net LLC profit for an owner well under the phase-out thresholds, the QBI deduction could reduce taxable income by $30,000, providing meaningful tax savings.

Federal Taxation of S-Corporations

S-corporations file Form 1120-S and issue Schedule K-1s to shareholders showing their proportionate share of income, deductions, and credits. Like LLCs, S-corporations are pass-through entities at the federal level—no federal income tax is paid at the corporate level.

The critical difference lies in self-employment tax treatment. S-corporation shareholders who work in the business must receive “reasonable compensation” for their services, and this compensation is subject to payroll taxes (FICA). However, distributions beyond reasonable compensation are not subject to self-employment tax or FICA. This creates the primary tax advantage of S-corporations over default LLC taxation.

Using the same $150,000 net profit example, assume the business has one owner who works full-time in the business. The S-corporation might pay the owner a salary of $80,000, which both the owner and the corporation pay FICA on (7.65 percent each side, or 15.3 percent total on the $80,000). The remaining $70,000 passes through as ordinary income on the K-1 but escapes FICA entirely. The payroll tax is $12,240 on the salary portion, compared to approximately $21,194 if the entire $150,000 were subject to self-employment tax as with a default LLC. The owner saves nearly $9,000 annually in payroll taxes.

The “reasonable compensation” requirement is not optional. The IRS scrutinizes S-corporations that pay artificially low salaries to maximize distribution-based tax savings. If audited, an S-corporation paying its full-time CEO-owner $30,000 annually while distributing $120,000 will likely face recharacterization of distributions as wages, along with penalties and interest. The salary must reflect what the business would pay an unrelated party for similar services. For most owner-operators working full-time, reasonable compensation typically falls between 50 and 70 percent of net profits, though this depends heavily on industry standards, geographic location, and the specific services performed.

S-corporation income also qualifies for the Section 199A pass-through deduction, applied to the K-1 income (not the W-2 wages). In the example above, the $70,000 distribution portion could generate a $14,000 QBI deduction, reducing taxable income accordingly.

Federal Taxation of C-Corporations

C-corporations pay federal income tax at a flat 21 percent rate on their taxable income (Internal Revenue Code section 11). When after-tax profits are distributed to shareholders as dividends, shareholders pay tax at qualified dividend rates—0 percent, 15 percent, or 20 percent depending on their income bracket, plus potentially the 3.8 percent net investment income tax for high earners.

Using the $150,000 profit example for a single-owner C-corporation where the owner takes no salary and the entire profit is taxable to the corporation:

The corporation pays $31,500 in federal corporate tax (21 percent of $150,000). The remaining $118,500 can be distributed as a dividend. If the shareholder is in the 15 percent qualified dividend bracket, federal tax on the dividend is $17,775. Combined federal tax burden: $49,275, or about 33 percent of the original $150,000. This significantly exceeds the LLC or S-corporation burden at this income level.

However, this analysis assumes distribution of all profits. Many C-corporations retain earnings for reinvestment, deferring the second layer of tax until dividends are actually paid. Additionally, C-corporation owners who are also employees can receive wages (deductible to the corporation), fringe benefits (often tax-free to the employee and deductible to the corporation), and qualified retirement plan contributions with higher limits than self-employed plans. Strategic compensation planning can mitigate the double taxation concern.

The strongest federal tax argument for C-corporations lies in the Qualified Small Business Stock provision. If stock is acquired at original issuance from a C-corporation, the corporation has gross assets of $50 million or less at the time of issuance and immediately after, the corporation is engaged in an active trade or business (not certain service businesses), and the shareholder holds the stock for more than five years, then gain on sale of that stock may be excluded from federal income tax. For stock acquired after September 27, 2010, the exclusion is 100 percent of the gain, up to the greater of $10 million or ten times the shareholder’s basis in the stock.

A founder who invests $10,000 into a C-corporation at formation and sells their stock five years later for $5,010,000 could exclude the entire $5 million gain from federal taxation under Section 1202. Without QSBS, that gain would generate $1,190,000 in federal tax (assuming 20 percent capital gains plus 3.8 percent NIIT). The QSBS benefit is potentially massive for high-growth startups expecting substantial exits.

