Most California business owners think choosing between an S Corp and C Corp is about “pass-through versus double taxation.” That’s true—but it’s also the reason thousands of them overpay by $20K-$50K every single year. The real difference between S Corp and C Corp tax treatment in 2026 isn’t just about how many times your profits get taxed. It’s about reasonable compensation requirements, California’s 8.84% franchise tax trap, self-employment tax exposure, accumulated earnings penalties, and a dozen other landmines that don’t show up in generic business advice.

Here’s what actually matters: If you’re a California LLC earning $80K-$500K in annual profit, the wrong entity election could cost you $31,200 this year alone. And if you’re a C Corp owner planning to sell your business in 3-5 years, you might be setting yourself up for double taxation that wipes out 20% of your exit proceeds. This guide breaks down the real tax consequences—federal and California-specific—so you can make the right choice before March 15, 2026.

Quick Answer

The core difference between S Corp and C Corp tax treatment is this: S Corps pass income directly to shareholders who pay tax once at personal rates (avoiding double taxation), while C Corps pay 21% federal corporate tax plus 8.84% California franchise tax, then shareholders pay again on dividends. For most California business owners earning $60K-$400K, S Corp election saves $8K-$18K annually through self-employment tax reduction—but only if you pay yourself a reasonable salary and file the right forms by the March 15 deadline.

The Federal Tax Treatment: How S Corps and C Corps Get Taxed Differently

At the federal level, the difference between S Corp and C Corp tax systems comes down to pass-through versus entity-level taxation. Here’s how each actually works in 2026:

S Corporation Federal Tax Treatment

Pass-through taxation means the S Corp itself pays zero federal income tax. Instead, all profits and losses “pass through” to shareholders’ personal tax returns via Schedule K-1. Shareholders pay tax at their individual income tax rates (10%-37% in 2026, depending on total income). This eliminates the double taxation problem entirely—profits are taxed once.

But here’s the catch most business owners miss: S Corp shareholders who actively work in the business must pay themselves a reasonable salary subject to payroll taxes (15.3% combined for Social Security and Medicare). Only the remaining profit distributions avoid self-employment tax. This is where the real savings come from.

Example: Maria runs a graphic design S Corp in San Diego. She earns $120,000 in annual profit. She pays herself a $50,000 W-2 salary (reasonable for her industry), which incurs $7,650 in payroll taxes (employer + employee portions). The remaining $70,000 passes through as a distribution—no self-employment tax. Total self-employment tax savings: $10,710 compared to Schedule C filing.

C Corporation Federal Tax Treatment

Entity-level taxation means the C Corp pays 21% federal corporate income tax on all profits before any distributions to shareholders. This is the “first tax.” When the corporation distributes profits as dividends to shareholders, those shareholders pay personal income tax on the dividends (0%-20% qualified dividend rate, plus 3.8% Net Investment Income Tax for high earners). This is the “second tax.” Combined, the effective rate can reach 39.8% on the same dollar.

C Corps can retain earnings indefinitely without distributing them—but California business owners need to watch for the accumulated earnings tax (20% penalty on retained earnings exceeding $250,000 that aren’t needed for reasonable business purposes, per IRC Section 531).

Example: David’s Los Angeles consulting C Corp earns $150,000 in profit. The corporation pays $31,500 in federal corporate tax (21%). David takes a $50,000 salary (taxed normally) and receives a $68,500 dividend (after corporate tax). He pays an additional $10,960 in qualified dividend tax (16% effective rate). Total tax on the $150,000 profit: $42,460. Effective combined rate: 28.3%.

When Does C Corp Make Sense Federally?

Despite double taxation, C Corps work well when you plan to retain earnings for business growth rather than taking distributions. The 21% corporate rate is lower than individual rates for high earners (up to 37%). Additionally, C Corps offer unlimited stock classes, making them ideal for venture capital or complex ownership structures. If you’re building a tech startup, real estate holding company, or business planning a major exit, C Corp structure may be strategically superior despite higher initial tax burden.

