California Law
California Corporate Tax Law
- Corporate Tax Law
Corporate Tax Law
Every business is responsible for paying a variety of local, state, and federal taxes, depending in part on how the business is organized, the services the business provides, and the products it sells. In general, businesses are liable for federal and state income taxes, state sales tax, Social Security and Medicare tax, federal unemployment tax, and state unemployment tax. Businesses involved in the sale of alcohol, tobacco, or fuel, and those that generate hazardous waste, are liable for additional taxes. Firms that do business both inside and outside of California are assessed state income tax based on a weighted formula that takes into account the percentage of property, payroll, and total sales attributable to the business' California operations. Businesses that have employees are responsible for withholding taxes from the pay of employees. This chapter discusses some of these liabilities and responsibilities.
Taxes and the Form of Organization
California businesses are responsible for different types of taxes depending on the way they are organized. The tax liabilities of the three common forms of business organization--sole proprietorships, partnerships, and corporations--are discussed here. A limited liability company in California is treated as a partnership for state tax purposes if it is treated as partnership for federal tax purposes. For more information on the forms of business organization, see the Closely Held Business Law chapter.
Sole Proprietorship
Under a sole proprietorship, the owner is the taxpayer. Thus, the individual tax rate applies, rather than the higher corporate rate. The owner reports income and expenses from the business on his or her individual federal income tax return, using federal Schedule C with Form 1040. Generally, a sole proprietor cannot claim personal insurance, such as health, dental, and life insurance, as a business expense. Most sole proprietors are liable for self-employment tax, discussed below, which is filed using federal Form SE. Usually, sole proprietors make estimated tax payments in quarterly installments during the year, using federal Form 1040-ES and California Form 540-ES. There is no special form for reporting sole-proprietorship income to the state. Instead, copies of the federal forms and schedules are attached to the California individual return, Form 540.
Partnership
A partnership itself does not pay taxes; each partner reports his or her income and deductions individually on federal Form 1040, Schedule E, and California Form 540. Thus, the individual tax rate rather than the higher corporate rate applies to each partner. Generally, benefits such as health, dental, and life insurance are not deductible by individual partners. Partners usually are liable for self-employment tax, and generally make quarterly estimated tax payments toward their year-end tax liability, using federal Form 1040-ES and California Form 540-ES.
Even though it does not pay taxes directly, a partnership is required to file a federal "information return" (Form 1065), which reports partnership income and distributions to the partners. Other forms and schedules may be required also. A partnership must file an information return (California Form 565) with the California Franchise Tax Board if it does business in California or has income from sources in California. As mentioned, a limited liability company is treated as partnership for tax purposes in California if it is treated as a partnership for tax purposes at the federal level. Limited liability companies that are treated as partnerships for tax purposes must file California Form 568 as an "information return."
Corporation
A corporation is an association of shareholders created under law and regarded by the courts as an artificial person with its own legal identity. There are two kinds of corporations, C corporations and S corporations, each subject to different tax laws.
C Corporation
At the federal level, a C corporation is taxed under the provisions of Subchapter C of the Internal Revenue Code, and is subject to a tax rate that is higher than the individual rate. For 1993, the corporate tax rate ranged from 15 percent for a corporation with an income of $50,000 or less, to 35 percent for a corporation with an income over $10 million. Corporations use federal Form 1120 or Form 1120-A to report income, deductions, and credits, and to compute tax. Other federal forms also may be required. In California, if a limited liability company is treated as a corporation for federal tax purposes, it will be treated as a corporation for state tax purposes as well.
The taxable income of a C corporation is determined prior to distribution of shareholder dividends. Each shareholder reports dividend income from a C corporation on his or her individual Form 1040. Thus, profits distributed as dividends are taxed twice--once on the C corporation's tax return and again on an individual shareholder's tax return. Shareholders may not use a corporation's losses for their individual tax purposes. However, dividends may be accumulated by the corporation--up to certain limits--to postpone the double taxation. For state taxes, a C corporation uses California Form 100 and is liable for a minimum franchise tax of $800.