Tax Comparison: California State Level

California Taxation of LLCs

California imposes two separate charges on LLCs: the annual tax and the LLC fee.

The annual LLC tax is $800, due every year for any LLC organized in California or doing business in California. This tax is owed regardless of whether the LLC has any income. It’s due by the 15th day of the 4th month of the taxable year. A calendar-year LLC formed on January 1 owes its first $800 by April 15 of that same year, then owes another $800 by April 15 of the following year, and so on.

The LLC fee is separate from the annual tax and is based on California-source gross receipts (not net income). The current fee structure is:

Total California-source gross receipts from $250,000 to $499,999: $900 fee
Total California-source gross receipts from $500,000 to $999,999: $2,500 fee
Total California-source gross receipts from $1,000,000 to $4,999,999: $6,000 fee
Total California-source gross receipts of $5,000,000 or more: $11,790 fee

This fee is estimated and paid with Form 3536 by the 15th day of the 6th month of the taxable year and reconciled when filing Form 568 (the LLC return) by the 15th day of the 4th month following the close of the taxable year.

Note that the fee is based on gross receipts, not net profit. A consulting firm with $600,000 in revenue but only $100,000 in net profit still pays the $2,500 fee. A product business with $3 million in revenue but thin margins and $50,000 in profit pays the $6,000 fee. This gross receipts basis makes the LLC fee particularly burdensome for high-revenue, low-margin businesses.

Beyond the entity-level taxes, LLC members pay California personal income tax on their share of the LLC’s income. California’s top personal income tax rate is 14.4 percent (including the mental health services tax), and it kicks in at $1 million in taxable income. For most small business owners, the marginal rate will likely fall between 9.3 percent and 12.3 percent.

California Taxation of S-Corporations

California respects the federal S-election but imposes a 1.5 percent tax on net income at the entity level, with an $800 minimum. An S-corporation with $200,000 in net income pays $3,000 in California franchise tax (1.5 percent of $200,000). An S-corporation with $40,000 in net income would calculate $600 at the 1.5 percent rate but pays $800 because of the minimum.

Shareholders then pay California personal income tax on their K-1 income at ordinary rates. There is no separate “LLC fee” for S-corporations, only the 1.5 percent net income tax with the $800 floor.

This structure means that at lower income levels, S-corporations pay more in California entity tax than LLCs. An LLC with $100,000 in net profit and $200,000 in gross receipts pays $800 to California (no LLC fee applies since gross receipts are under $250,000). An S-corporation with the same $100,000 in net profit pays $1,500 (1.5 percent of $100,000). However, at higher gross receipts levels, the math can flip. An LLC with $500,000 in gross receipts and $80,000 in net profit pays $800 plus $2,500 ($3,300 total). An S-corporation with the same $80,000 net profit pays $1,200 (1.5 percent of $80,000). The S-corporation wins by $2,100 at the California state level.

California Taxation of C-Corporations

C-corporations pay California franchise tax at 8.84 percent of net income (10.84 percent for banks and financial institutions), with an $800 minimum. This rate applies to taxable income calculated under California rules, which generally conform to federal but have certain modifications.

A C-corporation with $150,000 in net income pays $13,260 in California franchise tax (8.84 percent of $150,000). Combined with the $31,500 federal corporate tax, the total entity-level tax burden is $44,760 before any dividends are distributed. When dividends are distributed to California-resident shareholders, those shareholders pay California personal income tax at ordinary rates (not at a preferential capital gains rate—California does not distinguish between ordinary income and capital gains for state tax purposes).

The 8.84 percent California corporate rate, combined with the 21 percent federal rate, means C-corporations face nearly 30 percent entity-level taxation before a dollar reaches shareholders. This is substantially higher than the pass-through alternatives and explains why C-corporations are generally reserved for businesses expecting venture capital investment or QSBS-qualifying exits.