California-Specific Tax Traps: Where Most Advisors Get It Wrong

Federal tax treatment is only half the story. California imposes its own rules that create unique complications for both S Corps and C Corps—and this is where the biggest mistakes happen.

California Franchise Tax for S Corps

California does not fully conform to federal S Corp treatment. While S Corps avoid federal corporate tax, California hits them with a 1.5% franchise tax on net income (minimum $800 annually), plus the $800 annual franchise tax fee required for all corporations and LLCs. This means California S Corps pay both:

• $800 minimum franchise tax (due even with zero income)
• 1.5% tax on California-sourced net income above the minimum

Example: An S Corp with $200,000 California net income pays $800 + ($200,000 × 1.5% = $3,000) = $3,800 total California franchise tax. Shareholders then pay California personal income tax (1%-13.3% depending on bracket) on their K-1 income.

This is dramatically different from sole proprietorships and single-member LLCs, which pay zero entity-level tax in California. The 1.5% S Corp tax is a hidden cost most new business owners don’t budget for.

California Franchise Tax for C Corps

California C Corps face even steeper taxation: 8.84% franchise tax on California-sourced net income (minimum $800). This stacks on top of the 21% federal corporate tax, creating a combined corporate-level rate of 29.84% before any shareholder dividends get taxed.

Example: A C Corp earning $300,000 in California pays $63,000 federal corporate tax (21%) + $26,520 California franchise tax (8.84%) = $89,520 in corporate taxes alone. That’s 29.84% gone before shareholders see a dime. When dividends are distributed, shareholders pay California personal income tax (up to 13.3%) on top of federal dividend tax.

For California-based C Corps, the combined effective tax rate on distributed profits can exceed 45%—one of the highest in the nation. This is why strategic tax planning becomes critical for C Corp owners considering long-term growth versus annual distributions.

The Double Minimum Tax Trap

If you convert from C Corp to S Corp mid-year, California hits you with two $800 minimum franchise taxes in the same year—one for the C Corp period, one for the S Corp period. The IRS requires a split tax year (short C Corp year + short S Corp year), and California treats these as two separate taxable entities. Budget for $1,600 in franchise tax liability during conversion years, plus the administrative costs of filing two separate California returns (Form 100 for C Corp, Form 100S for S Corp).

Self-Employment Tax: The Real Savings Behind S Corp Election

The biggest reason California business owners elect S Corp status isn’t about California franchise tax—it’s about federal self-employment tax savings. Here’s the math that matters:

How Self-Employment Tax Works for Schedule C Filers

Sole proprietors and single-member LLCs filing Schedule C pay 15.3% self-employment tax on all net business income (12.4% Social Security + 2.9% Medicare, up to the Social Security wage base of $168,600 in 2026). Above that threshold, the 2.9% Medicare tax continues indefinitely, plus an additional 0.9% Medicare surtax kicks in for high earners (over $200K single, $250K married).

Example: Jennifer, a freelance marketing consultant in Sacramento, earns $100,000 net profit on Schedule C. She owes $15,300 in self-employment tax (15.3% of $100,000). She also pays California income tax and federal income tax on the same $100,000. Total federal self-employment tax alone: $15,300.

How S Corp Reduces Self-Employment Tax Exposure

S Corp shareholders who work in the business must pay themselves a reasonable W-2 salary subject to payroll taxes. But the remaining profit distributed as K-1 income is not subject to self-employment tax. This creates immediate savings.

Example: Jennifer elects S Corp status and pays herself a $60,000 reasonable salary (industry standard for her role). She pays $9,180 in payroll taxes on the salary (15.3% of $60,000). The remaining $40,000 is distributed as S Corp profit—no self-employment tax. Total self-employment tax: $9,180. Savings: $6,120 annually.

The IRS watches S Corp salary levels closely. If you pay yourself $20,000 but distribute $150,000, expect an audit. “Reasonable compensation” is determined by industry standards, comparable salaries for similar work, time spent in the business, and qualifications. The IRS uses data from the Bureau of Labor Statistics and industry salary surveys to challenge unreasonably low salaries.

