California can be an expensive state in which to do business, and it's not getting any cheaper. Small businesses in the state are particularly hard hit under the state tax laws.
California has a higher than average state income tax imposed on business and personal income, plus it engages in double-taxation when it comes to business entities structured so that the income passes through to the owner.
The Franchise Tax Board is the agency responsible for administering personal and business income tax in the State of California. While the state generally follows the lead of the IRS in setting policy, it does not do so in every instance, as we shall see.
Small Business Taxation in California
California, besides having a higher than average state income tax, also imposes both business and personal income taxes on small business owners running pass-through entities. Limited Liability Companies and S-Corporations are both business structures that allow pass-through of business income to the owner(s).
The federal government does not collect personal income taxes on these business owners, seeing it as double taxation. California, however, requires you to pay both business and personal income tax. These practices can nearly double a small business owner’s tax burden depending on:
- The net income of the pass-through entity
- The amount of personal income derived from the business
- And other factors
High taxes, along with a high cost of living, make California a challenging state for entrepreneurs and businesses other than traditional corporations.
Types of Business Entities and How They Are Taxed
A traditional corporation that is taxable as an entity. Profits are not subject to the Self-Employment Tax.
Owner(s) must pay personal income tax on any dividends, potentially at a marginal tax rate as high as 33%. Any non-dividend personal income derived from the business must also be filed for personal income tax.
Tax advantages include income splitting while the disadvantages include potential double taxation of dividends.
It is a more complex entity from the accounting and legal viewpoints than LLCs, sole proprietorships, or partnerships.
Corporate Tax Rate: 8.84% or AMT of 6.65% depending on whether it claims net taxable income.
Provides similar legal and financial protection as a C-Corporation. Profits pass through to the owner who must pay personal income tax on those profits.
Owner(s) must be paid a “reasonable salary” which is subject to Social Security and Medicare withholding. Only if a reasonable salary is paid can there be a profit distribution.
Any tax savings will only take effect once the business is making a substantial income.
Owner(s) must pay a franchise tax of 1.5% of net income with a minimum of $800 even if the business shows zero or negative net income, which is waived in the first year of incorporation.
There are nine (9) tax brackets for personal income tax from 1% to 12.3%. Corporate losses can be deducted from the individual tax returns of the shareholders.
Limited Liability Company (LLC)
A pass-through entity where net income passes through to owner(s) who then pay personal income tax at marginal rates from 1% to 12.3%.
The first taxes are due 75 days after the formation of the LLC.
Must pay a self-employment tax, about 15%, on all income. Net income is not taxed at a flat percentage rate; instead, it is taxed at a flat dollar amount based on multiple gross income tiers.
Gross Income Tax
$250,000 to $499,999 $900
$500,000 to $999,999 $2,500
$1M to $4,999,999 $6,000
Over $5M $11,790
Less than $250,000 pays a minimum franchise tax of $800.
Net income passed through to owner(s) is taxed at a marginal rate of 1% to 12.3% for personal income tax.
Filing Deadlines for Estimated Taxes:
Flexible in how profits and losses are split between partners.
Sole Proprietorship and General Partnerships
Personal income tax is paid on owner’s income. Business partners must pay personal income tax on income passing through from the partnership.
Complications Do Arise
Not all entities or partnerships are so straightforward.
For example, LLCs and C-Corporations can elect to be taxed as an S-Corporation. Considering C-Corporations pay a marginal tax rate that is one of the highest rates in the United States, doing so makes sense.
C-Corporations can also engage in “income splitting,” in which the income is split in such a way that part is taxable to the corporation and part is taxable to the corporation’s owners. Income splitting can allow each to be considered in a lower tax bracket.
C-Corporations and S-Corporations must split corporate profits and losses proportionally to the percentage of shares owned by each shareholder. LLCs are allowed more flexibility in sharing out profits and losses among partners.
State taxes in California tend to be higher than the average state taxes across the U.S. Also, the Franchise Tax Board, the agency responsible for collecting state income tax, permits double taxation of business owners whose companies are structured as pass-through entities.
The owners pay taxes on both business and personal income, even though it is the same pot of money in a pass-through entity.
Business structures can also be complicated as when an LLC elects to be taxed as a C-Corporation. Financial S-Corporations must pay a tax rate of 3.5%, 2% higher than a typical S-Corporation.
There are multiple tax brackets for personal income tax from an S-Corporation although corporate losses can be deducted from individual tax returns of the shareholders.
A small business owner who decides to set up shop in California should consult an experienced accountant and a knowledgeable tax attorney to determine what taxes must be filed, when they are due, and how each business entity is taxed by the Franchise Tax Board.