Real-Number Scenarios at Different Profit Levels

Scenario One: $100,000 Net Profit, $180,000 Gross Receipts

Default LLC:
Federal self-employment tax: approximately $14,130 (15.3 percent on 92.35 percent of $100,000)
California LLC tax: $800 (no LLC fee since gross receipts under $250,000)
Federal income tax: Varies by total income, but assume 22 percent bracket on QBI-reduced amount
QBI deduction: $20,000 (20 percent of $100,000), reducing taxable income to $80,000
Federal income tax on $80,000: approximately $17,600
Total tax burden: approximately $32,530 plus California personal income tax on $100,000

S-Corporation (reasonable salary: $65,000; distribution: $35,000):
Payroll tax: $9,945 (15.3 percent of $65,000)
California entity tax: $1,500 (1.5 percent of $100,000)
QBI deduction on $35,000 distribution: $7,000
Federal income tax on wages plus reduced distribution: approximately $15,500
Total tax burden: approximately $26,945 plus California personal income tax
Savings over LLC: approximately $5,585

C-Corporation (assuming all profit retained, no salary, unrealistic but illustrative):
Federal corporate tax: $21,000 (21 percent of $100,000)
California corporate tax: $8,840 (8.84 percent of $100,000)
Total entity tax: $29,840
No personal-level tax until distributed
If distributed as dividend with 15 percent qualified dividend rate federally: additional $10,524 plus California personal tax

At $100,000 in net profit, the S-corporation provides meaningful payroll tax savings over the default LLC while avoiding the heavy entity-level burden of the C-corporation. The S-corporation’s California 1.5 percent tax exceeds the LLC’s $800, but the federal payroll tax savings more than compensate.

Scenario Two: $300,000 Net Profit, $500,000 Gross Receipts

Default LLC:
Federal self-employment tax: approximately $27,825 (Social Security maxes out at $176,100 wage base in 2025)
California LLC tax: $800
California LLC fee: $2,500 (gross receipts between $500,000 and $999,999)
California total: $3,300
QBI deduction: $60,000 (20 percent of $300,000), though phase-outs may apply for specified service businesses
Federal income tax: approximately $48,000 (varies by total income)
Total tax burden: approximately $79,125 plus California personal income tax

S-Corporation (reasonable salary: $150,000; distribution: $150,000):
Payroll tax: $22,950 (15.3 percent of $150,000)
California entity tax: $4,500 (1.5 percent of $300,000)
QBI deduction on $150,000 distribution: $30,000
Federal income tax: approximately $39,000
Total tax burden: approximately $66,450 plus California personal income tax
Savings over LLC: approximately $12,675

At this profit level, the S-corporation advantage increases substantially. The LLC’s gross receipts-based fee ($2,500) combines with the self-employment tax burden to make the default LLC expensive. The S-corporation’s 1.5 percent California tax ($4,500) exceeds the LLC’s California total ($3,300), but the federal payroll tax savings dwarf this difference.

Scenario Three: $1,000,000 Net Profit, $2,000,000 Gross Receipts

Default LLC:
Federal self-employment tax: approximately $36,700 (capped Social Security plus full Medicare plus Additional Medicare)
California LLC tax: $800
California LLC fee: $6,000 (gross receipts between $1 million and $5 million)
California total: $6,800
QBI deduction: likely limited by phase-out provisions or W-2 wage limitations
Federal income tax: approximately $330,000
Total tax burden: approximately $373,500 plus California personal income tax

S-Corporation (reasonable salary: $400,000; distribution: $600,000):
Payroll tax: $29,000 (approximate, accounting for wage base limits and Additional Medicare Tax)
California entity tax: $15,000 (1.5 percent of $1,000,000)
Federal income tax: approximately $300,000
Total tax burden: approximately $344,000 plus California personal income tax
Savings over LLC: approximately $29,500

At $1 million in profit, the LLC’s gross receipts-based fee becomes particularly punishing, and the S-corporation’s 1.5 percent tax, while significant, still results in meaningful overall savings when combined with federal payroll tax efficiency.