C Corps Avoid Self-Employment Tax Entirely—But Create Other Problems

C Corp shareholder-employees also avoid self-employment tax on dividends. However, dividends are taxed twice (corporate + personal levels), whereas S Corp distributions are taxed only once. For most small businesses, the S Corp self-employment tax savings outweigh any C Corp dividend tax benefits unless you’re retaining significant earnings or planning a strategic exit.

How to Actually Elect S Corp or C Corp Status in California

Entity structure (LLC, corporation) is separate from tax classification (S Corp, C Corp). Here’s how to make the election correctly:

Step 1: Form Your Legal Entity

File Articles of Incorporation with the California Secretary of State to create a corporation, or file Articles of Organization to create an LLC. Obtain your federal Employer Identification Number (EIN) from the IRS—this is required for any entity election.

Step 2: Elect S Corp Status (If Desired)

To elect S Corp taxation, file IRS Form 2553 (Election by a Small Business Corporation). Key deadlines:

• For existing businesses: File by March 15, 2026 to have S Corp status apply for the entire 2026 tax year
• For new businesses: File within 2 months and 15 days of incorporation to have S Corp status from day one
• Late elections are possible under IRS relief procedures if you qualify

California automatically recognizes your federal S Corp election—you don’t file a separate California S Corp election. However, you must file California Form 100S (S Corporation Franchise or Income Tax Return) annually and pay the 1.5% franchise tax.

Step 3: C Corp Is the Default (No Election Needed)

If you incorporate and do not file Form 2553, you’re automatically treated as a C Corp for tax purposes. LLCs without any election are treated as disregarded entities (sole proprietorships) or partnerships, depending on the number of members.

Step 4: Maintain Compliance

S Corps must meet ongoing requirements:

• 100 shareholders or fewer
• Only one class of stock
• Shareholders must be U.S. citizens or residents (no foreign ownership)
• Pay reasonable salaries to shareholder-employees
• File payroll tax returns (Form 941 quarterly, Form 940 annually)
• Distribute K-1s to shareholders by March 15

C Corps have no ownership restrictions but face more complex compliance: annual shareholder meetings, corporate minutes, potential AMT liability, and accumulated earnings tax scrutiny if retaining significant profits.

KDA Case Study: Sacramento Consultant Saves $12,500 First Year Through S Corp Conversion

Mark, a solo IT consultant in Sacramento, was filing Schedule C and earning $135,000 annually. He paid $19,183 in self-employment tax every year (15.3% on the first $118,500, then 2.9% on the remaining $16,500). After California and federal income taxes, he kept roughly 62% of what he earned.

KDA helped Mark elect S Corp status and set up compliant payroll. We established a $70,000 reasonable salary (matching Bureau of Labor Statistics data for IT consultants in Sacramento) and distributed the remaining $65,000 as S Corp profit. Here’s what changed:

• Self-employment tax on salary: $10,710 (15.3% of $70,000)
• Self-employment tax on $65,000 distribution: $0
• Total self-employment tax savings: $8,473
• California franchise tax (new cost): $2,825 ($800 + 1.5% of $135,000)
• Payroll service and bookkeeping (new cost): $1,200
• Net first-year savings: $4,448

By year two, once setup costs were eliminated, Mark saved $6,673 annually. Over five years, that’s $30,000+ in tax savings from a single strategic decision. Mark paid KDA $2,500 for the S Corp setup and first-year compliance—a 4.9x first-year return on investment.

Ready to see how we can help you? Explore more success stories on our case studies page to discover proven strategies that have saved our clients thousands in taxes.

The Salary Requirement Nobody Explains Correctly

The IRS requires S Corp shareholder-employees to pay themselves “reasonable compensation” before taking distributions. This isn’t optional—it’s the law under IRC Section 3121(d). But what does “reasonable” actually mean?

