Doing Business in California

I get asked all the time, “If I incorporate a business that will be located in California and will be strictly online with no principal office location, do I still have to register to do business in California?”  This is an important question, most importantly for tax reasons.

Before you even make your first sale, the California franchise tax board says that all corporations and LLCs are required to pay at least an $800 franchise tax if they:

  • Incorporated or organized in California.
  • Qualified or registered to do business in California.

Under the rules of the Franchise Tax Board, you are doing business in California, whether or not they incorporated, organized, qualified, or registered under California law.

Furthermore, entities are required to pay the minimum franchise tax whether they are active, inactive, or operating at a loss.

Okay, but that still doesn’t define “doing business in California.”  Through 2010, doing business in California was broadly defined as “actively engaging in any transaction for the purpose of financial gain or profit.”  It was a pretty vague definition to say the least.

Since 2011, an entity is considered to be doing business in California if it meets one of the following criteria:

  • The entity’s California compensation exceeds either $50,000 (annually adjusted for inflation) or 25 percent of the total compensation paid by the entity.
  • The entity is actively engaging in any transaction for the purpose of financial gain or profit.
  • The entity is organized or commercially domiciled in this state. To be commercially domiciled in this state generally means that this state is the principal place from which the trade or business of the entity is directed or managed.
  • The entity’s California sales exceed either $500,000 (annually adjusted for inflation) or 25 percent of their total sales. “Sales” include sales made by an agent or independent contractor of the entity.
  • The entity’s California real property and tangible personal property exceeds either $50,000 (annually adjusted for inflation) or 25 percent of their total real property and tangible personal property.

Though the new definition was written to include the original definition of doing business, I think the added tests make it clear that if you are a corporation or LLC generating income in California or maintaining tangible property in California, YOU ARE DOING BUSINESS IN CALIFORNIA, and should file a foreign qualification there.

Out of State LLCs Treated as “Doing Business” in California

Individuals and entities, including those from outside California, who invest in or do business through an out-of-state limited liability company (“LLC”) may be surprised to find out that they have filing obligations and tax liabilities in California as a result of California’s far-reaching rules and interpretations related to when an LLC is treated as “doing business” in California.

California Law

Under California law, all LLCs are required to annually file a California tax return and pay at least an $800 California franchise tax if they:

  • Engage in any transaction in California for the purpose of financial gain or profit.
  • Are incorporated or organized in California.
  • Have qualified or registered to do business in California.
  • Are “doing business” in California, whether or not they incorporated, organized, qualified or registered under California law.
  • Under the Franchise Tax Board (“FTB”), an LLC organized in a jurisdiction outside California is nevertheless “doing business” in California if:

    • It is a member of an LLC that does business in California.
    • It is a general partner in a partnership that does business in California.
    • Any of the LLC’s members, managers, or other agents conducts business in California on behalf of the LLC.

    In addition, an out-of-state LLC is “doing business” in California if:

    • The amount paid in California by the LLC for compensation exceeds the lesser of $50,000 or 25% of the total compensation paid by the LLC.
    • The LLC is commercially domiciled in California (i.e., California is the place where realistic control of the LLC’s functions is centered).
    • Real or tangible property of the LLC in California exceeds the lesser of $50,000 or 25% of the LLC’s total real and tangible property.
    • Sales, including sales by the LLC’s agents and independent contractors, in California exceed the lesser of $500,000 or 25% of the LLC’s total sales.

    For purposes of these calculations, the sales, property and payroll of the LLC include the LLC’s pro‑rata or distributive share of any pass‑through entities (i.e., partnerships, LLCs and S‑corporations).

    Some examples that may surprise you:

    • A Arizona LLC acquires a passive minority membership interest in a Delaware LLC that owns and operates several California shopping centers.  The Arizona LLC may be treated as “doing business” in California simply by reason of its ownership of a membership interest in the Delaware operating LLC, resulting in the Arizona LLC’s own California tax filing obligations.
    • A Florida LLC owns an apartment building in Florida that is managed by an on-site (Florida) property manager.  One of the three LLC managing members is a California resident.  The Florida LLC may be treated as “doing business” in California simply by reason of the existence of a California managing member.

    Penalties:

    The State can impose a penalty of $2,000 per taxable year if an out-of-state LLC is doing business in California and fails to file a tax return and pay the taxes and fees due. The penalty is due only if the FTB sends a written demand that a return be filed and the LLC does not file the return within 60 days.

