LLC vs. S-Corp vs. C-Corp: A California CPA's Guide to Choosing the Right Entity

Almost every time someone asks me "should I be an LLC or an S-corp?", the question itself is built on a misunderstanding. It's like asking whether you should drive a Honda or a four-door. Those aren't competing choices — they're different categories of thing.

So before we get to the tax math, let's fix the frame. Get this part right and the rest of the decision gets a lot clearer.

The distinction nobody explains: legal entity vs. tax election

There are two separate questions hiding inside "what should my business be," and people mash them into one.

Question one is legal: what entity do you form under state law? Your real options are a sole proprietorship (no entity at all), an LLC, or a corporation. This is what governs your liability protection — the legal wall between your business and your personal assets.

Question two is tax: how does the IRS treat that entity? This is the election.

Here's the part that unlocks everything: an LLC is not a tax classification. By default, a single-member LLC is taxed as a sole proprietorship and a multi-member LLC as a partnership — the IRS "disregards" it. But an LLC can elect to be taxed as an S-corp, or even a C-corp, without changing its legal form at all. A corporation, meanwhile, is a C-corp by default and can elect S-corp status under §1362.

So "S-corp" is a tax election, not an entity. Most of my small-business clients are legally an LLC that has elected S-corp tax treatment. They get the simpler legal entity and the tax structure they want. Once you see that, the question stops being "LLC or S-corp" and becomes the two real questions: what's my legal entity, and what tax election sits on top of it.

The default: sole prop or single-member LLC

If you do nothing, you're a sole proprietor (or, if you formed the LLC, a disregarded single-member LLC — same tax result, plus liability protection).

The upside: dead simple. One return, no payroll, no separate filings.

The catch is self-employment tax. Every dollar of net profit flows onto your personal return and gets hit with SE tax under §1402 — 15.3% (12.4% Social Security up to the annual wage base ($184,500 for 2026), plus 2.9% Medicare with no cap, plus an extra 0.9% Medicare on high earners). That's on top of income tax. On $120,000 of profit, the SE tax alone can run well into five figures. That number is exactly what drives most people to the next step.

The S-corp election: the self-employment tax play

This is the workhorse for profitable small businesses, and the logic is clean. As an S-corp, you split your income into two buckets:

1. Reasonable salary — paid to you as a W-2 employee, subject to payroll (FICA) tax.
2. Distributions — the remaining profit, which is not subject to SE or FICA tax.

That second bucket is the whole game. The profit you take as distribution escapes the 15.3% layer.

A rough example. Say your business nets $150,000. As a sole prop, essentially all of it faces SE tax. As an S-corp, you might pay yourself a $70,000 reasonable salary (FICA applies) and take $80,000 as distribution (no FICA). You've just removed the Social Security/Medicare layer from $80,000 of income.

But "reasonable" is doing heavy lifting — and it's the single most-litigated word in this area. You cannot pay yourself a $10,000 salary and call $140,000 distributions. The IRS knows that move, and the courts have backed them up: in Watson v. Commissioner, a CPA who took an artificially low salary got his distributions recharacterized as wages, with back payroll taxes and penalties. Reasonable compensation is a facts-and-circumstances test — your role, your hours, what you'd pay someone else to do your job. Set it too low and you're not saving tax, you're deferring an audit adjustment.

The S-corp also costs something

• Payroll administration and a separate return (Form 1120-S).
• In California, the 1.5% S-corp franchise tax on net income, with an $800 minimum (R&TC §23802 / §17941). California recognizes the S election but still taxes the entity — a detail that surprises people who read a national blog and assume the federal treatment carries straight through.
• The savings only outrun those costs once profit is high enough. Below roughly $40,000–$50,000 of net profit, the payroll cost and the 1.5% often eat the benefit. There's no universal threshold — it depends on your reasonable comp and your state — which is precisely why this gets run on real numbers, not a rule of thumb.

The C-corp: powerful, but rarely the answer for a small operating business

A C-corp is its own taxpayer. It pays a flat 21% federal rate (§11) on its profits — and that's where the appeal starts and, for most small businesses, ends.

The problem is double taxation. The corporation pays 21% on its profit, and then when it distributes that profit to you as a dividend, you pay tax on the dividend. The same dollar is taxed twice. For an owner who needs to pull the profits out to live on, that's usually a worse outcome than the single layer of pass-through taxation an S-corp gives you.

So when does a C-corp actually make sense? Specific situations:

• You're raising venture capital or taking on institutional investors who require C-corp structure (and can't be S-corp shareholders anyway).
• You're reinvesting profits to grow rather than pulling them out, so the second layer is deferred.
• You're playing the long game on Qualified Small Business Stock under §1202, which can exclude a large chunk of gain on a future sale of C-corp stock held long enough. That's a real planning tool — but it's a sale-of-the-company strategy, not an operating-cash strategy.

In California, layer on the 8.84% corporate franchise tax (S corporations pay 1.5% instead, with an $800 minimum) on top of the federal 21%. For most South Bay small businesses I work with, the C-corp is the wrong tool — but for the founder building something to sell or raise on, it's occasionally exactly right.

The §199A wrinkle that ties into all of this

There's one more piece that affects the pass-through options (sole prop, partnership, and S-corp): the Qualified Business Income deduction under §199A, which can shave up to 20% off qualifying pass-through income. It was scheduled to sunset after 2025 but was made permanent by the 2025 legislation.

Why it matters here: §199A interacts with your S-corp salary decision. Your W-2 wages reduce your QBI, but above a taxable-income threshold ($201,750 single, $403,500 joint for 2026) the deduction is limited by how much W-2 wages the business pays, and "specified service" businesses (consulting, law, accounting, health, and similar) lose the deduction entirely once income passes the top of the phase-in range ($276,750 single, $553,500 joint for 2026). Translation: the salary number that minimizes your payroll tax and the one that maximizes your QBI deduction aren't always the same number. Optimizing one in isolation can quietly cost you on the other. This is the kind of thing that's genuinely worth modeling rather than guessing.

So how do you actually decide?

Strip away the noise and it's a sequence:

1. Form an LLC for the legal liability protection. For most owners, that's the right legal entity. (A corporation is the other option, mainly if you're heading toward C-corp territory.)
2. Stay default-taxed while profits are modest — the simplicity wins.
3. Elect S-corp treatment once profit is consistently high enough that the SE-tax savings clear the payroll cost and California's 1.5% — and commit to paying yourself genuinely reasonable comp.
4. Consider C-corp only for the specific cases: outside investment, heavy reinvestment, or a §1202 exit play.

The right answer is the intersection of your profit level, how much cash you pull out, your state, and where you're taking the business. There is no entity that's "best" in the abstract — there's only the one that's best for your numbers.

This is general information, not advice for your situation, and reading it doesn't create a client relationship. The election deadlines alone (the S-election timing under §1362 is unforgiving) are reason enough to get your specific facts looked at before you file anything.

If you want this run on your actual numbers — your profit, your reasonable comp, the California layer, and the §199A interaction modeled together — that's exactly the kind of analysis I do before a client commits to a structure. Let's talk before you elect, not after.