Entity selection is the most consequential tax decision most business owners make, and it's usually made at the wrong time, for the wrong reasons, with the wrong advice. Your attorney sets up an LLC because it's "standard." Your accountant suggests an S-election because it "saves on self-employment tax." Nobody models what happens when you want to sell.

The Three Structures

LLC (taxed as partnership or disregarded entity): Maximum flexibility. Pass-through taxation. Special allocations possible. No restrictions on ownership. But: self-employment tax on active members, and some states (including California) impose an annual LLC fee based on gross receipts.

S-Corporation: Pass-through taxation with self-employment tax savings on distributions above reasonable compensation. Popular for service businesses. But: one class of stock only, 100-shareholder limit, no nonresident alien shareholders, and the 5-year built-in gains tax if converted from a C-corp.

C-Corporation: Separate entity taxation at 21% flat rate. Required for QSBS §1202 eligibility. Preferred by investors and acquirers. But: double taxation on distributions and certain sale structures.

The Exit Planning Lens

Most entity selection advice focuses on current-year tax minimization. That's shortsighted. The entity you choose today determines your tax treatment at the most important moment: when you sell.

A C-corp can access QSBS §1202, potentially excluding $10M+ in federal capital gains. An S-corp cannot. If you're building a business you plan to sell, the entity decision you make today can be worth millions at exit.

Conversely, a C-corp that fails to qualify for QSBS faces double taxation on asset sales, potentially a 40-50% effective rate. The same business as an S-corp would face a single layer at capital gains rates.

California Considerations

California adds its own layer of complexity:

  • $800 minimum franchise tax on LLCs, S-corps, and C-corps (waived for first year)
  • LLC gross receipts fee: up to $11,790 on gross receipts over $5M
  • 1.5% net income tax on S-corps (in addition to pass-through taxation)
  • No conformity to QSBS §1202. California taxes excluded gains in full

When to Restructure

Entity structure isn't permanent. Conversions are possible, but each has tax consequences and timing requirements:

  • LLC to S-corp: Relatively clean. Elect S-status via Form 2553.
  • S-corp to C-corp: Revoke S-election. Simple mechanically, but consider the QSBS holding period and loss of pass-through benefits.
  • C-corp to S-corp: 5-year built-in gains tax period applies. Must plan well in advance of a sale.
Entity selection isn't a legal question. It's a tax architecture question that should be answered with your 5-10 year plan in mind, including the exit you haven't planned yet.

This article is for general informational purposes only and does not constitute tax, legal, or investment advice. Business owners should consult qualified tax and legal advisors before entering into a transaction.