Taxes in California for Small Business: The Basics

Small business owners enjoy several distinct advantages from doing business in California. The state is home to several populous, growing and dynamic metropolitan areas, including Los Angeles, San Francisco and San Diego. These cities are ripe with talent, flush with upper-class and wealthy residents, and all are home to prestigious universities that pump out new classes of educated workers every spring and winter. Additionally, California is a pleasant place to live. In most parts of the state, winters are not too cold, and summers are not too hot or humid. The state offers diverse scenery and landscapes, including beaches, deserts, mountains and valleys.

That said, California is not all easy living for small business owners. In particular, business taxes in California are some of the most oppressive of any state. High taxes, combined with the onerous business regulations for which California is also known, have led many business owners in the 21st century to flee the state for places they perceive as more friendly operating grounds, such as Texas and Florida. In 2014, a California business owner encapsulated this phenomenon with a state map he circulated on social media; on top of the map he printed, "The Best Avenues for Business Owners in California," and then highlighted all the interstates and highways leading out of the state.

California imposes higher-than-average state income taxes on business and personal income. However, this is not the worst part. California is one of the few states that imposes both taxes, business and personal, on small business owners who set up their businesses as pass-through entities, such as S corporations or limited liability companies (LLCs). Businesses formed using these designations avoid federal income tax because the income they earn passes through to the business owners. The federal government considers it double taxation to tax both the business owners on the pass-through income and the business itself, so it taxes only the business owners at personal income tax rates. While most states follow the same philosophy, California stands out as one that hits these business owners from both sides.

Depending on several factors, including the net income of a pass-through entity and the amount of personal income derived from the business by its owners, this double taxation imposed by California can as much as double a small business owner's tax burden. Considering the state also has a very high cost of living, the tax treatment of small businesses in California can make it difficult for an entrepreneur to get his venture off the ground.

California imposes three types of income taxes on businesses: a corporate tax, a franchise tax and an alternative minimum tax. Nearly all businesses in the state are subject to at least one of these taxes, and sometimes more than one.

The corporate tax applies to corporations and LLCs that elect to be treated as corporations. This tax rate is 8.84%, which is higher than average in the United States, and it applies to net taxable income from business activity in California. Corporations are not subject to the state's franchise tax, but they are subject to the alternative minimum tax (AMT) of 6.65%, which limits the effectiveness of a business writing off expenses against income to lower its corporate tax rate.

The franchise tax applies to S corporations, LLCs, limited partnerships (LPs) and limited liability partnerships (LLPs). Additionally, traditional corporations, or C corporations, that do not earn positive net incomes and, therefore, are not subject to the corporate tax must pay the franchise tax instead.

The alternative minimum tax of 6.65% is based on federal AMT rules and applies to C corporations and LLCs that elect to be treated as corporations. This is a tax that prevents corporations from effectively writing down income to minimize corporate tax.

C corporations, or traditional corporations, pay the corporate tax of 8.84% or AMT of 6.65%, depending on whether they claim net taxable income. For example, a corporation with a net taxable income of $1 million owes 8.84% of that, or $88,400, in California state income tax. Additionally, the state taxes shareholders on any personal income they derive from the corporation. If that income is paid in the form of dividends, California is a particularly brutal state. The state's top marginal tax rate on dividends, at 33%, is one of the highest in the U.S.

S corporations, which provide similar legal and financial protections as C corporations but pass through income to business owners, pay a franchise tax of 1.5% of net income. The minimum franchise tax is $800, even for S corporations that claim zero or negative net income. Therefore, an S corporation with a net income of $1 million owes 1.5% of that, or $15,000, in California state income tax. The business' income then passes through to the business owners, who must pay personal state income tax on it. California has nine brackets for personal income tax, which carry marginal rates from 1 to 12.3%.

Limited liability companies also pay the franchise tax, but it is calculated differently than for S corporations. Instead of a flat percentage rate based on net income, LLCs are taxed at flat dollar amounts based on gross income tiers. Gross incomes between $250,000 and $499,999 pay a tax of $900. Gross incomes between $500,000 and $999,999 pay a tax of $2,500. Gross incomes between $1 million and $4,999,999 million pay a tax of $6,000. Gross incomes of $5 million or greater pay a tax of $11,790. For businesses with less than $250,000 in gross income, the $800 minimum franchise tax applies. The net income from an LLC passes through to the business owners, who must pay personal income tax at marginal rates from 1 to 12.3%.

Tax treatment of partnerships depends on the specific type. Limited liability partnerships (LLP) and LPs must pay the $800 minimum franchise tax, and the business owners must pay personal income tax on any income that passes through from the partnership. For general partnerships in which income is distributed directly to business owners, only the personal income tax applies. This is also the case with sole proprietorships.