When it comes to taxes and business obligations in California, it’s important to understand the difference between California source income and "doing business" in California. Although these two concepts are closely related, they have distinct legal and tax implications for businesses, particularly when determining if you need to file taxes, pay fees, or register with the state.
This article will break down the differences and explore the unique implications of each.
What Is California Source Income?
California source income refers to income that is derived from activities or assets located within California. A business or individual may have California source income even if they don’t have a physical presence or registered business in the state. Common examples of California source income include:
- Rental income from property located in California.
- Wages earned for work performed in California, regardless of where the employer is based.
- Sales income from goods or services delivered (or provided) to California customers.
- Income from partnerships or pass-through entities that operate in California.
Even if you’re based outside of California, if your business earns income from California sources, you may be required to file a California tax return and pay taxes on that income.
Implications of California Source Income:
- Tax Filing Requirements: A company or individual that has California source income must file the appropriate tax forms to report that income, such as Form 568 for LLCs or Form 540NR for individuals.
- No Secretary of State Registration Needed: Having California source income does not automatically mean you need to register with the California Secretary of State. This means a business can earn income from California without being classified as “doing business” in the state.
- Limited Scope: Businesses or individuals with California source income are typically only required to file taxes on the portion of income derived from California sources, not their entire income.
What Does It Mean to Be "Doing Business" in California?
"Doing business" in California is a broader concept than California source income. According to the California Franchise Tax Board (FTB), a company is considered to be doing business in California if it is actively engaged in any transaction for financial gain within the state. You may also be considered "doing business" if your company meets certain economic thresholds, even without a physical presence in California.
Some common criteria for "doing business" include:
- Maintaining an office, store, warehouse, or other physical presence in California.
- Having employees or agents operating within California.
- Exceeding California’s economic nexus thresholds: Sales in California exceed $690,144 (as of 2024), Property in California exceeds $69,015, Payroll in California exceeds $69,015.
If your business meets any of these criteria, it is considered to be doing business in California, even if it is based outside of the state.
Implications of Doing Business in California:
- Secretary of State Registration: If a business is considered to be "doing business" in California, it must register with the California Secretary of State. This involves filing formation documents for California LLCs or foreign qualification forms for out-of-state businesses (foreign LLCs or corporations).
- Franchise Tax Obligations: LLCs, corporations, and other entities doing business in California must pay the annual franchise tax, which includes a minimum $800 tax for LLCs. This applies regardless of whether the business is profitable.
- Comprehensive Tax Filing: Businesses doing business in California are required to file tax returns and report all income (not just California-source income) as part of their state obligations.
Tax and Legal Implications
The implications of earning California source income versus "doing business" in the state can be quite different when it comes to taxes and legal obligations:
1. Filing Requirements and Taxes
- California Source Income: If your company has income from California sources but is not "doing business" in the state, you may only need to report the specific California source income. There’s no obligation to pay California’s annual franchise tax unless you're considered to be doing business in the state.
- Doing Business in California: If your business is considered to be doing business in California, you must file comprehensive tax returns, report all income (including non-California income), and pay the $800 minimum LLC tax or other applicable corporate taxes. Even out-of-state businesses must comply if they meet the "doing business" criteria.
2. Registration with California Secretary of State
- California Source Income: If your business only has California source income but does not meet the thresholds for "doing business," there is no requirement to register with the California Secretary of State. This means your business can operate without being subject to California’s annual filing fees and regulations associated with state registration.
- Doing Business in California: Businesses that are "doing business" in the state must register with the Secretary of State. This involves filing necessary documents, such as registering as a foreign LLC or corporation, and paying associated fees. Failure to register can result in penalties and loss of legal protections.
- If you’re doing business in California but fail to register or file the necessary tax forms, you may face significant penalties, including back taxes, late fees, and loss of the LLC’s limited liability protection in California.
- While both California source income and "doing business" in California can create tax obligations, they differ in scope and requirements. If your business has income tied to California but does not meet the criteria for doing business in the state, your obligations may be limited to filing tax forms for California-source income. However, if your business meets the "doing business" criteria, you'll need to register with the state, file comprehensive tax returns, and pay the required annual franchise taxes.
- Understanding these distinctions is crucial for ensuring your business complies with California laws and avoids potential penalties. When in doubt, consult a tax professional or legal expert to determine your specific obligations.
As always, this is quite complicated and it is possible that there are variations I have not considered. Please consult with your tax professional for how this affects you and/or your entity.