Administrative and Compliance Burdens

LLC Compliance Requirements

Forming an LLC in California requires filing Articles of Organization (Form LLC-1) with the California Secretary of State, paying the $70 filing fee, and submitting a Statement of Information (Form LLC-12) within 90 days of formation. The Statement of Information must be updated biennially, with a $20 filing fee each time.

LLCs must adopt an operating agreement (though this is not filed with the state), maintain a registered agent in California, and keep appropriate records. If the LLC elects to be manager-managed rather than member-managed, that information appears on the Articles of Organization.

For tax compliance, a single-member LLC files Schedule C with the owner’s personal return. A multi-member LLC files Form 1065 (partnership return) with the IRS and Form 568 (LLC return) with the Franchise Tax Board. Members receive Schedule K-1s showing their allocable share of income, deductions, and credits.

LLCs must pay estimated taxes quarterly if the owner expects to owe $1,000 or more in tax. The $800 annual LLC tax is paid via voucher (Form 3522), and the LLC fee (if applicable) is estimated and paid via Form 3536.

The administrative burden for LLCs is lighter than corporations in terms of formalities. No requirement exists for annual meetings, maintaining meeting minutes, or formal resolutions for every business decision. The operating agreement governs internal affairs, and members have flexibility in how they document decisions.

S-Corporation Compliance Requirements

S-corporations face the same formation requirements as any California corporation. Articles of Incorporation (Form ARTS-GS for a general stock corporation) must be filed with the Secretary of State with a $100 filing fee. The corporation must adopt bylaws, hold an organizational meeting, elect officers, issue stock, and file a Statement of Information (Form SI-550 for stock corporations) within 90 days of formation and annually thereafter for a $25 fee.

Corporate formalities are not optional. The corporation should maintain corporate minutes, hold annual shareholder and director meetings, document major decisions through resolutions, and keep the corporation’s affairs separate from personal affairs of shareholders. Failure to observe formalities can lead to piercing the corporate veil, eliminating the liability protection the corporate structure provides.

The S-election requires filing Form 2553 with the IRS within 2 months and 15 days of the beginning of the tax year in which the election is to take effect. California also requires filing a separate S-corporation election with the Franchise Tax Board.

Tax compliance is more complex than for LLCs. The S-corporation files Form 1120-S federally and Form 100S with California. Shareholders receive Schedule K-1s. The corporation must run payroll for shareholder-employees, which means filing quarterly 941 returns with the IRS, quarterly DE 9 and DE 9C with California’s Employment Development Department, annual Form 940 (FUTA), annual W-2s, and handling withholding and remittance obligations. Payroll compliance adds substantial administrative overhead and often requires engaging a payroll service provider.

The reasonable compensation requirement demands ongoing attention. Compensation should be reviewed periodically to ensure it reflects market rates. Documentation supporting the compensation level—such as industry surveys, job descriptions, and time allocation—should be maintained in case of IRS audit.

C-Corporation Compliance Requirements

C-corporations share the same formation and corporate formality requirements as S-corporations—Articles of Incorporation, bylaws, organizational meeting, annual meetings, minutes, and annual Statement of Information filings. The difference lies in tax compliance and the absence of S-corporation restrictions.

C-corporations file Form 1120 federally and Form 100 with California. They pay estimated taxes quarterly at the corporate level. If dividends are distributed, shareholders report dividend income on their personal returns.

C-corporations can provide tax-advantaged fringe benefits to employee-shareholders—health insurance premiums deducted by the corporation and excluded from the employee’s income, group term life insurance up to $50,000, qualified retirement plans with potentially higher contribution limits, and other benefits. These perks are less available or unavailable in S-corporation or LLC contexts.

Stock issuance and maintenance in C-corporations involves securities law compliance at both federal and state levels. California exemptions must be claimed properly, stockholder records must be maintained, and any equity compensation plans (stock options, restricted stock) must be carefully structured.

