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 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 income 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 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.
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 any California sourced income, and you will unfortunately be subjected to the minimum franchise tax of $800 (as of 2019). 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
Note how this centers 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.
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-
Major New York tax reform was passed in April 2015 which aligned taxation between New York City and New York State. NYC was like Rome, and was off in the weeds as compared to New York State. Regardless, 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.
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 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 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 have to 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 the Watson CPA Group to nail this down.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition