Guide to California Business Taxes 1
The form of business entity that you establish determines what income tax form you must
file, and will affect your legal and tax rights and obligations. The five business entities from
which you may choose are Sole Proprietorship, Partnership, Corporation, S-Corporation, and
Limited Liability Company.
A Sole Proprietorship is an unincorporated business owned by one person. A sole
proprietor should report business income on his or her state and federal personal income tax
returns. California Income Tax Return form 540 should be used for state income taxes, and U.S.
Individual Income Tax Return form 1040 and Schedule C (Form 1040), Profit or Loss from
Business for federal income taxes. A Sole Proprietor may also be responsible for Self
Employment Tax, Social Security and Medicare Income tax withholding, and/or making
estimated tax payments throughout the year. For forms, instructions, and complete information
on federal income taxes for Sole Proprietorship’s see the Internal Revenue Service’s Sole
A Partnership is a business relationship between two or more persons who each
contribute property, money, or labor in exchange for sharing in the profit or loss of the business.
A Partnership must file an annual federal information return, using U.S. Return of Partnership
Income Form 1065, in order to report income and expenses, but it does not pay taxes. Instead, it
passes on any net income or loss to its partners. Partners should each receive a copy of Schedule
K-1 (Form 1065). Each partner should then report his or her share of the business’s profit or loss
on his or her personal income tax return. California Income Tax Return form 540 should be used
for state income taxes and U.S. Individual Income Tax Return form 1040 for federal income
taxes. The Partnership may also need to file federal forms for Social Security and Medicare
Income tax withholding, Federal Unemployment Tax, and/or depositing employment taxes. For
forms, instructions, and complete information on federal income taxes for Partnerships see the
Internal Revenue Service’s Partnerships webpage.
A Corporation, or C-Corporation, is owned by shareholders who exchange money and
property for the Corporation’s capital stock. For tax purposes, a C-Corporation is considered a
separate taxpaying entity. It conducts business, realizes a profit or loss, pays taxes, and then
passes on any profit to its shareholders. The Corporation pays income taxes on its profit, and
each shareholder pays income tax on his or her profit. This creates a double tax. Corporations,
however, are entitled to some special deductions, which a sole proprietor is not. A Corporation
should use U.S. Corporation Income Tax Return 1120 for federal income tax returns and
California Corporation Franchise or income tax return Form 100 for state income tax returns. A
C-Corporation may also be responsible for certain employment taxes. For forms, instructions,
and complete information on federal income taxes for C-Corporations, see the Internal Revenue
Service’s Corporations webpage.
An S-Corporation is a Corporation that has decided to pass income taxes on to its
shareholders. Shareholders report gains and losses on their personal tax returns and are assessed
taxes at their individual income level. This allows the S-Corporation to avoid the double tax on
Corporation’s income. S-Corporations are responsible for the tax on certain passive income and
built in gains. To qualify for S corporation status, a corporation must be a domestic corporation,
have only allowable shareholders (individuals, or certain trusts and estates), have no more than
100 shareholders, have one class of stock, and not be an ineligible corporation (certain financial
institutions, insurance companies, and domestic international sales corporations). In order to
become an S corporation, the corporation must submit Election by a Small Business Corporation
Form 2553 signed by all the shareholders. S-Corporations should use 1120S and 1120S Sch. K-
1 for federal income taxes, and California’s S Corporation Franchise or Income Tax Return and
state form 100S Schedule K-1 for state income taxes. An S-Corporation may be responsible for
certain federal employment taxes. For forms, instructions, and complete information on federal
income taxes for S-Corporations, see the Internal Revenue Service’s S-Corporations webpage.
A Limited Liability Company (“LLC”) is a business structure allowed by state law. In
California, an LLC may chose to be taxed as a Corporation or as a Partnership. Those classified
as Corporations, should use California Corporation Franchise or income tax return Form 100 for
state income tax returns. LLCs classified as partnerships will determine their California income,
deductions, and credits under the Personal Income Tax Law and should file California Income
Tax Return form 540. They will be subject to an annual tax as well as the LLC fee based on total
California income. To determine the LLC fee, and LLC should file form 568. Because federal
law does not recognize LCCs, they must file federal taxes as either a Sole Proprietor,
Partnership, or Corporation. For more information on federal classification of LLCs see the
Internal Revenue Service’s Limited Liability Companys webpage.
Once you have chosen a legal structure for your business, you should obtain an Employer
Identification Number (“EIN”), often referred to as a Federal Tax Identification Number. An
EIN is used to identify your business for tax purposes, just as an individual would use a Social
Security Number for identification purposes. You may use the Internal Revenue Service’s EIN
Chart to determine if you need an EIN.
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