There are many types of business entities in the United States, including sole proprietorships, partnerships, and corporations. A corporation can be a regular C type, which is what most people think of when they hear “corporation,” and then there are S-corps that offer a different set of advantages when being taxed. You can also form an LLC. LLCs are simple to form and maintain and offer many of the same benefits as any type of corporation, including tax benefits, as well as a level of anonymity and limited liability protection for the owners, known as asset protection.
In an LLC, owners are referred to as members. These members are typically able to decide how they wish to be taxed, highlighting the flexibility of LLCs. Since LLCs come in many forms, such as single-member LLCs or multi-member LLCs, there’s a lot to be wary of. It's important to understand the requirements, including the drafting of an operating agreement and understanding the fees associated with setting up and maintaining an LLC, such as filing an annual report. Here are key considerations for LLC taxation in California.
A Limited Liability Company (LLC) is a flexible business structure that provides several protections and benefits. Each state has a different set of rules to follow when forming an LLC. Depending on which state you form your LLC in there may be restrictions with ownership. You can have multiple members that vary by type, such as individuals, corporations, or other LLCs and foreign entities. There is no maximum number of members for an LLC. However, there are some types of businesses that cannot be LLCs such as banks and insurance companies. This can change from state to state, so it’s important to check on what is allowed to be an LLC in California.
An LLC can be taxed differently depending on the type you choose to form. You can be taxed as a sole proprietorship, or as a partnership, based on whether you have a single-member or multi-member LLC.
A single-member LLC is treated as a sole proprietorship, meaning all the profits and losses are reported on the owner’s taxes rather than by the LLC. This “pass-through” taxation offers numerous benefits, such as the choice of how to be taxed as well as the ability to claim business deductions for the LLC.
Meanwhile, a multi-member LLC is treated as a partnership. This means every member must report individual distributive shares by filing a form 1065.
Every business must pay taxes. What you ultimately pay will differ based on whether you form a single-member or multi-member, and how you elect to be taxed.
A single-member LLC is a business entity separate from the owner. Only the assets associated with the business are at risk in the event of a lawsuit. The IRS sees a single-member LLC as a disregarded entity, meaning it’s disregarded for tax purposes. Instead, a Schedule C is filed with the government on the owner’s personal income tax return.
If you have more than one member in your LLC, then the IRS will view it as a partnership. Each member must file a separate Schedule E form and pay taxes based on their share of profits on their personal tax returns.
By default, an LLC is taxed as a sole proprietorship. One of the advantages of forming a business as an LLC is that you can elect taxation. That means if it’s more beneficial to be taxed as a corporation, then you can choose that option for your company. If you regularly keep a large amount of your company’s profits in the LLC (known as retained earnings) then corporate taxation might be the right choice. Filing IRS form 8832, Entity Classification Election, and checking the corporate tax treatment box will update the government on how you want your business to be taxed.
One advantage to operating a business is that you can deduct, or write off, legitimate business expenses on most of the money your business spends. These deductions lower the amount you can get taxed on because they more accurately show how much net profit your business earned. These expenses may include:
There are many more possible write-offs. What’s possible can change depending on the nature of your business.
LLCs can also be eligible for an income tax deduction for pass-through entities established by the Tax Cuts and Jobs Act. In effect since 2018, if you own a pass-through entity, you can deduct up to 20% of your net income up to an annual threshold. This doesn’t apply to businesses being taxed as a C Corp.
Beyond federal taxes, there are also state taxes and self-employment taxes that you’ll have to keep in mind.
Based on where you choose to form an LLC, you will pay taxes according to the laws of that state. California imposes hefty taxes which are explained in detail below. Depending on the structure of your LLC, there are different rates to pay and potentially additional fees based on the earnings of your company.
LLC members generally aren’t counted as employees. However, they do still have to pay Medicare and Social Security taxes. Since you don’t have an employer to withhold wages to cover these taxes, you will have to pay them directly to the IRS.
Most states impose taxes on LLCs the same way the IRS does. There might also be an annual franchise or privilege tax. California imposes a whopping $800 franchise tax, even when your business earns no money for that year. Just having formed a business entity is all it takes. On top of that, California is one of the few states that taxes an LLC depending on the amount of income earned. If you operate as a sole proprietorship, then you’re subject to these taxes in addition to the franchise tax:
| If Total LLC Income Is: | The annual fee is: |
|---|---|
| $250,000 to $499,999 | $900 |
| $500,000 to $999,999 | $2,500 |
| $1,000,000 to $4,999,999 | $6,000 |
| $5 million or more | $11,790 |
You also pay income tax based on your LLC’s net income (rates can range anywhere from 1% to 13.3%.)
If you elect to be taxed as a corporation in California, you’ll still pay the $800 tax, then you will either pay a flat 8.84% tax on net income (if you operate as a C Corp) or you’ll pay a 1.5% net income tax (if you’re running as an S Corp) California is one of a few states imposing a tax on S Corps.
Understanding more about how taxes work in California will better prepare you for when it's time to pay them. If you have any inquiries regarding the structuring of your California company, please contact us via our contact form or call us at +1 (307) 683-0983. Our team of experienced paralegals will assist you in navigating the process.