California Franchise Tax is the annual tax for conducting business in California. For noncorporate entities, it is a flat fee of $800. For corporate entities, the fee is a minimum of $800. Failure to pay the franchise tax will result in a minimum penalty of 5% and a maximum penalty of 25% of the unpaid tax.
9 out of 50 states in the U.S. have franchise tax. The purpose of this tax in all states is for the state to receive their portion of tax for operating within their jurisdiction. Most states do not charge an extraneous tax for operating businesses in their state. However, most extraneous fees and penalties of the franchise tax are the result of failing to file the tax return with the California Franchise Tax Board in a timely manner.
Failure to file in a common issue with franchise tax. For individuals who have lived in other states or opened a business in California for the first time, it is easy to forget after filing their personal, corporate, and state returns that the franchise tax is also due every year.
What is a Franchise Tax?
A franchise tax is a nominal fee to operate business in certain states (in this case, California). Despite the confusing name, it has nothing to do with franchised locations such as chain restaurants or stores. Instead, it is a tax on all businesses entities that wish to do business in California.
Understanding Franchise Tax
California Franchise Tax Rates
California Franchise Tax rate varies based on the entity. It’s important to understand the state of California divides their franchise tax into two tiers: corporate and noncorporate. They are one of few states to give a separate tax rate to corporations. For example, Texas has an annual franchise tax but treats all of its entities the same, offering the same tax rate of 3.75% that exceeds their no tax threshold.
Limited Liability Companies and Limited Partnerships
In the case of limited liability companies and limited partnerships (with limited partners, not general partnerships), the annual fee for franchise tax is $800. General partnerships instead pay no annual franchise tax even when they are pass-through entities.
S-Corporations and Corporations
With S-corporations and corporations, the tax rate is phenomenally different. Corporations are charged a 8.84% tax on their net income. For example, if a corporation has a net income of $100,000, their tax is $8,840. Even if a corporation did not make money in a tax year, they are still required to pay a minimum tax of $800.
S-Corporations are treated differently. While they are still required to pay the minimum franchise tax of $800 for years the business was not making money, their tax rate is significantly lower. Their tax rate is only 1.5% of a net income. So, if their net income was $100,000, their tax is $1,500.
Like mentioned in the previous section, special considerations are given to different entities under California Franchise Tax. General partnerships are not required to pay the franchise tax as they are equally liable for debts accrued by the company (limited partners are not subject to the liability). Charities, which by federal guidelines, are often formed as corporations can apply for exemption from the California Franchise Tax however, it will cost them. In cases of rush requests, the fee is $40 only if the entity is in good standing with the California Franchise Tax Board, otherwise the fee may be $56.
Franchise Tax vs. Income Tax
Franchise tax, income tax, isn’t it the same tax in California? Wrong. California corporations and other entities are required to pay both taxes. The average taxpayer assumes they have taken care of their taxes when they file their annual tax returns to the federal and state governments. Those tax returns cover income tax but not franchise tax which is required to be filed on the California Franchise Tax Board website.
The confusion most likely arises from the rate imposed on corporations. Corporations are charged the same rate of 8.84% on their state income tax as they are on their franchise tax. S-Corporations, LLCs, and other pass-through entities are instead taxed on their income tax on ordinary tax rates.
Examples of Franchise Tax
Read the following examples to understand the tax rates of California Franchise Tax.
Example #1: When There’s No Income
Corporation A was formed on December 1, 2018. Corporation A did not make any money the previous year. However, Corporation A receives a letter from the California Franchise Tax Board (FTB) on June 15, 2019. The FTB wants their franchise tax. The tax was due April 15, 2019. The total fee will be $848. How? The FTB requires the penalty be an initial 5% of the tax due which in this case would be the minimum $800 plus 0.5% per month the filing was late.
Example #2: LLC Partnerships
LLC A has eight partners and was formed on January 1, 2019. LLC A made $200,000 in TY2019. On April 15, 2020, they are obligated to file their franchise tax report. However, it has been a busy year and they forget to file an extension. On January 15, 2021, they receive a penalty request letter from FTB. The amount is for $1,008. Is this correct? Yes. The FTB charges $18 per member per month (up to 12 months after the tax is due). In this case, the months are calculated to seven months. It will stay the same penalty until the next month, in which the partners will receive an additional $144 in penalties.
Common penalties and fees
The California franchise tax charges different penalties based on company structure. The penalties include late filing penalties (the most common), underpayment penalty for LLCs, and bad check penalty.
Late Filing Penalty
In the case of corporations, they receive a 5% penalty of the tax due plus an additional 0.5% per month penalty since the filing was due. The max penalty allowed is a total of 25% of the original amount due even if the amount was the minimum $800.
LLCs and S-Corporations are treated differently. Instead of a percentage penalty, they are charged per partner, member, or shareholder a fee of $18 per month (up to 12 months after the tax is due).
Individuals, such as sole proprietors or disregarded entities, is a little more complex. If an individual owes $540 or less, the penalty is $135 or 100% of the amount due, whichever is less.
Underpayment for LLCs
Just as the IRS penalizes individuals who do not meet their advance payment responsibilities, so does the California Franchise Tax. For LLCs who know they owe every year or have a history of owing tax when their returns are due, California has enacted a penalty to remind LLCs to pay their obligations ahead of time. The penalty is 10% of the required LLC fee for the year or 100% of the previous year’s fee whichever is lesser.
Bad Check Penalty
Bad checks, one would think, would be a thing of the past especially in the era of online banking. However, for those who think they are clever enough to cheat the FTB, California has a minimum bad check penalty of $25 for payments less than $1,250. For payments greater than $1,250, a penalty of 2% applies.