    Also, any contract made by an out-of-state LLC in California that is neither qualified to do business nor has a corporate account number from the FTB is voidable by any other party to that contract for the period during which the out-of-state LLC fails to file a tax return required by the FTB.

    Note that the FTB’s determination of when an out-of-state LLC must file tax returns is in contrast with the California Corporations Code.  Under the California Corporations Code, any entity that “actively engages in any transaction in California for the purpose of financial gain or profit” must register with the California Secretary of State.  But for this purpose, an out-of-state corporation is not considered to be transacting business in California merely because it is a member or a manager of a domestic or out-of-state LLC or a limited partner of a domestic or out-of-state limited partnership.  Moreover, the new California Revised Uniform Limited Liability Company Act, effective as of January 1, 2014, provides that an out-of-state LLC “may” register in California and does not impose penalties for failing to do so.

    Non-residents of California are also not necessarily off the hook for California taxes arising from ownership of an LLC.  Such non-residents may owe taxes on pass-through income sourced from an LLC’s California activities despite their non-resident status.

    BOTTOM LINE:  Your out-of-state LLC may have nexus and filing obligations in California and taxes may be owed for such LLC’s activities in California!

    LLC Members: Can They Be Paid As Employees Of The Business?

    A limited liability company (LLC) is quickly becoming the most popular entity to form in order to shield personal assets from business liabilities. This is because this type of entity offers flexibility when organizing the management and economic structure of the company.  One of the areas where LLCs offer flexibility is how to structure payments to owners of the business. Today’s post talks about the fact that owners of an LLC can only be considered “employees” if the LLC elects to be taxed as a corporation.

    Can LLC Members be Paid as Employees?

    Members (also known as owners) of an LLC cannot be considered “employees” of the business unless the LLC elects to be taxed as a corporation–either an S corporation or C corporation. Below is a breakdown of how an LLC can be taxed and how this affects the compensation for owners:

    Fork in the Road

    Default Taxation for LLCs

    For tax purposes, an LLC is by default a pass-through entity—i.e. any money that comes into the business will “pass-through” to the individual members of the comp
    any regardless of whether they receive distributions, and the members are required to report their share of any income or loss on their individual tax returns.

    For example, if the business has $10,000 in net profit and has two Members who each own 50% of the business, then each Member will owe tax on $5,000 regardless of whether or not the LLC distributes any cash to the Members.

    In this situation, the LLC is being taxed as a partnership and the owners cannot be employees and are not allowed to pay themselves a salary. Instead, the LLC can distribute cash to owners and those distributions are subject to self-employment taxes.

    LLCs Can Elect to be Taxed as Corporations

    C Corporations: Corporations are taxed quite differently than partnerships. Corporations are subject to double taxation—money that comes into the corporation is taxed as corporate income, and the same money is taxed again when it is distributed to shareholders as dividends or to employees as wages.

    When you form an LLC, you can elect to be taxed as a C corporation and the owners of a C corporation can be employees and be paid salaries. Again, depending on the individual financial circumstances of each owner, electing to be an employee versus strictly an owner (and having to pay self-employment taxes) can have a significant tax impact.

    You should always consult with an accountant about your personal financial situation to see which option will best minimize your tax liability.

    S Corporations: An S corporation refers to the tax treatment of the entity. That is, an S corporation is not a type of entity, but a type of tax status—specifically subchapter S of the U.S. Tax Code governs the tax treatment of entities that elect to be taxed as an S Corporation. When you form an entity, whether it’s a corporation or an LLC, you can elect for the entity to be taxed as an S corporation.

    Paying Owners of LLCs

    As I discussed above, an LLC is by default taxed as a pass through entity. An S corporation also offers pass-through taxation. So why would you elect to have your pass-through LLC taxed as a pass-through S corporation? Because an LLC that elects to be taxed as a S corporation can have its owners be employees of the LLC and pay them a regular salary that is subject to standard federal withholding taxes (and not self-employment taxes). Depending on the individual financial circumstances of each owner, electing to be an employee versus an owner (and having to pay self-employment taxes) can have a significant tax impact.

    Written contracts and the delivery requirement

    As a small business owner you undoubtedly enter into many contracts, most of them written.  Some may be contracts others initiate to enter into with you.  Some may be contracts you seek out.  In either case, any written contract you enter into, must be “delivered to the party in whose favor it is made.” California Civil Code 1626.

    So when you enter into a written contract, make sure it is delivered to all parties involved.  It may be a good idea to document delivery of the contract as well, to clear up any questions of whether someone received a copy of the contract.