How the IRS Determines Reasonable Salary

The IRS uses a multi-factor test based on IRS Revenue Ruling 74-44 and case law. Factors include:

• Industry standards: What do comparable businesses pay for similar roles?
• Duties performed: Are you doing CEO-level work or entry-level tasks?
• Time spent: Full-time (40+ hours/week) versus part-time work
• Qualifications: Education, certifications, years of experience
• Business size and complexity: Managing $2M in revenue versus $80K
• Dividend distributions: Taking $150K distributions but paying $25K salary = red flag

The IRS cross-references Bureau of Labor Statistics (BLS) data, industry salary surveys, and comparable W-2 wages in your geographic area. In California, salaries are generally 10-20% higher than national averages due to cost of living.

Real-World Salary Guidelines by Business Type

• Solo consultants/freelancers: 40-50% of net profit as salary
• Professional services (law, accounting, engineering): 50-60% of net profit
• Product-based businesses (e-commerce, retail): 30-40% of net profit
• Real estate investors: Salary only required if actively managing properties full-time
• Passive S Corp shareholders (not working in business): Zero salary required

Example: A California attorney earning $250,000 through her S Corp should pay herself at least $125,000-$150,000 as W-2 salary. Paying herself $40,000 and distributing $210,000 would trigger an IRS audit and likely result in reclassification of distributions as wages, plus penalties and interest.

When C Corp Actually Saves Money (The Scenarios Advisors Ignore)

Despite the double taxation problem, C Corps make strategic sense in specific situations:

Scenario 1: Retaining Significant Earnings for Growth

If you’re reinvesting 80%+ of profits into business expansion and not taking distributions, C Corp taxation at 21% federal + 8.84% California = 29.84% is lower than personal income tax rates for high earners (37% federal + 13.3% California = 50.3% top marginal rate). The second layer of tax only applies when you actually distribute profits.

Example: A Sacramento software company earns $500,000 annually and reinvests $450,000 into product development, hiring, and marketing. As a C Corp, they pay $149,200 in corporate taxes (29.84%) and retain $350,800 for growth. As an S Corp, the owners would pay personal income tax on the full $500,000 (even if not distributed), potentially owing $251,500 in combined federal and California taxes at top rates. C Corp saves $102,300 in this growth scenario.

Scenario 2: Planning a Business Sale or IPO

C Corps offer Qualified Small Business Stock (QSBS) exclusion under IRC Section 1202. If you hold C Corp stock for 5+ years and meet requirements, you can exclude up to $10 million (or 10x your basis) in capital gains from federal taxes when you sell. California doesn’t conform to QSBS, but federal savings alone can be substantial for high-growth businesses planning exits.

S Corps don’t qualify for QSBS treatment. For entrepreneurs building venture-backed startups or planning $5M+ exits, C Corp structure can save $2M-$3M+ in federal capital gains tax at exit despite higher annual tax burden during growth years.

Scenario 3: Attracting Venture Capital Investment

Venture capital firms and institutional investors cannot invest in S Corps due to S Corp ownership restrictions (U.S. citizens/residents only, one class of stock). If you’re raising institutional capital, C Corp is required. Most Silicon Valley startups form as Delaware C Corps for this reason—even California-based companies.

Special Situations and Edge Cases

What If I Have Foreign Investors?

S Corps cannot have foreign shareholders. If you have non-U.S. citizen or non-resident investors, you must operate as a C Corp or structure ownership through a multi-tiered entity arrangement (foreign investors hold C Corp, which owns operating assets).

Can I Convert from C Corp to S Corp Mid-Year?

Yes, but it triggers a split tax year—a short C Corp year and a short S Corp year. You’ll file two federal returns (Form 1120 for C Corp period, Form 1120-S for S Corp period) and two California returns (Form 100 and Form 100S). California charges two $800 minimum franchise taxes in the conversion year. Additionally, you must watch for built-in gains tax under IRC Section 1374 if you have appreciated assets at conversion (5-year recognition period).

Do I Need to File Anything to Be a C Corp?

