When you started your eCommerce business did you dream of reading through complex tax law to understand if you need to pay income taxes in a certain state?
We understand most people don't love talking taxes like we do, but all businesses, especially eCommerce sellers, should have at least a basic understanding of the relevant rules. That's what we are here for - let's take a walk through state income tax 101.
In order for a state to require you to pay state income tax or to register with their state authorities, your business would need to have a significant connection, or 'nexus' to that state.
There are two types of nexus:
(1) Physical - where you have some kind of physical connection to the state, such as a warehouse or an office, or
(2) Economic - a certain threshold of transactions occurred in the state.
The definition and threshold for creating nexus in a state may be different for state income tax purposes and for state sales tax purposes and differs amongst the states.
For California, what generates state income tax nexus?
California imposes a franchise tax on the net income of any corporation (1) doing business in California, or (2) not doing business in California but which earns income from activities in California.
The real question comes down to this - what qualifies as doing business?
The California tax code graciously answers this question by defining 'doing business' as actively engaging in any transaction for the purpose of financial gain or profit.
Does this mean if you make no profit your activity doesn't count? Umm, no unfortunately this is not the case. If this definition is met, even if no actual profit is derived from the activity, you may still be 'doing business' in CA.
When is a corporation considered to be doing business in California?
California provides thresholds to determine if your business has sufficient activities to be considered as 'doing business' in the Golden State. If your business meets any of these, you are considered to be doing business in CA (these numbers apply to 2021 but may be adjusted each year):
- Your business entity is organized in California
- Your sales in California exceed $637,252 or are 25% or more of your total sales;
- You have real and tangible property in California that is greater than $63,726 or 25% or more of your business' total property;
- You paid compensation in California that is greater than $63,726 or 25% or more of the total compensation paid by your business.
It is important to note that even if the sales, property or payroll requirements are not met, a company could still be considered as doing business in CA if it meets the definition of actively engaging in any transaction for the purpose of financial gain or profit.
There is a narrow exception, where a corporation meeting the above thresholds will not be “doing business” in California. This exception may apply if its only activities in the state are purchasing personal property or services solely for its own, or an affiliate's, use outside the state and if the corporation has 100 or fewer employees in California whose tasks are not more than solicitation, negotiation, liaison, monitoring, auditing, and inspecting or providing technical advice regarding the above personal property.
In order to qualify for this exception, a corporation must petition the CA FTB for a determination that its activities qualify for this narrow exception to “doing business” in California.
In California, an out-of-state corporation must obtain authority from the Secretary of State before doing business or you could be subject to penalties.
When is a partnership considered to be doing business in California?
Partnerships and LLCs are considered as doing business in California if they have a general partner or member doing business on their behalf in California. Likewise, general partners and members are considered doing business in California if the partnership or LLC, respectively, is doing business in California.
An important exception to income tax
There is an exception that applies to many states, including California, called Pub. L. 86-272. This has been a saving grace to many eCommerce businesses.
To summarize the law, if the only business activity in California consists of the solicitation of orders for sales of certain property and activities connected to solicitation, it shouldn't be subject to income tax.
This is good news but comes with an important caveat - this exception only applies to taxes measured on net income. This means that if an out-of-state entity is considered to be doing business in California, and falls under this exception, it may still be required to file a tax return and pay taxes that are not measured on net income, such as the minimum franchise tax, annual LLC tax, and the LLC fee, unless an exception applies.
Examples of activities that fall under this exception include:
- Soliciting orders for sales through any type of advertising
- Carrying samples and promotional materials only for display or distribution without charge
- Soliciting orders by an in-state employee as long as the person does not maintain or use any office other than a home office
- Passing orders or complaints to the home office
Examples of activities not covered under this exception include:
- Approving or accepting orders
- Consigning stock of goods to any person, including an independent contractor, for sale
- Owning, leasing or using a warehouse in California
State income tax can be pretty complex. Unless the answer is a no-brainer for you, we highly recommend you speak to a tax advisor or CPA to ensure your business is compliant with state tax requirements.
We are a technology company providing automated end-to-end accounting service to eCommerce businesses. Our system connects to your apps, syncs all your data and reconciles your books in real-time, replacing your bookkeeper. We offer reconciled books available 24/7, tax-saving insights, and a single place for all your financial data.
The information provided on this website does not, and is not intended to, constitute legal advice. All information, content, and materials available on this site are for general informational purposes only. Readers are advised to consult with their attorney or accountant with any questions or concerns.