S Corp vs C Corp Tax Differences in California

If you are researching how to set up your business structure in California, you’ve come to the right place.

Short Recap: S Corp vs C Corp

What is an S Corporation?

An S Corporation is a specific tax classification under the IRS code for what is known as a pass-through entity. This classification allows a business owner to pass business income and losses directly to their individual level and avoid corporate-level taxation.

Contrary to belief, S Corporations are never formed by themselves. They are spawned from an entity on the state level, such as an LLC or a Corporation that elects to be taxed as an S Corp on the federal level. After the S Corp election is made, your entity becomes an S Corp, but the underlying entity on the state level does not change. Many business owners say, "I have an LLC taxed as an S Corp." But they could rightfully just say, "I have an S Corp." For tax purposes, those S Corp and LLC taxed as an S Corp are the same things. The only difference is only in the state legal paperwork.

What is a C Corporation?

A C Corp pays taxes twice on income: the business pays corporate taxes, and then individual shareholders pay income taxes on any salary they receive, plus dividends from business profits.

C Corps can reduce their tax liability by drawing a large salary for the officer and deducting it on the C Corp tax return. This would avoid corporate taxes since the taxable income would be brought down to zero by a large salary expense. However, this tactic shifts all tax liability to the officer, who would have to pay regular tax (in their own tax bracket) along with Social Security and Medicare taxes on these wages. The IRS can also question the reasonableness of the compensation. Large wages used to reduce the taxable income of a C Corporation are scrutinized by the IRS.

Taxation Differences on California Level

S Corporations: As I have mentioned before, S Corps are designed to avoid double taxation. Instead of paying federal income taxes at the corporate level, they pass their income, deductions, and credits through to their shareholders, who report them on their individual tax returns. However on California level, S Corps are still subject to double taxation. S Corps pay either $800 a year or 1.5% of net income, whichever is higher. In addition, the same income passes on the individual level and the shareholder pays their share of taxes to California on their personal return.

C Corporations: C Corps are taxed separately from their owners. They pay 21% to the IRS and they pay to California $800 or 8.84% of net income (whatever is higher). As I mentioned above, shareholders also pay personal income taxes on dividends they receive from the corporation on both California and Federal levels.

Interestingly, a C Corporation or a Corporation converted to an S Corporation in California can opt out from SDI (disability insurance) taxes, potentially saving $1,387 annually in 2023. This works only when the S Corp has only one shareholder. However, if an S Corp is set up as an LLC, it does not have this option, and the owner has to pay SDI taxes from their wages. Here is more about it.

So, what's the main difference between S Corp and C Corp tax-wise in California? Well, it is a tax rate. 8.84% of net income for C Corps vs 1.5% of net income of S Corps. Plus you can opt out from the SDI tax if you set up your business entity as a corporation on the state level.

Is it better to be an S Corp or C Corp to establish in California?

If you are just starting your business in California and do not know your projected net income and there are no legal concerns, we always suggest starting as a sole proprietor who files Schedule C (which is completely different from a C corp, by the way). We also suggest not getting into an LLC unless you really need to for legal reasons. California LLC is $800 a year, plus it would cost you $200–$300 in filing fees. So, just getting an LLC in California will cost you around $1,000. Why not get good insurance coverage for the same amount of money and avoid the tax headache if you are just starting out?

As your business grows and you reach the appropriate income threshold, you can either set up an LLC and convert it to an S Corp or set up a C Corporation and convert it to an S Corp. Or stay as a C Corp, if this suits your needs.

And one more thing: with an LLC setup, you are allowed to request S Corp status retroactively. For example, you might start the year as an LLC without knowing if an S Corp makes financial sense (S Corp accounting fees can be hefty), but then realize that you made too much money that year and S Corp status is what you want. In this case, you are allowed to request S Corp status as of the beginning of the year, even though it is now the end of the year. However, if you initially set up as a C Corp, you don’t get that late-filing election benefit, but you can benefit from not paying SDI taxes on wages, as mentioned above.

And the last thing ( I promise!): In California, many professionals don’t have the option to create an LLC. For those individuals, there are only two options: stay a Schedule C filer with good liability insurance or go for a C Corp that is converted to an S Corp from the very start.

And now a little bit of self promotion: We are a virtual CPA firm that helps S Corp owners with their taxes and accounting. You are welcome to check out our services here. We will be happy to help you out.