California is not known for its tax friendliness to business entities in general. In fact, many businesses choose to incorporate in other states to avoid the California tax structure that applies to business corporations. There are California taxes that are imposed simply to give a company the privilege of doing business in California.
The problem with incorporating out of state is that, while on its face, it may seem the corporation can save money, in the long run, it is not effective. California taxes businesses based on their location in California, not on where their incorporation documents were filed.
California is trying to get the message to businesses that they really do not save money by incorporating out-of-state and encourages them to incorporate in California. One roadblock corporations have faced is that California, in addition to other taxes, imposes an $800 annual tax on all Limited Liability Companies (LLCs) registered to do business in the state.
Effective January 1, 2021, California will waive that $800 annual franchise tax for the first year an LLC does business in California.
In California, professionals like doctors, dentists, optometrists, and veterinarians are not allowed to form Limited Liability Companies (LLCs). They instead form Professional Corporations (PCs). The new law applies to “every corporation incorporated, qualified to transact business, or doing business in California. A corporation that incorporates or qualifies to do business in California is exempt from paying the minimum franchise tax in its first taxable year.” It appears clear that the waiver will apply to PCs as well as LLCs.
Dates of incorporation for which the waiver applies. The waiver applies to businesses that “organize, register, or file with the Secretary of State on or after January 1, 2021, and before January 1, 2024. Therefore, entities taking advantage of the 15-day rule by registering on December 17, 2020, and on or before December 31, 2020, are not eligible for the first-year tax exemption, regardless of whether the 15-day rule would apply for that short period. Only LLCs, LLPs, or LPs that organize, register, or file after January 1, 2021, are eligible for the first taxable year annual tax exemption.”
The law will take a close look at the date of incorporation. The waiver will not apply to those LLCs that have been doing business in California but then reincorporate hoping to take advantage of the waiver.
The legislative goal. The legislative goal, as expressed in AB 85 § 24(b)(1) “is to help and reduce costs for first-year California small businesses. Existing law imposes an annual minimum franchise tax of eight hundred dollars ($800) on every corporation, and an annual tax of eight hundred dollars ($800) on every limited liability company (LLC), limited partnership (LP), and limited liability partnership (LLP), which may be difficult to afford for first-year businesses. As such, these taxes may stifle economic growth and job creation and may inhibit the formation of many small businesses.”
Beginning with the second year of formation or doing business in California, the annual $800 minimum franchise tax must be paid every year until the LLC or PC is dissolved.
Before the waiver, there was a 15-day rule that exempted LLCs from paying the minimum $800 tax if:
For example, if a business was formed on December 17 but conducted no business until after December 31, it would not pay the $800 annual tax.
Some incorrectly thought the waiver of the first-year rule provided in AB 85 would apply. They filed their LLC papers with the Secretary of State in the last part of December 2020 but conducted no business until 2021. Unfortunately, the 15-day provision will not help them avoid paying the $800 tax in 2021. The law only applies to those who filed their corporation papers after January 1, 2021.
The waiver only applies to the $800 tax imposed on all businesses. There is an additional fee that all businesses must pay when the business earns an annual income of more than $250,000. The fee depends on the LLC's gross income. The applicable fees are:
LLCs must make a payment based on their estimated annual income on the 15th day of the sixth month of their current tax year. The payment is made using the Franchise Tax Board (FTB) form 3536.
The new law may seem straightforward, but when it comes to taxes, there can be stiff penalties for violations even if the violation was not intentional. Although the waiver of the $800 tax will help, the date of the incorporation is important in determining whether the waiver applies to you and your LLC or PC.
Also, there are additional fees that are imposed depending on your LLCs or PCs income. State income tax returns must still be prepared. It can be complicated and complex.
For assistance, contact Dental & Medical Counsel to schedule a complimentary consultation with attorney Ali Oromchian. We can help you take advantage of the new $800 waiver and make sure you are compliant with all other aspects of the California Franchise Tax laws.
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