Starting your first California business is a great idea. Dealing with taxes and the Internal Revenue Service (IRS) can shake that confidence, but don’t let it.
By following my expertise and familiarizing yourself with the different business structures and entity types, you will know what to expect and minimize your business's tax worries.
California Franchise Tax
The state of California Franchise Tax Board has a franchise tax similar to other state’s privilege taxes. In return for being allowed to do business in California, you must pay the state’s franchise tax.
If a C corporation doesn’t report a net income, it will need to pay the franchise tax. Pass-through entities, such as S corporations, LLCs, limited partnerships, and limited liability partnerships, must also pay the California franchise tax. Sole proprietorships and general partnerships do not pay the state franchise tax.
The franchise tax is calculated differently for the various business structures and entity types.
Limited partnerships and limited liability partnerships pay a flat rate of $800 per year under the franchise tax rule.
The rate for LLCs is calculated per the income range the net income value falls within. Their franchise tax rate can range from $800 to as high as $11,790 if an LLC’s net income is above $5,000,000.
S corporations pay a minimum franchise tax of $800 or 1.5% of their net income, whichever amount is the largest. This can be easily calculated by multiplying the net income of the business by 1.5% or 0.015.
California State Income Tax
The California State Franchise Tax Board requires individuals and some businesses to pay California state income taxes. The income tax is a marginal income tax rate, meaning your rate will differ according to your tax bracket and the amount of income you made over a certain amount.
The California Franchise Tax Board provides tables of that information on their site.
Residents are required to file FTB Form 540 to pay their state income tax.
California Business Taxes
Some businesses are taxed exclusively due to the products they sell or deal with. I recommend reviewing this list of various taxes and fees from the California Department of Tax and Fee Administration. These taxes and fees are collected by the state to help fund local and state services and programs.
Here’s a description of the different business structures and their taxes:
Sole Proprietorship
Sole proprietorships are the most common and basic business structure. For legal and tax purposes, the owner is the business. The owner conducts and manages the work of the business. Selling products, such as refurbished motorcycles or cupcakes, or providing a service, such as mobile oil changes, are examples of possible sole proprietorship businesses. Obviously there are thousands of possibilities.
The IRS and the government see you and your business venture as one entity under this business structure. Legally and financially they are one entity. This structure does not separate your personal assets from your business assets. This means that should you get sued your personal assets could be targeted.
No fear, you have options to protect you and your personal assets. You can learn how to create a limited liability corporation (LLC) and protect your possessions. As an LLC, the business is separated from your personal assets.
Sole Proprietorship Taxes
Being a single entity, your business and personal income will need to be combined and reported to the IRS on your state tax and federal tax return. The net income of the business will be the reported number.
Sales minus expenses will be your net income and the amount you will file on your tax return. The sales will be money your business brought in while expenses are the costs of running your business.
Calculating your tax burden as a sole proprietor is easy to do. Let’s you are a mobile oil change specialist.
By keeping an accurate record of your sales, you total your calendar year sales to be $10,000. That is one of the numbers you need. The other is going to be your expenses and deductions. These will include your equipment, the wear you put on your company vehicle, fuel, and possible advertising you purchased to promote your new business.
By saving receipts and tracking your mileage, you are able to add the costs up for a total of $5,000.
You are going to need to report your net income, which is your sales ($10,000) minus the business expenses ($5,000) for a total profit of $5,000. This is the reportable and taxable income for your business.
If you have a separate job, your job’s salary in addition to your business income will be reported and taxed at the federal tax rate on your tax return. Thankfully sole proprietorships do not pay any business taxes in California.
Tax Documents
You will only need a few IRS forms to report your taxes to the federal government as well as California. These forms include the standard Form 1040 for personal federal income tax returns and a Schedule C Form. The IRS recommends filing these federal forms quarterly throughout the year for your business.
The Schedule C Form is the Profit or Loss from Business form from the IRS. This is where accurate record keeping and receipts will help you calculate your business’s total income and expenses. The IRS totals these expenses into various categories, including vehicles, insurance, office supplies, travel costs, meals and entertainment, and utilities.
Use California Resident Income Tax Return, Form 540, to file your state tax return.
There are plenty of easy-to-use tax reporting software that can walk you through the process of putting the numbers together.
Partnerships (Including Limited and General)
Business partnerships are a type of business structure and they come in three different forms in California: general partnership, limited partnership, and limited liability partnership. They involve two or more people that have ownership of the business.
Depending on the partnership type, whether it is a pass-through entity or not, will determine if the business must pay a California franchise tax.
General Partnership
A general partnership pays no business taxes, but also has no liability protection. Each of the partners in a general partnership can make executive decisions for the business. If the business gets sued, the personal assets of the partners are potential vulnerabilities.
At the establishment of a general partnership, the business is set up and organized by an official agreement, often called an operating agreement. The profits and losses at the end of the year are split according to that agreement. The partners will each be responsible for their share of the tax burden of the company profits. If you decide to go this route, ensure you trust and are confident in your partners due to the potential exposure of your personal assets.
General partnerships also do not pay a California franchise tax.
Limited Partnership
A limited partnership requires two or more partners, usually a general partner along with limited partners. The general partner manages and operates the business. The limited partners are hands off. The general partner is responsible for the business debt, while the limited partners are only at risk up to the amount of money they invest into the business venture.
A limited partnership is a pass-through entity, so the partnership is required to pay the $800 California franchise tax. They are taxed again on the income earned and reported by each of the partners on their individual tax return.
