The California LLC Tax
California entrepreneurs have some choice when it comes to establishing a business entity. Understanding the California LLC Tax will help business owners make this decision. With the options of a corporation or limited liability company (LLC) come important considerations such as potential income tax burden and fees for doing business in the state. While an LLC may provide some welcome flexibility in business operations, the financial impositions from state and federal authorities can be substantial.
What is an LLC?
An LLC is described as a “hybrid” business entity by the state of California because it combines the limited liability of a corporation with the operational aspects of a partnership or sole proprietorship. LLC owners are responsible for the debts and obligations of the business only to the extent of their financial investments, and partners have the right to participate in the business’s management. All profits and losses of the LLC flow through to the owners.
Owners of an LLC are called members, who need not be individuals. Members might include corporations or other LLCs. While the IRS might make reference to LLCs, these structures are actually created by the states, which decide the rules of their establishment.
California Fees on LLCs and the California LLC Tax
The state imposes at least two different fees on an LLC. The first is a franchise fee, an annual tax that is $800 as of 2016. The franchise fee is payable by any entity that does business in California, and is due in the first quarter of an LLC’s accounting period. The tax may be avoided if the LLC is canceled within certain guidelines.
The second financial imposition by the state of California is an LLC fee. This is another annual obligation, but based on the entity’s total gross income, rounded to the nearest whole dollar. The scheme exempts LLCs with revenue of less than $250,000, but imposes a flat tax according to four tiers, as follows:
- $900 for income between $250,000 and $499,999;
- $2,500 for income between $500,000 and $999,999;
- $6,000 for income between $1,000,000 and $4,999,999;
- $11,790 for income of $5,000,000 or more.
In cases where members of an LLC are other LLCs, the fee is based on total income not included in the fee calculation of another LLC. In theory, this should avoid a circumstance where LLC gross income is overestimated for the purpose of the California LLC tax.
In general, LLCs must estimate and pay the fee by the 15th day of the sixth month of the current tax year. The state of California may impose a penalty for underestimation of the fee, but only if this year’s estimation is less than the fee owed for the previous tax year.
Owner State and Federal Income Tax
By default, LLCs are “pass through” entities. This means that the owners receive the income and loss of the entity and are taxed as though they are in a partnership or, if there is only one owner, a sole proprietorship. However, the IRS permits owners to elect to have the LLC taxed as if it were a corporation, an election the state of California also respects.
As a result, there are three distinct ways state and federal income tax may be calculated in the case of an LLC:
- As a “disregarded entity,” for an LLC with one member;
- As a partnership, for an LLC with multiple members;
- As a corporation. (S-Corp or C-Corp)
This is another layer of taxation about which entrepreneurs should be aware when choosing a business entity. In particular, a corporate taxation structure might offer benefits that are not afforded to LLC members taxed as sole proprietors or partners.
Sole proprietors are taxed, essentially, as self-employed individuals. In addition to the normal personal tax rates, they are subject to a self-employment tax of 15.3 percent, if they turn a profit. This tax covers social security and Medicare, and applies not only to sole proprietors but those who earn a profit from a partnership.
The self-employment tax essentially covers both the employer and employee contributions to social security and Medicare in a traditional employment arrangement. Although self-employed people must pay both portions, they may also take a tax deduction on the amount that would have otherwise been paid by the employer.
If an LLC is taxed as a corporation, forming an “S corporation,” it is possible for owners to take income from the business, part as salary and part as a disbursement. This potentially reduces an individual’s overall tax burden. In this scenario, however, the entity would be bound by regulations that govern payroll taxes, increasing the complexity of one’s legal and financial obligations.
Opting to Form a C-Corporation
Unlike an S corporation, a C corporation creates a distinct legal entity that has an annual profit or loss. Among the features of the corporation is that the entity files a corporate tax return. This has the effect that the corporation pays taxes on its income and owners also pay tax on the dividends they receive from the company. This is one form of double taxation, but can offer the legal and financial protections most appropriate for certain businesses. In addition, if you prefer to be taxed as a corporation but have foreign owners or owners that are organized as an LLC or a Corporation, then a C-Corporation may be the right choice for you.
What Structure Works Best?
The distinctions between a corporation and LLC are complicated and have a direct impact on how a business is taxed and the personal financial obligations of owners. Regardless of the size of an organization, it is worthwhile to discuss the pros and cons of different options with an attorney familiar with the California LLC Tax, who can recommend the optimal structure for your needs and those of your business.