How Important for Officers to Take Salary in C Corporation?

If a C corporation is profitable, it's generally advantageous for the owners to take salaries (deductible at the corp level) rather than have earnings distributed in the form of dividends that are nondeductible by the corp and taxed to the stockholders. With respect to C corporations the IRS is mostly concerned to see that stockholder/ employees' salaries are not excessive relative to the value of the services performed.

If the stockholders perform no services, or minimal services, for the corporation, they should take no or minimal salaries. If the corporation is not profitable (as a real estate corp probably would not be until the property is sold), there is no reason for the stockholders to take salaries unless they need the cash.

There are a couple of bigger questions here. One is where the stockholders are residents for tax purposes. For example, if they are California residents, the corporation will be required to qualify to do business in California and pay the $800 minimum tax after the first year if the stockholders conduct any business activities in California on the corporation's behalf. California law defines "doing business" (so as to be subject to the franchise tax) very broadly as "engaging in any activity for the purpose of pecuniary gain or profit." Writing a check to pay a bill has been held to constitute "doing business" in California. So the stockholders, if they are California residents and want to keep this corp out of CA, must be careful to go to Nevada (or someplace else) to do absolutely everything they do on its behalf, and maintain records to document the fact that they did so. If they are residents of some other state, they need to look at that state's statutory definitions to determine whether the corporation needs to file a return there.

The second, and biggest, question is why on earth would you want to put real estate, presumably (eventually) an appreciating asset, into a C corporation? That's almost always a bad idea from a tax perspective. Since the repeal of the 1-year liquidation rule (old IRC Sec. 331) in 1986, it is pretty much impossible to get appreciated property out of a C corporation without paying tax on the gain twice

-- once at the corporate level and again at the stockholder level when the proceeds are distributed as dividends.

Katie in San Diego

This is great to know. It sounds like California's regulations on this are in very bad faith. A Nevada corporation that owns *Nevada* real estate obviously has the substance of its business activity centered in Nevada. It is amazing that California would use the ownership of a bank account in their state as a way to extract a licensing fee. I guess I shouldn't be surprised.

The obvious reason would be liability protection. Tenants can sue for arbitrary reasons, for amounts a lot larger than any potential capital gains.

Your point is still taken. Your point would be use an S Corporation?

,,,

Not that I would put it past them, but California's rule as I understand it isn't quite as drastic as you describe.

It isn't the ownership of a bank account in the state that triggers the "doing business" effect. Rather it is having an officer of the corporation who is resident in California conducting management activities for the corporation while physically located in California. In other words, if said officer sits at home in California and writes checks to pay corporation bills, then that is considered doing business. That is because an important administrative function of the corporation is being conducted by an employee who is working on corporate business while in California.

Thus Katie's (snipped) remark about making sure to travel out of California before doing any corporate business.

Are you sure that is the California rule? Do you have a citation? I looked online and many sources talk about Nevada corporations that do business in California, but none of those referred to where the management is located.

Of course if a dividend goes to a California shareholder, that's income to a California resident and gets taxed.

If the corporation has mostly California customers, then it is doing business in California, and California probably has a rightful claim on some of the corporation's income.

If the corporation has suppliers in California, that seems a bit far fetched as a basis for taxing the corporation's income. Show me any corporation in the country that doesn't buy some supplies from some business in California. Does that make every corporation in the country a California based corporation?

If your point is correct, then no business that incorporates outside of California should ever have any corporate officer be a California resident. If true, it's very harsh.

Sorry, I don't. I'm just a tax layman. Perhaps Katie has something handy.

...

Well, I don't think it's quite that harsh. I think the correct formulation would be

"no business that incorporates outside of California and DOESN'T OTHERWISE DO BUSINESS IN CALIFORNIA should ever have any corporate officer be a California resident"

But that seems to me to just be a special case of not having employees in any particular state if you don't want to be considered to be doing business in that state. For that is essentially what this situation is: A corporate officer (an employee of the corporation) is conducting corporate business while in California. Viewed that way the rule seems reasonable. It is just the edge cases where the employee activity is minimal (like writing a single check) that it seems perhaps unfair. But having strict thresholds often means that cases close to the edge don't always turn out to be reasonable.

It's kind of like getting a parking ticket for having your car extend

1 inch into a no parking area. It hardly seems reasonable, but I would imagine that a ticket issued in such circumstances would hold up in court.

says if you "do business" in California you have to pay corporation taxes. I take that to mean the common sense definition of "do business", meaning that you write a check while your body is within California borders.

If the corporation is an S corporation, it is also taxable in California, even if the person receiving the dividend/distribution resides outside California. This is because CA never taxed it at the corporate level.

I disagree. If you have a restaurant in Lake Tahoe and are on the Nevada side and most of your customers are CA residents but all your business is done in CA, then it is still NV source income. If you rent kayaks in NV, and your customers kayak all the way into CA, I still think it is NV source income.

If your company is entirely in NV and owns property in CA, then rental of CA property is considered CA source income and I suspect a CA corporate tax return is due.

An employee who is a CA resident may do work for the corporation, and the corporation will not be considered a CA corporation, but of course the employee's income will be taxed.