Limited Liability Partnership
Limited liability partnerships protect each of the partners from actions taken by their partners. Under an LLP, the individual partners are protected should an individual partner be sued. This liability protection does not protect the assets of the business itself.
Similar to a limited partnership, a limited liability partnership is a pass-through entity and will be required to pay the $800 franchise tax for conducting business in California. A limited liability partnership in California is subject to double taxation because the partners will also pay taxes on their share of the business income.
Partnership Tax Information
Like I said above, the partners will pay taxes on their share of the business income. The business itself, not including general partnerships, will be required to pay the California franchise tax.
The partners will report their business income on their state tax and federal tax returns along with any other income including jobs or other businesses. The reported income will account for the expenses and deductions from throughout the year, much like the sole proprietorship example.
Since partners are not employees, they will not be given W-2 forms.
Tax Documents
Filing their federal taxes, the partnership will need to file and submit a Form 1065, Return of Partnership Income. This is a partnership version of the Schedule K form. Additional documents will be required for the taxes collected throughout the year. These forms can be found on the IRS partnership website.
As an individual partner of a partnership, you will need to file Form 965, for tax liabilities, and Schedule E, for supplemental income, alongside the standard Form 1040 for the federal income return.
For California you will need to complete FTB Form 565 “Partnership Return of Income” to report your earnings from the partnership.
If you have an ownership interest in other partnerships or LLCs, you will be required to file Schedule EO 568 “Pass-Through Entity Ownership” as well.
Limited Liability Companies (LLC)
Limited liability companies (LLC) are pass-through entities. The profits and losses are handed to each of the LLC members. Individually, they will be taxed for their portion of the LLC's profits.
Companies elect to be LLCs for the liability protection they provide to their members. By separating personal and business assets, only the business may be a target of lawsuits.
For more information, read my comprehensive guide to starting your own LLC.
The government allows single-member LLCs created by an individual, but the risk is the legal interpretation of where the individual ends and business begins, similar to a sole proprietorship. This may expose the personal assets of the single member as a liability.
LLC Tax Information
Since LLCs are pass-through entities, they pay federal income tax on the business income at individual federal income tax rates. The LLC owners will be taxed federally for their profits after accounting for their expenses and deductions. The businesses are still required to pay Alabama’s business privilege tax due to being classified as a limited liability entity.
In California, an LLC owner can elect for their LLC to be treated as a corporation. As a corporation, the LLC will need to report its profit and would be taxed at the California corporate tax rate of 8.84%. If such an LLC does not report a profit for the tax year, they are required to pay the alternative minimum tax rate of 6.65% or the $800 franchise tax, whichever amount is greater.
A standard LLC that reports a net income will pay the franchise tax according to their net income bracket. If the standard LLC does not report a net income, they will pay the minimum franchise tax of $800 to the state of California. The income that passes through to the owners will also be taxed per California’s marginal tax rates.
Tax Documents
The required federal tax documents for an LLC are similar to the other pass-through business structures.
Members of an LLC will file the standard Form 1040 to the IRS. The partners will also be required to file Form 1065 and a Schedule K-1 form that reports their share of the income, losses, and deductions.
If your LLC has employees, you will need to file additional forms to pay the payroll taxes. You should familiarize yourself with Forms 940, filed annually, and 941, filed quarterly.
C Corporation
C corporations are typically larger companies that have formal requirements, such as company operating rules. They are required to have stockholder and director meetings and register with the California Secretary of State.
C Corporation Tax Information
A C corporation pays corporate income taxes on its profits, calculated just like our sole proprietorship example. They are likely to be more complex due to their scale, real estate, the associated employee taxes, and insurances involved.
The profits of a C corporation may be subject to double taxation or being taxed twice. This happens when corporations pay out a dividend to their shareholders. The shareholders are then responsible for paying the taxes on those dividends.
California has a corporate tax rate of 8.84% or an alternative minimum tax of 6.65%; this number will be based on the corporation’s net taxable income.
If the C corporation distributes a dividend, the shareholders receiving that dividend will be responsible for reporting that income on their tax returns.
Tax Documents
Due to the complexity of C corporations and their taxes, I recommend hiring an accountant. The corporation will need to file a Form 1120.
In California, you will need to file Form 100 “California Corporation Franchise or Income Tax Return” to report your earnings. California also requires the filing of Form Schedule R “Apportionment and Allocation of Income.”
S Corporation
S corporations are unique among business structures because they serve as pass-through entities while also providing liability protection. They share characteristics with C corporations as well as limited liability entities, like LLCs.
S Corporation Tax Information
As a pass-through entity, an S corporation is required to pay a minimum franchise tax of $800, or 1.5% of their net income, depending on which amount is larger. Reporting a positive net income will require the company to pay the 1.5% franchise tax to the state of California. Otherwise, the business pays the minimum franchise tax of $800 per year.
Double taxation occurs since the S corporation pays the franchise tax and the members of the corporation must also pay taxes on their reported earnings.
Tax Documents
For federal income taxes, an S corporation files a Form 1120-S. The shareholders and those that benefit from the pass-through income of the business are required to file Schedule K-1 form along with their Form 1040.
California requires the business to file a California S Corporation Franchise or Income Tax Return as Form 100S. The business will also need to file a Schedule R form for income inside and outside of California to determine the amount of income received in California.
Conclusion
California business taxes can be intimidating, but don’t let that stop you from pursuing a business venture of your own.
By keeping accurate records, contacting a business attorney when necessary, and using the correct state and federal tax forms, stressing over state and federal taxes won’t be a barrier to success.
