Estimated reading time: 5 minutes
Small businesses in the state of California are drivers of economic growth—creating two-thirds of new jobs and employing nearly half of all private sector employees. In fact, California is home to 4 million small businesses, representing 99.8 percent of all businesses in the state and employing 7 million workers in California—or 48 percent of the Golden State’s total workforce.
The small businesses based in California experience numerous advantages, such as doing business in dynamic metropolitan areas with talented, educated, and affluent residents—and very pleasant weather all year long.
However, running a California corporation also means that you will need to navigate a complex set of rules and regulations, which are unique to California taxpayers. Business owners should expect to pay more in state taxes and have a higher cost of living than you would in almost any other U.S. state. For more specific information on taxation in California, read on.
Double Taxation for Small Businesses: California enforces higher-than-average state income taxes on business, as well as personal income. In addition, California is one of the few states that imposes both taxes—business and personal—on business owners who set up pass-through business entities, such as S corporations or limited liability companies (LLCs).
These types of businesses avoid federal income tax because the income they earn passes through to the business owners. Because the federal government considers it double taxation to tax both the business owners on the pass-through income and the business itself, it taxes only the business owners at personal income tax rates.
It is important to keep in mind that this double taxation imposed by the state of California can sometimes double a small business owner’s tax return burden. And because California also has a high cost of living, the tax burden on small businesses can create significant financial challenges for some small business owners.
Categories of Business Taxes: There are several types of income taxes imposed on California businesses: corporate tax, franchise tax, and an alternative minimum tax (AMT).
The corporate income tax applies to corporations and LLCs that choose to be treated as corporations. The tax rate is 8.84%, which is above the average U.S. rate. It applies to net taxable income from business activity in the state.
While corporations are not subject to the franchise tax, they are subject to the alternative minimum tax of 6.65%. This restricts the effectiveness of writing off expenses against income in order to reduce the corporate tax rate.
The franchise tax applies to S corporations, LLCs, limited partnerships (LPs), and limited liability partnerships (LLPs). Keep in mind that C corporations that do not earn positive net incomes are not subject to the corporate tax—but must pay the franchise tax.
An alternative minimum tax (AMT) places a floor on the percentage of taxes that business owners must pay to the government—no matter how many deductions or credits the filer may claim. The alternative minimum tax of 6.65% is based on federal AMT rules and applies to C corporations and LLCs that elect to be treated as corporations. This tax stops corporations from claiming income to minimize corporate tax.
You can also refer to the California Franchise Tax board as know as ftb for the latest rules and regulations as they are subject to change without notice.
Taxation on C Corporations: C corporations (also called traditional corporations) pay the corporate tax of 8.84% or AMT of 6.65%, depending on whether the corporation claims net taxable income. California also taxes shareholders on personal income derived from the corporation. If that income is paid in dividends, California’s top marginal tax rate on dividends is 13.3%, which is considered to be quite high.
Taxation on S Corporations: S corporations (similar to C corporations) pay a franchise tax of 1.5% of net income. A total of $800 is the minimum franchise tax—even for S corporations that claim zero or negative net income. The income of the business passes through to business owners, who must pay personal state income tax on it. California offers nine different brackets for personal income tax, with rates from 1% to 12.3%.
Taxation on LLCs: While limited liability companies pay the franchise tax, it is calculated differently than for S corporations. Instead of a flat percentage rate based on net income, LLCs are taxed at flat dollar amounts based on gross income tiers. In California, gross incomes between $250,000 and $499,999 pay $900 in taxes. Gross incomes between $500,000 and $999,999 pay $2,500. Gross incomes between $1 million and $4,999,999 million pay $6,000. And gross incomes of $5 million or more pay $11,790.
In addition, the $800 minimum franchise tax applies to businesses with less than $250,000 in gross income. The net income from an LLC passes through to the business owners, who must pay personal income tax at marginal rates from 1% to 12.3%.
Taxation on Partnerships and Sole Proprietorships: If you are a business owner with a limited liability partnership (LLP), you need to pay the $800 minimum franchise tax. In addition, business owners must pay personal income tax on any income that passes through from the partnership. For general partnerships and sole proprietorships in which income is distributed directly to business owners, the personal income tax applies.
While the state of California boasts easy living for residents, this is not necessarily the case for small business owners. Business taxes in the Golden State are some of the highest of any U.S. state. And high taxes, combined with burdensome business regulations, have led many California business owners to leave in search of more friendly business states.
Have questions or want to learn more? Our Business Formation Experts are ready to assist you. Inc Authority is here to answer all your questions and provide you with qualified guidance and support. Form your free LLC today!