Sole Proprietors, whether operating businesses in California or acting as independent contractors, have a specific set of obligations with regard to business taxes. It is important to understand the taxes in California for a Sole Proprietorship when planning a business not only for compliance but also for business financial planning.

This article will delve into the various types of taxes that Sole Proprietors in California are liable for, including income tax, self-employment tax, and sales tax. We will provide a clear outline of each tax type to equip you with the essential knowledge to fulfill your obligations with regard to small business taxes.

Income Taxation of Sole Proprietorships in California

The net taxable income of a California Sole Proprietorship is considered the personal income of the Sole Proprietor, who is liable for federal income tax and California income tax.

Federal Income Taxes in California Sole Proprietorship

For Federal Income Taxes, a Sole Proprietorship in California is not taxed separately from the personal income tax of the owner of the business.

The income generated by the business is reported on the personal tax return of the business owner when they file taxes on Internal Revenue Service Form 1040, by using Schedule C or C-EZ to calculate the net profit or loss on the business income. The owner is then taxed on the profits at their individual tax rates rather than a corporate tax rate. This is unlike corporations, which are taxed separately from their owners.

Even if the profits of the business are reinvested or kept in the business for future use, they are still taxable in the year they were earned. Calculation of these taxes must take into account all business revenues and allowable business expenses.

California Income Taxes in California Sole Proprietorship

When it comes to California State Income Taxes, Sole Proprietors will also report their business income on their personal income tax return with the California Franchise Tax Board. California has set tax brackets for single filers, married/RDP (Registered Domestic Partners) filers, and head of household filers, with rates ranging from 1% to 13.3%. The net income from the business is subject to these rates.

California state income tax is a progressive tax, meaning the tax rate increases as the taxable income increases. The net income from the Sole Proprietorship is combined with any other income, deductions, and credits to calculate the total California tax liability when filing California Franchise Tax Board Form 540 to pay personal income taxes in California. Just like federal income tax, these taxes are due even if the profits are reinvested into the business.

Federal and California Alternative Minimum Tax for Sole Proprietorships in California

The Alternative Minimum Tax is another important tax consideration for Sole Proprietors in California. This tax applies to both federal and state levels and is designed to prevent high-income individuals from using various tax benefits to pay very little or no tax.

Federal Alternative Minimum Tax for Sole Proprietorships in California

At the federal level, the alternative minimum tax is calculated independently of the regular tax. It encompasses more sources of income and allows fewer deductions and credits. If the calculated alternative minimum tax is greater than the regular tax, the taxpayer is required to pay the difference as the alternative minimum tax is in addition to the regular tax.

California Alternative Minimum Tax for Sole Proprietorships in California

Similarly, California has its own alternative minimum tax that mirrors the federal alternative minimum tax in many ways, including its purpose of ensuring that high-income individuals pay more taxes.

Self-Employment Taxes in California Sole Proprietorships

Self-employment tax is a key requirement for Sole Proprietors in California. This tax is imposed to cover the Social Security and Medicare obligations of self-employed individuals. Unlike employees who share these costs with their employers, as a Sole Proprietor, you are responsible for the full amount.

Understanding Self-Employment Tax Rates for California Sole Proprietors

The total self-employment tax rate is 15.3%, where 12.4% is for Social Security and 2.9% is for Medicare taxes. This rate applies up to a statutory maximum of income, which maximum amount increases most years. Any income above the statutory maximum is not subject to the Social Security portion of the tax but continues to be subject to the 2.9% Medicare tax.

Additional Medicare Tax for California Sole Proprietors

For high-earners, an additional Medicare tax of 0.9% applies on earnings above certain thresholds: $200,000 for single filers and $250,000 for married couples filing jointly.

Paying Self-Employment Taxes as a California Sole Proprietor

Sole proprietors must pay quarterly estimated taxes using Internal Revenue Service Form 1040-ES, Estimated Tax for Individuals. If you do not pay enough tax through withholding or estimated tax payments, you may be charged a penalty.

Deducting Self-Employment Taxes from Net Income as a Sole Proprietor

Although self-employment taxes can be substantial, half of what you pay can be deducted from your income when calculating your federal income tax. This deduction only affects your income tax and has no impact on your net earnings from self-employment or your self-employment tax.

