CA Business Owner’s Guide to State Income Taxes & FTB Audit and Appeal Process
Small Business Taxation in California
With higher than average state income tax imposed on business and personal income, California can be an expensive state to do business in. The state’s small businesses are particularly hard hit under its tax laws. California has a higher than average state income tax imposed on business and personal income. Even if your California business is structured as a pass-through entity, meaning income should only be taxed at one level; the California Franchise Tax Board may still be double-taxing your income.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.
Aside from having a higher than average state income tax,California imposes both business and personal income taxes on small business owners running pass-through entities.
Limited Liability Companies and S-Corporations are two examples of 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. However, California 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;
- Among 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
C-Corporation | 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 percent. 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 percent or AMT of 6.65 percent depending on whether it claims net taxable income. Filing Deadlines:
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S-Corporation | 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 percent 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 tax brackets for personal income tax from 1 percent to 12.3 percent. Corporate losses can be deducted from the individual tax returns of the shareholders. Filing Deadlines:
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Limited Liability Company (LLC) | A pass-through entity where net income passes through to owner(s) who then pays personal income tax at marginal rates from 1 percent to 12.3. The first taxes are due 75 days after the formation of the LLC. Must pay a self-employment tax, about 15 percent, 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 percent to 12.3 percent 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 the owner’s income. Business partners must pay personal income tax on income passing through from the partnership. Filing Deadlines:
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Complications 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 percent — 2 percent 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.
Why Do I Owe State Taxes?
California is one of 43 states that collects state income taxes and currently has the highest state income tax rate in the U.S. at 13.3 percent. It comes in fourth for combined income and sales tax rates at 11.2 percent, behind New York, New Jersey and Connecticut.
We are here to explore the common reasons for higher state taxes in California and ways to ease the bite they take from your earnings and revenue.
California State Tax Agencies
Aside from the IRS, there are three major tax agencies in California that impact you as an individual and your business.
The Franchise Tax Board (FTB) is the agency responsible for administering the state income tax and corporation tax. It handles collections, penalties, and dispute resolution as well as a number of other state programs.
The Board of Equalization administers California’s sales and use tax, and taxes on fuel, alcohol, and tobacco. Businesses must register with the BOE to obtain permits and licenses.
The Employment Development Department (EDD) is one of the largest state departments, administering payroll taxes, unemployment, disability and many other state programs.
How do State Taxes Differ From Federal Taxes?
The Internal Revenue Service (IRS) of the federal government administers income taxes for the entire United States, according to the federal Internal Revenue Code.
However, state income tax codes can and do differ from federal law. Each of the 43 states taxing income has different tax laws. Additionally, states can charge sales and use tax; there is no federal sales tax.
Each state has its own department of revenue and may have very different tax refund statuses.
Before filing in any state, check its specific tax laws or consult a tax professional specializing in that state. California, for example, sometimes differs from the IRS on due dates for estimated quarterly taxes.
Can You Owe Taxes in More Than One State?
If you performed work in a state and tax was withheld from your income, you may owe or be due a refund from that state. If taxes were not withheld and you received a Form 1099 listing your earnings, you are not required to file in that state.
However, your 1099 income is subject to taxation by your state of operation or residence.
If you lived in more than one state during the tax year, you must file a state income tax return for each state to determine your refund status. It does not matter how long you resided in that state.
If you worked in or earned income from more than one state, you may need to file a return even if you did not live in that state.
For example, if you are a resident of California who contracted out to a company in New York and met one of these conditions, you need to determine refund status for both New York and California:
- You briefly traveled to New York for work
- You worked remotely from your home state
They get you coming and going.
Common Reasons for Increased State Taxes
When it comes tax time, there are several ways to find yourself owing more than you expected.
You may not have had enough withholding or deductions. This leaves more income to be taxed resulting in a lower refund or the need to pay additional taxes with your return. If you received unemployment, that is also taxable.
If you have previously been eligible for the Earned Income Tax Credit (EITC) and your income increased, your EITC may be reduced or eliminated entirely. Since the EITC is a direct deduction from your tax liability, the elimination of the deduction will increase what you owe.
Did you take an additional job or did your spouse start working? Again, if you did nor adjust withholding, you may come up short at tax time.
Other money eligible for income tax includes:
- Gambling winnings
- Social Security, if this was your first year receiving benefits
- You did not contribute to an IRA, increasing your taxable income
Finally, whether we like it or not, income taxes do go up every year. If you did not change your withholdings in response, you might not have enough withholding by the end of the year.
You may owe taxes or receive a lower than expected refund.
More reasons for increased taxes:
- Change in filing status
- Gain or loss of child tax credit eligibility
- Change in education or tuition deduction
- Change in home or property tax
- Change in military service
Keep accurate records of anything that may change your taxable income or tax status.
State Business Taxes
If you run a business in California, you are required to pay sales and use tax, which you can levy at the point of purchase and pass along to the CDFTA. Sales and use tax is required on all cash and credit card sales, installment sales, lay-away sales and trade-ins or property exchanges.
Depending on what you sell, you may owe excise tax.
If you also have employees, you must withhold income tax from their earnings and pay employment taxes (Medicare and Social Security), workers’ compensation and other taxes.
On the other hand, if you are self-employed, you must pay self-employment tax. You are paying both your contribution and an employer contribution into Social Security and Medicare.
Paying or Disputing Your Taxes
To avoid paying interest, penalties, and legal issues, pay your tax bill in full and on time. If you cannot pay in full, pay as much as possible to reduce the interest and penalty liability.
If you have a dispute with any tax agency, you must prepare a timely protest. The draft should include your statement of the right of appeal, a copy of the tax notification and documentation for relevant tax years, and statements of law and fact supporting your tax return position.