Most startup founders in California pick their business entity the same way they pick a domain name: fast, based on gut instinct, and with almost no understanding of what it’s going to cost them later. Then they spend years wondering why their tax bill is so high. The decision between an S corp or C corp for startups isn’t just administrative paperwork. It is one of the most financially consequential choices you will make in the first 90 days of building a company, and most founders get it wrong.

This information is current as of 2/28/2026. Tax laws change frequently. Verify updates with the IRS or FTB if reading this later.

Quick Answer: S Corp or C Corp for Startups?

If you are a bootstrapped founder expecting to take a salary and distribute profits to yourself, an S Corp is almost always the smarter tax move in 2026. It eliminates double taxation and saves you between $8,000 and $40,000 per year in self-employment taxes depending on your income. If you are a VC-backed startup planning to issue multiple stock classes, bring in foreign investors, or aim for an IPO, a C Corp is the correct structure because S Corp rules will immediately disqualify you the moment you try to scale that way.

Here is the breakdown that actually matters for California founders making this call in 2026.

How Each Entity Taxes Your Startup Differently

An S Corp is a pass-through entity. That means the business itself pays no federal income tax. Instead, profits and losses flow directly to shareholders and get reported on their personal tax returns. If your startup clears $120,000 in profit and you pay yourself a reasonable salary of $70,000, only the $70,000 salary is subject to payroll taxes (Social Security and Medicare). The remaining $50,000 passes through as a distribution, free of self-employment tax. At a 15.3% self-employment tax rate, that is $7,650 back in your pocket on that $50,000 alone.

A C Corp operates completely differently. It is a separate taxpaying entity. Profits are taxed at the federal corporate rate of 21%. Then, if the company distributes those profits to shareholders as dividends, those dividends are taxed again on the shareholder’s personal return at 0%, 15%, or 20% depending on income level. This is the infamous double taxation problem that makes C Corps expensive for founders who plan to live off their company profits.

The California Layer Nobody Warns You About

California adds a third layer of cost that most online entity guides skip. S Corps in California pay an 1.5% franchise tax on net income, with a minimum of $800 per year. C Corps pay 8.84% in California franchise tax, with the same $800 minimum. For a California startup generating $300,000 in net income, that C Corp franchise tax bill alone is $26,520 before you factor in the federal 21% rate or any dividend taxes. An S Corp on the same income pays $4,500 to the FTB. That is a $22,020 difference at the state level alone, in a single year.

Many business owners discover this gap only after their first California tax return, when the shock of the FTB bill hits and there is nothing left to do about it for that year.

S Corp Eligibility Rules That Can Derail You

Before you commit to an S Corp, you need to pass every eligibility test the IRS imposes. Under IRS S Corporation rules, your company must meet all of the following:

• No more than 100 shareholders
• All shareholders must be U.S. citizens or resident aliens
• Only one class of stock is permitted
• Shareholders must be individuals, certain trusts, or estates (not other corporations or LLCs)

If you violate any of these rules after making the S Corp election, the IRS terminates your S Corp status retroactively. That can trigger a significant tax bill for a year you thought was covered. C Corps have none of these restrictions, which is why venture capitalists insist on them before writing checks.

KDA Case Study: Bootstrapped SaaS Founder Saves $31,400 in Year One

A Sacramento-based software developer launched a B2B project management tool in early 2025. He initially formed an LLC and operated as a sole proprietor, paying self-employment tax on every dollar of profit. By the time his revenue reached $185,000 in net profit, his self-employment tax liability had grown to $26,239 for the year. His accountant at the time told him to “keep good records” and said nothing about entity restructuring.

He came to KDA in Q4 2025. We reviewed his structure and immediately recommended an S Corp election via Form 2553, retroactive to January 1, 2025 under the IRS’s late election relief rules. We established a reasonable salary of $75,000 based on comparable market compensation for his role and set up a payroll system through his S Corp. The remaining $110,000 in profit passed through as a distribution with no self-employment tax applied.

The result: his payroll tax liability dropped to $11,475 on the salary portion. Combined with the QBI deduction he became eligible for under Section 199A, his total federal and state tax savings in year one came to $31,400 compared to his prior sole proprietor structure. His investment with KDA was $3,200. That is a 9.8x first-year return.

