State Income Tax: An Overview of State Business Tax Laws
Find out how state business tax laws work and the different types of taxes a business might owe for doing business or earning income in a state.
Generally speaking, if your business makes money, then that money will be subject to income tax in the state where your business is located. The tax will either be paid directly by the business, or by the individuals who ultimately receive the business income. Moreover, apart from a tax on income, your business may be subject to a tax merely for existing in a particular state. There are various possible names for this type of tax (“franchise tax;” “privilege tax”), which may consist of a flat fee or a calculated amount based on your business’s net worth.
The particular details regarding what tax you must pay on business income depend not only on what state you’re in, but also on the legal form of your business. To take a key example: Traditional C corporations are taxable entities that must file their own, separate state tax returns, but S corporations, limited liability companies (“LLCs”), and partnerships are—with rare exceptions—subject to “pass-through taxation,” meaning individuals alone, and not the business, pay state tax on business income. Moreover, the applicability of a given state’s franchise, privilege, or similar tax also usually depends on the legal form of your business.
State Tax on C Corporations
If your business is structured as a traditional corporation, also known as a C corporation, then, in many states, it must pay income tax in much the same way as you, personally, pay income tax. However, there is substantial variation among states regarding the details of corporate taxation.
First, most states have an income tax specifically for corporations. In some states, the rate for this tax is the same regardless of net income. However, in other states, the rates vary, so that businesses with higher net incomes need to pay incrementally higher rates. Moreover, some states will require corporations to pay an alternative minimum tax (AMT) on income that fits within the federal AMT rules for corporations. Also, a few states have special tax rates for particular types of businesses (although the business types involved, such as financial institutions or insurance companies, will not often be relevant to small businesses).
Next, some states have a franchise or similar tax. This is different from an income tax: it is often considered to be a tax on the privilege of having a business in the state, and it is frequently based on some measure of the value of the corporation, rather than on net income. For example, it may be calculated on the basis of the value of a corporation’s outstanding stock or similar capital paid in to the corporation. Unlike corporate income tax rates, which generally range from around 4% to near 9%, franchise tax rates tend to be fractions of 1%.
Finally, bear in mind that corporate income taxes and franchise taxes are not necessarily mutually exclusive. For example, Illinois charges a flat 7% corporate income tax (excluding adjustments), but also an annual franchise tax of 0.1% of the amount of paid-in capital for a twelve-month period. Also, states that do not charge an individual income tax often nonetheless tax corporations. In New Hampshire, for example, there is no individual income tax—but there is a de facto 8.5% corporate income tax called the “business profits tax,” as well as a de facto 0.75% franchise tax called the “business enterprise tax.”
State Taxation of Pass-Through Entities
If your business is formed as an S corporation, a typical LLC, or a partnership, then—with rare exceptions—the business itself will not need to pay income tax. Instead, these business structures are subject to “pass-through taxation,” meaning that you, personally (along with any fellow LLC members, S corporation shareholders, or partners), are responsible for paying tax on income from the business as part of your personal state tax return. (Note that while, by default, multi-member LLCs, like S corporations, are taxed as partnerships at the federal level, and are subject to pass-through taxation, an LLC may elect to be taxed as a corporation, in which case corporate tax rules would apply.)
This means that for income from S corporations, LLCs, and partnerships, you generally should look to your state’s personal income tax rules for guidance. In most cases, you will ultimately be relying on the adjusted gross income claimed on your federal tax return, which in turn will be based on key information from federal Schedules K-1 and E (for sole proprietorships, look to federal Schedule C). Also in most cases, apart from various exemptions and deductions, you will pay tax at various marginal tax rates as defined by the state.
While the federal pass-through status regarding income from S corporations and LLCs usually carries over to the individual states, this does not mean that S corporations and LLCs are exempt from any state business taxes. More particularly, a significant number of states impose a franchise, privilege, or similar tax on S Corporations, LLCs, or both.
Note on “Nexus”
Our primary focus here is on businesses operating in a single state. However, if you’re doing business in several states, your business may be obligated to pay taxes in each of those states. More particularly, regardless of whether you believe your business is “located” in more than one state, if your business has “nexus” in other states, it may be subject to income tax or franchise tax in those states. Unfortunately, determining whether nexus exists in a particular state for purposes of the latter taxes is not a straightforward matter.
Just to give you a taste of the complexities involved, consider that one traditional view is that your business must have a physical presence in a state in order for the state to be allowed to charge it income tax. Then, consider that a decades-old federal law, PL 86-272, states that, notwithstanding having a physical presence in a state, your business cannot be subject to state income tax if its activities in the state are limited to “the solicitation of orders by [a] person, or . . . representative . . . for sales of tangible personal property . . . which . . . are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the State.” Next, note that this same law does not limit imposition of a franchise, as opposed to income, tax—and also does not apply if your business is involved in soliciting sales in a state for something other than tangible personal property. Finally, consider that some states follow a 1992 South Carolina Supreme Court decision holding that the presence of so-called intangible property in a state—such as a trademark—creates sufficient nexus to require your business to pay income tax.
From these various considerations, we can perhaps derive at least one general piece of advice: If your small business strictly speaking is located only in one state, but you are also doing business in other states, including having some presence in those other states beyond having products delivered there by independent delivery companies, you should check with those other states’ departments of revenue regarding nexus requirements for purposes of income and franchise taxes.
This article presents only a broad outline of state income and franchise taxes. For more specific information on these taxes in your own state, check Nolo’s 50-State Guide to Business Income Tax. Also, if you’re looking for detailed guidance on federal income tax, check Tax Savvy for Small Business, by Federick Daily (Nolo).