California Business Tax Guide for Small Businesses

When you think about your business tax responsibilities, you probably picture federal taxes related to the Internal Revenue Service (IRS). Preparing and filing your federal tax return is an integral part of operating your business, but don't forget about your state tax obligations. While most state tax rules and regulations share some commonalities, they can also be distinct, as seen in California.

Whether you're considering establishing your business in the state of California, have just launched, or are celebrating your first year in business, it's essential to understand how the state's tax rules will impact your operations. Use this blog as your guide to the fundamentals you’ll need to learn to prepare and file your small business tax return in California.

California Business Tax Key Takeaways: 

• Learn how California taxes impact each business entity 

• Understand multistate obligations for California-based businesses 

• View the forms you'll need to file your California taxes 

What to Know About Small Business Taxes in California

California is a beautiful state and a popular place to establish a small business. However, as attractive as California can be for businesses, it has multiple income tax rates and strict rules to abide by.

The impact of these rates on your business will depend on the type of business entity you select. While certain entities, such as LLCs and S corporations, avoid being taxed twice due to pass-through taxation, this isn't always the case in California. If your business meets specific criteria, you can expect to be subject to double taxation, meaning your business's tax bill will be up to double what it might be in another state. While establishing a business in California offers numerous advantages, tax considerations and onerous regulations have created opportunities for competing states to seize entrepreneurial investments.

Corporate taxes in California

California imposes three layers of taxes on businesses headquartered in its state, including:

• Corporate taxes are applied to the profits of corporations and any LLC that chooses to be treated as a corporation. 

• Franchise tax or privilege tax is paid by businesses that want to conduct business in a different state.

• The alternative minimum tax is a percentage of taxes paid to the local government, regardless of whether or not deductions can be applied.

C corporations and LLCs electing to be taxed as corporations are subject to a corporate tax rate of 8.84%, which is flat, while banks and other financial institutions might be subject to a higher rate of 10.84%. The alternative minimum tax rate is 6.65%. 

C corp taxes in California

California corporations may not be required to pay a franchise tax, but are subject to a corporate tax rate of 8.84% on their net taxable income. This corporate tax rate is a flat rate applicable to 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 a corporation's ability to claim deductions with an alternative minimum tax of 6.65%. C corporations can deduct expenses from their taxable income, but cannot reduce their tax burden below the alternative minimum. You can measure your alternative minimum tax rate by applying it to your adjusted gross income without all of the same deductions.

While the alternative minimum tax rate is lower than the corporate tax rate, the alternative minimum tax base is broader due to restrictions on 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. This means that the S corporation will not pay taxes on business income as its own entity; instead, that income will pass through to its shareholders, who will report it on their own tax returns. States vary in how they treat S corporations, however.

In California, S corporations don’t pay the corporate tax rate but must pay the California 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 is required to pay a minimum franchise tax of $800. After the franchise tax payment, the S corporation's income still passes through to the business owners, who report it on their personal tax returns.

There are scenarios where an S corporation is effectively double-taxed, including when it is subject to built-in gains tax and shareholder-level taxation. 

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, you will pay the corporate tax rate or alternative minimum franchise tax that C corps pay to the franchise tax board and be subject to double taxation.

Other LLCs will pay the state franchise tax, allowing business income to pass through to be taxed at personal income tax rates. The franchise tax for LLCs still requires a minimum fee of $800; however, it is calculated differently than for S corporations. 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, reaching a maximum franchise tax of $11,790 for gross income exceeding $5 million.

Partnership taxes in California

California businesses using a partnership as their business entity may not be required to pay any annual business tax in the state. It will depend on the specific kind of partnership. 

• All partnerships still qualify as pass-through entities in that individual owners must file and pay tax on business income on their personal tax returns. 

• Limited liability partnerships (LLPs) filed with the state must pay the franchise tax minimum of $800. 

• General partnerships without limited partners are exempt from taxation. 

In a general partnership, the business's income 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 you don't fit into the other categories, your business entity may be considered a sole proprietorship.

A sole proprietorship is a small business owned entirely and directly by an individual. The business owner might hire contractors or employ others, but the debt and income go through the owner. A business with a 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 state income tax with marginal tax rates ranging from 1.0% to 12.3% for the highest brackets. Sole proprietors and other business owners operating pass-through entities will use these rates for all of their business income.

Multistate taxes

If your business operates or sells goods or services in multiple states, you may owe corporate income tax in each of those states. The tax you owe in each state will depend on the revenue you earned there. For example, if a California business has a physical or economic presence in another state, this will trigger a nexus and result in additional tax obligations.

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 from one state to pay off your tax burden in another state.

California Tax Deductions

Tax deductions reduce the taxable income for California businesses. All deductions your small business is eligible for should be claimed.

You can itemize deductions or claim the standard deduction to reduce your business's taxable income. The standard deduction is a fixed dollar amount that you use to reduce your taxable income, providing a simplified method for doing so. Itemizing deductions, which is typically reserved for businesses and self-employed individuals, requires more time and effort, but may yield greater savings than taking the standard deduction for California businesses.

Knowing when to use either is essential. For example, if you don't have many expenses or the bandwidth to itemize your expenses, the standard deduction may be optimal. However, if you have several expenses that exceed the standard deduction, it is best to adopt this method to minimize your business tax liability in California.  

2% rule and business expense deductions

The 2% rule is a federal tax provision that allowed taxpayers to deduct miscellaneous itemized deductions on their federal income tax return. To qualify, the total expenses had to exceed 2% of a taxpayer's Adjusted Gross Income (AGI).

While the 2% rule has been suspended federally in the wake of the Tax Cuts and Jobs Act (TCJA), California has continued to apply the 2% on state income tax returns.

From the 2% rule to the TCJA, tax laws are constantly changing and shifting. Ensure your California-based small business is ready for any tax challenge with 1-800Accountant's affordable, tax-deductible tax advisory service. 

Common California tax mistakes to avoid

Common missteps and mistakes California businesses make during the calendar year can be costly and time-consuming to correct. It's essential to avoid the following issues as you build your business. 

• Forgetting to file the $800 minimum franchise tax

• Misreporting multistate income

• Confusing the LLC gross receipts fee with income tax

• Overlooking industry-specific deductions (e.g., green energy, R&D tax credits)

Filing Small Business Taxes in California

When you file your California business taxes will depend on your entity type. For example, general partnerships have a different tax filing date than C corporations, but both adhere to the same quarterly tax payment schedules.

Check with the California Franchise Tax Board for more details about due dates that impact your business. Once your business materials are ready for submission, you can typically e-file or file by mail. While the state can quickly receive files transmitted electronically, sending your taxes by mail can take significantly longer. As a result, the California Franchise Tax Board also outlines overnight and express delivery options.

Ensure your taxes are calculated and submitted on time with 1-800Accountant's full-service quarterly estimated tax solution. 

Partner With a California Business Tax Specialist

Handling your business's California tax obligations is incredibly complex and time-consuming. You not only have to prepare your materials while avoiding costly mistakes and submit them by their respective due dates, but you also have to keep up with ongoing tweaks and changes to California's complex tax rules.

Many California-based business owners don't have the time or capacity, which is why they trust 1-800Accountant, America’s leading virtual accounting firm, for their financial needs. Whether you require business tax preparation, entity formation, or any of our affordable, tax-deductible accounting services, we have the solutions you need to ensure your business remains compliant with a minimal tax liability. Schedule a quick consultation — usually 30 minutes or less—to learn more.