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.

When a C Corp Actually Makes Sense for Startups

The C Corp is not always the enemy. For certain startup profiles, it is the only structure that makes strategic sense. Here are the scenarios where a C Corp wins:

Venture Capital or Angel Funding Is in Your Immediate Future

Institutional investors and most angel investors require a Delaware C Corp before they will sign a term sheet. They need preferred stock with liquidation preferences, anti-dilution provisions, and other investor protections that require multiple stock classes. An S Corp legally cannot issue preferred stock. The moment you accept outside investment structured this way, your S Corp election is terminated. If you are planning a seed round within 12 to 24 months, form a C Corp from day one and skip the conversion cost later.

You Plan to Issue Stock Options to Employees

Employee stock option plans (ESOPs) and incentive stock options (ISOs) are standard tools for attracting talent in competitive startup markets. ISOs receive favorable tax treatment under IRS Topic 427, but they are exclusively available to C Corp employees. S Corp equity incentives are far less flexible and do not carry the same preferential treatment. If building an equity-compensated team is part of your growth plan, C Corp wins this comparison.

You Are Reinvesting All Profits Back Into the Business

S Corps pass profits through to shareholders whether distributions are made or not. If your startup is generating $200,000 in profit but reinvesting all of it into product development, hiring, and infrastructure, you still owe personal income taxes on that $200,000 as an S Corp shareholder. A C Corp pays the 21% federal corporate rate on retained earnings, and shareholders owe nothing until dividends are actually paid. For high-growth startups burning cash on expansion, C Corp tax deferral can be a real advantage.

You Qualify for QSBS Exclusion

Qualified Small Business Stock (QSBS) under IRC Section 1202 allows founders and early investors to exclude up to 100% of capital gains on stock sale, up to $10 million or 10 times their cost basis, whichever is greater. This exclusion only applies to C Corp stock. For a startup founder planning an exit, the QSBS exclusion alone can save millions in federal capital gains tax. This is one of the most powerful tax benefits in the entire tax code, and it is C Corp exclusive.

To explore how entity formation strategy fits into your startup’s long-term tax plan, it helps to run the numbers on both options before you commit.

The Reasonable Compensation Trap S Corp Founders Walk Into

The biggest IRS risk attached to S Corps is misclassifying the salary-to-distribution split. The IRS requires that S Corp owner-employees pay themselves a “reasonable compensation” for services rendered before taking any distributions. This is not optional, and the IRS monitors it actively.

Reasonable compensation is determined by comparing your salary to what you would pay an outside hire to perform your same duties. A software engineer running his own S Corp cannot pay himself $18,000 per year and take $180,000 in distributions. The IRS uses databases, industry surveys, and third-party compensation reports to challenge these splits during audits.

What Happens If You Get This Wrong

If the IRS determines your salary was unreasonably low, they reclassify the excess distributions as wages, apply back payroll taxes with a 100% penalty on trust fund taxes, and add interest. The total damage can easily exceed the tax you saved in the first place. According to IRS enforcement data, S Corp reasonable compensation is one of the top five audit triggers for small businesses. Getting this right matters as much as making the election in the first place.

Pro Tip: Document your reasonable compensation calculation in writing every year. Use a compensation report from a third-party service or compare your salary against published wage data for your role. Keep this documentation in your corporate files in case the IRS ever questions your split.

The 2026 California Compliance Requirements for Both Entities

Choosing your entity structure is only step one. California has specific compliance requirements for both S Corps and C Corps that can catch founders off guard.

S Corp Compliance Checklist for California

• File Form 2553 with the IRS to make the federal S Corp election. Deadline: March 15 of the year you want the election to be effective, or within 75 days of formation for new entities.
• File FTB Form 3560 with California to establish your state S Corp status. California does not automatically recognize the federal election.
• Pay the $800 minimum franchise tax by April 15 using FTB Form 3522 for new entities or with your annual return.
• Run payroll for any owner-employee taking a salary. Use Form DE 9 for quarterly payroll tax reports with the EDD.
• File Form 1120-S federally and Form 100S in California by March 15 (or September 15 with extension).

