California has long allowed newly formed corporations or corporations newly registered in the State to avoid paying the minimum state Franchise tax of eight hundred dollars a year for the first year of operation. This was done to encourage entrepreneurs to incorporate or register in the state.
This same tax break was not given to other types of business structures that commenced operations in California.
Due to the effect of the Covid pandemic, the State has now enlarged the limited liability entities that are granted this advantage, at least for a limited time.
The Change in the Law:
Limited liability companies (“LLCs”), limited partnerships (“LPs”) and limited liability partnerships (“LLPs”) that are registered to do business in California were previously required to pay a minimum annual franchise tax of eight hundred dollars to the state’s Franchise Tax Board (the “FTB”). Oddly, this requirement was not imposed for the first year on corporations registered to do business in California. Why one limited liability entity received that benefit while others did not has puzzled many. One would think that if the purpose is to encourage business start ups, that same motivation would exist for any type of limited liability entity.
But now California has extended the first year exemption to LLCs, LPs and LLPs. To encourage the registration of new businesses, Governor Newsom extended the first-year Franchise Tax exemption to LLCs, LPs, and LLPs, as part of the 2020 Budget Act. Any LLC, LP or LLP that registers or files with the California Secretary of State on or after January 1, 2021 and before January 1, 2024, is exempt from paying the minimum tax in its first taxable year. The purpose of this change is to remove a barrier to small business creation, particularly for new businesses that are still operating at a loss or have limited income in their first year. Note that if income is above a specified minimum, tax would still have to be paid, as described below.
Starting in their second taxable year, all LLCs, LPs, LLPs, and corporations that are organized in California or qualified to do business in California become subject to the annual minimum franchise tax, until they formally dissolve. Additionally, LLCs, LPs and LLPs that have gross income of more than two hundred fifty thousand dollars ($250,000) in their first year, will continue to be required to pay a gross receipts tax, beginning at nine hundred dollars ($900) and up to eleven thousand seven hundred ninety dollars ($11,790).
Essentially, this gives to other entities the same tax break given to corporations previously. And if the entity is profitable in the first year, then while the tax is due it would not be particularly harmful to the start up.
Note that the tax breaks aside from those for the corporation end as of January 1, 2024. The State plans to review annual reports from the Franchise Tax Board for the next several years and determine whether the new law does indeed increase the number of LLCs, LPs and LLPs that form in California.
Of course, it is just as likely that entities that were previously formed as corporations will, instead, be formed as LLCs, LPs and LLPs thus not really demonstrating an increase in overall business formation in this State. Further, an eight hundred dollar exemption is unlikely to create a massive influx of new business given the actual high cost of doing business in California…from costs of leaseholds, energy and equipment to the high costs of labor and taxes at the local level. It certainly helps but, alone, is unlikely to be a deciding factor.
What does keep California as a leading industrial and commercial power is the simple fact that high tech of all types is centered in the State and despite predictions that it will flee to other states, remains firmly planted as the leading tech center of the entire world. This is not simply electronic high tech, but social media, entertainment, robotics, defense industries, biotech, medical research, etc. The synergy of the hundreds of existing companies and thousands of start ups in a five hundred mile radius has offset the apparent lesser expenses available if locating elsewhere. Despite dire predictions of an exodus of business from California, those predictions have been not only inaccurate, but precisely wrong. Business continues to expand in this State.
It is to be remembered that worldwide, California is normally ranked in the top five economies in the entire world. Or, as one Indian client advised the writer, “If you do not have a location in Silicon Valley, you are not playing in the big leagues. It is a rite of passage to open your operations here.”