Last updated: October 2026
An S corporation is not an entity type. It is a federal tax election that a corporation or an LLC can make, and its main effect is to remove the entity-level federal tax that a C corporation pays. For an owner-operated California business it can meaningfully reduce self-employment tax. What it cannot do is remove California tax — this state charges S corporations a franchise tax on net income regardless of the federal election, which is the point most owners are surprised by. Bay Legal, P.C. advises California businesses on whether the election fits and handles the formation and governance work around it.
Definition: An S corporation is a corporation or LLC that has elected federal pass-through tax treatment under Subchapter S, so income is taxed to the owners rather than at the entity level.
Does an S corporation pay California tax?
Yes, and this is where the federal picture and the California picture diverge. Federally, an S corporation pays no corporate income tax; the income passes through to shareholders. California does not follow that treatment. Under Revenue and Taxation Code section 23802, an S corporation doing business in California pays a state franchise tax on its net income at a reduced rate, and it remains subject to the $800 annual minimum under section 23153 whether or not it is profitable.
So the election removes one layer of tax, not both. Owners who model an S corporation on federal treatment alone consistently understate what the entity will owe, and the difference is large enough to change the comparison against an LLC for some businesses.
The Franchise Tax Board publishes the current rates and filing requirements. An S corporation files its own California return in addition to the shareholders reporting their shares.
Who qualifies to elect S corporation status?
Eligibility is federal and the criteria are strict. Per the Internal Revenue Service, the entity must:
- Be a domestic corporation or an LLC electing corporate treatment
- Have no more than 100 shareholders
- Have only allowable shareholders — individuals, certain trusts, and estates, but not partnerships, corporations, or non-resident aliens
- Have only one class of stock
- Not be an ineligible corporation, which excludes certain financial institutions, insurance companies, and domestic international sales corporations
The election is made on IRS Form 2553, signed by all shareholders, and it is time-sensitive: to take effect for a given tax year it must generally be filed by the fifteenth day of the third month of that year, or at any time during the preceding year. Late elections can sometimes be accepted with reasonable cause, but relying on that is a poor plan.
The single-class-of-stock rule is the one that ends most conversations. A company that wants to issue preferred shares to investors cannot maintain an S election, and differences in distribution or liquidation rights create a second class. Differences in voting rights alone do not.
Why do owner-operated businesses elect it?
Self-employment tax. A sole proprietor or an LLC member taxed as a partnership generally pays self-employment tax on the whole of their business income. An S corporation shareholder who works in the business takes a salary, which is subject to employment taxes, and may take the remaining profit as a distribution, which generally is not.
The constraint is that the salary must be reasonable for the work performed. This is the most heavily examined aspect of S corporation practice, and paying an artificially low salary to convert wages into distributions is the specific pattern the IRS looks for. The saving is real for a genuinely profitable business paying a defensible salary; it is not a mechanism for eliminating employment tax.
Two further points that decide whether the election is worth it. It only helps where profit meaningfully exceeds a reasonable salary — below that threshold the additional payroll and filing costs can exceed the saving. And an S corporation must run actual payroll, which is an administrative burden a single-member LLC does not carry.
S corporation or LLC?
| LLC (default taxation) | S corporation election | |
|---|---|---|
| Self-employment tax | Generally on all business income | On salary only; distributions generally exempt |
| California entity tax | $800 minimum, plus the fee on gross income above $250,000 | $800 minimum, plus franchise tax on net income |
| Payroll required | No | Yes — the owner must be on payroll |
| Ownership restrictions | None | 100 shareholders, no entities or non-resident aliens, one class of stock |
| Administrative burden | Lower | Higher — payroll, separate return, formalities |
| Best fit | Lower-profit or passive businesses | Profitable owner-operated businesses |
The comparison turns on the two state charges, which work differently. The LLC fee under Revenue and Taxation Code section 17942 is levied on gross income above $250,000 regardless of profitability, while the S corporation franchise tax is levied on net income. A high-revenue, low-margin business can therefore pay considerably more as an LLC than as an S corporation, and a low-revenue, high-margin business the reverse. This is a calculation to run with a CPA rather than a rule of thumb.
