Corporation and Business Issues
The Franchise Tax Board is responsible for the collection of income and franchise taxes on entities that do business in California. Corporate taxes are the third-largest source of income for the state. According to the Tax Foundation, California ranks 48th out of 50 as a favorable tax climate for businesses.
For more information, check below for some issues commonly associated with doing business in California.
The five common forms of business in California include:
- C Corporation-C Corporations, which are traditional corporations, with taxable income are subject to the state’s corporate income tax. A C Corporation is taxed separately from its shareholders and is subject to the infamous “double-taxation” structure.
- S Corporation-An S Corporation is created by first forming a traditional corporation and then filing a special form with the IRS to elect “S” status. An S Corporation is generally not responsible for separate federal income tax, which is passed through to individual shareholders, making it a “pass-through” entity. California is unusual among other states in that even though it recognizes 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 percent franchise tax on income. Individual shareholders will also owe tax to the state.
- Limited Liability Company (LLC)-Limited Liability Companies are also 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. Standard LLCs are required to pay the minimum California franchise tax of $800. If the LLC is classified as a corporation, it will also be subject to state corporate income tax and, as necessary, the alternative minimum tax.
- Partnership-Income from partnerships is distributed to the individual partners, who then pay federal and state taxes. Limited partnerships and limited liability partnerships must pay the $800 minimum state franchise tax.
- Sole Proprietorship-Sole proprietors pay tax on the income received from their business directly through their individual tax return.
California Business Tax
Depending on the amount of taxable income and its entity type, a business operating in California or receiving income from a source in California is subject to one or more of these taxes:
- Corporation Franchise Tax-Corporations and limited liability companies doing business in California are responsible for the corporation franchise tax. Doing business in California is defined as actively engaging in any state transaction for the purpose of financial gain or profit. Foreign corporations, or non-California corporations, that are general partners of partnerships or members of limited liability companies doing business in California are also responsible for the corporation franchise tax.
- Corporation Income Tax-If a corporation or limited liability company receives income from sources within California, even if its business is not located in California, it is responsible for corporation income tax. This applies to corporations formed outside of California as well.
- Alternative Minimum Tax-Unless you are an S corporation, you are responsible for the alternative minimum tax set forth in federal tax law as modified by California law.
When a business ceases all operations in California, it needs to terminate its legal existence within the state. Entities registered with the California Secretary of State can dissolve, surrender or cancel their businesses in the state. This does not, however, nullify the entity’s legal tax requirements or outstanding liabilities, and the business or its transferees will remain liable for the business’ tax debts.
Business Tax Audit
There are a variety of factors and issues that might cause an audit of a business tax return. The most common are:
- Abusive Tax Shelters-Abusive tax shelters have become a major issue in California, and have resulted in billions of dollars of lost tax revenue. The FTB has joined forces with other state agencies and the IRS to exchange information related to audit activity and leads to identify abusive tax shelters.
- Enterprise Zone Credit-The FTB works with other state agencies to address the issuance of invalid hiring vouchers. The FTB reviews documentation for vouchers determined to be inappropriately issued and give taxpayers an opportunity to obtain a valid voucher.
- Manufacturers’ Investment Credit (MIC)-Although the MIC was repealed as of January 1, 2004, the FTB will audit for tax years prior to 2004 with issues that include qualified property, qualified costs and payment of state sales tax.
- Research & Development Credit (R&D)-There has been a recent increase in the number of R&D credit audits because documentation of qualified expenditures has been inadequate.
- Employee Stock Ownership Plans (ESOP)-A change in tax law permitted ESOPs to become shareholders of an S Corporation. Because ESOPs are tax-exempt retirement plans, the income that would have normally flowed through to individual shareholders flows through to a tax-exempt entity instead. It has come to light that in some situations tax avoidance is the primary motivation behind these arrangements, and has made this a focused issue for both the IRS and the FTB.
- Sales Factor-For apportioning business entities, common audit issues include defining gross receipts, distortion of income and whether or not receipts should be assigned to California, particularly receipts from intangible income. This is significant because income earned within California is taxed differently than income earned out of state.
- Unity-Often there is no arbitrary benchmark to determine the date of when the parent company unites with a newly acquired subsidiary.
- Business/Nonbusiness-Analyzing excess cash or liquid investments to determine whether the resulting income is business or nonbusiness income is frequently an audit issue. In addition, the sale of assets such as stock and partnership interests often raises the question of whether or not the income from the sale is business or nonbusiness income to the corporation.
The FTB’s business tax system is one of the most complex in the nation, and when dilemmas arise either through audits or allegations of wrongdoing, a knowledgeable and experienced law firm like Brown, PC is needed to help navigate through the bureaucracy and red tape. We represent clients in Los Angeles and throughout California. To discuss your matter with one of our attorneys, please contact the firm online or by calling 424-252-1100.