How High-Income Californians Can Avoid the Top 5 State Tax Traps

California has the highest marginal income tax rate in the country at 13.3 percent, with no preferential treatment for capital gains. For high earners, the state tax bill is large — and several planning mistakes make it significantly larger than it needs to be. These are the five most common.

Trap 1: Ignoring the Pass-Through Entity Election

California's Pass-Through Entity tax election (AB 150) allows qualifying S-corps, partnerships, and LLCs to pay California income tax at the entity level at a 9.3 percent rate and deduct that payment federally. This partially restores the SALT deduction that was capped federally at $10,000 — and now at $40,000 for 2025 through 2029. For a business owner whose share of entity income generates $60,000 in California tax, the PTE election turns roughly $20,000 of that state tax into a federal deduction — saving several thousand dollars in federal tax that would otherwise be lost to the cap.

The trap is not electing when it is beneficial. Many California business owners have never had the PTE election modeled for their specific situation. It requires a June 15 estimated payment at the entity level to avoid a penalty, so it is not something to discover in April.

Trap 2: Selling Appreciated Assets Without Timing Analysis

California taxes capital gains as ordinary income with no preferential rate. A California resident selling a business or investment property pays up to 13.3 percent state on the gain on top of the federal capital gains rate. For high earners, the combined rate on long-term capital gains can exceed 37 percent.

The timing of asset sales — by year, by quarter, even by day — affects whether a gain falls in a high-income year or a lower one. Installment sales spread recognition over multiple years. Qualified Opportunity Zone investments defer the original gain and potentially eliminate appreciation on the new investment after 10 years. These strategies require lead time. A decision made in October can change the tax outcome significantly. The same decision made in December has fewer options.

Trap 3: The LLC Franchise Tax on Every Entity

California charges an $800 minimum franchise tax on every LLC — every year, regardless of whether the entity made money. For investors and business owners with multiple LLCs, these $800 charges accumulate. Four LLCs is $3,200 in franchise tax per year before any other state tax. Ten LLCs is $8,000.

The planning question is whether each entity is generating enough liability protection or tax benefit to justify the annual cost. Some investors maintain entities out of inertia — entities that were set up years ago for a purpose that no longer exists. A review of the entity structure can identify which ones can be dissolved without losing meaningful protection, and which should be restructured or consolidated.

Trap 4: Missing the Real Estate Professional Status Election

High-income Californians with rental real estate almost universally have passive losses accumulating that they cannot use — because their income is too high and they have not qualified as real estate professionals. Those losses sit on the return as suspended passive losses, carried forward year after year, producing no current benefit.

For investors who spend significant time on their rental activities, qualifying as a real estate professional under IRC §469 converts those suspended losses into active losses deductible against wages and other income. The 750-hour threshold and 50 percent personal service test are achievable for investors who are active in their portfolios. The documentation requirement — contemporaneous logs kept during the year — is the part that most people miss.

Trap 5: Under-Utilizing Retirement Accounts

A W-2 high earner contributing only the employee maximum to a 401(k) is capturing a fraction of available retirement-account deductions. Business owners with self-employment income, ownership of professional corporations, or partnership income have access to contribution limits that are several times larger — solo 401(k)s, defined benefit plans, and profit-sharing arrangements that can generate $100,000 or more in annual deductions.

The constraint is that these plans must be established and funded before the end of the tax year. Defined benefit plans require actuarial work and setup time. The planning conversation needs to happen early in the fourth quarter, not after the W-2s arrive in January.