TL;DR — Key Takeaways
- A C corp pays corporate income tax on profits, then shareholders pay personal income tax on dividends — that’s double taxation. An S corp passes income through to shareholders, avoiding double taxation.
- C corps have no ownership restrictions. S corps are limited to 100 shareholders, no foreign owners, one class of stock, and no entity owners with limited exceptions.
- Venture-backed startups almost always choose C corps because the structure supports preferred stock, foreign investors, and complex equity arrangements that S corps can’t accommodate.
- Small profitable businesses without outside investors usually prefer S corps for the tax advantages.
- California layers its own taxes on top: 8.84% C corp tax, 1.5% S corp tax, plus the $800 minimum for either.
What Is Double Taxation and Does It Apply to C Corps in California?
Yes. C corp profits are taxed at the corporate level, then taxed again when distributed to shareholders as dividends. Two layers of tax on the same money.
Federal level. C corp income is taxed at the federal corporate rate of 21% (under the Tax Cuts and Jobs Act, generally in effect for tax years beginning after 2017). When the corporation distributes after-tax profit as a dividend, shareholders pay tax on the dividend at qualified dividend rates (0%, 15%, or 20% depending on income).
California level. California adds its own layer. C corps pay 8.84% on net income. The combined federal and California corporate effective rate is approximately 28% before any deductions or credits.
Worked example. A California C corp with $1 million in pretax profit pays $210,000 in federal corporate tax and $88,400 in California corporate tax, leaving $701,600 after corporate tax. If that’s all distributed as a dividend, the shareholder pays additional tax (federal qualified dividend rate plus California personal rate up to 13.3%). The total combined tax can approach 50% of the original profit.
Double taxation only matters when profit is distributed. C corps that retain earnings and reinvest in the business avoid the second layer until distribution. This is one of the reasons C corps work well for growth-stage startups that aren’t paying dividends.
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Why Do Venture-Backed Startups Typically Choose C Corporations?
Several reasons converge to make C corps the default for venture-backed companies.
Preferred stock. Venture investors require preferred stock — equity with rights superior to common stock (liquidation preferences, anti-dilution protection, voting controls). S corps can’t issue preferred stock because the one-class-of-stock requirement prohibits multiple classes with different economic rights. C corps can issue any number of classes with any rights.
Foreign and entity investors. Many venture funds are organized as LPs or LLCs that themselves have foreign LP investors. S corps can’t have entity shareholders or foreign shareholders. C corps can.
100 shareholder limit. Late-stage and pre-IPO startups easily exceed 100 shareholders through employee stock options, convertible notes, and multiple investor rounds. The S corp limit makes scaling impossible.
QSBS exclusion (Section 1202). Founders and early investors in certain C corps can exclude up to $10 million (or 10x basis) of capital gain on a sale, if the stock is held for 5+ years and other requirements are met. This is one of the most valuable tax breaks in the code, and it’s only available for C corp stock.
Standard documentation. Venture term sheets, stock purchase agreements, voting agreements, and option plans are all built around Delaware C corp structure. Using a different structure adds friction, cost, and risk to financings.
Even non-venture-backed growth companies sometimes choose C corp for the QSBS benefit. A founder who builds and sells a successful business after 5+ years can save millions in capital gains tax.
How Many Shareholders Can an S Corporation Have?
- The S corp shareholder cap is set at 100 under IRC § 1361.
Family members can be counted as one shareholder under specific rules, which can extend the practical cap. But the limit is hard. Once you cross 100 individual shareholders, the S election terminates.
Practical implication. S corps work for closely-held businesses — usually a handful of owners, occasionally with family or friends as additional investors. They don’t work for businesses with broad employee equity programs, multiple investor rounds, or anything resembling a venture-backed structure.
If you might need to take on many shareholders later, choose C corp from the start or choose an LLC (which has no shareholder limit). Switching from S corp to C corp is possible but creates a 5-year window during which the company can’t re-elect S status.
Can a California S Corp Convert to a C Corp Later?
Yes. An S corp can voluntarily revoke its S election or have it terminated by violating an eligibility rule.