But if the employee is also an owner of the corporation, then maybe the rules are different. I find that hard to believe though, because what if there is a publicly traded company ABCD that I buy a few hundred shares in. It's located in another state. Then I just happen to get a job for them, telecommuting job. Certainly they can't be considered a CA company just because of that.

According to the PDF cited above, you pay Franchise Tax if you are doing business which they define as:

"Doing business in California is defined as actively engaging in any transaction in California for the purpose of financial gain or profit."

To me that definition focuses on the business *transaction*, and the key components of that would be where the buyer and seller are each located. If you have a Nevada corporation that owns and manages Nevada real estate leased to Nevada citizens, it's hard to understand how California would distort the act of writing a check for a Nevada based employee to perform a service in Nevada for the Nevada property constitutes active engagement of California, just because the check was written in California, but drawn on a Nevada bank.

I'm not surprised if California tries to distort things for its own benefit, but the definition they give above is vague and doesn't seem to be an adequate definition.

The same document says you pay income tax if the corporation "receives income from sources within California...." So that's not the case in my example. So I guess at worst for the case I cite you would pay franchise tax not corporate income tax?

Agreed, but that wasn't my example. In my example, corporation and the real estate it owns are in Nevada.

If anyone has a link to a more authoritative California source document please post it.

Well, I suppose the perception really turns on the matter of degree.

I can see how one can object to having the writing of one check trigger the "doing business" clause.

But what if all of the payroll for the Nevada corporations was handled by someone in California writing checks. Surely you would agree that would constitute doing business in California, since a key component of the administration of the Nevada corporation was carried out in CA.

Even more extreme, what if all of the accounting was done in California. In essence, you then have the accounting division of the corporation operating in California.

The California take is that ANY transaction is sufficient. This has the benefit of being very clear, although as you note, it can be a bit daunting and seem unfair for extremely rare occurrences. Any other simple rule would seem to be problematic in one way or another. And the alternative would be to have some type of multi-factor or even worse a subjective rule for making the determination.

Flextronics, a major multinational corporation, does all of its accounts payable accounting in India. All checks and wires are initiated from India.

Does that make Flextronics an Indian corporation?

Well, I can see two scenarios for this:

(1) Flextronics has their own employees in India who do the accounting.

In that case, Flextronics is not an Indian corporation, but they are certainly "doing business in India" and I would expect that there could be tax consequences because of their Indian employees.

Similarly, "doing business" in California doesn't make the corporation a California corporation, since that is presumably governed by where the corporation is incorporated. But it can subject the corporation to taxes, even though it isn't a California corporation.

(2) Flextronics contracts out payroll support to an Indian corporation.

In that case Flextronics is also not an Indian corporation, and I would expect them not to have any direct tax consequences because of this. The Indian corporation with the contract, would, however.

If I'm not mistaken, the franchise tax and corporate tax are the same thing. The actual corporate tax is the larger of $800 and 8.84% of taxable income for C corporations, or the larger of $800 or 1.5% of taxable income for S corporations.

Disagree. If the someone in California was not affiliated with the company but rather a contractor or corporation, then it has nothing to do with your Nevada corporation. But if they are your employee, then yes, your company is now a Nevada corporation doing business in California. Think about it. Say I find a company online that processes W-2, now I have to look to see where they're located before I decide to go with them?

What if you send your receipts and such to a third party who happens to be located in CA? A lot of tax preparers do book-keeping work too. Surely, because you're entirely in NV, and you use the services of someone in CA, I don't think CA corporation taxes are due.

I think only if it's an transaction by an employee, or 5% owner of the corporation. Or that's what common sense tells me.

I seem to recall that New York was trying to do something like that with respect to sales tax. They were trying to charge sales tax to Amazon.com, as I recall, even though Amazon's only contact with NY was that some books were shipped to them from independent publishers or warehouses in the state.

Um, no. Amazon collects sales tax on sales to NY.

You may have been thinking of North Carolina, which asked for Amazon's sales records for stuff shipped to NC so they could check tax compliance. Sales tax is different from franchise tax, and is due on anything sold in or delivered to a state. The question is only about who has to collect it, since in practical terms it's difficult to collect it later if the vendor doesn't at the time of sale.

R's, John

Don't know what the right answer is (I only ask questions :) ), but this does sound unreasonable.

If a company has 100,000 employees, makes a billion dollar profit and has one employee in CA doing something for them, do they have to pay taxes on their billion dollar profit to CA? Sounds unreasonable, but may be that's the law.

I guess this is why companies probably have things like separate wholly owned subsidiaries?

-Antony

So imagine your Nevada corporation has three shareholders, located in California and two other states that also have similar rules about when a corporation needs to pay tax in their state. Imagine that all three shareholders have signing authority for checks on the Nevada bank account. Can it be the case that a corporation needs to pay income tax to three different states simultaneously, simply because three shareholders wrote checks in three states?

You would hope there would be some kind of "substantial presence" test to decide about when - and how much of the corporations income - is subject to a state income tax.

Remember there is an apportionment formula -- number of employees in state X divided by total number of employees, plus a real estate ratio, plus a sales ratio. If there is a ratio for time worked in state X divided by total time worked, then you're all set, because the time worked in other states is negligible. So what I'm saying is that apportionment formulas save you from over-taxation. But the CA apportionment formula does not appear to take time worked into account.