Navigating the complex world of business taxes is crucial for any entrepreneur. Businesses in the United States are subject to various taxes at both federal and state levels, which can differ significantly based on the type of tax, the structure of the business, and the income generated. This blog will explore the five key differences between federal and state business taxes, focusing on the regulations in California.
1. Types of Taxes Collected
Federal Business Taxes
The federal government collects several types of business taxes:
- Business Income Tax: Applied to the income earned by businesses.
- Employment Taxes: Include Social Security, Medicare, federal income tax withholding, and federal unemployment tax (FUTA).
- Self-Employment Tax: Encompasses Social Security and Medicare taxes for self-employed individuals.
California State Business Taxes
In contrast, the state of California imposes the following business taxes:
- Corporate Taxes: Applied to the net taxable income of corporations.
- Franchise Taxes: Levied on businesses for the privilege of operating within the state.
- Alternative Minimum Tax (AMT): Ensures that businesses pay at least a minimum amount of tax.
- Employment Taxes: Include unemployment insurance, employee training taxes, and state disability insurance, including paid family leave.
2. Business Income Tax Obligations
Corporations (C-Corporations)
C-Corporations are treated as separate entities and must file annual income tax returns. They are taxed at rates ranging from 15% to 35% based on their taxable income. Corporations can also avail of special deductions but cannot deduct dividends distributed to shareholders.
S-Corporations
S-Corporations pass business income and losses to shareholders, who report this on their personal income tax returns, avoiding double taxation at the federal level. However, California imposes both business and personal income taxes on these entities, subjecting them to higher tax burdens.
Limited Liability Companies (LLCs)
LLCs in California have their net income passed through to the owners, similar to S-Corporations. This setup avoids double taxation federally but not at the state level, where both business and personal incomes are taxed.
Sole Proprietorships
For sole proprietorships, all income is reported on the individual’s personal income tax return. There is no distinction between the business and the owner for tax purposes.
3. Employment Taxes: Federal vs. State
Federal Employment Taxes
Businesses with employees must pay federal employment taxes, including:
- Social Security Tax: As of 2017, the rate is 6.2% for both employee and employer, with sole proprietors paying the full 12.4%.
- Medicare Tax: The rate is 1.45% for both employee and employer, with sole proprietors paying the full 2.9%.
- Federal Unemployment Tax (FUTA): The rate is 6% on the first $7,000 paid to each employee, with potential tax credits reducing this rate.
California State Employment Taxes
California collects various employment taxes:
- Unemployment Insurance: Paid by employers at a rate starting from 3.4% on the first $7,000 of wages per employee.
- Employee Training Tax: A 0.1% tax on the first $7,000 of wages per employee.
- State Disability Insurance and Paid Family Leave: Employees pay these taxes, with rates adjusting annually.
4. Corporate Tax Rates
Federal Corporate Tax Rates
Federal corporate tax rates vary from 15% to 35% depending on the corporation’s taxable income.
California Corporate Tax Rates
For traditional or C-Corporations, the tax rate in California is 8.84% on net taxable income, with different rates for financial entities. S-Corporations pay a 1.5% tax on net income, with a minimum of $800. LLCs are taxed based on their classification as disregarded entities, corporations, or partnerships.
Potential Outcomes of the Audit
- No Change: Your tax filings are accurate.
- Adjustment: Discrepancies are found, leading to changes in your tax returns.
- Penalties: Noncompliance or underreporting can result in penalties.
5. Alternative Minimum Tax (AMT)
Federal AMT
The federal AMT is designed to ensure that businesses pay a minimum amount of tax, even if deductions and credits reduce their taxable income.
California AMT
In California, the AMT is 6.5% of the federal AMT rate and applies to C-Corporations and certain LLCs. This ensures that these entities pay a minimum level of tax regardless of other deductions or credits.