Voluntary revocation. The corporation files a statement with the IRS revoking the election, signed by shareholders holding more than 50% of the stock. The revocation can be effective immediately, on a future date, or retroactive to the start of the year if filed within the first 2.5 months.
Involuntary termination. Adding a foreign shareholder, an entity shareholder (other than allowed trusts), or a 101st shareholder; issuing a second class of stock; failing to meet other S corp requirements. Termination is automatic on the date the violation occurs.
5-year re-election rule. After termination, the corporation generally cannot re-elect S status for five years without IRS consent. This rule exists to prevent corporations from flip-flopping based on short-term tax considerations.
Tax consequences of conversion. The corporation transitions to C corp tax treatment from the conversion date forward. Built-in gains tax can apply to assets that were appreciated when the conversion occurred, if those assets are sold within five years. AAA (accumulated adjustments account) and other S corp tax attributes need to be tracked through the transition.
If you anticipate a venture round or large investor coming in, the S-to-C conversion is straightforward. The opposite direction — C to S — is usually harder because C corps with prior accumulated earnings face more complex transition rules.
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Which Structure Is Better if I Want to Offer Employee Stock Options?
C corp, almost always.
Employee stock options (ISOs and NSOs). C corps can grant ISOs (incentive stock options) and NSOs (non-qualified stock options) without restriction. The framework for option grants, vesting, and exercise is well-established and supported by standard documents.
S corp option limitations. S corps face structural problems with broad option programs. Each option recipient becomes a shareholder when they exercise. If exercises push the corporation over 100 shareholders or include a non-eligible person, the S election terminates.
S corp restricted stock. S corps can grant restricted stock, but the one-class-of-stock requirement limits flexibility. Restricted shares with vesting that creates economic differences (different distribution rights pre-vest vs. post-vest) can create eligibility problems.
Profits interests in LLCs. An alternative to C corp options is operating as an LLC and granting profits interests, which work like equity grants but have specific tax-favored treatment under Rev. Proc. 93-27. LLCs are a third path that some growth companies choose specifically for the equity flexibility.
If equity compensation is core to your hiring strategy, default to C corp. If you have a small team and don’t anticipate broad equity plans, S corp can work.
Quick Decision Framework
Choose a C corp if: you plan to raise venture capital, you want to issue preferred stock, you have foreign investors, you want broad employee equity, you anticipate selling the company in 5+ years (QSBS), or you want to retain earnings for growth without immediate shareholder tax.
Choose an S corp if: you have a small ownership group of U.S. individuals, you want pass-through taxation, you want to take part of business income as distributions free of self-employment tax, you don’t plan to raise capital from institutional investors, and you can live within the 100-shareholder, one-class-of-stock limits.
Choose an LLC instead if: you want maximum tax flexibility (LLC can elect S, C, or default), you want simpler maintenance, or you might need creative equity structures (profits interests).
Most California small businesses without outside investors choose either an LLC (often with S corp election) or an S corp directly. C corps are the choice when external capital, complex equity, or QSBS is on the table.
Call (650) 668-8000 or schedule a consultation at baylegal.com/contact.
This article is for informational purposes only and does not constitute legal advice. California real estate law is complex and changes frequently. Contact Bay Legal, PC to discuss your specific situation.
Frequently Asked Questions
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Is a C corp better than an S corp for a California startup?
If you plan to raise venture capital or want QSBS treatment on a future exit, a Delaware C corp is the standard choice. For a small profitable business without outside investors, an S corp is usually better.
Does a California C corp pay double taxation?
Yes. The corporation pays 21% federal plus 8.84% California on profits, and shareholders pay tax again when profits are distributed as dividends. Retained earnings only face the corporate-level tax until distribution.
Can a California S corp have foreign owners?
No. S corps can only have U.S. citizens, U.S. residents, certain trusts, and estates as shareholders. A foreign shareholder terminates the S election.
What is QSBS and why does it matter?
Qualified Small Business Stock under IRC § 1202 allows founders and early investors to exclude up to $10 million (or 10x basis) of capital gain on the sale of qualifying C corp stock held for 5+ years. It’s one of the largest tax breaks for entrepreneurs.
Can I switch from S corp to C corp?
Yes, by revoking the election. After termination, the 5-year re-election rule generally prevents going back to S status without IRS consent.
