Is the California S corporation tax deductible on the shareholders' California returns?
Edvin Givargis Published 5 minute read
The short answer
Not on the California returns. The 1.5 percent California tax an S corporation pays on its net income is deductible in computing the corporation's income for federal purposes, so it reduces the income that flows through to shareholders federally. California disallows the deduction: Revenue and Taxation Code Section 17220 provides that IRC Section 164(a)(3), relating to the deductibility of state, local, and foreign income taxes, shall not apply, and it separately bars any deduction for taxes imposed under the Corporation Tax Law itself. The shareholders' California income is therefore computed without relief for the entity-level tax. In ordinary years the mismatch is a modest add-back; in a stock sale with a Section 338(h)(10) election, where the deemed asset gain and the entity tax land in a single year and the buyer has agreed to bear the tax, it becomes a gross-up computation the parties negotiate line by line.
The tax and where it lands
A California S corporation pays a franchise tax of 1.5 percent of its net income, with the minimum franchise tax as the floor (Revenue and Taxation Code Section 23802), and its income passes through to shareholders under the usual S corporation rules, so the same income is taxed once lightly at the entity and again at the shareholder level. When a stock purchase is made with a Section 338(h)(10) election, the California treatment follows the federal treatment as a matter of incorporation rather than analogy: Revenue and Taxation Code Section 24451 incorporates Subchapter C of the Internal Revenue Code, which includes Section 338, none of the modification sections that follow it alters Section 338, and Section 24451.1 makes the point express for elections, providing that a Section 338 election made for federal purposes binds the taxpayer for California purposes and that no separate California election is permitted. The corporation is accordingly treated as having sold its assets, the deemed sale gain runs through the final S corporation return, the 1.5 percent tax applies to it, and the gain passes through to the selling shareholders. Purchase agreements in these deals routinely make the buyer responsible for the incremental taxes the election creates, which is what turns the deductibility question from a compliance footnote into a priced term.
The federal wash
For federal purposes the analysis is symmetrical. The entity-level California tax is a deductible state tax in computing the S corporation's income, so the additional amount the buyer funds to cover the tax raises the sellers' proceeds while the tax itself reduces the flow-through income, and the two effects offset. A seller modeling only federal consequences correctly concludes that no gross-up is needed for the entity tax beyond the tax itself. The error is stopping there.
The California mismatch
California builds its personal income tax without the federal deduction. Section 17220 turns off IRC Section 164(a)(3) in exactly the terms quoted above, and for good measure it denies any deduction for taxes imposed under Part 11 of the Revenue and Taxation Code, which is where the S corporation tax lives. The same section is why the federal SALT deduction cap never mattered for California purposes: there was no California deduction to cap. The consequence in the deal is a one-way street. The amount the buyer pays to fund the entity tax is additional consideration the selling shareholders must report, their basis computations absorb the entity tax without a corresponding deduction, and no California deduction offsets the inclusion. Resident sellers therefore pay California personal income tax on money that exists only to pay the corporation's California tax. They are taxed on the tax.
The gross-up arithmetic
Making the sellers whole requires a second payment: compensation for the personal tax on the tax-funding payment. The parties in these negotiations typically compute it one of two ways, and the difference should be a drafting decision rather than a surprise. The single-round computation multiplies the entity tax amount by the sellers' marginal California rate, on the theory that the gross-up itself will not be treated as additional taxable proceeds. The iterative computation divides the entity tax amount by one minus the rate and takes the difference, which compensates for tax on the gross-up, on the tax on the gross-up, and so on, on the theory that every dollar the buyer adds is itself consideration the sellers must report. The iterative number is always larger, the gap grows with the rate, and which formula the agreement calls for should be stated in the tax adjustment provision expressly, because both sides can cite a coherent theory and the difference on a large deemed sale gain is real money.
Practice notes
Three drafting points prevent most of the disputes. First, define the taxes being grossed up: the entity-level 1.5 percent tax on the deemed sale, the shareholders' California tax on the inclusion of the tax-funding payment, and the formula, single-round or iterative, that closes the loop. Second, sort the sellers: the computation runs on each seller's own facts, resident sellers bear California tax at their marginal rates while nonresident sellers present their own sourcing questions, and a single blended gross-up rate is a negotiation convenience that should be recognized as one. Third, reconcile the returns to the agreement: the final S corporation return, the shareholders' returns, and the tax adjustment schedule should tell one consistent story about who bore which tax, because the gross-up clause will be read again if any of those returns is examined.
This article states the law as of September 12, 2026
Statutes, rates, thresholds, and agency practice change, and a different set of facts can change the answer. Before acting on anything discussed above, contact G&G State Tax Group to confirm what has changed since this was written and how the rules apply to a specific situation.
G&G State Tax Group, LLC is a state and local tax advisory firm. The firm provides state and local tax consulting and representation in state and local tax controversies. G&G does not prepare or file tax returns, perform attest services, or provide bookkeeping, and is not a CPA firm.