Financing and Investment Considerations

Attracting Investors with an LLC

Venture capital firms and institutional investors generally avoid investing in LLCs. The primary reason is tax structure—LLCs pass through income to members via Schedule K-1, and many institutional investors (pension funds, endowments, foreign entities) face complications receiving K-1 income. Tax-exempt investors may trigger unrelated business taxable income. Foreign investors may face withholding requirements and U.S. tax filing obligations they prefer to avoid.

Additionally, LLCs lack the standardized equity compensation infrastructure of corporations. While LLCs can grant profits interests (a form of equity compensation), these are less familiar to investors and employees than stock options. The absence of multiple stock classes makes it difficult to create the preferred stock/common stock structure typical in venture financing.

Angel investors and individual investors may be more comfortable with LLCs, particularly if the business is in real estate or professional services where LLC structures are common. However, if the business has any realistic prospect of seeking venture capital, forming as an LLC creates friction that will need to be resolved through conversion later.

Attracting Investors with an S-Corporation

S-corporations cannot accept investment from venture capital funds (which are typically LLCs or limited partnerships), corporations, or nonresident aliens. The 100-shareholder limit further restricts capital-raising possibilities. These restrictions make S-corporations incompatible with traditional venture financing.

S-corporations can accept investment from individual angel investors who are U.S. citizens or residents, making them workable for businesses seeking modest outside capital from friends, family, or individual angels. However, the single-class-of-stock requirement prevents creating preferred stock with liquidation preferences, anti-dilution provisions, and other investor-friendly terms standard in venture deals.

For businesses that never intend to seek institutional capital—service businesses, professional practices, lifestyle businesses—the S-corporation’s investor restrictions are irrelevant, and the tax benefits dominate the analysis.

Attracting Investors with a C-Corporation

C-corporations are the default choice for venture-backed companies. They accommodate unlimited shareholders of any type (individuals, corporations, LLCs, foreign entities, tax-exempt organizations), support multiple stock classes (common, preferred Series A, Series B, etc.), and enable standard equity compensation plans (incentive stock options, nonqualified stock options, restricted stock units).

Venture capital financing documents are built around C-corporation structures. Model legal documents from organizations like the National Venture Capital Association assume C-corporation form. Convertible notes, SAFEs, and priced rounds all contemplate C-corporation conversion or formation.

The QSBS benefit provides additional incentive for investors. Founders, employees exercising options, and investors who receive stock directly from the C-corporation can all potentially qualify for Section 1202 exclusion, making the exit much more tax-efficient than selling LLC membership interests or S-corporation stock.

If the business plan includes seeking venture capital or expects an IPO or acquisition by a public company, forming as a C-corporation from the outset avoids the disruption and expense of converting later. Converting an LLC to a C-corporation mid-stream has tax consequences and legal complexity that planning ahead can eliminate.

Exit and Long-Term Planning

Exiting from an LLC

When selling an LLC, the transaction typically structures as either a sale of membership interests or a sale of the LLC’s assets.

In an interest sale, the sellers transfer their ownership in the LLC to the buyer. The sellers recognize gain equal to the difference between their sales proceeds and their outside basis in the LLC interests. This gain is generally capital gain, though depreciation recapture can cause a portion to be taxed as ordinary income.

In an asset sale, the LLC sells its assets to the buyer, and the LLC then distributes the proceeds to its members (either in liquidation or as a distribution). Because the LLC is a pass-through entity, the gain on asset sale passes through to members and is taxed on their individual returns. The character of the gain depends on the assets sold—inventory generates ordinary income, depreciable property generates Section 1231 or Section 1250 recapture income, and capital assets generate capital gain.

Buyers often prefer asset sales because they receive a stepped-up basis in the acquired assets, enabling higher depreciation deductions and lower future gain. Sellers prefer interest sales to obtain capital gain treatment. Negotiating this structure is a significant deal point.

Importantly, LLC membership interests do not qualify for QSBS exclusion. No matter how long held or how the LLC is structured, Section 1202 does not apply. The inability to access QSBS is a substantial disadvantage for high-growth LLCs expecting significant appreciation.

Exiting from an S-Corporation

S-corporation exits typically structure as stock sales or asset sales.

