Top Strategies for Reducing Your California Business Taxes Legally

Top Strategies for Reducing Your California Business Taxes Legally

Top Strategies for Reducing Your California Business Taxes Legally

There are many benefits to having a business based in California, but taxes are not considered one of them. California has a relatively high tax burden compared to other states. As a business owner, finding business tax savings may be high on your list of financial moves to stay competitive. 

Here’s how to do that. 

California’s High Tax Rates

The Tax Foundation rates California in the top 10 of worst small business tax climates (ranking it at 48 out of 50, with 50 being the worst), and tax climates in general. 

Type of TaxRanking (out of 50)
Corporate Tax Rank46
Individual State Income Tax Rank49
Sales Tax Rank47
Property Tax Rank19
Unemployment Insurance Tax Rank24
Overall Ranking48

Source: Tax Foundation 2023 State Business Tax Climate Index Ranks and Component Tax Ranks

Importance of Reducing Taxes

It’s simple math: the more profit your business generates, the more it can save or invest in the business. Reducing your business and personal tax bill allows your business to save money. You can use that money to hire or retain employees, invest in new locations or add new products or services. 

It can also improve cash flow, which in turn can allow your business to pay down debt or reduce the need for small business loans. A cushion in your business savings account can help your business if it encounters setbacks, whether that’s a physical disaster or an economic downturn. And if your business continues to thrive, it will be able to continue to pay its required taxes (which benefits your employees and other Californians), while also contributing to your community. 

Strategy 1: Take Advantage Of Deductions

Tax deductions reduce taxable income. Business owners have a number of opportunities to take tax deductions to reduce taxable income, which then reduces tax liability. With many types of businesses, profits from the business flow through to the owner’s personal tax returns. Reduce the taxable income of the business, and your personal tax bill can go down. 

How To Keep Track Of Deductible Expenses

If you’re going to take advantage of tax deductions, you must keep good records. It is non-negotiable. Both the IRS and the state of California require you to maintain documentation of your expenses to stay compliant with tax laws. 

There are a few ways you can make this task easier, though. 

  1. Use a business bank account. Run business income and business expenses through your business checking account, not your personal bank account, even if you operate as a sole proprietor. 
  2. Use a business credit card for business expenses. Again this is helpful so you know which expenses are for business purchases. 
  3. Keep receipts. Accounting software programs often allow you to upload copies of your receipts to attach to expenses. This is one of the easiest ways to keep them organized. Or you can create an online folder where you save copies. (Label them well so they are easy to find.) 

Deductions Specific To California

You may have seen Tiktoks or YouTube videos that make it sound like you can deduct everything as a business owner. That’s usually an exaggeration, to put it mildly. But there may be lots of legitimate expenses your business can deduct and you want to make sure you take advantage of them. 

California generally follows the federal tax code when it comes to tax deductions. That means many of the tax deductions available for your businesses’ federal income taxes will also be available to help reduce your tax liability at the state level. 

Examples of these popular tax deductions that follow federal rules include: 

  • Advertising
  • Bad business debt
  • Car/vehicle expenses
  • Charitable contributions
  • Gifts
  • Home office
  • Insurance
  • Legal and professional fees
  • Rent
  • Salaries
  • Startup costs
  • Supplies
  • Travel expenses
  • Utilities

There are some variances in the way California handles some common business tax deductions when compare to the IRS:

Entertainment deduction: Not allowed at federal level but deductible in California if you meet one of two tests (the “Directly related test” or the “Associated test”). Deductions are limited to 50% of unreimbursed expenses and require proper documentation.

Section 179 depreciation: Allowable deduction on first year property up to $25,000 (phased out for asset values over $200,000)

Taxes: No deduction allowed for taxes measured by income or profits (federal and state).

Get more details about California small business tax deductions here

Strategy 2: Incorporate Your Business

Another potential way to reduce your business tax liability is by forming a business entity such as a Limited Liability Company (LLC) or corporation, and electing a more favorable tax treatment. 

This is a step you must think through carefully, though, due to California’s Franchise Tax which requires most businesses to pay an annual fee of $800 (or more for some businesses). Businesses that operate without a formal business structure are known as sole proprietorships and they are not subject to the Franchise Tax. The California Franchise Tax Board administers this and other California taxes.

Benefits Of Incorporating A Business For Tax Purposes

There can be a variety of tax benefits to forming a business entity, depending on the type of entity you choose. Each has its pros and cons. 

Corporations can often carry losses forward into future tax years, for example. 

Some businesses choose to be taxed as S corporations. When a business elects to be taxed as an S corporation, corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders report their income and losses on their personal tax returns and pay taxes at their individual income tax rates. 

