State and Local Taxes
Most new businesses are concerned with federal taxes, but very few small businesses realize that many states also have state and local taxes that may affect their business. This article will cover a few of the basic state and local taxes that your business may face.
State Income Taxes
Forty-three states have income taxes. These taxes are in addition to the federal taxes that you must pay. Seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—all have no state income taxes.
The majority of businesses formed in the U.S. are Limited Liability Companies (LLC). These LLCs are typically taxed either as a sole proprietorship, partnership, or S Corporation. This means that most LLCs are what we call flow-through entities—the taxes flow through to the owners of the LLC.
Jim’s barbershop is an LLC that is taxed as a sole proprietorship because he is the sole owner of the LLC and did not elect to be taxed as an S or C Corporation. The barbershop made a net profit of $50,000 in 2019. Because Jim’s LLC is taxed as a sole proprietorship, the $50,000 in net profit from the barbershop will be reported on Jim’s good old IRS form 1040 since Jim’s barbershop is taxed as a sole proprietorship.
Sole proprietorships—also known as solos— are great ways of starting your business. In fact, you don’t even need to start an LLC to be a sole proprietorship.
Solos are more often called self-employed, independent contractors, small-time operators, etc. The IRS treats solos as one in the same as their business. There are no formalities necessary to open a business as a solo.
States With Flat Income Tax Rates
Eleven of the forty-three states that have state income taxes have flat income tax rates. A flat income tax rate means that regardless of how much your business makes the business will be taxed at a flat rate.
Jim’s barbershop made a net profit of $50,000 in 2019. The barbershop is located in New Hampshire, which charges a flat income tax rate of 5%. This means that in addition to the IRS taxes Jim’s barbershop will owe, the barbershop will also owe an additional 5% in New Hampshire state income taxes.
States With Progressive Income Tax Rates
The remaining thirty-three states have progressive tax rates, which are similar to federal tax rates. This means that your business will pay more state income taxes the more your business makes. The progressive tax rates range anywhere from 1% to 12%.
Jim’s barbershop made a net profit of $200,000 in 2019 and is located in California. Because Jim’s made $200,000 of net profit, Jim will be in the 8% tax bracket for California, meaning that he will owe $15,444 in taxes to California since the tax rate is progressive.
Watch Out for the State C Corporation Double Taxation
If your business operates as a C corporation, you should check to see if your state has a tax for C corporations. Some states have their own corporate income tax rates. State corporate tax rates range anywhere from 4% to 10%.
For example, Florida charges either a 5.5% flat tax on federal taxable income or a 3.3% alternative minimum tax (AMT)—whichever is higher. This means that on top of paying federal income taxes, federal corporate taxes, you could also be paying state corporate taxes too!
Caution: While the new Tax Cuts and Jobs Act (TCJA) passed in 2017 made C Corporations more attractive, a C Corporation is still not a great option when compared to a partnership or S Corporation because C Corporations result in double taxation.
Other State and Local Taxes
Many states also impose additional taxes for use taxes, business transfer taxes, inventory and other property taxes, internet taxes, payroll taxes, telecommuter taxes, license fees, and out-of-state taxes. Here’s a brief description of each of these additional taxes:
Most states will tax purchases your business makes on out of state items that are then used within your state. Use taxes do not apply when you have already paid sales taxes. Sound confusing? We agree. Speak to a qualified tax pro if you have questions about use taxes.
Business transfer taxes
If you purchased a local business or are selling a business, be aware that many states, counties, or cities will charge a tax on the purchase.
Inventory and other property taxes
States and local governments will often impose taxes on business equipment (e.g. vehicles used in a trade or business) and real estate used in a trade or business.
Thanks to a 2018 Supreme Court decision, states can now require businesses selling goods online to collect state sales taxes on their sales.
If your business sells goods online you will need to be aware of which states require your business to collect state sales taxes on sales. There is also a high likelihood that you will have to register with each state that requires your business to collect these sales taxes.
If your state imposes income taxes, you will also have to pay payroll taxes. Make sure you are withholding payroll taxes properly.
Every state and local government impose licensing fees. These licensing fees vary depending on your business. Speak with a qualified tax pro, your local government agencies, or chamber of commerce to make sure you have the right licensing for your business.
If you have out-of-state employees then your business may be responsible for withholding state income taxes for those employees.
Be aware that many state and local tax enforcement agencies are much more aggressive than the IRS. If you find yourself under a state and local tax audit, we recommend reaching out to a respected local tax law firm immediately.