Avoiding S-Corp Taxes in California

Content provided for general information. Talk to your advisor to confirm the details for your specific situation before taking action.

While S-corporations often have federal income tax benefits, California has an additional tax for S-corps. That tax can eat into your federal tax savings or make you want to look for alternatives to a California S-corporation.

What counts as a California S-corporation?

California recognizes your S-corp election with the federal Internal Revenue Service.

If you’ve formed a C-corp in California and made a federal S-corp election, California will recognize you as an S-corp.

If you have a California Limited Liability Company, California will treat you like a corporation for tax purposes if you’ve elected to have the IRS tax you as a C-corporation or S-corp.

Out-of-state businesses subject to California taxes also pay taxes according to their federal income tax election.

Can an LLC be an S-corp only for federal income taxes not California income taxes?

No, if you’ve chosen to receive S-corp benefits for federal taxes, you can’t choose to not be an S-corp for state income tax.

While it may seem unfair that California is taking some of your federal tax savings for itself without giving you additional benefit, that’s how California taxes work.

Tax Benefits of Being an S-corporation

The primary benefits of being an S-corp in California will come from reducing your federal taxes.

Federal Income Tax Benefits of S-Corporation Status

When you have an S-corp, you have to pay federal income tax on your profits. That’s the same as any other business entity unless you have a C-corp subject to double taxation.

The main advantage of an S-corp is that you don’t have to pay self-employment tax on distributions. So that can give you up to a 15.3% tax savings compared to an LLC.

But the catch to S-corporations is that before you can take distributions not subject to self-employment tax, you have to take a reasonable salary.

Reasonable compensation depends on the type of work you do and how you get it done.

  • If you’re performing services on your own, a reasonable salary will often be all or substantially all of your S-corp income because the S-corp income is essentially payment for your own services.
  • If you hire workers, have automated production, have passive income from prior work, or other ways of producing income that aren’t from your direct labor, you can typically take a smaller share of business profits as a reasonable salary (and a bigger draw not subject to self-employment taxes).

California Income Tax Benefits of S-Corporation Status

California has essentially no tax benefit of being an S-corp.

You do get the federal S-corp savings, but you’ll also have to pay the California Franchise Tax and other costs.

As a reminder, there are potential legal benefits to being an LLC or corporation. Don’t base your business entity choice solely on taxes.

Costs of Having an S-Corporation in California

All S-corporations in California have to pay the California Franchise Tax.

Franchise tax is generally equal to 1.5% of your net income.

However, there’s also a minimum franchise tax of $800. (The $800 minimum is 1.5% of $53,333.33.)

The minimum general applies in any year you have your S-corporation open even if you’re operating at a loss or not actively doing business.

It also typically applies even to your first, partial year in business, although California frequently passes laws that temporarily waive or reduce the first-year tax.

Because you have to pay yourself a salary and file payroll tax returns, you’re also usually looking at a minimum of $20 per month or $240 per year for a payroll service. 

You can also typically expect to pay at least $1,000 per year to have a tax professional prepare your Form 1120-S S-corp tax return.

You may also need to hire a lawyer, pay bank fees, or purchase bookkeeping software to help you run, correctly set up, and manage your S-corp.

Is it worth having an S-corp in California?

To determine whether having an S-corp in California is worth it, you have to compare the potential costs to the federal tax reduction.

As a ballpark, assume that your tax savings will be 13.8%. That’s the 15.3% federal-self employment tax rate minus the 1.5% franchise tax rate.

Then figure out your accounting, legal, and other costs.

For example, if an S-corp will help you avoid self-employment tax on $10,000 in income, that’s a potential $1,380 in tax savings. But as we discussed above, your accounting fees will be roughly equal to that.

Once you start to increase the amount of income you can avoid self-employment tax on, then the S-corp tax savings start to outweigh the costs.

However, the reasonable compensation rules and other tax laws mean there are a lot of moving parts here.

Talk to your tax advisor to get a clearer picture of the potential costs and savings from having an S-corp in California.

Alternatives to Being an S-Corp in California

Do you want to get away from the 1.5% franchise tax? Does having an S-corp look like it might not be worth it for your situation?

Here are some other alternatives to consider.

Moving Out of California

Moving out of California is a possible way to avoid having to pay income tax and franchise tax to California. However, the California Franchise Tax Board is very aggressive about saying you haven’t actually left California.

One thing you definitely can’t do is have a California LLC, do all your work in California, open a Nevada LLC, keep working in California, and say California LLC tax no longer applies to you.

You have to pay income tax and at least the minimum franchise tax to California if your S-corp is either registered in California or doing business in California.

Additionally, California generally considers you to be doing business in California if California residents or businesses are gaining a benefit from your services even if you work entirely outside of California.

For example, the Office of Tax Appeals has ruled that a writer living in Arizona who worked only in Arizona and never came to California once owed California taxes for services performed for California limited liability companies.

Now the good news is that if you’re a non-resident, California taxes only apply to your California income.

So if you leave California and set up a new S-corp in your new state, you can escape California taxes on your non-California clients.

In short, moving from California generally only saves you taxes on your outside-of-California work.

Dissolving Your LLC or Corporation

Another option you might want to consider is dissolving your LLC or S-corp and going back to a basic sole proprietorship with no special tax status.

In California, a sole proprietor generally has to pay state income tax but no franchise tax or business income tax.

Of course, you’ll also give up the federal benefits of having S-corp tax status.

So dissolving your S-corp generally works when you’ve realized that the overall tax savings of having your LLC or S-corp are worth less than the extra taxes and costs of having it.

Two additional points to keep in mind:

  • Consider any possible legal protections that you may be giving up.
  • You’ll need to file a final tax return and pay the usual taxes for the year you dissolve your S-corp.

Returning to a Single-Member LLC (Non-S-Corp)

Returning to a single-member limited liability company can be an option when an S-corp doesn’t help you reduce your taxes but you still want a separate legal entity.

(Consider talking to a lawyer because there may be a small number of situations where it’s better to have either an LLC or corporation instead of the other.)

A single-member LLC that isn’t an S-corp does have two costs.

First, there’s a flat LLC tax of $800. This is similar to the S-corp franchise tax but doesn’t increase with your income.

Second, there’s an LLC fee based on your California income.

  • $250,000 to $499,999: $900
  • $500,000 to $999,999: $2,500
  • $1 million to under $5 million: $6,000
  • $5 million or more: $11,790

The LLC tax plus LLC fee will generally add up to less than the 1.5% franchise tax on an S-corp.

Paying Yourself a Higher Salary

Another possible option is to increase your salary.

Increasing your salary increases your FICA tax which wipes out your self-employment tax reduction.

But, increasing your salary reduces your California franchise tax (if you’re over the $800 minimum), because the tax is 1.5% of your net profit. You deduct your salary from the net profit.

Of course, this usually won’t make sense because the extra federal taxes will cost you more than you’ll save on California franchise tax.

Even if you hit the Social Security wage base for the year and won’t be paying more Social Security tax, the 2.9% Medicare tax is still more than the 1.5% California S-corp tax.

Paying yourself a higher salary makes the most sense when you want to:

  • Stick it to California at all costs
  • Increase your Social Security earnings to increase your future retirement benefits


There are ways to avoid the S-corp tax in California, but you’ll often end up paying more somewhere else.

The only clear winners in the alternatives to a California S-corp are business entities that do business out-of-state and are willing to relocate out of state.

Otherwise, in many situations, a California S-corp will be your best option. It will just be worth less than an S-corp in other states.

Because this is a complex topic with a lot of different factors that can change the analysis, ask a tax professional to help you run the numbers for your specific situation.