In a stock sale, shareholders sell their stock to the buyer. Gain is the difference between sale proceeds and stock basis, taxed as capital gain (long-term if held more than one year). This single level of taxation, combined with capital gains rates, makes stock sales attractive to sellers.

Buyers of S-corporation stock do not receive a stepped-up basis in the underlying assets—they take the seller’s basis in the assets. To obtain a basis step-up, buyers push for asset sales. When an S-corporation sells assets, the gain passes through to shareholders on their K-1s and is taxed once at the shareholder level. Shareholders prefer stock sales for simplicity and certainty of capital gain treatment.

S-corporation stock also does not qualify for QSBS exclusion. Section 1202 applies only to C-corporation stock meeting specific requirements. An S-corporation’s pass-through status disqualifies it.

For S-corporations that converted from C-corporations within the prior ten years, built-in gains tax rules may apply, imposing a corporate-level tax on gains inherent in assets at the time of conversion. This is an important consideration for businesses contemplating S-election after years of C-corporation operation.

Exiting from a C-Corporation

C-corporation exits structure as stock sales or asset sales, with dramatically different tax consequences.

In a stock sale, shareholders sell stock and recognize capital gain. If the stock qualifies as QSBS under Section 1202, up to 100 percent of the gain may be excluded from federal income tax (for stock acquired after September 2010), with the exclusion capped at the greater of $10 million or ten times the shareholder’s basis. For a founder who acquired stock for $100,000 and sells for $10 million, the entire $9.9 million gain could be excluded. Without QSBS, that gain faces 20 percent federal capital gains tax plus 3.8 percent net investment income tax, totaling $2.35 million. The QSBS benefit is extraordinary.

California does not conform to Section 1202, meaning California taxes QSBS gain at ordinary income rates. This partially offsets the federal benefit but does not eliminate it.

In an asset sale, the C-corporation sells its assets and recognizes gain at the corporate level, paying 21 percent federal tax and 8.84 percent California tax. After these taxes, the remaining proceeds distributed to shareholders are taxed again as dividends or liquidating distributions. Double taxation applies fully in asset sales, making them much less attractive than stock sales for C-corporation shareholders.

Buyers prefer asset sales (stepped-up basis) while C-corporation sellers strongly prefer stock sales (QSBS benefit, avoiding double tax). This conflict shapes deal negotiations significantly.

Section 1244 provides a minor benefit on the downside: if the C-corporation fails and the stock becomes worthless, shareholders can treat up to $100,000 of loss ($50,000 if married filing separately) as ordinary loss rather than capital loss, providing more immediate tax benefit. This is small consolation compared to the QSBS upside but worth noting.

The “Doing Business” Nexus Trap

California aggressively asserts taxing jurisdiction over businesses with California connections. Revenue and Taxation Code section 23101 defines “doing business” in California broadly: engaging in any transaction for the purpose of financial gain, or meeting any of the bright-line tests based on California sales, property, or payroll.

The bright-line thresholds for 2025 (these are indexed annually) are approximately:

• California sales exceeding $757,070, or California sales representing more than 25 percent of total sales
• California real and tangible personal property exceeding $75,707, or California property representing more than 25 percent of total property
• California compensation exceeding $75,707, or California compensation representing more than 25 percent of total compensation

Meeting any one of these tests or engaging in any transaction for financial gain in California causes the entity to be “doing business” in California, triggering the $800 minimum franchise tax (or the 1.5 percent/8.84 percent income tax, whichever is higher) regardless of where the entity was formed.

This means a business formed in Delaware, Wyoming, Nevada, or any other state must still pay California taxes if it meets California’s nexus standards. The common misconception that forming in Delaware avoids California taxes is false for businesses with California operations. A Delaware LLC with California customers, California employees, or California property faces California’s $800 annual tax plus the LLC fee—all while also maintaining Delaware annual reporting ($300 annual tax for Delaware LLCs) and registering as a foreign LLC in California (additional fees and compliance obligations).