The deductions permitted to C corporations under California state tax law differ in some important ways from those allowed under federal tax law. For example, under California law C corporations are not permitted to deduct interest income from United States Treasury obligations. An attorney experienced in tax law can advise a corporation regarding allowable deductions.
C corporations generally must make estimated tax payments. Federal estimated tax payments are made quarterly to an authorized financial institution or Federal Reserve Bank, using Form 1120-W. California estimated tax payments are due quarterly also. They are made with Form 100-ES to the Franchise Tax Board. Penalties may be assessed for failure to pay estimated taxes promptly.
S Corporation
Subchapter S of the Internal Revenue Code applies to an S corporation, which generally is not directly liable for federal income tax. Instead, each shareholder pays tax on his or her share of the S corporation's income and deductions by including it on federal Form 1040. However, an S corporation is required to file federal Form 1120-S with supporting schedules. California has adopted most of the federal provisions for S corporations. There is a state tax imposed at the corporate level, however, in addition to the individual tax on income. S corporations that do business in California or have income from sources in California must pay the state tax on S corporations unless they have made a California C corporation election. California S corporations must file Form 100S and pay at least the minimum franchise tax or a 1.5 percent income tax.
S corporations are required to pay estimated tax on any income that is not passed to shareholders. For purposes of state income tax, a corporation may carry forward a net operating loss and may use the loss to offset future years' income. However, a net operating loss may not be used to offset tax paid on personal income in previous years.
Tax Credits
Various federal tax credits are available to certain businesses. Some examples of these tax credits include:
- Businesses with 30 or fewer full-time employees or $1 million or less in gross receipts may credit expenses related to complying with the Americans with Disabilities Act.
- Employers of persons from targeted groups with particularly high unemployment rates or special employment needs may credit wages paid to members of the targeted groups.
- Some businesses that increase their research activities over a base amount may credit about 20 percent of the amount of increase.
California also provides a number of state tax credits to businesses to encourage them to engage in socially beneficial endeavors. For example, an enterprise zone credit is available to partnerships and corporations, and this credit may be passed to partners and S corporation shareholders. Enterprise zones are areas that have been designated for encouragement of business growth. Enterprise zone businesses may qualify for certain sales tax exemptions, as well as income and property tax credits. However, a corporation may not reduce its tax below the minimum franchise tax. The Franchise Tax Board is the contact office for more information on these credits.
Taxpayer Identification Numbers
There are generally two types of taxpayer identification numbers that apply to California businesses: the Federal Employer Identification Number (EIN) and the California Employment Development Department (EDD) Account Number. An EIN is required for all businesses. A sole proprietor generally uses his or her personal Social Security Number as the EIN. However, certain sole proprietors and all partnerships and corporations must apply for an EIN from the Internal Revenue Service (IRS) using Form SS-4. Additionally, sole proprietors must obtain an EIN if they have employees or a retirement plan, or if they are liable for federal excise taxes, such as for alcohol, tobacco, or firearms. The California Employment Development Department issues an EDD Account Number to all employers required to register with the EDD. This number is assigned when the business registers.
Selecting the Tax Year
A tax return is based on an accounting period called a tax year. A tax year may be either a calendar year or a fiscal year. A calendar year is 12 consecutive months from January 1st through December 31st. A fiscal year is composed of any other 12 consecutive months. Once a tax year is established, a business needs IRS approval to change it. Businesses use the same tax year for federal and state tax returns. Sole proprietorships usually use a calendar tax year. A partnership generally must use the same tax year as the partners who own a majority interest. If the majority partners' years differ, the business must use the same tax year as the principal partners--those with a five percent or greater interest in partnership profits or capital. If the principal partners' years conflict, a partnership generally uses a calendar tax year. A fiscal tax year can be used if the IRS agrees that there is a business purpose for using a fiscal year, or if the partnership files IRS Form 8716, Election to Have a Tax Year Other than a Required Tax Year, also known as a "Section-444 election." In the latter case, a business may have to pay a fee that represents the amount of tax deferral benefit that results from using a fiscal, rather than calendar, year. A C corporation's first income tax return establishes its tax year. The first tax year must not be greater than 12 months from the date of incorporation. A C corporation that provides personal services must use a calendar tax year unless it has IRS approval to use a fiscal year or it makes a Section-444 election. An S corporation must use a calendar tax year unless it gets IRS approval. In some cases, S corporations may make a Section-444 election.