California Sales Tax for Sole Proprietors

In California, Sole Proprietors selling tangible personal property have to comply with specific sales tax obligations. This process involves registering for a seller’s permit, collecting sales tax from customers, and remitting the collected tax to the California Department of Tax and Fee Administration (CDTFA).

Registering for a Seller’s Permit

As a Sole Proprietor, you must register for a seller’s permit if you’re engaged in business in California and intend to sell or lease tangible personal property that would ordinarily be subject to sales tax if sold at retail. The registration can be done online on the CDTFA website, and it is free of charge. Upon successful registration, a seller’s permit will be issued and remain valid until it is surrendered or revoked.

Collecting Sales Tax

With a seller’s permit, Sole Proprietors are required to collect sales tax from their customers at the time of sale. The tax is calculated based on the selling price of the tangible personal property. The rates may vary depending on the location of your business, as California allows local cities and counties to impose additional sales and use tax rates.

Filing and Paying Sales Tax Returns

The collected sales tax must be remitted to the CDTFA. The frequency of filing your sales tax returns (monthly, quarterly, or yearly) generally depends on the volume of your sales. However, even if a business did not make any sales during a reporting period, a sales tax return must still be filed.

Sales tax returns can be filed and payments made online through the online services system of the CDTFA’. The due date is typically at the end of the month following the reporting period. For instance, for a quarterly reporting period ending in March, the sales tax return would be due by the end of April.

Sole Proprietors should maintain detailed records of transactions including invoices, receipts, and tax collected as CDTFA may audit your business to ensure compliance with sales tax laws.

Estimated Taxes for Sole Proprietors in California

Sole Proprietors are typically required to pay estimated taxes every quarter, which covers their income tax and self-employment tax obligations.

Federal Estimated Taxes for Sole Proprietors in California

Federal estimated taxes apply to income that is not subject to withholding, which includes earnings from Sole Proprietorships. Sole proprietors in California must pay these taxes quarterly if they expect to owe $1,000 or more when their return is filed.

The estimated tax constitutes income tax and self-employment tax, the latter encompassing Social Security and Medicare tax. The net taxable income of the Sole Proprietor is subject to self-employment taxes at a current rate of 15.3%, which is then halved to account for the employer-equivalent portion. This adjusted self-employment tax is then added to the total tax liability in calculating the estimated tax.

Estimated taxes are calculated using the IRS Form 1040-ES. Once calculated, payments are due on four set dates throughout the year, typically April 15, June 15, September 15, and January 15 of the following year. Failure to pay, or underpayment of estimated taxes, can result in penalties by the Internal Revenue Service, making correct calculation and prompt payment of estimated taxes important to avoid such penalties.

California Estimated Taxes for Sole Proprietors in California

California Estimated Taxes for Sole Proprietors in California follow a similar concept to federal estimated taxes. These are prepayments made towards your anticipated tax liability for the year, including income tax and self-employment tax.

If you anticipate owing at least $500 in taxes for the year after accounting for all withholdings and credits, you will likely need to make estimated tax payments. These payments help you avoid having a large tax bill when filing your annual income tax return.

California has its own form for calculating estimated tax payments known as California Franchise Tax Board Form 540-ES. This form takes into account your expected adjusted gross income, taxable income, deductions, and credits for the year.

The due dates for California Estimated Taxes for the year are the same as the federal estimated tax due dates, typically April 15, June 15, September 15, and January 15 of the following year.

Just like with federal taxes, failure to pay or underpayment of California Estimated Taxes can result in penalties. Therefore, it is essential to accurately calculate and promptly pay these taxes.

Local Taxes for Sole Proprietorships in California

Depending on the location of the business, a Sole Proprietor may also be liable for additional local taxes such as city or county taxes. Local taxes for Sole Proprietorships in California vary largely based on the location of the business. These taxes often fall under the category of Business License Taxes, Utility User Taxes, Transient Occupancy Taxes, Sales and Use Taxes, and Property Taxes.