For businesses truly operating in California—founder lives in California, customers are in California, services performed in California—forming in another state provides no California tax advantage and adds complexity and cost. The sole benefit of Delaware formation is access to Delaware’s well-developed corporate law and Court of Chancery, which matters primarily for complex governance disputes. For most small businesses and startups, California formation is more practical.

Which Entity Type Makes Sense for Different Situations

Choose a Default LLC When

The business is a single-owner service business with modest revenue (under $250,000 gross receipts) and the owner does not plan to seek outside investment. The simplicity of LLC administration, combined with the absence of the LLC fee at lower revenue levels, makes this attractive. The self-employment tax burden exists but may be tolerable given the administrative ease.

The business has multiple owners with differing capital and labor contributions, and the owners need flexibility in allocating profits and losses disproportionately to ownership percentages. Real estate joint ventures, investment partnerships, and family businesses often fall here.

Foreign owners are involved, disqualifying S-corporation status.

The business is a service business in a licensed profession where California law prohibits LLCs (certain professions must use professional corporations or limited liability partnerships), but where that is not the case, the LLC offers flexibility without corporate formalities.

Choose an S-Corporation When

The owner works actively in the business, earns substantial profits (generally exceeding $75,000-$100,000 net annually), and wants to reduce self-employment tax liability through the salary/distribution split. The payroll tax savings outweigh the administrative burden of running payroll and maintaining corporate formalities.

All owners are U.S. citizens or residents, and no institutional investment is anticipated. Family-owned businesses, professional service firms (that are not legally required to be other entity types), and owner-operated companies with stable ownership structures fit well.

The owner is comfortable with the increased record-keeping and corporate governance requirements—annual meetings, minutes, bylaws, formal resolutions—and either enjoys the structure or engages professionals to handle compliance.

Choose a C-Corporation When

The business has realistic potential for venture capital financing or institutional investment. The ability to issue preferred stock, accommodate diverse investor types, and provide standard equity compensation is essential.

The founding team is building a high-growth technology startup with an exit strategy (acquisition or IPO) likely to generate substantial capital gains. The QSBS exclusion potential justifies accepting double taxation during the growth phase, particularly if the company reinvests profits rather than distributing them.

The business has significant fringe benefit needs—providing comprehensive health insurance, life insurance, and retirement benefits to owner-employees—where the C-corporation structure provides tax-advantaged treatment.

Foreign ownership is present or anticipated, precluding S-corporation status, and the flexibility limitations of LLC membership structures make C-corporation preferable.

Frequently Asked Questions

Can I start as an LLC and convert to a C-corporation later if I seek venture capital?

Yes, and this is a common path. An LLC can convert to a C-corporation through a statutory conversion (where California law permits), a merger of the LLC into a newly formed corporation, or a contribution of LLC assets to a corporation in exchange for stock. Each method has different tax consequences.

The conversion is generally treated as a taxable event where the LLC members exchange their membership interests for corporate stock. If the LLC’s assets have appreciated, the members recognize gain. Additionally, QSBS qualification begins only when the C-corporation issues the stock—prior time as an LLC does not count toward the five-year holding requirement.

Converting later adds transaction costs, requires legal and tax advice, and resets the QSBS clock. If venture capital is a realistic possibility, forming as a C-corporation initially avoids these complications. However, if venture capital is uncertain, starting as an LLC (for tax efficiency) and converting only if and when institutional investment becomes likely is a reasonable strategy.

What happens if I am an S-corporation shareholder and I move to another state?

The S-corporation itself remains subject to California taxation as long as it does business in California. The shareholder’s personal state of residence determines where the shareholder pays personal income tax on K-1 income.

If a California resident shareholder moves to Texas (no state income tax), the shareholder no longer pays California personal income tax on K-1 income from the S-corporation (assuming the income is not California-source income based on the S-corporation’s apportionment). However, the S-corporation continues paying California’s 1.5 percent entity-level tax because it is doing business in California.

If the shareholder moves to another income tax state like New York, the shareholder pays New York tax on their K-1 income. State income tax planning becomes more complex with multi-state shareholders.

