Primer on California S Corporation Taxation

You can get extremely detailed information about how California taxes both in-state and out-of-state S corporations from the California Franchise Tax Board instructions for completing the California 100S tax return  (click here to get that). But I thought I’d do a quick, nutshell overview of how California taxes S corporations for this week’s blog post.

Especially for out-of-state S corporations, the rules and accounting take some getting used to.

Furthermore, many out-of-state businesses probably can arrange their operations to minimize the minimum S corporation tax and to eliminate the requirement that individuals who reside outside of California pay California state income taxes.

Understanding the California S Corporation Tax

Okay, so the first thing to know: California assesses a franchise tax equal to whatever amount is larger: $800 or a 1.5% franchise tax on the S corporation’s income.

An S corporation that makes, for example, $100,000 in profits pays $1500. This makes sense, right? The S corporation pays the larger value: 1.5% of $100,000 which equals $1500… or the minimum S corporation franchise tax which equals $800.

Another example: An S corporation that makes $10,000, for example, pays $800. Why?  The S corporation pays the larger value: 1.5% of $10,000 which equals $150… or the minimum S corporation franchise tax which equals $800.

Understanding S Corporation Shareholder Taxation

Here’s the next thing to know: When the S corporation allocates its profits to the shareholders, that allocation means that shareholders need to pay California income taxes on the allocated profits.

For example, if a California S corporation with one shareholder makes $100,000 for some year, the shareholder receives a K-1 showing his or her share of the S corporation profit as equal to $100,000. Because this income gets sourced, or “apportioned,” to California, the shareholder pays California state income taxes on the $100,000.

One other quick note: If the shareholder lives in some other state—say Washington State—California can still tax the shareholder because the $100,000 of income was earned in California.

Out-of-state S corporations

Another quick point: California can’t tax a corporation that operates entirely out-of-state.

In other words, California can’t tax some corporation that operates in, say, Washington State. Even if the business is delivering some Washington-produced products to some customers or clients in California.

Furthermore, if an out-of-state corporation has a sales person inside California and that sales person only solicits orders for sales of personal property, California basically can’t tax the corporation and can’t tax shareholders either. (A federal law, Public Law 86-272, protects you in this special situation. You probably don’t want to look at this, but if you’re interested, you can click here for a long-winded Franchise Tax Board discussion of how California addresses Public Law 86-272)

Note: In the special case where an out-of-state S corporation does have a sales person inside California, the corporation should pay the $800 minimum S corporation tax.

But an important caveat: If an S corporation does basically anything else, California can probably assess the franchise tax on the S corporation and possibly an income tax on its shareholders.

For example, any of the following activities conducted by an out-of-state S corporation inside of California will mean that California gets to hit the S corporation with the franchise tax and the shareholders with a state income tax:

• Signing contracts
• Performing accounting tasks
• Training customers or clients
• Providing customer support
• Owning or renting property (except property used by a sales person)
• Employing anyone other than a sales person

Summing up, pretty much anything you do within the state of California—with the single exception of soliciting orders for sales of personal property—triggers California franchise tax and state income tax.

Handling Multi-state Corporations

If a corporation operates in more than one state, the S corporation’s taxable income is apportioned  and allocated to the states of operation. How this multi-state apportionment and allocation works is complicated—and something your tax accountant needs fairly sophisticated tax software for to handle correctly.

In some situations, however, the California tax laws require income to be apportioned on the basis of where the sales occur. In this case where an S corporation earns $100,000 and generates half of the sales in California and half in some other state like Washington, California gets to collect an $800 S corporation franchise tax (calculated as the greater of $800 or 1.5% of the $50,000 of apportioned profit) and California gets to tax nonresident shareholders on 50% of their “share” of the S corporation profit.

Note: If you want to get the down and dirty details about how an S corporation’s income is apportioned and allocated to California, you need to read through the Instructions for Schedule R pdf document available at the Franchise Tax Board website. I will caution you that the accounting quickly gets more complicated than I’ve described here. For example, more complicated apportionment formulas look not just at sales by state, but also at payroll by state and property owned or rented by state.  Further, some income isn’t apportioned using a formula, but is rather allocated based on a direct connection to a particular state.

And by the way, a California resident that owns an interest in a multi-state S corporation that makes half of its profits in California and half in some other state like Washington will pay California income taxes on all of his or her “share” of the S corporation income. As a resident, California gets to tax all of the shareholder’s income—even if some of the income is earned outside of California.

Minimizing California S corporation franchise and income taxes

S corporations can use a handful of tricks and techniques to minimize their California franchise and income taxes.

A full treatment of this topic, however, requires more than a few sentences. Accordingly, building on what you’ve read here, let me point out that to minimize California taxes, you have only three basic gambits:

Tax Minimization Gambit #1: Disconnect completely from California so that you owe neither the franchise tax nor the income tax. In other words, don’t own property in California. Don’t employ people in California. Don’t do anything in the state—rather operate from outside the state. (Obviously, this won’t work for any small business that’s mostly or entirely based on California.)

Tax Minimization Gambit #2: Restructure the way your business operates so that the apportioned income value is minimized. For example, if an S corporation uses a more complicated formula that apportions based not just on sales but also on property and payroll, very possibly the income apportioned to a state like California can be, well, fiddled with by changing the state where property and employees are situated.

Tax Minimization Gambit #3: Decrease the overall S corporation income (such as by accelerating deductions) so that the taxable income value that plugs into the franchise tax calculations and into shareholder tax returns is less. This last gambit isn’t anything new obviously. It’s the standard tactic used by business owners to minimize (legitimately) their federal and state income taxes.

Do you want a free California incorporation or LLC formation kit?

Can I make one last, tangential remark?

You may already know this, but we’ll give away free ebooks that describe the steps and provide example forms for forming an S corporation in any state, including California.

If you’re interested, click here: California S corporation kits.