Employment Taxes
A number of taxes are of interest to businesses with employees.
Payroll Taxes
The taxes discussed here usually are referred to as payroll taxes because an employer is responsible for deducting an employee's share of tax from his or her earnings before the employee is paid.
FICA Taxes
Taxes under the Federal Insurance Contributions Act (FICA) help pay for Social Security and Medicare benefits. Businesses without employees do not pay FICA tax. Most sole proprietors and partners in partnerships without employees pay a self-employment tax, which is discussed later in this chapter. Businesses that have employees contribute half of the total FICA tax, and are responsible for collecting the other half from employees through payroll deductions. For 1995, the tax rate for the Social Security portion of FICA tax was 6.2 percent each for employers and employees (a total of 12.4 percent). The maximum wage subject to the tax changes annually. The 1995 tax rate for the Medicare portion of FICA tax was 1.45 percent each for employers and employees (2.9 percent total). Special rules apply to employees who receive tips, to persons who receive both wages and self-employment income, and to employees receiving non-wage payments for items such as meals, lodging, clothing, and some services. The employer's share of FICA taxes is deductible as a business expense.
Income Tax Withholding
Along with the employee's share of FICA tax, employers must withhold federal and state income tax from the employee's pay. The amount to withhold is determined by the amount of the employee's pay and by the number of withholding allowances that the employee claims on federal Form W-4, Withholding Allowance Certificate. Employees are required to complete Form W-4 when hired, and generally the employer retains the form. However, the form must be filed with the IRS if the employee claims more than ten withholding allowances, or if the employee claims exemption from withholding and his or her wages normally exceed $200 per week. A California employee may file Form DE 4 if the employee wants to claim a different status or number of allowances for state tax purposes.
Employers must furnish a statement of wages and taxes (federal Form W-2) to employees by January 31st of each year or, if requested by the employee, within 30 days of termination. The federal copy of Form W-2 must be submitted to the IRS, accompanied by federal Form M-3, Transmittal of Income and Tax Statements. The state copy must be sent to the Franchise Tax Board. In California, employers are liable for the required tax whether or not it is withheld.
Payroll Tax Return
Generally, employers report FICA taxes and withheld federal income tax together on federal Form 941, Employer's Quarterly Federal Tax Return, which is filed at the end of each calendar quarter. There are different forms to be used for agricultural and household workers and for employees who are not subject to FICA taxes. Most employers are required to make deposits for payroll taxes before returns are actually due. How often deposits must be made is determined in part by how much tax liability a business has accrued in the past. For example, a business that owed $50,000 or less in payroll taxes during a specific previous 12-month period may be designated a monthly depositor; a business that owed $50,000 to $100,000 during the specific period may be designated a semi-weekly depositor. The depositor designation is reevaluated annually. A business' actual tax liability at the end of each deposit period determines whether it actually must make a deposit. If the amount of accumulated undeposited liability reaches $100,000 in any period, taxes must be deposited the day after that volume is reached, and if the business' deposit status was monthly, it is immediately changed to semi-weekly.
