3.3 Federal & California Tax Obligations for Contractors
Key Takeaways
- Sole proprietorships and default single-member LLCs are pass-through entities taxed on the owner's personal return via Schedule C, with all net earnings subject to self-employment tax; electing S corporation tax treatment lets an owner split income into a reasonable salary (subject to payroll tax) and distributions (not subject to self-employment tax).
- Self-employment tax is 15.3% (12.4% Social Security plus 2.9% Medicare) on net self-employment earnings, applying the 12.4% Social Security portion only up to the annual wage base ($184,500 for 2026) while the 2.9% Medicare portion applies to all net earnings with no cap.
- Under California Code of Regulations Title 18, Regulation 1521, a C-20 contractor is generally the consumer of materials (ductwork, fittings, fasteners) that lose their identity when installed, paying tax on the purchase, but the retailer of fixtures (furnaces, air conditioning units, heat pumps) that remain identifiable after installation, owing tax on the fixture's selling price; labor charges are not taxable either way.
- California uses an uneven quarterly estimated tax schedule (30% / 40% / 0% / 30%) due April 15, June 15, September 15, and January 15, which differs from the IRS's equal 25%-per-quarter federal schedule due on the same four dates.
- California's Employment Development Department (EDD) administers four payroll taxes on employers: Unemployment Insurance (UI) and Employment Training Tax (ETT), both paid by the employer on the first $7,000 of each employee's wages; State Disability Insurance (SDI), withheld from employee wages with no wage cap; and California Personal Income Tax (PIT), withheld based on each employee's DE 4 form.
Business Entity Types and Federal Tax Treatment
Chapter 2 covers the licensing and legal differences between business entity types; this section focuses on how each type is taxed.
| Entity Type | How Federal Income Is Taxed | Self-Employment / Payroll Tax |
|---|---|---|
| Sole Proprietorship | Pass-through to owner's Form 1040, Schedule C | Owner pays SE tax on all net Schedule C profit |
| Single-Member LLC (default) | Disregarded entity; taxed the same as a sole proprietorship (Schedule C) | Owner pays SE tax on all net profit |
| Multi-Member LLC / Partnership (default) | Pass-through via Form 1065 and Schedule K-1 to each partner | Each general partner generally pays SE tax on their share |
| C Corporation | Taxed at the entity level at a flat 21% federal corporate rate; dividends are taxed again at the shareholder level ("double taxation") | Owner-employees pay payroll (FICA) tax on wages only, not SE tax |
| S Corporation (election) | Pass-through to owners via Form 1120-S and Schedule K-1; no entity-level federal income tax | Owner-employees pay payroll tax only on their reasonable salary; distributions above salary are not subject to SE or payroll tax |
A Limited Liability Company (LLC) is a state-law legal structure, not itself a federal tax classification — by default the IRS taxes a single-member LLC as a sole proprietorship and a multi-member LLC as a partnership, but an LLC can elect to be taxed as a C corporation or, if eligible, as an S corporation.
The S corp self-employment tax strategy: because only wages, not distributions, are subject to payroll tax for an S corp owner-employee, many contracting business owners elect S corp tax treatment once profits grow large enough to justify the added payroll and compliance costs — commonly cited as somewhere in the $50,000-$75,000-plus net profit range. The IRS requires the owner to pay themselves a reasonable salary for the services performed before taking any distributions; setting the salary artificially low to reduce payroll tax is a well-known audit trigger, and the IRS can reclassify distributions as wages and assess back payroll taxes and penalties.
California adds its own layer of entity-level tax on top of federal treatment: a C corporation pays California's 8.84% corporate franchise tax; an S corporation pays a 1.5% tax on net income (or the $800 minimum, whichever is greater); and virtually every corporation, LLC, and LP doing business in California owes the $800 minimum annual franchise tax regardless of profit. Corporations receive a first-year exemption from the $800 minimum, but LLCs formed in 2024 or later do not — the temporary LLC first-year exemption created by Assembly Bill 85 expired after tax year 2023.
Self-Employment Tax
Self-employment (SE) tax funds Social Security and Medicare for sole proprietors, single-member LLC owners, and general partners — the equivalent of the FICA tax that an employer and employee split for a W-2 worker. For 2026, the SE tax rate is 15.3%, made up of:
- 12.4% for Social Security, applied only to net self-employment earnings up to the annual Social Security wage base ($184,500 for 2026)
- 2.9% for Medicare, applied to all net self-employment earnings with no cap
A taxpayer with combined wages and self-employment income above $200,000 (single) or $250,000 (married filing jointly) also owes an Additional Medicare Tax of 0.9% on the excess. As a partial offset, a self-employed taxpayer may deduct half of their SE tax as an adjustment to income on Form 1040 (an "above-the-line" deduction), which reduces income tax but not SE tax itself.