Penalties when you file a tax return late or don’t file
The penalty for filing a tax return late varies based on business structure. Read below for specific penalties based on structure.
For individuals, they are penalized $135 or 100% of the tax due whichever is lesser (for amounts up to $540 owed).
Partners are charged $18 per member/partner up to 12 months after the tax return was originally due.
S-Corporation are like partnerships. Their penalty is $18 per member/shareholder up to 12 months after the tax return was originally due.
Penalties when you pay late or don’t pay
As discussed in the common penalties and fees, the penalties become steep when not dealt with in a timely manner. For companies who decide simply not to file their franchise tax reports as they believe it will not affect them, they are wrong.
Penalty – individuals
For individuals who fail to heed to the late filing penalty, they are subject to the demand letter penalty if they wait too long. The penalty can extend up to 25% of the original tax due.
Penalty – businesses
California is more aggressive than other states in their pursuit of franchise tax. After not filing or paying for a year, the penalty is raised to 25%. Why? After a year, companies will receive a demand letter from the FTB, meaning they are tired of waiting on the return and the tax owed to them. Still don’t pay or file? The FTB adds an additional fee of $316 to $322 (depending on company structure) for collection recovery cost.
If companies are still unwilling to pay the amount due, the FTB then files for a lien and charges for the filing of the lien. One way or another, FTB will receive their fees.
Estimated Tax Penalty
The estimated tax penalty is reserved for those who did not pay their tax ahead of time, pay their tax in a timely manner, or simply didn’t file. The tax begins to accrue interest (the interest rate changes year to year). For TY2021, the interest is limited to 3% for individuals and corporations.
Common Franchise Tax Questions
How do I avoid paying franchise tax in California?
In general, you don’t. There are exceptions to this rule – (1) the first year in business, there is an exemption to paying the franchise tax. But, only the first year.
(2) If a company is formed with less than 15 days left of the tax year, they will not have to pay franchise tax. For example, if a company is established December 27, 2020, they will not owe tax as there are less than 15 days left in the tax year.
(3) If a qualified 501(c)(3) operates in California and has applied for their charity exemption (and received confirmation of the filing), they are exempt from franchise tax.
What happens if I don’t pay the franchise tax Board?
Several bad things. First, you’ll accrue heavy penalties up to 25% of the original tax due. If you allow it to go on for years, you’ll accrue interest on the original amount due. Eventually, the FTB will assess collection recovery costs plus file a lien against your business.
Do I have to pay California Franchise Tax?
Like the old saying goes, “There’s only two certainties in life – death and taxes.” Individuals and companies must pay their California Franchise tax. If not, the company could face an incredible hardship. Need a loan to expand the business? Denied. Need a good credit score for a government contract? Gone.
Who is exempt from California Franchise Tax?
In general, only charities (if they applied for the exemption) unless the company falls under the 15-Day Rule or the first year in business rule.
Common Questions if You’re Leaving California
Q: I am planning to move away from California this summer. Do I need to continue paying state income tax?
California, like many states, a several tests to calculate this dilemma. There’s the physical presence test which determines if you were physically present in California for half the year. There’s also the income test. Even if you move away from California, are you still receiving income derived from the state?
For example, let’s say you move to Florida which has no state income tax and you decide to rent out your home in California while you’re waiting for it to sale. Then, yes, you absolutely must pay the tax on the income derived from California.
Q: What is a California “resident” for tax purposes?
A California resident for tax purposes is anyone who is present in California for any reason other than temporary or transitory purpose. Meaning if a taxpayer decided for the summer they wanted to stay with their relative in California and had a small part-time job, they are not a resident.
However, if the same taxpayer decided they really loved California and decided to enroll in college and take up a long-term part-time job for several months, they would be a resident.
Q: How does the FTB determine whether or not I still reside in the state for tax purposes?
Franchise tax is treated differently than income tax in California. If a resident moves to the other side of the country like Georgia and no longer lives in California but continues to operate their business remotely in California, they are still required to pay their franchise tax.
However, if a company filed for dissolution in the state of California and reopened their company in Georgia, they will not owe California Franchise tax on the years going forward but only if they dissolved in California.
Q: What if only one or two of those factors point to California? Does that establish California income tax residency?
No one factor alone determines income tax residency under California tax law. Under California tax laws, several questions are asked – where is the taxpayer’s family, source of income, car registered, etc. to determine residency.
Q: What if I move out-of-state, but leave some of my stuff in a California storage facility and/or rent out my house?
There are several answers for this question.
(1) If you move out of California for a permanent change to Florida in January 2021, you are a resident of Florida. You will still owe income tax to California on renting out your house.
(2) If you moved out of California to take a job in Qatar, then you will fall under the employment contract. This applies even if your possessions are in storage and your house is rented out as the contract is considered temporary.
Q: How long will the state presume that I am still a resident after I leave?
So, under the Safe Harbor Rule, if you initially leave on a work contract you will be a resident until you reach at least 546 consecutive days on being gone. Unless you simply left California to take a job in a different state, in which case the physical presence test must be used. If you were living in California for less than 183 days of the tax year, then you’re a part-year resident. If you lived in California for 183 or more days of the tax year, you must file as a resident of California.
Q: What if I move to another state, but work remotely as an employee of a California business?
If you move to another state but work remotely, you’re a nonresident of California but you still have an obligation to file a California tax return in which you may receive a refund or be obligated to pay further tax.
Professional Help with Tax Issues
Are you experiencing issues with California state tax? The experienced financial professionals at The Tax Crisis Institute have been helping California and Nevada residents with federal, state and property tax issues since 1983, and they are committed to making sure that their clients do not pay the government any more than they have to. If you need help with a tax matter, you can fill out our online form or call one of our offices. We have locations in Orange County, Bakersfield, Los Angeles and Las Vegas.