C Corp Compliance Checklist for California

• File Form 1120 federally and Form 100 in California by April 15 (or October 15 with extension).
• Pay California franchise tax at 8.84% of net income, minimum $800.
• Make quarterly estimated tax payments using FTB Form 100-ES. California requires 100% of estimated tax paid in four installments.
• Track E&P (earnings and profits) carefully if you plan to pay dividends, as California has specific rules on dividend taxation that differ from federal treatment.
• Register with the California Secretary of State and maintain a registered agent for service of process.

Missing any of these steps generates automatic FTB penalties. The failure-to-file penalty alone is 5% of the unpaid tax per month, up to 25%. If you are just launching and want to set up your entity compliance correctly from day one, our tax planning services walk through this entire process with you before you file anything.

Side-by-Side: S Corp vs C Corp for California Startups in 2026

Factor	S Corp	C Corp
Federal Tax Rate on Profits	Pass-through (individual rate, up to 37%)	21% flat corporate rate
California Franchise Tax	1.5% of net income ($800 min)	8.84% of net income ($800 min)
Double Taxation Risk	None	Yes, on dividends paid to shareholders
Self-Employment Tax	Only on reasonable salary	None at entity level
Investor Compatibility	Limited (no VC, no preferred stock)	Full (preferred stock, VCs, angels)
Stock Options (ISO)	Not available	Available and tax-advantaged
QSBS Exclusion (IRC 1202)	Not eligible	Eligible (up to $10M+ gain exclusion)
Shareholder Restrictions	100 max, U.S. only, one stock class	Unlimited, no restrictions
Profit Retention Tax Strategy	Taxed at personal level regardless	Tax deferral on retained earnings
Best For	Profitable, bootstrapped, owner-operated	VC-backed, high-growth, exit-oriented

The Mistake That Costs Founders $40K: Choosing C Corp When They Should Have Chosen S Corp

This scenario plays out constantly in California. A solo founder launches a consulting, software, or professional services business. They read online that “Delaware C Corp is best for startups” because that is what TechCrunch articles about Y Combinator companies say. They form a C Corp, pay 21% federal tax on their $200,000 in profits, then pull out $150,000 as a salary and pay income taxes on that too.

Here is what that actually costs in 2026 at $200,000 net profit:

• Corporate tax (21%): $42,000
• California franchise tax (8.84%): $17,680
• Total entity-level tax: $59,680
• Remaining after-tax profit available to distribute: $140,320
• Dividend tax on that distribution (15%): $21,048
• Total tax burden: $80,728 on $200,000 in profit

Now run the same $200,000 through an S Corp with a $90,000 reasonable salary:

• Payroll taxes on $90,000 salary (7.65% employer side): $6,885
• California franchise tax (1.5%): $3,000
• Pass-through income to personal return: $110,000
• QBI deduction (20% of $110,000): $22,000 reduction in taxable income
• Total tax burden (assuming 32% marginal rate on $88,000 net QBI): roughly $41,000 combined

The S Corp saves this founder approximately $39,000 to $40,000 in a single year. That is not a rounding error. That is a real estate down payment.

How to Make the S Corp Election in 2026: Step-by-Step

1. Form your LLC or corporation with the California Secretary of State. File the Articles of Organization (LLC) or Articles of Incorporation (Corp) at bizfileonline.sos.ca.gov.
2. Obtain your EIN from the IRS at IRS.gov/EIN. This takes five minutes online and is required before filing Form 2553.
3. Complete IRS Form 2553. You will need your business name, EIN, incorporation date, tax year type, and shareholder signatures. Every shareholder must sign the consent statement.
4. File Form 2553 with the IRS. Mail to the IRS service center for your state (for California, that is the Ogden, UT or Kansas City, MO center depending on entity type). File by March 15 for the election to be effective for the current tax year.
5. File FTB Form 3560 with California to make the state-level S Corp election. California requires a separate election and does not automatically accept the federal Form 2553.
6. Set up payroll. Register with the California EDD as an employer. Set up a payroll system (Gusto, QuickBooks Payroll, or a payroll provider) and begin processing your owner salary.
7. Open a dedicated business bank account and keep personal and business finances completely separate. Commingling funds is an audit trigger and weakens your corporate protection.
8. Establish a formal salary in writing. Document your reasonable compensation decision with a corporate resolution signed by all directors or members.