One benefit is that it allows them to avoid double taxation on corporate income. Another is that owners shareholders who work in the business may be able to pay themselves a a reasonable salary that will be subject to payroll taxes (FICA taxes), and take other profits in the form of distributions which are not. (Income taxes apply to both types of income.) 

Limited Liability Companies (LLCs) may be treated as a corporation, partnership, or as a disregarded entity (part of the owner’s tax return, depending on the number of members (owners) and elections made by the LLC. Some LLCs elect to be taxed as S corporations for the benefits just mentioned. 

In California state, qualifying PTE’s may be eligible for the pass-through entity (PTE) elective tax. A PTE is an entity taxed as a partnership or S corporation. Qualifying PTEs may annually elect to pay an entity level state tax on income for taxable years starting January 1, 2021, and before January 1, 2026. If they qualify for and elect this credit, taxpayers receive a credit for their share of the entity level tax, reducing their California personal income tax.

It’s wise to get professional advice to determine the best business structure both for taxes as well as for asset protection, attracting investors, etc. Note that your business entity must be the same at the state and federal level for tax purposes. For example, if you form a California LLC and elect to be taxed as an S corporation you must also do the same for federal tax purposes. 

Strategy 3: Utilize Tax Credits

Tax credits reduce the amount of taxes owed on a dollar-for-dollar basis. Some tax credits can actually result in a tax refund. 

These credits are usually designed to encourage certain economic activity, such as investing in energy-saving products or to hire individuals who may face barriers to employment. 

California business tax credits include:

California Competes Tax Credit (CCTC): for businesses that come to California and stay and grow in California (meeting certain milestones);

California Research Tax Credit: A modified version of the research credit,  businesses engaged in qualified research activities in California may qualify for a credit of 15% of qualified expenses that exceed a base amount plus 24% of basic research payments.

Cannabis Tax Credits. With the Cannabis Equity Tax Credit (CETC), qualified cannabis businesses may receive a tax credit of $10,000 for taxable years beginning January 1, 2023 through December 31, 2027. And the High-Road Cannabis Tax Credit (HRCTC) provides a tax credit of up 25% of qualified expenditures per taxable year (up to $250,000 per year), for taxpayers conducting a qualified cannabis business.

Homeless Hiring Tax Credit (HHTC): A tax credit available to California businesses that hire eligible homeless individuals as employees. Businesses that qualify may get a credit equal to 50% of the wages paid to eligible employees, up to a maximum credit of $5,000 per employee per year.

California Motion Picture and Television Production Credit: This program encourages film and television production in California by providing a tax credit equal to 20% or 25% of qualified production expenses, depending on the type of production and the location of the filming.

New Employment Credit: Employers may be eligible for a tax credit of up to $56,000 per employee (over 5 years) when they hire employees in a Designated Geographic Area (DGA) and pay or incur qualified wages. Certain types of businesses don’t qualify, including certain retail, food service or drinking establishments or casinos, for example, and there are a number of other requirements that must be met. 

Strategy 4: Hire A Tax Professional

Another way to make sure you are taking advantage of tax deductions and credits, as well as meeting myriad state and federal tax requirements, is to work with a tax professional. Professional bookkeepers can help you keep your accounting up-to-date while Certified Public Accountants (CPAs), Enrolled Agents (EAs) and other tax professionals can help you with tax compliance and tax preparation. 

CPAs, EAs and tax attorneys aren’t required to register as a tax preparer with the California California Tax Education Council (CTEC), but anyone else who receives a fee or other compensation for assisting with or preparing tax returns must do so. (And that includes entering tax information into a computer!) 

Benefits Of Working With A Tax Professional

Tax law is complicated and is constantly changing. Some business owners may have simple tax needs that accounting software and tax preparation software can meet. But it’s not unusual to run into questions or require expert help. Working with a tax professional can help you take advantage of both federal and California tax reduction strategies. 

They can help your business save time and money by making sure you stay on top of filing deadlines and pay the taxes you are legally required to pay, but no more. 

Conclusion: Reducing California Taxes

Business owners face a complicated tax system both at the state and federal level. But if you want your business to be successful in the long run, you need to set up systems to make sure you follow the rules, pay your taxes on time, and take advantage of tax deductions and tax credits when they make sense.

The sooner you set up good money management systems, the better. It can be time-consuming (and expensive) to play catch up.

Keeping your bookkeeping up to date, separating your business and personal finances, and taking advantage of the expertise available from tax professionals can help your business avoid costly mistakes so you can focus on your business. 

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