Learn more about keeping your business compliant with state tax requirements.
In California, you're generally free to choose to operate your business as a C corporation, S corporation, partnership, limited liability company (LLC), or sole proprietorship. However, the entity type you select for your business may, in some cases, decide whether you or your business pays income taxes on the business income.
California differs from nearly all other states in that it taxes the income of pass-through entities (S corporations, limited liability companies, and partnerships) at the entity level. If you operate your business as a partnership, the partnership itself does not have to pay federal tax on its income; rather the income is "passed-through" to the partners who pay tax on their individual tax returns. This allows you to avoid "double taxation" on your business earnings. Nearly all states follow the federal rules. But, not California.
California imposes a franchise tax on pass-through entities, albeit a smaller one than the corporate income tax imposed upon regular corporations. The amount of tax varies based upon the business entity, but all entities that do business in California are subject to a $800 minimum tax—even if they have no net income for the year.
All C corporations are required to pay an annual corporate tax of 8.84 percent on the net income generated in California. (Corporations that do not have taxable income for the year are subject to the franchise tax. The minimum tax is $800, but an alternative minimum tax of 6.65% may be applied instead.
If you meet the federal tax law requirements to operate as an S corporation, the IRS allows your business to "pass through" its income to the shareholders. This means that your business will not pay any IRS corporate level income tax. However, you'll have to claim your entire share of the business income on your personal federal income tax return even if you did not take any money out of the business.
California extends this favorable tax treatment to state corporate income tax liability, but only with respect to the 8.84 percent corporate income tax. The income your S corporation makes in California will still be subject to the 1.5 percent franchise tax or $800, whichever is higher. Accordingly, if your business has income that was not generated in California, you may obtain state tax savings by electing to be treated as an S corporation.
If you operate your business as a partnership, you will pay no tax at the partnership level on business income. Instead, all the partnership income will be allocated to the partners and recognized on their personal income tax returns. You will however have to pay franchise tax.
California law recognizes businesses operating as limited liability companies (LLCs) and follows the federal classification scheme. In most cases, as an LLC, your business will be treated exactly like a partnership for tax purposes. Accordingly, all LLC income will be allocated to the members and recognized on their personal income tax return.
How you do business will determine the extent of your franchise tax liability, as well as your liability for corporate-level income tax. The following table provides the franchise tax rates.
|Type of Entity||Tax Imposed|
|S Corporations||1.5% of net income or $800, whichever is higher|
|Partnerships||$800 minimum tax imposed on limited partnerships, otherwise no entity-level tax measured by income or net worth/capital value|
|Limited Liability Partnerships||$800 minimum tax, otherwise no entity-level tax measured by income or net worth/capital value.|
|Limited Liability Companies||Fee imposed on income attributable to state sources
|Entities subject to the California income tax are not subject to the minimum franchise tax. A 6.65 percent alternative minimum tax applies instead.|