Self-Employment Tax
Self-employment tax is a Social Security and Medicare tax for individuals who work for themselves. This includes sole proprietors and most partners in partnerships without employees. Net earnings of $400 or more are subject to self-employment tax, and there are ceilings on the amount of earnings subject to the tax. In 1995, there was a ceiling of $61,200 for the Social Security portion of the tax, but no ceiling for the Medicare portion. The Social Security portion was assessed at 12.4 percent of earnings, and Medicare was assessed at 2.9 percent, for a total self-employment tax of 15.3 percent. Federal Schedule SE is used to calculate self-employment tax, which then is added to one's total tax liability on Form 1040. One-half of the self-employment tax is deductible as an adjustment to gross income on Form 1040.
Unemployment Tax
Federal and state governments have programs to help support able workers who lose their jobs. Tax under the Federal Unemployment Tax Act (FUTA) is reported by eligible employers once per year on federal Form 940 or 940-EZ. The form usually is due one month after the end of the calendar year. However, deposits toward the annual payment are required at the end of any quarter in which the employer accrues $100 or more in FUTA tax liability. Penalties may be imposed for late filing and late deposits. Most employers, even those with part-time employees, are responsible for paying FUTA tax. The general rule is that a business is subject to FUTA tax if the business pays wages of $1500 or more in any calendar quarter, or the business had a least one part-time employee in each of 20 different (not necessarily consecutive) calendar weeks. In addition, FUTA tax is due on cash wages of $1000 or more paid in any calendar quarter to a domestic worker who works in a private home, local college club, or local fraternity or sorority house.
A business that employs farm workers is subject to FUTA tax on their wages if the wages total $20,000 or more in any calendar quarter, or if there was at least one day in each of 20 different calendar weeks when the business had 10 or more at least part-time farm workers. The tax is figured at a rate of 6.2 percent of the wages paid to the employee up to $7000. Tip income reported by an employee to an employer for FICA tax purposes is considered wages for calculating FUTA tax. However, the tax does not apply to some payments, such as workers' compensation payments, nor does it apply to certain types of employment, such as earnings paid to cooperative education students. A business is credited for up to 5.4 percent of the amount it pays for state unemployment tax, which can reduce the actually tax liability to 0.8 percent. The IRS administers the FUTA tax.
The state has its own unemployment program and corresponding taxes. All tax-rated employers in California are required to pay contributions to the California Unemployment Insurance (UI) Fund. New employers pay UI contributions at 3.4 percent for the first three calendar years of operation. Thereafter, the UI contribution rate is calculated based on a formula that measures the stability of the employer's employment history and the potential for future unemployment. Employers who maintain fairly stable payrolls and who file and pay taxes on time generally have lower UI contribution rates than those who experience high turnovers in payroll or do not file and pay taxes on time. Individual UI tax rates are established based on all UI contributions paid, taxable payroll reported, benefit charges and prorated credits, and charges to the UI reserve account. A Note of Contribution Rates and Statement of UI Reserve Account (Form DE 2088) is sent each December to all tax-rated employers to notify them of the relevant rates and limits for the next tax year.
California requires that businesses pay unemployment taxes and file wage reports quarterly. The quarterly tax return has two parts: the Contribution Report, which contains summarized information, and the Wage Report, which shows information for each employee. There are penalties and fines that can be imposed on businesses that fail to file on time, do not pay the necessary employment taxes, or fail to keep accurate employment records.
Acquired Businesses
A California firm that acquires an existing business that has been subject to unemployment tax may request the previous owner's reserve account balance. If the transfer is approved by the Employment Development Department, the employer's UI contribution rate will be redetermined and may result in a immediate rate reduction. If the EDD determines that the transfer would not benefit the new employer, the application for the transfer is returned to the employer with an explanation for the determination. An employer who receives a reserve account transfer is responsible for the unemployment insurance benefit charges for the previous business owner's former employees.
