Most individuals and organizations that operate limited liability companies, or LLCs, are only concerned about the tax laws and filing processes that are required by the state in which their LLC is registered. However, a surprising number of LLCs are required to fulfill tax filing obligations in the state of California, even if their business is not located within the boundaries of the state.
This fact confounds business owners around the country, but the fact of the matter is California has tax laws that require LLCs to file with the state if they are considered to be conducting business with businesses or residents in the state.
The California franchise tax
On the surface, the California Franchise Tax appears to be similar to other corporate tax structures that have been implemented in states across the country. Essentially, the California Franchise Tax requires a business to:
- Pay an $800 minimum franchise tax in order to operate and conduct business in California.
- The $800 fee can be increased for a business, depending on the income of the organization. S corporations must pay a 1.5 percent tax on total income, or $800, whichever is larger. C corporations or professional corporations must pay an 8.84 percent tax on total income, or $800, whichever is larger.
This franchise tax is required for any business in California that meets the following qualifications:
- The organization engages in business in California that results in profit, or that is for the purpose of generating a profit.
- The LLC is registered in the state of California.
- The LLC is qualified to conduct business in the state of California.
- The LLC is not registered in California but it regularly completes business transactions in the state.
It should be noted by business owners that the minimum franchise tax fee is required by all LLCs in California or doing business in California, regardless of whether or not they have generated a profit within the last tax year. Any business that exists in the state or that meets the qualifications for the franchise tax fee must pay the annual fee. It’s an implication that leaves many individuals and entrepreneurs wary of starting up a new business in California.
Out-of-state LLCs and the California franchise tax
Recognizing the fact that they may have to pay a franchise tax fee to the state of California simply for conducting business with people or organizations who reside in the state, many out-of-state proprietors try to avoid meeting the qualifications for this tax. As it stands, they are already responsible for filing taxes within their own state, and they are not always open to the idea of paying corporate taxes to a state in which their business is not located and in which they do not reside.
Any LLC that is determined to be doing business in California must pay the $800 minimum franchise tax fee. The state of California considers the following actions to be conducting business within the state:
- If an individual is a member of an LLC that regularly completes business transactions in California or a business is part of a general partnership LLC that does frequent business in California.
- If the LLC is registered in another state, but the vast majority of its business operations are centered in California.
- If more than 25 percent of the total sales completed by the LLC in a given year take place in California or with California organizations.
- If more than 25 percent of the tangible property owned by the LLC is located in California.
- If more than 25 percent of the compensation paid to staff members of the LLC goes to California residents who are employed by the LLC.
Penalties associated with the California franchise tax
Naturally, many businesses – both within California and outside of the state – try to work the system so that they do not have to pay the hefty franchise tax fee imposed by the state government. However, it is not advisable for businesses to go to great lengths to avoid this tax. The reality is, there are strict penalties associated with tax evasion, and additional penalties that can be imposed for avoiding the franchise tax fee specifically.
The penalties associated with the California Franchise Tax include:
- Having any and all contracts created by the LLC voided by the state, rendering the business unable to conduct and complete business in the state of California.
- Imposing a $2,000 per year penalty fee on out-of-state LLCs that conduct business in California without filing the annual franchise tax forms.
In order to avoid these severe penalties that may have long-lasting consequences for the strength and viability of an LLC, individuals and business professionals who are conducting business in California should register their LLC with the Franchise Tax Board. This will ensure that they can complete all business transactions in the state as efficiently and effectively as possible, and will give them a better understanding of which tax obligations they must meet at the end of the taxable year. It is recommended that LLCs doing business in California work closely with a business lawyer to make sure that they understand all of the rules and regulations within the state, and that they create a plan that allows them to conduct their business in the state.
The California Franchise Tax may come as a surprise to out-of-state business people who are simply trying to provide their goods and services to the people of California. However, it’s important to adhere to these tax regulations and to avoid attempting to evade these fees. Tax evasion can come with significant penalties, and even out-of-state LLCs are required to adhere to the state’s tax laws.
Business owners who want to create a viable business plan that will allow them to conduct business in California in a cost-efficient manner should partner with a legal team who can advocate for them and design a legal plan of action that adheres to the rules and regulations of the state. For more information on business law in California, contact us today.