No. C Corp is the default tax status for corporations. If you incorporate and don’t file Form 2553 to elect S Corp status, you’re automatically a C Corp. For LLCs, the default is disregarded entity (sole proprietorship) for single-member LLCs or partnership for multi-member LLCs unless you file Form 8832 (Entity Classification Election) to be taxed as a C Corp or Form 2553 to be taxed as an S Corp.

What Happens If I Miss the S Corp Election Deadline?

If you miss the March 15 deadline, your S Corp election won’t take effect until the following tax year—meaning you’re stuck as a C Corp or default LLC for the entire current year. However, the IRS offers late election relief under Revenue Procedure 2013-30 if you meet requirements (reasonable cause for missing deadline, file within 3 years and 75 days of intended effective date). KDA has successfully filed dozens of late S Corp elections for California business owners who missed the deadline.

Red Flags and Penalties

What Happens If You Pay Yourself Too Little as an S Corp?

The IRS can reclassify your S Corp distributions as W-2 wages, subjecting them to payroll taxes retroactively. You’ll owe back payroll taxes plus penalties (up to 25% for failure to pay) and interest (currently 8% annually for underpayments). The IRS has won numerous cases against S Corp owners who paid themselves $15K-$25K salaries while distributing $200K+ in profits.

Case example: In Watson v. United States (2012), a CPA paid himself $24,000 in salary while taking $175,000 in distributions. The court ruled this was unreasonable and reclassified $91,000 of distributions as wages, resulting in $20,000+ in back taxes and penalties. The CPA argued his salary was reasonable because he worked from home and had low overhead—the court disagreed.

California Accumulated Earnings Tax Trap for C Corps

If your C Corp retains earnings beyond $250,000 without a legitimate business purpose, the IRS can impose a 20% accumulated earnings tax under IRC Section 531. Legitimate purposes include funding expansion, acquiring equipment, paying down debt, or building working capital reserves. Retaining $800,000 “just because” or to avoid dividend distributions is not acceptable.

FTB Penalties for Late Filing

California charges a 5% late filing penalty per month (up to 25% maximum) on unpaid franchise tax. If you owe $3,800 in franchise tax and file 5 months late, you’ll pay $3,800 + $950 in penalties + interest. The FTB is aggressive with collections and can suspend your entity’s corporate powers, making it illegal to conduct business in California until you’re current on filings.

The 2026 Decision Framework: S Corp or C Corp?

Use this decision tree to determine which entity election makes sense for your California business:

Choose S Corp If:

• Your business earns $60,000-$500,000 annually in profit
• You plan to distribute most profits to owners annually
• You want to minimize self-employment tax immediately
• You have fewer than 100 shareholders, all U.S. citizens/residents
• You’re willing to run payroll and pay a reasonable salary
• You operate a service business (consulting, law, accounting, marketing)

Choose C Corp If:

• You’re raising venture capital or institutional investment
• You plan to retain 80%+ of profits for business growth
• You’re building a high-growth business planning an exit/IPO
• You want to qualify for Qualified Small Business Stock (QSBS) exclusion
• You need foreign investors or multiple classes of stock
• You’re forming a Delaware corporation for institutional reasons

Stay as LLC (Default Taxation) If:

• Your business earns less than $40,000 annually
• You want maximum simplicity and minimal compliance
• You have consistent losses (S Corp doesn’t make sense without profit)
• You’re a passive real estate investor not working in the business

Book Your Entity Optimization Strategy Session

If you’re earning $60K-$400K through your California business and you’re still filing as an LLC or sole proprietorship, you’re likely overpaying by $8,000-$18,000 annually in unnecessary self-employment taxes. And if you’re a C Corp owner planning to distribute profits or sell your business, you need to understand the double taxation impact before it costs you tens of thousands at exit. Book a personalized consultation with our strategy team and we’ll analyze your specific situation, calculate your exact savings potential, and handle the S Corp election or C Corp conversion properly—before the March 15 deadline. Click here to book your consultation now.