Tax Law ✦ Entity Selection & S Corp Planning
California Charges You for the Wrong Entity Every Year.
The LLC fee, the S corporation tax, the $800 minimum, the pass-through entity election, and the federal self-employment and qualified business income rules all interact, and the combination decides what a California business owner pays for the next decade. North Star Law Firm models the options on your actual numbers before anything is filed, then does the filing. Attorney-CPA. Flat fees. Statewide.
The Short Answer
For most profitable California businesses, an S corporation. For most everything else, it depends.
A profitable operating business with one to a few owners usually saves real money as an S corporation: California takes 1.5 percent of net income instead of the LLC gross-receipts fee, and federally the owners pay payroll tax on a reasonable salary instead of self-employment tax on every dollar. A real estate holding company usually should not be an S corporation, because appreciated property inside one cannot come out without tax. A business raising outside capital or planning a sale under the federal qualified small business stock rules may want a C corporation, with the caveat that California does not honor those rules at all. And a business with less than $250,000 in revenue and thin margins may simply be an LLC paying the $800 minimum. The right answer is a spreadsheet, and we build it before you form anything.
- Choice of entity: LLC, S corporation, C corporation, partnership, or sole proprietorship, modeled on your numbers
- S corporation elections (Form 2553), late elections under Rev. Proc. 2013-30, and revocations
- Reasonable compensation planning for S corporation owners
- California’s elective pass-through entity tax (R&TC § 19900) and the federal SALT cap
- Section 199A qualified business income planning; California non-conformity
- Multi-entity structures: holding companies, management companies, and real estate carve-outs
The California Layer
What does each entity cost in California?
California’s entity-level taxes are the part most online formation services never mention. These are the state amounts; the federal treatment stacks on top.
| Entity | California tax | Federal owner tax | Watch out for |
|---|---|---|---|
| LLC (default partnership or disregarded) | $800 annual tax (R&TC § 17941) plus a fee on gross receipts: $900 at $250,000, $2,500 at $500,000, $6,000 at $1 million, $11,790 at $5 million (R&TC § 17942) | Self-employment tax on active members’ entire share; § 199A deduction may apply | The fee is on gross receipts, not profit; a high-volume, low-margin business pays it whether or not it makes money |
| S corporation (corporation or LLC electing) | 1.5% of net income, $800 minimum (R&TC § 23802) | Payroll tax on reasonable salary only; distributions exempt from SE tax; § 199A on the pass-through | Salary must be reasonable (the IRS and EDD both audit it); one class of stock; no non-resident-alien owners |
| C corporation | 8.84% of net income, $800 minimum (R&TC § 23151) | 21% federal corporate rate, then tax on dividends | California does not conform to § 1202 qualified small business stock; a QSBS exit is fully taxed by the state |
| Limited partnership / LLP | $800 annual tax | Partnership rules; SE tax on general partners | Used mainly for funds and for professionals who cannot form an LLC |
| Sole proprietorship | None at the entity level | SE tax on all net profit | No liability protection; the option most owners outgrow first |
When does the S election pay for itself?
When the savings on self-employment tax exceed the added cost of running payroll and California’s 1.5 percent. As a rule of thumb, an owner netting $80,000 to $100,000 or more from an operating business benefits; below that, the payroll costs and the state tax often eat the savings. The variable is the reasonable salary. The IRS expects an S corporation owner who works in the business to take a wage comparable to what the business would pay someone else for the same work, and the EDD expects the same for California payroll tax purposes. A salary set too low invites reclassification of distributions as wages, with payroll taxes and penalties; a salary set too high wastes the election. We set it from compensation data for your role and document the basis.
The election itself is a two-page form, but it has to be filed within two months and fifteen days of the start of the tax year to be effective for that year. A missed election can usually be made late under Rev. Proc. 2013-30, with a reasonable-cause statement, and California follows the federal election automatically.
What is the pass-through entity tax, and should you elect it?
The federal cap on the state and local tax deduction limits what you can deduct for California income tax on your federal return. California’s workaround (R&TC § 19900, originally AB 150, extended by later legislation) lets an S corporation, partnership, or LLC taxed as either elect to pay a 9.3 percent tax on each consenting owner’s share of income at the entity level, where it is fully deductible federally, and gives the owner a credit on the California return for the same amount. For an owner in the top brackets whose California tax exceeds the federal cap, it converts a non-deductible personal tax into a deductible business expense. Timing rules apply: an initial payment is due by June 15 of the tax year to preserve the election. We model whether the election helps at your income level and calendar the payments.
The Attorney-CPA Difference
The formation service files the form. We decide what the form should say.
- Entity options modeled on your actual revenue, margin, and owner count
- S elections filed on time, or fixed when they were not
- Reasonable compensation set from data and documented for the IRS and the EDD
- Pass-through entity election evaluated and calendared
- Formation and governing documents prepared through the business law practice
Questions & Answers
Entity selection questions California owners ask
I already have an LLC. Can it become an S corporation?
Yes, by filing Form 2553 to elect S corporation treatment for the LLC; no new entity is required. The operating agreement usually needs amendments to satisfy the single-class-of-stock rule, and the election timing rules apply.
Should my rental properties be in an S corporation?
Almost never. Appreciated real estate distributed out of an S corporation is taxed as if sold, and the properties lose the ability to be refinanced and distributed tax-free. Rentals belong in an LLC taxed as a partnership or disregarded entity, or held directly.
Does the $800 minimum apply in the first year?
Currently, yes. The first-year exemption for LLCs, LPs, and LLPs that formed in 2021 through 2023 has expired, and corporations pay the minimum from their first year. The tax is due whether or not the entity has any income.
Is the § 199A deduction available in California?
Federally, yes, subject to the income and business-type limits. California does not conform, so there is no state equivalent; the state cost of pass-through income is the same regardless.
Get the entity right before the first return, not after the tenth.
A free entity analysis with an attorney-CPA, and a flat fee in writing for the formation and the elections.