What If I Already Formed a C Corp But Want to Switch to S Corp?

You can convert. The process requires filing Form 2553 to elect S Corp status for your existing C Corp. However, there are traps to watch for:

The IRS imposes a built-in gains (BIG) tax under IRC Section 1374 on any asset that appreciated in value while you were a C Corp. If you recognized those gains within five years of the S Corp election, you owe corporate-level tax on them at the 21% rate. This is particularly relevant for tech startups with appreciated intellectual property or other intangible assets built during the C Corp years.

California also charges its 1.5% franchise tax from the date of the S Corp election, not from the start of the tax year, so timing the conversion correctly can affect your first-year California tax bill. For startups with accumulated C Corp earnings, converting without a proper cleanup strategy can trigger unexpected tax consequences. This is not a conversion to make without professional guidance.

You can also use a comprehensive S Corp tax strategy guide to understand all the moving parts before you decide whether conversion makes sense for your specific situation.

Frequently Asked Questions: S Corp or C Corp for Startups

Can a startup switch from C Corp to S Corp after taking VC money?

No. Once you have issued preferred stock, accepted foreign investors, or added shareholders that violate S Corp eligibility rules, you cannot elect S Corp status until you unwind those arrangements. This is why the VC structure decision is irreversible in practice once funding closes.

What is the minimum profit level where S Corp makes sense?

As a general rule, once your net self-employment income exceeds $60,000 to $75,000 annually, the S Corp election saves enough in payroll taxes to justify the added cost of running payroll and filing a separate business return. Below that level, the administrative costs can erode the tax savings.

Will a C Corp protect me from personal liability better than an S Corp?

Both C Corps and S Corps provide the same level of personal liability protection from business debts and lawsuits, assuming you maintain proper corporate formalities (separate accounts, minutes, capitalization). The liability protection is a function of the corporate structure, not the tax election. Neither offers better protection than the other in that regard.

Can I start as an S Corp and convert to C Corp later for a funding round?

Yes, and this is actually a common path for bootstrapped founders who later attract investor interest. You would revoke the S Corp election by filing a formal revocation statement with the IRS and file Form 8832 to change your tax classification if needed. The timing needs to be handled precisely to avoid triggering built-in gains issues or creating a gap year tax problem.

Is Delaware C Corp always better for startups seeking VC funding?

For VC-backed startups, yes, a Delaware C Corp is the industry standard. Delaware offers a mature body of corporate law, predictable court rulings, and investor-friendly governance structures. But if you are not raising VC money and you are based in California, forming a Delaware entity still requires you to register as a foreign corporation with the California Secretary of State and pay California franchise taxes on top of Delaware fees. For non-VC-backed founders, a California S Corp is simpler and cheaper.

Red Flag: The Entity Decision You Cannot Undo Easily

Once you have issued QSBS-eligible C Corp stock, you cannot convert to an S Corp without destroying the QSBS eligibility for those shares. Once you have taken VC money with preferred stock, you cannot elect S Corp status without returning the investment. Once you have operated as a C Corp for several years with appreciated assets, converting to an S Corp triggers built-in gains exposure.

The entity decision you make in month one of your startup has compounding consequences over years. Choosing wrong is not a form you file to fix. It is a restructuring project that costs $10,000 to $50,000 in legal and accounting fees to unwind, and that assumes no adverse tax events along the way. Get this right the first time.

Key Takeaway: The S corp or C corp decision for startups is not about which entity sounds more professional. It is about matching your funding strategy, ownership structure, and profit expectations to the tax and legal rules that will govern your company for the next decade. Founders who make this choice deliberately save tens of thousands of dollars annually. Founders who default to a generic answer pay for it every tax season.

“The best entity structure for your startup is not the one everyone else uses. It is the one built around your actual numbers.”

Stop Guessing on Your Entity Structure

If you are launching a California startup and still unsure whether an S Corp or C Corp gives you the best outcome, you are not alone. But the cost of guessing wrong is measured in tens of thousands of dollars per year, not a minor inconvenience. Our team at KDA works with founders at every stage to run the actual numbers on both entities, weigh the long-term trade-offs, and build an entity structure that protects your income and positions you for growth. Click here to book your consultation now.