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State Business Taxes (Not Just Income Taxes)
By Jason Watson, CPA
Posted Sunday, October 29, 2023
State tax laws might not treat S Corp income and subsequent K-1 income in the same benevolent manner as the IRS. Recall that S corporations do not pay a federal income tax directly. Rather the income is passed onto the shareholders who are then taxed on that income at their individual tax rates. However, some states impose an additional tax. For example, California imposes a 1.5% franchise tax on S Corp net ordinary business income (profit) after expenses and deductions with a minimum of $800. Yuck. So, your 8% savings in federal tax turns into 6.5% after you pay California.
Other income tax free states, such as Texas, have similar taxations and various exemptions too. Franchise tax is another buzzword you might come across. Why do they call it a franchise tax, or a business and operating tax as they do in Washington State? They can’t call it an income tax because of the Interstate Income Act of 1959. Yup. Way back when, and it is battled every year in court, in various representations. Consider that in 1959, interstate commerce was quite small compared to what we have today with Amazon and all the interwebs. States are tired of businesses skirting local income taxes.
Before we get into that, there are two issues at play here and we’ll pick on California to illustrate some points. One, if you are an S corporation headquartered in California you will be subjected to the franchise tax. Period. End of story.
But the other side of the coin is state nexus (which was broached earlier) where you are not physically headquartered in California but have a nexus either physically or economically in California. This too would subject your income sourced from California to the franchise tax.
In some cases, you might have nexus in California but not have any California sourced income, and you will unfortunately be subjected to the minimum franchise tax of $800 (for the 2024 tax year). Nutty. You have nexus, but no taxable income, and you still pay the minimum franchise tax? Yes. This happens when you create an LLC, but all your income sources are outside California and they exceed certain thresholds. There are other situations where this can happen.
Conversely, if you are a sole proprietor in California (and not an LLC or corporation), you do not pay a franchise tax. Yes, you will be subjected to federal self-employment taxes which is why you want to consider an S Corp election. So therein lies the rub. Franchise tax versus self-employment tax.
About half of the states have some sort of franchise, business or excise tax. Back to the Interstate Income Act of 1959- it is against Federal Public Law 86-272 for states to charge an income tax on foreign businesses in certain circumstances. Remember, foreign does not mean domestic and international. Foreign is a business registered in Nevada doing business in California, as an example.
Here is a snippet of Federal Public Law 86-272–
No state, or political subdivision thereof, shall have power to impose … a net income tax on the income derived within such state by any person from interstate commerce if the only business activities with in such state by or on behalf of such a person during the taxable year are either, or both, of the following-
1. The solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside of the state; and
2. The solicitation of orders by such a person, or his representative, in such State in the name of or for the benefit of a prospective customer of such a person, if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are orders described in paragraph (1).
States are therefore prevented under Public Law 86-272
- from taxing out-of-state businesses on income derived from activities within the state
- if the activities are limited to mere solicitations of tangible personal property, and
- the orders are processed from outside the state.
Note how this focuses on tangible property and not services. Huge distinction! Is internet hosting a service or tangible personal property? How about an eBook? This is discussed more in a later chapter, and the current news is not great. The future isn’t good either.
Let’s have California’s Franchise Tax Board offer a few words on Public Law 86-272-
Public Law 86-272 (15 USC Section 381) prevents States from asserting their right to impose a tax based on net income, such as the corporate income tax or franchise tax. Public Law 86-272 protection is available to out-of-state business entities that:
Sell tangible personal property in this state
Who’s in-state activities are limited to the solicitation of orders for their goods
As a result, if a taxpayer is protected by Public Law 86-272, they will not be required to pay the franchise tax or the corporate income tax, as both are measured by net income. However, even if protected by Public Law 86-272, an out-of-state entity that is doing business (R&TC Section 23101) in California is still obligated to file a tax return and pay taxes that are not measured upon net income, unless certain exceptions apply, such as:
The minimum franchise tax
Annual limited liability company tax
The limited liability company fee
You are probably asking, “What does this mean, how does this work?” First of all, protection under Public Law 86-272 does not apply to businesses that derive in-state income from the solicitation or sale of:
Any combination of goods and services
Technical Advice Memorandum: 2018-03 addresses the application and interpretation of Public Law 86-272 in the context of delivering goods by company owned delivery vehicles. This memorandum concluded the delivery via a private delivery truck is protected activity under Public Law 86-272. However, any activity that goes beyond the scope of delivery, such as backhauling, is not protected activity.
For example: Corporation C, an out-of-state corporation that does not file a combined return, sells tangible goods over the internet and qualifies for protection under Public Law 86-272. For the 2019 taxable year, Corporation C has $1,000,000 of California sales but no property or payroll in California. Corporation C, though considered doing business in California because it has $1,000,000 in California sales, will not be subject to California’s franchise tax as it is protected under Public Law 86-272. This is true even if the tangible goods are delivered using Corporation C’s vehicles. However, Corporation C must still file a California return and pay the minimum franchise tax of $800. If Corporation C’s vehicles are used for any other business activity along with the delivery, such as backhaul of goods (like hauling off the customer’s old items), this activity would go beyond the solicitation of orders and would no longer be protected.
California has a lot to say!
So the wizards at various states came up with a tax that is not based on income or at least not called an income tax. Some states tax your gross receipts, no matter what your expenses are! Amazing. It is also noteworthy that Public Law 86-272 does not protect businesses located in and doing business in the respective state (only interstate activities, not intrastate activities). But it appears that states keep things consistent, and impose a franchise tax, a business tax or an excise tax on local businesses just the same. Genius.
Here are some sample state links-
|wcginc.com/1307||New York City|
New York City S Corp tax rate is 8.85%. Tennessee is 6.5%. Texas is about 1% on gross receipts exceeding $1 million. Washington DC has a tax it imposes on S corporations, but tax is exempt if over 80% of the revenue is from personal service. All kinds of rules!
Do you want more wrinkles? Here you go- California (we just love to pick on them) has a unique rule to their franchise tax. As a garden-variety LLC, you are taxed on gross receipts in addition to the $800 franchise tax. For example, you could have $1,000,000 in gross receipts and $1,000,000 in expenses. Your franchise tax would be $800 + $6,000 (for the 2023 tax year) although you do not have any net income. Yuck.
However, if this LLC is taxed as an S corporation, then it would pay 1.5% of the net income (profits) or $800, whichever is higher. Using the example above California’s franchise tax would be $800 versus $6,800. Therefore, the lesson is that you might be forced into electing S corporation status in California just to avoid its silly gross receipts tax.
To complicate things even more, you must apply nexus rules to all this. You might not be subjected to another state’s franchise or business tax if you don’t have an economic or physical presence in that state.
The issue of state business taxes and nexus is discussed in nauseating detail later in a chapter dedicated to state nexus. More buzzwords such as economic presence, throwback rules, tangible personal property, commerce and due process clauses, etc. Bottom line- talk to your nexus experts at WCG CPAs & Advisors to nail this down. It is extremely tricky, and states are extremely aggressive.
Before that, here are some big takeaways with this section-
- Income tax nexus and sales tax nexus are woefully different, and one doesn’t invite the other to the nexus party. Income tax cannot just show up with a plus 1.
- Each state is unique and different, like snowflakes, but without the innocence and the ability to be shoveled away.
- Tripping nexus wires can unwittingly expose your business to additional taxes beyond income taxes.
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