Most states tax at least some types of business income derived from the state. As a rule, the details of how income from a specific business is taxed depend in part on the business’s legal form. In most states corporations are subject to a corporate income tax, while income from pass-through entities such as S corporations, limited liability companies (LLCs), partnerships, and sole proprietorships is subject to a state’s tax on personal income. Tax rates for both corporate income and personal income vary widely among states. Corporate rates, which most often are flat regardless of the amount of income, generally range from roughly 4% to 10%. Personal rates, which generally vary depending on the amount of income, can range from 0% (for small amounts of taxable income) to around 9% or more in some states.
Currently, six states – Nevada, Ohio, South Dakota, Texas, Washington, and Wyoming – do not have a corporate income tax. However, four of those states – Nevada, Ohio, Texas, and Washington – do have some form of gross receipts tax on corporations. Moreover, five of those states – Nevada, South Dakota, Texas, Washington, and Wyoming – as well as Alaska and Florida currently have no personal income tax. Individuals in New Hampshire and Tennessee are only taxed on interest and dividend income.
Apart from taxing business income through a corporate income tax or a personal income tax, many states impose a separate tax on at least some businesses, sometimes called a franchise tax or privilege tax. This is frequently justified as a tax simply for the privilege of doing business in the state. As with state taxes on business income, the specifics of a state’s franchise tax often depend in part on the legal form of the business. Franchise taxes are generally either a flat fee or an amount based on a business’s net worth.
California has a franchise tax, a corporate income tax, and an alternative minimum tax. Your business may be subject to one or more of these taxes depending on both its amount of taxable income and its legal form. Additionally, if income from your business passes through to you personally, that income will be subject to taxation on your personal state tax return.
California’s franchise tax, which is essentially a tax on doing business in California, applies to S corporations, standard limited liability companies (LLCs), limited partnerships (LPs), and limited liability partnerships (LLPs), as well as to traditional corporations (C corporations) and LLCs electing to be treated as corporations that are not subject to corporate income tax. For S corporations, the franchise tax is 1.5% of the corporation’s net income with a minimum tax of $800. For standard LLCs, the franchise tax is a flat fee rather than a percentage rate, and the fee varies depending on total income (essentially gross income) coming from California. The specific breakdown is as follows:
In addition, as with S corporations, there is a minimum franchise tax on LLCs of $800 regardless of income. Limited partnerships and limited liability partnerships are subject only to the minimum $800 franchise tax.
Traditional corporations and LLCs electing to be treated as corporations are subject to a state income tax of 8.84% of net income derived from business transacted in California. The corporations and LLCs that are subject to the corporate income tax are not subject to the franchise tax. However, these same businesses are subject to a 6.65% alternative minimum tax (AMT), which is based on the federal AMT rules, though with certain modifications.
Here’s a brief look at additional details for five of the most common forms of California business: corporations (C corporations), S corporations, LLCs, partnerships, and sole proprietorships.
California corporations without taxable income are subject to California’s franchise tax. California corporations with taxable income are subject to the state’s corporate income tax and, potentially, the state’s alternative minimum tax.
Example: For the latest tax year, your California corporation had taxable net income of $100,000. Other things being equal, your corporation will owe California corporate income tax in the amount of $8,840 (8.84% of the amount over $100,000). Your corporation will not owe the franchise tax to the state.
An S corporation is created by first forming a traditional corporation, and then filing a special form with the IRS to elect S status. Unlike a traditional corporation, an S corporation generally is not subject to separate federal income tax. Rather, taxable income from an S corporation is passed through to the individual shareholders, and each shareholder is subject to federal tax on his or her share of that income. In other words, S corporations are pass-through entities. (Note that a shareholder’s share of the S corporation’s income need not actually be distributed to the shareholder in order for the shareholder to owe tax on that amount.) California is unusual among the states in that, while it does recognize the federal S election, it does not treat S corporations as pass-through entities for state tax purposes. Instead, California requires S corporations to pay a 1.5% franchise tax on income, with a minimum tax of $800. In addition, an individual S corporation shareholder will owe tax to the state on his or her share of the company’s income.
Example: For the latest tax year, your S corporation had net income of $100,000. The corporation will owe state franchise tax in the amount of $1,500 (1.5% of $100,000). In addition, the net income will be allocated to you and your fellow shareholders, and you will each pay tax on your own portions on your respective state tax returns. The rate for each shareholder will vary depending on his or her overall net income for the year.
Like S corporations, standard LLCs are pass-through entities and are not required to pay federal income tax. Instead, income from the business is distributed to individual LLC members, who then pay federal and state taxes on the amount distributed to them. Also, as mentioned above, standard California LLCs are required to pay the minimum franchise tax of $800.
Note that while by default LLCs are classified for tax purposes as partnerships (or, for single-member LLCs, disregarded entities), it is possible to elect to have your LLC classified as a corporation. In that case, the LLC would also be subject to California’s corporate income tax and, as necessary, alternative minimum tax.
Example: For the latest tax year, your multi-member LLC, which has the default tax classification of partnership, had total income from California of $100,000 and net income of $60,000. The LLC will owe the minimum state franchise tax of $800. In addition, the net income will be divvied up between you and your fellow LLC members, and you will each pay tax on your own portions on your respective state tax returns. The rate for each member will vary depending on his or her overall net income for the year.
Income from partnerships is distributed to the individual partners, who then pay tax on the amount distributed to them on both their federal and state tax returns. (However, limited partnerships and limited liability partnerships must pay the $800 minimum state franchise tax.)
Example: For the latest tax year, your partnership, which is not a limited partnership or limited liability partnership, had net income of $100,000. The $100,000 in net income will be divvied up between you and your fellow partners, and you will each pay tax on your respective portions on your respective state tax returns. The rate for each partner will vary depending on his or her overall net income for the year.
Income from your business will be distributed to you as the sole proprietor, and you will pay tax to the state on that income.
Example: For the latest tax year, your sole proprietorship had net income of $100,000. The $100,000 in net income is distributed to you personally, and you pay tax on that income on your individual state tax return. The rate will vary depending on your overall net income for the year.
The primary focus here is on businesses operating solely in California. However, if you’re doing business in several states, you should be aware that your business may be considered to have nexus with those states, and therefore may be obligated to pay taxes in those states. Also, if your business was formed or is located in another state, but generates income in California, it may be subject to California taxes. The rules for taxation of multistate businesses, including what constitutes nexus with a state for the purpose of various taxes, are complicated. If you run such a business, you should consult with a tax professional.
For further guidance on California’s franchise tax, corporate income tax, and alternative minimum tax, visit the California Franchise Tax Board. For information on business-related taxes in other states, check Nolo’s 50-State Guide to Business Income Tax. And, if you’re looking for detailed guidance on federal income tax issues, check Tax Savvy for Small Business, by Frederick Daily (Nolo).