Business License Taxes

Business License Taxes are imposed on individuals or entities that carry out business within a particular city or county. The rate is typically determined by the nature of the business and its gross receipts. As a Sole Proprietor, you are required to obtain a business license from the city or county where your business is located and pay the applicable tax.

Utility User Taxes

Some cities in California may impose a Utility User Tax on businesses for the use of utilities such as electricity, gas, water, sewer, telephone, sanitation, and cable services. The rate of this tax varies by city.

Transient Occupancy Tax

In case your Sole Proprietorship involves offering short-term lodging (like a bed and breakfast or vacation rental), you may have to pay Transient Occupancy Tax. This tax is often imposed on operators of hotels, motels, and other short-term lodging facilities.

Sales and Use Taxes

In addition to the statewide sales tax, some cities and counties in California also impose a local sales tax on the sale of tangible personal property. If you sell such products, you are required to collect this tax from your customers and remit it to the local taxing authority.

Property Taxes

Property tax is based on the assessed value of real and tangible personal property used in your business. If your Sole Proprietorship owns such property, you may have to pay property tax to the county tax collector.

Sole Proprietorship Alternatives in California

In California, there are several alternatives to a Sole Proprietorship that you might consider for your business structure. These include a California General Partnership, California Corporation, California S Corporation, and California Limited Liability Company (LLC),. Each of these entities provides different taxation options. Choosing the right entity depends on your business needs and strategic tax planning.

California General Partnership Taxation

A General Partnership in California consists of two or more people who agree to operate a business together. For taxation purposes, California General Partnerships are considered pass-through entities. This means the partnership itself does not pay income tax. Instead, income and losses are passed through to the individual partners when the California General Partnership files Internal Revenue Service Form 1065 and California Franchise Tax Board Form 565 to report the income or loss of the partnership. The partners of the California General Partnership then report the income or loss of their personal tax returns and pay taxes on the business income.

California Corporation Taxation

California Corporations are subject to both federal and state taxation. On the federal level, corporations are taxed on their net income at a flat rate of 21%, as per the Internal Revenue Service. This is known as the Corporate Income Tax, and corporations are required to file Form 1120 to report income, gains, losses, deductions, and credits.

In addition to federal taxes, California corporations must pay a state-level corporation tax. The California Franchise Tax Board levies an 8.84% tax on all net income earned within the state when the California Corporation files California Franchise Tax Board Form 100. Furthermore, there is a minimum franchise tax of $800 that all corporations must pay, regardless of income.

California S Corporation Taxation

California S Corporations are considered pass-through entities, similar to a California General Partnership. This means that the corporation itself doesn’t pay federal income tax. Instead, the income, deductions, losses, and credits of the S Corporation are passed through to the shareholders when the California S Corporation files Internal Revenue Service Form 1120S, and the shareholders report these on their individual tax returns. This avoids the double taxation issue that regular corporations face.

California S Corporations are subject to a 1.5% state tax on their net income, imposed by the California Franchise Tax Board when the S Corporation files California Franchise Tax Board Form 100S. Additionally, a minimum franchise tax of $800 applies, regardless of income.

California Limited Liability Company (LLC) Taxation

A Limited Liability Company (LLC) in California can be treated in several ways for taxation purposes, primarily based on the number of members and the election made by the LLC.

By default, a Single-Member California LLC is disregarded for tax purposes and taxed as a Sole Proprietorship, and a Multi-Member LLC is taxed as a partnership. However, a California LLC may elect to be subject to double taxation like a California Corporation or taxed as a California S Corporation.

Regardless of taxation type, every California LLC is subject to an annual franchise tax of $800 annually regardless of income, and the California LLC Fee applies to California LLCs disregarded for tax purposes of taxed as a partnership.

Need Help Choosing a Business Structure?

Sole Proprietorship, and all of the alternatives listed, offer varying levels of liability protection and tax benefits that can be suitable for some business owners and not for others.

San Diego Corporate Law helps business owners navigate the complexities of choosing the right business structure for their unique needs and business plans. Given the significant financial and legal implications tied to this decision, it is important to seek professional guidance. Do not leave things to chance; schedule a consultation with one of our knowledgeable corporate attorneys today, and let us help you make the most informed decision for your business.