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

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            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

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                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

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            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