California Sales and Use Tax: Materials vs. Fixtures
California's Sales and Use Tax Law (California Code of Regulations, Title 18, Regulation 1521) treats a construction contractor's tax obligation differently depending on what is being installed:
- Materials are items that lose their separate identity and become an integral part of the structure when installed — ductwork sections, sheet metal, fasteners, insulation, refrigerant line sets, and similar components. A contractor is generally treated as the consumer of materials: sales or use tax is owed on the contractor's purchase price when the materials are bought, and the contractor does not separately charge the customer sales tax on those materials (their cost is simply built into the contract price).
- Fixtures are items that remain identifiable as a distinct unit after installation and are considered accessories to the building. Regulation 1521's own list of examples specifically names furnaces, boilers, and heating units, as well as air conditioning and heating units, as fixtures. A contractor is generally treated as the retailer of fixtures: the contractor owes sales tax on the fixture's selling price and must hold a seller's permit from the California Department of Tax and Fee Administration (CDTFA) to purchase fixtures for resale (using a resale certificate) and then charge or self-assess tax when the fixture is installed.
- Labor charges — for both materials and fixtures — are not subject to sales tax, whether the job is billed lump-sum or time-and-materials, as long as labor is not itself being sold as tangible personal property.
In practice, this means a C-20 contractor installing a new furnace and a ductwork run is the retailer of the furnace (owing tax on its selling price) and the consumer of the ductwork and fittings (having already paid tax when purchasing them), with installation labor exempt either way. Contractors should register for a CDTFA seller's permit and track material versus fixture purchases separately to stay compliant; misclassifying a fixture as a material, or vice versa, is a common audit finding.
Estimated Quarterly Tax Payments
Business owners who don't have taxes withheld from a paycheck — including sole proprietors, partners, LLC members, and S corp shareholders on their distribution income — must generally pay estimated income tax quarterly to avoid an underpayment penalty.
Federal (IRS Form 1040-ES): four equal installments (25% each) due April 15, June 15, September 15, and January 15 of the following year. The standard safe harbor is paying at least 90% of the current year's tax liability or 100% of the prior year's liability (110% if the prior year's Adjusted Gross Income (AGI) exceeded $150,000).
California (FTB Form 540-ES): California does not use equal quarterly installments. Instead, the required percentages are front-loaded: 30% by April 15, 40% by June 15, 0% (no payment required) by September 15, and the remaining 30% by January 15. A contractor who assumes California follows the same even 25%-per-quarter pattern as the IRS can significantly underpay the June installment and miscalculate the intentionally $0 September installment.
EDD Payroll Tax Obligations
Any C-20 contractor with employees must register with California's Employment Development Department (EDD) and withhold or pay four payroll-related taxes:
| Tax | Who Pays | 2026 Rate / Wage Base |
|---|---|---|
| Unemployment Insurance (UI) | Employer | 1.5%-6.2% (experience-rated); new employers pay 3.4%; first $7,000 of each employee's wages |
| Employment Training Tax (ETT) | Employer | 0.1%; first $7,000 of each employee's wages |
| State Disability Insurance (SDI) | Employee (withheld by employer) | 1.3%; no wage cap |
| California Personal Income Tax (PIT) | Employee (withheld by employer) | Varies by employee's DE 4 withholding allowance certificate |
UI and ETT rates and wage bases can change; a contractor should always confirm the current-year rate on the EDD's own published tables rather than relying on a memorized figure from a prior year.
A sole proprietor's HVAC business earns $120,000 in net profit. If the owner instead elects S corporation tax treatment and pays themselves a reasonable salary of $70,000 while taking the remaining $50,000 as a distribution, what is the main federal tax advantage?
For 2026, what is the combined self-employment tax rate on net self-employment earnings up to the Social Security wage base?
Under California Regulation 1521, how is a C-20 contractor generally treated for sales and use tax purposes when installing a new residential furnace?
California's Franchise Tax Board (FTB) Form 540-ES estimated tax schedule requires what percentage of the total estimated tax to be paid with the September 15 installment?
Which California payroll tax, administered by the Employment Development Department (EDD), is withheld from employee wages with no annual wage cap?