Are the LLC fee thresholds based on net income or gross receipts?

Gross receipts. This is one of the most significant California LLC costs and catches many business owners by surprise. A business with $600,000 in gross receipts pays the $2,500 LLC fee regardless of whether net profit is $200,000 or $10,000. For high-revenue, low-margin businesses (product companies, distributors, certain retailers), the LLC fee can exceed the entity-level tax of an S-corporation dramatically.

The gross receipts threshold applies to California-source gross receipts specifically. If the LLC has both California-source and non-California-source receipts, only the California portion counts toward the fee calculation.

How do I determine “reasonable compensation” for an S-corporation?

No single formula exists, and the IRS does not provide bright-line rules. Factors include the nature of the services performed, industry standards for similar positions, comparable salaries in the geographic area, time devoted to the business, economic conditions, and the S-corporation’s overall financial performance.

Practically, many advisors recommend the shareholder-employee salary represent a substantial portion of net profit—often 50 to 70 percent for owner-operators working full-time in the business. If net profit is $120,000 and the owner works full-time, a salary of $60,000 to $85,000 may be reasonable depending on the specific circumstances.

Documentation is essential. Maintain evidence supporting the compensation level—job descriptions, industry surveys, comparable company data, time tracking, and records showing how the compensation was determined. If audited, the IRS will reclassify distributions as wages if compensation appears artificially low, imposing back payroll taxes plus penalties and interest.

Does California offer any tax advantages for startups?

Unlike some states that offer tax holidays or incentives for new businesses, California does not waive the minimum franchise tax for new LLCs or corporations. The $800 annual minimum applies from year one (the first-year exemption for LLCs that existed under AB 85 expired for taxable years beginning on or after January 1, 2024).

California does offer certain research and development tax credits that can benefit technology companies with qualifying expenditures. Additionally, California allows net operating loss carryforwards, which can offset income in future profitable years if the business generates losses initially. However, these are not special startup incentives but rather standard corporate tax provisions.

The absence of California startup tax breaks makes entity choice cost analysis particularly important. Every entity type faces the $800 minimum floor at minimum, and the California layer cannot be avoided for businesses operating here.

What if my business operates entirely online with no California physical presence, but I live in California?

California asserts that a business is “doing business” in California based on either having a physical presence or meeting the economic nexus thresholds (sales, property, payroll). If the business owner resides in California and performs services for the business from California—even remotely—the business likely has California-source income.

For pass-through entities (LLCs, S-corporations), the member’s or shareholder’s California residency alone triggers California personal income tax on the pass-through income. The entity itself may also be “doing business” in California by having California-resident owners performing services.

Simply incorporating outside California does not eliminate California obligations when the economic activity occurs in California. The FTB’s position is aggressive on these matters, and residency of owners is a significant factor. Consulting with a California tax advisor is essential for businesses with remote or multi-state operations.

Can I avoid the California LLC fee by restructuring my LLC to elect S-corporation tax treatment?

Yes. An LLC that elects to be treated as a corporation for federal tax purposes and then makes the S-election becomes subject to California’s S-corporation taxation (1.5 percent of net income, $800 minimum) rather than the LLC tax structure ($800 annual tax plus gross receipts-based fee).

This election is made by filing Form 8832 (entity classification election) with the IRS to be treated as a corporation, followed by Form 2553 to elect S-corporation status. California requires a separate S-corporation election filing.

The trade-off is increased administrative burden (payroll compliance, corporate formalities) and potentially higher entity-level tax at lower income levels. But for high-gross-receipts, moderate-net-income businesses, eliminating the LLC fee can produce significant savings. A detailed calculation comparing LLC treatment versus S-corporation treatment for the specific business circumstances is necessary before making this election.

This guide provides general legal and tax information regarding California business entity choice and is current as of publication date. Tax laws and regulations change frequently. This information should not be construed as legal or tax advice for your specific situation. Consult with a qualified California attorney and tax advisor regarding your particular circumstances before making entity choice decisions.