BILL ANALYSIS Senate Committee on Labor and Industrial Relations Mark DeSaulnier, Chair Date of Hearing: April 14, 2010 2009-2010 Regular Session Consultant: Gideon L. Baum Fiscal: Yes Urgency: No Bill No: SB 1244 Author: Walters Version: As Amended April 5, 2010 SUBJECT Employment: taxes and contributions: limited liability company. KEY ISSUE Should the Legislature conform the Unemployment Insurance Code to existing federal regulations on Limited Liability Companies (LLCs)? PURPOSE To conform Unemployment Insurance Code to federal regulations on Limited Liability Companies (LLCs) so LLCs may offset federal unemployment insurance tax (FUTA) costs. ANALYSIS Existing law defines, for the purposes of Unemployment Insurance taxation, an employer as an employing unit, which for some portion of a day, has within the current calendar year or had within the preceding calendar year employed one or more employees and pays wages for employment in excess of one hundred dollars ($100) during any calendar quarter. Existing law requires employer contributions to the Unemployment Fund shall accrue and become payable by every employer for each calendar year with respect to wages paid for employment. The contributions cannot be deducted in whole or in part from the wages of individuals in his employ. Existing law defines wages, for the purposes of Unemployment Insurance taxation, as all remuneration payable to an employee for personal services, whether by private agreement or consent or by force of statute, including commissions and bonuses, and the reasonable cash value of all remuneration payable to an employee in any medium other than cash. This bill would treat "reasonable compensation" paid to a managing member of a limited liability company or "S" corporation as wages for the purposes of unemployment insurance taxation. This bill would exclude guaranteed payments to non-managing members of a limited liability company or "S" corporation as wages for the purposes of unemployment insurance taxation. COMMENTS 1. Need for this bill? The unemployment insurance system is a hybrid federal-state system, both in terms of policy and administrative statutes and regulations, as well as in taxation structure. This bill seeks to conform the state's unemployment tax structure to federal regulations from 1997 which allowed business entities to classify themselves as corporate or non-corporate entities for tax purposes. This regulatory change was primarily done to clarify tax law surrounding limited liability companies (LLCs). Limited liability companies are a business structure that combines elements of partnerships and corporate business structures. The LLC is well structured for single owner business entities, and, as the name suggests, serves to limit liability. From a federal taxation perspective, LLCs are treated as pass-through or "disregarded entities" - a single owner would treat profits as their own income, or multiple owners would file as a partnership, but the LLC itself does not file taxes. Hearing Date: April 14, 2010 SB 1244 Consultant: Gideon L. Baum Page 2 Senate Committee on Labor and Industrial Relations Instead, an LLC elects how they wish to be taxed with the IRS by depending on the ownership structure in place. One of these possible elections is as an "S" corporation. An "S" corporation can have 1-100 shareholders, and all profits and losses are passed on directly to these individuals. With both "S" corporations and LLCs, the Internal Revenue Service (IRS) requires that a "reasonable compensation" be paid to all shareholders - the assumption is that no one works for free. From a state unemployment insurance taxation perspective, all of the above is basically inapplicable. Current unemployment taxation law does not address the existence of LLCs directly, and therefore does not deal with "S" corporations. Due to existing law, the Employment Development Department is not able to view an LLC as a corporation. Therefore, they are not an employer, and therefore they do not have employees, and therefore they do not pay unemployment insurance taxes. This can pose significant challenges for LLCs, as this opens them up to full federal unemployment insurance tax (FUTA) liability, whereas in other states LLCs are able to offset FUTA liability through the payment of their state unemployment insurance taxes. Most business accounting software assumes that such an offset occurs, also placing California's LLCs in a difficult position. NOTE: SB 1244 has been double-referred to the committee on Revenue and Taxation. 2. Questions for the Committee to Consider: In communications between the author's office and the Committee, the author's office has made a commitment to continue to work with the Employment Development Department (EDD) and the Committee to clarify and strengthen the technical provisions in the bill. While this is an ongoing process, the Committee may wish to seek additional clarity on the following issues: Hearing Date: April 14, 2010 SB 1244 Consultant: Gideon L. Baum Page 3 Senate Committee on Labor and Industrial Relations 1) Wages for Managing and non-Managing LLC and "S" Corporation Members: As currently written, compensation to managing members of a LLC or "S" corporation are counted as wages for the purposes of UI taxation, but not non-managing members. Why was this approach taken? What guarantees are there in the legislation to ensure the avoidance of a perverse outcome where managers are eligible for unemployment insurance benefits, but stockholder-employees are not? 2) "S" Corporations and LLCs: Since many "S" corporations are a taxation election by a LLC, it is unclear why addition mention of the "S" corporation is necessary. Why do "S" corporations need specific mention in Unemployment Insurance Code? 3) Defining "Reasonable Compensation": Currently, the unemployment insurance code does not contain a definition of "reasonable compensation" for LLCs and "S" corporations. While this is a commonly used term in the federal business tax world, this term in not defined in the bill and may need to be. 3. Committee Amendments: Currently, while SB 1244 defines the earnings of LLCs and "S" corporations' members as wages for the purposes of unemployment insurance taxation, it does not define members as "employees". Therefore, the Committee may wish to suggest an amendment to define an employee as "Any member of a limited liability company that is treated as a corporation for federal tax purposes." 4. Proponent Arguments : The sponsor of this measure believes that SB 1244 would Hearing Date: April 14, 2010 SB 1244 Consultant: Gideon L. Baum Page 4 Senate Committee on Labor and Industrial Relations conform Unemployment Insurance Code to existing federal regulations. The sponsor notes that this was done in 1997 and 1998 with the Revenue and Taxation Code and the Corporations Code. The sponsor believes that this will improve the business climate for LLCs and "S" corporations, and make their tax filings simpler. 5. Opponent Arguments : None received. 6. Prior Legislation : AB 1704 (Leach), Statutes of 1998, Chapter 243, conformed the Corporations Code to federal regulations regarding Limited Liability Companies. SB 1234 (Alpert), Statutes of 1997, Chapter 608, conformed Revenue and Taxation Code to federal regulations regarding Limited Liability Companies. SUPPORT California Society of Enrolled Agents OPPOSITION None received. * * * Hearing Date: April 14, 2010 SB 1244 Consultant: Gideon L. Baum Page 5 Senate Committee on Labor and Industrial Relations