Filling out the federal tax return for yourself or your business can be hard enough, but you’re not finished until you’ve handled state taxes as well.
Each state has its own unique rules and regulations for taxes on small businesses. A few states don’t have an income tax for you to worry about, but California is not one of them. If you’re starting a small business in California, you need to be sure you’re informed and ready to handle California’s requirements.
Here’s a guide to the fundamentals you’ll need to prepare and file a small business tax return in California.
What to Know About Small Business Taxes in California
California is a beautiful state to live in and a popular place for businesses, but that doesn’t mean the state makes it easy for new small businesses. The state has multiple income tax rates and strict rules for how they apply to business and personal income.
How these rates affect you will depend on your particular business entity.
Corporate Taxes in California
California imposes multiple layers of taxes on corporations located within their borders. If you form a C-Corp in the state, you’ll need to learn how these apply to you.
C-Corporations in California are subject to a corporate tax rate of 8.84% of net taxable income. This is the same flat rate for all businesses recognized by the state as corporations for tax purposes.
Businesses can write off eligible expenses to make deductions from their net taxable income under that rate, but there’s a catch. California limits corporations’ ability to claim deductions with an alternative minimum tax of 6.65%.
C-Corporations can deduct expenses from their taxable income, but they cannot reduce their tax burden below the alternative minimum. You measure your alternative minimum tax rate by applying it to adjusted gross income without all of the same deductions.
S-Corp Taxes in California
An S-Corporation is a business entity with a special tax status approved by the IRS. Corporations of a smaller size can apply to be treated as pass-through entities at the federal level. That means that the S-Corporation will not pay taxes on business income as its own entity, but that income will pass through to shareholders who will pay for that income on their own tax returns.
States vary in how they treat S-Corporations, however. S-Corporations in California don’t pay the corporate tax rate, but they must pay the franchise tax as a fee for doing business in the state.
The state franchise tax in California is 1.5% of net income for S-Corporations, with a minimum payment of $800. Even with no recorded income, every S-Corporation in California must pay that minimum of $800 for the franchise tax.
After the franchise tax payment, the S-Corporations income then still passes through to the business owners to be filed on their personal returns.
LLC Taxes in California
Most limited liability companies in California will have a tax situation similar to S-Corporations, but not all.
If your business entity is an LLC, you have a certain degree of control over how the state recognizes your business. If your LLC elects to be treated as a corporation, then you will pay the corporate tax rate or alternative minimum faced by C-Corps.
Other LLCs will pay the state franchise tax, and then the business income will pass through to be taxed at personal income tax rates.
The franchise tax for LLCs still requires a minimum fee of $800, but otherwise, it is calculated differently than for S-Corps. Instead of paying a flat percentage of net income, LLCs pay a specific and pre-set franchise tax amount depending on their gross income level.
The franchise tax is $900 for LLCs with gross income between $250,000 and $499,999. It steadily increases at each tier, up to a maximum franchise tax of $11,790 for gross income above $5 million.
Partnership Taxes in California
California businesses using a partnership as their business entity might not have to pay any annual business tax. It will depend on the specific kind of partnership. All partnerships still qualify as pass-through entities in that individual owners will have to file and pay tax on business income on their personal tax returns.
Limited liability partnerships filed with the state must pay the franchise tax minimum payment of $800. General partnerships without limited partners are exempt.
In a general partnership, income to the business is immediately and directly distributed among the business owners. These partnerships are not subject to the franchise tax and are treated as sole proprietorships.
Sole Proprietorship Taxes in California
If your business doesn’t fit into one of these other categories, your business entity may be a sole proprietorship. A sole proprietorship is a small business owned entirely and directly by one individual. The business owner might hire contractors or employ others, but its debt and income all go through the owner.
A business with one single owner does not exist outside the owner, so sole proprietorships do not pay business taxes. All income for the business is paid and filed on the individual’s personal tax return.
Personal Income Tax
Personal income tax in California is a progressive tax that depends on your income. Marginal tax rates on income go from 1.0% to 12.3% for the highest brackets.
Sole proprietors will use these rates for all of their business income. Other business owners with pass-through entities will also pay taxes at these rates.
If your business operates or sells goods or services in multiple states, you may owe income tax in each of those states. The tax you owe in each state will depend on the revenue you earned in that state.
California businesses that owe taxes across states can participate in California’s multistate offset program. This program allows California and other states to directly transfer your tax refund in one state to pay off your tax burden in another state.
Consult With a Tax Professional
If you’re concerned or uncertain about your tax obligations under California state law, take the time to find a tax consultant you can seek out for advice. A local professional will know how to navigate federal, state, and municipal tax requirements and can give you the guidance you need.
If you’re just setting out to start your business now, an accountant can also help you put together a plan and contemplate your business entity options. As you can tell from these varying tax rates, few decisions are more consequential for your business than that of the business structure itself.
The more informed and prepared you are as a business owner, the better off your business will be.