Certain pass-through entities filing first-year California tax returns are exempt from the state’s $800 minimum franchise tax beginning in 2021. The exemption applies to limited partnerships (LPs), limited liability partnerships (LLPs), and limited liability companies (LLCs) filing first-year returns in 2021, 2022, and 2023.
California’s Minimum Franchise Tax
California imposes a minimum franchise tax on corporations and S corporations incorporated, qualified to transact business, or doing business in California. LPs, LLPs, and LLCs are subject to an eight hundred dollar ($800) annual tax if they are organized in California, registered to do business in the state, or doing business in California. (General partnerships are excluded from the tax.) Prior to the 2021 tax year, corporations that incorporated or qualified to do business in California were exempt from the tax for their first taxable year. LPs, LLPs, and LLCs, however, were required to pay the tax during their first taxable year.
AB 85, signed into law in 2020, extended the first-year exemption to cover LPs, LLPs, and LLCs that register or organize to do business in the state for taxable years beginning on or after January 1, 2021 and before January 1, 2024. The legislature enacted the law during the economic downturn caused by the COVID-19 pandemic in an effort to reduce costs for new small businesses and to encourage businesses formation. Prior to AB 85, an entity’s first franchise tax payment would be due by the 15th day of the fourth month after formation. With the change, an entity’s first franchise tax payment is not due until April 15 of the following calendar year.
In addition to reducing costs for small businesses, the change resolves a timing issue that required LPs, LLPs, and LLCs formed later in a calendar year to pay the tax twice in a matter of months. Before AB 85, an entity formed in the last quarter of a calendar year would have to pay the first-year annual franchise tax during the fourth month after formation, which occurred in the first quarter of the following calendar year, and then pay the second-year tax on April 15 of that calendar year. With the first-year exemption, the first payment for an entity formed later in a calendar year is the second-year payment due April 15 of the next calendar year.
LPs, LLPs, and LLCs should also be aware of how California’s “15-day rule” affects the first-year exemption. Under California law, taxpayers are exempt from the minimum franchise tax if they did not conduct business in the state during the taxable year and the taxable year was 15 days or less. An entity that qualifies under the 15-day rule does not count that period as its first tax year. The first-year exemption then applies to the following tax year provided that the entity otherwise qualifies.
Pass-through entity filers that are eligible for this first-year exemption must determine which period counts as their first tax year and when their second year payment is due. To find out how this change could affect your business, please contact Weaver's state and local tax team.
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