State Business Tax Laws
In addition to paying taxes to the IRS, a business or its owners likely will need to pay taxes on any profits of the business to taxing authorities in the state where the business is located. A state even may impose a tax on a business if it does not earn any income. This often takes the form of a franchise tax, which is discussed further below. Different state tax rules apply to different types of businesses, and each state takes its own approach to business taxes.
If your business operates across multiple states, you may need to pay taxes in all of those states. This does not necessarily mean that your business has physical locations in multiple states. A business or its owners may need to pay taxes based on a nexus to a certain state. Defining nexus is tricky, so you may want to consult the tax authorities in a state if you are not sure whether you will be required to pay franchise tax or income tax in that state. Alternatively, you can consult a tax attorney in the appropriate state.
State Tax for Pass-Through Businesses
Most businesses are considered to be pass-through businesses, which means that the owners of the business pay income tax rather than the business. Common examples of pass-through businesses are sole proprietorships, partnerships, LLCs, LLPs, and S corporations. In some cases, however, an LLC can choose to be taxed as a corporation at the state level even though it is taxed as a pass-through entity by default under federal tax rules. Many states impose an additional franchise tax on LLCs and S corporations.
Thus, personal income tax rules generally will govern state taxes for these types of entities. You should use the adjusted gross income on your federal tax return as the basis for calculating your state taxes. Certain deductions and exemptions may apply in various situations. Otherwise, the state will set marginal tax rates to which you must adhere.
State Tax for C Corporations
The standard type of corporation is known as a C corporation. Taxes on these corporations are not passed through to individuals but instead are paid directly by the corporation. Some states impose a higher tax rate on corporations that generate higher profits. A state also may impose an alternative minimum tax on corporations if they receive income that falls within federal alternative minimum tax rules.
A franchise tax applies to C corporations and other businesses in many but not all states. The concept behind this tax is that the business is paying the state for the privilege of operating within its boundaries. A state may apply a franchise tax to only certain types of businesses, or it may limit the tax to a certain size of business. Rates also may vary according to the scale or type of business. Failing to pay a franchise tax can result in serious consequences, including not only fines and penalties but also the loss of the right to do business or enforce contracts in a state. A specific agency in the state government oversees the collection of a franchise tax and enforces its rules.
Each state calculates its rates differently. Net income is not always the basis for a franchise tax. It may depend on the value of the outstanding stock of the business or another estimate of its overall value. Franchise tax rates are much lower than corporate income tax rates. A corporation always needs to pay the franchise tax in its home state, and it may need to pay franchise taxes in other states in which it conducts business or owns property.
Individual income tax, corporate income tax, and franchise tax are three separate types of taxes. Some states impose all of these, but others impose just one or two. Just because a state imposes or does not impose a certain type of tax does not mean that it does or does not impose others.
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