Creating an LLC in another state to avoid California's $800 annual LLC fee is a common misconception, but it generally doesn't work for California residents or businesses operating in California. Here are the key reasons why:
1. California Nexus Rule: If the LLC does business in California or has any presence in the state, it must register as a foreign LLC and pay the $800 annual fee. This includes maintaining an office, having employees, or conducting business transactions in California.
2. Tax and Reporting Obligations: Even if the LLC is formed in another state, if it derives income from California, it must file and pay California state taxes. This includes the $800 annual fee and any applicable franchise taxes.
3. Legal Requirements: California law mandates that any entity conducting business within the state, regardless of where it was formed, must comply with California’s tax and regulatory requirements. This includes registering with the California Secretary of State and paying the appropriate fees.
4. Piercing the Corporate Veil: If the primary purpose of creating an out-of-state LLC is to avoid California fees and taxes, and the business operates predominantly in California, the state can challenge the LLC’s legitimacy. This can result in penalties and back taxes.
5. Administrative Complexity: Forming an LLC in another state while doing business in California creates additional administrative burdens. This includes maintaining compliance with the laws and regulations of both states, filing taxes in multiple jurisdictions, and managing potential legal challenges.
6. Franchise Tax Board Enforcement: The California Franchise Tax Board (FTB) actively monitors and enforces compliance. They have measures in place to identify businesses attempting to circumvent state tax obligations and can impose significant penalties for non-compliance.
Two doing business tests under California tax law are:
1. The taxpayer actively engages in any transaction for the purpose of financial or pecuniary gain or profit.
2. The taxpayer meets the factor threshold economic Nexus test by being organized or commercially domiciled in California, having California sales exceeding $711,538 for 2023 or 25% of the entity's total sales, having California real or tangible personal property valued at original costs exceeding $71,154 or 25% of the entity's total real property and tangible personal property, or having California compensation exceeding $71,154 or 25% of the total compensation paid by the entity.
California defines nexus for out-of-state businesses in the following ways:
- Having an office, employees, or property in California
- Engaging in transactions in California for the purpose of financial or pecuniary gain or profit, even if the business has no physical presence in the state
- Meeting the factor threshold economic nexus test, which includes having California sales, property, or payroll exceeding certain thresholds
- Registering to do business in California, even if the business has no actual business activities in the state
The penalties for non-compliance with California tax filing requirements can be severe:
- A Maryland S corporation was liable for over $14,000 in per shareholder penalties for failing to timely file its 2018 and 2019 tax returns, even though it had no business activities in California during those years.
- The per shareholder penalties can be $18 per shareholder per month, imposed for up to 12 months, which can quickly add up.
- The decision is a "harsh reminder that ignorance of California's tax filing requirements is no excuse" for non-compliance.