Sales and Use Taxes
California sales and use taxes must be paid for most sales and taxable purchases for which tax has not yet been paid. The tax is imposed on retailers for the privilege of selling in the state and on any storage, use, or consumption in the state of an item purchased from the retailer. However, a wide variety of persons, entities, items and transactions are exempt from the sales and use tax. Some of the most common exemptions include:
- Animals sold for food
- Bottled water
- California State Lottery shares or tickets
- Candy and chewing gum
- Food products for human consumption
- Various goods sold to non-profit organizations
- Video tape rentals
Other items and transactions are exempted from either sales tax or use tax. An attorney experienced in tax or business law can assist a business in determining when sales and use tax must be paid or whether a particular business or sale is exempt.
The California sales tax rate is 7.25 percent, based on six percent state tax and 1.25 percent local tax. Rentals and leases of tangible personal property are taxed on the rental amount payable. The sales and use tax also applies to furnishing, preparing, or serving food, meals, or drinks, and to newspapers and periodicals. Out-of-state retailers must collect use tax if they have an in-state place of business, sales representatives, or certain other business connections with California.
Certain California taxpayers also may be required to pay additional taxes for transit and traffic districts and education funding. The tax rate varies by county, from 7.25 percent to 8.5 percent.
Local and Sales Taxes
In addition to the sales tax imposed by the state, all California counties and municipalities impose the uniform local added 1.25 percent sales-use tax remitted with the state tax return. Some districts of the state levy an additional 0.25 to 1.75 percent. Also, all cities or counties in California have the right to impose a hotel occupancy tax or a mobile home tax on lodging and mobile home rentals under 31 days.
In addition, both Los Angeles and San Francisco levy taxes on certain utility users. Los Angeles imposes a five percent tax on users of telephone, electricity, and gas service. San Francisco collects a 5.5 percent tax on users of intrastate telephone, gas, electricity, and water.
Other Taxes
Business owners should be aware of a variety of miscellaneous taxes. For example, the federal government assesses various excise taxes. Excise taxes are imposed on the sale, use, or lease of the following articles by the manufacturer, producer, or importer: sport fishing equipment, electric outboard motors and certain sonar devices, bows and arrows, highway-type tires, gas-guzzling automobiles, certain vaccines, coal, and alcohol sold as fuel but not used as fuel. There are environmental excise taxes, such as taxes on the sale or manufacturing use of certain ozone-depleting chemicals and there are luxury taxes, such as a tax on the sale of passenger vehicles that cost over $30,000.
Many of these taxes are reported using federal Form 720, Quarterly Federal Excise Tax Return. Although the return is filed quarterly, the taxes generally must be deposited before the return is due. There are additional excise taxes that are reported separately from those described above. For example, certain heavy vehicles, including buses, truck tractors, and trucks with gross vehicle weights of 55,000 pounds or more, are subject to a federal highway use tax. Pickup and panel trucks are not subject to the tax. Generally, the vehicles must be used on public roads more than 5000 miles per year. This tax is reported on IRS Form 2290, Heavy Vehicle Use Tax Return. There also are taxes on alcohol, tobacco, and firearms that are filed with the Bureau of Alcohol, Tobacco, and Firearms.
Resources
For California tax information, use the Fast Answers about State Taxes (F.A.S.T.) toll-free telephone service at (800) 338-0505. Information is available in English and Spanish. Tax information and assistance also can be obtained through the regular toll-free telephone service at (800) 852-5711, TDD (800) 822-6268. To order California tax forms, write to Tax Forms Request Unit, Franchise Tax Board, P.O. Box 307, Rancho Cordova, CA 95741-0307. Forms also can be ordered through the F.A.S.T. service. The California Franchise Tax Board also has booklets and other publications specifically for corporations, partnerships, and limited liability companies.
For a California Employer's Guide and other information for California businesses, contact the Employment Development Department, 800 Capitol Mall, Sacramento, CA 95814, (916) 654-8210, or on the Internet at http://www.edd.cahwnet.gov/. The EDD also has local offices throughout the state.
For federal forms, including the Employer's Tax Guide (Circular E, Pub. 15), contact the Internal Revenue Service, (800) TAX-FORM.