Who advises on S corporation elections at Bay Legal?
Managing attorney Jayson R. Elliott leads the firm’s business practice, covering entity selection, formation, and the governance documents an S corporation needs. The firm does not provide accounting or tax filing services and works alongside the client’s CPA on the election itself, the reasonable salary determination, and the annual filings.
Bay Legal, P.C. serves businesses statewide from offices in Palo Alto and Los Angeles, including founders across San Francisco and the wider Bay Area.
Frequently Asked Questions
Does an S corporation pay California tax?
Yes. California does not follow the federal treatment. An S corporation doing business here pays a state franchise tax on its net income at a reduced rate under Revenue and Taxation Code section 23802, and remains subject to the $800 annual minimum under section 23153 whether or not it is profitable. The election removes federal entity-level tax, not California’s.
Who can be a shareholder in an S corporation?
Individuals, certain trusts, and estates. Not partnerships, not corporations, and not non-resident aliens. The company may have no more than 100 shareholders and only one class of stock. A company wanting to issue preferred shares to investors cannot maintain the election, which is why venture-backed companies are C corporations.
How do I elect S corporation status?
By filing IRS Form 2553, signed by all shareholders. Timing matters: to take effect for a given tax year it must generally be filed by the fifteenth day of the third month of that year, or during the preceding year. Late elections can sometimes be accepted with reasonable cause, but that should not be the plan.
What is a reasonable salary, and why does it matter?
An S corporation shareholder working in the business must be paid a salary reasonable for the work performed, subject to employment taxes, before taking profit as distributions. Paying an artificially low salary to convert wages into distributions is the specific pattern the IRS examines. The saving is real; the shortcut is not.
Can an LLC elect S corporation status?
Yes. An S corporation is a tax election, not an entity type, and an LLC can make it by electing corporate treatment and then filing Form 2553. The LLC keeps its simpler governance while changing how it is taxed — though it must then run payroll for owner-employees.
Is an S corporation better than an LLC in California?
It depends on profit and revenue. The California LLC fee is charged on gross income above $250,000 regardless of profitability, while the S corporation franchise tax is charged on net income. A high-revenue, low-margin business often does better as an S corporation; a low-revenue business often does not. Model both.
Related Questions
Can a professional corporation elect S status?
Yes, subject to the same federal eligibility rules. Many owner-operated professional practices do, which is one reason the election comes up so often among physicians, dentists, and attorneys.
What happens if the election is terminated?
The entity reverts to C corporation treatment, and there is generally a five-year wait before re-electing without IRS consent. Terminations often happen inadvertently, by admitting an ineligible shareholder or creating a second class of stock.
Do S corporation shareholders pay tax on money they leave in the business?
Yes. Income is taxed to shareholders as it is earned, whether or not it is distributed. Owners are sometimes surprised by a tax bill on profit still sitting in the company account.
Does an S corporation still need bylaws and meetings?
If it is a corporation, yes — the tax election changes nothing about corporate formalities. Ignoring them is a factor courts weigh in deciding whether to disregard the entity.
Talk to a California business attorney
Whether the election saves money depends on your profit, your salary, and which of the two California charges lands harder on your business. To discuss the structure with a Bay Legal attorney, call the office nearest you or email intake.
Bay Legal, P.C. — serving California statewide
Northern California office
667 Lytton Ave Ste 3, Palo Alto, CA 94301
(650) 668-8000
Southern California office
3211 Cahuenga Blvd W Ste 212, Los Angeles, CA 90068
(213) 668-8000
Intake: intake@baylegal.com
Fax: (650) 963-0041
Website: https://baylegal.com
This page is general information about California law and does not constitute legal advice or create an attorney-client relationship. Bay Legal, P.C. does not provide tax advice. For advice on your specific situation, contact a licensed California attorney and a qualified tax professional.