BILL ANALYSIS Ó
SENATE GOVERNANCE & FINANCE COMMITTEE
Senator Lois Wolk, Chair
BILL NO: SB 556 HEARING: 5/18/11
AUTHOR: Gaines FISCAL: Yes
VERSION: 5/11/11 TAX LEVY: Yes
CONSULTANT: Grinnell
Federal Conformity: CREATING Small Business Jobs Act of
2010
Provides a 100% income exclusion for qualified small
business stock acquired in 2011.
Background and Existing Law
Existing federal and state laws provide that gross income
includes all income, from whatever source derived,
including compensation for services, business income, gains
from property, interest, dividends, rents, and royalties
unless specifically excluded. Exclusions are generally
enacted to change behavior, encourage growth in the
economy, or for other stated policy objectives. California
typically conforms to federal law for exclusions to gross
income for ease of administration.
Federal law excludes from income for personal income tax
purposes fifty percent of the gain on qualified small
business stock acquired at issue and held for five years,
up to ten times the stock's basis or $10 million, whichever
is less. To qualify investors for the exclusion, the gross
assets of the corporation cannot exceed $50 million, and
must meet certain active trade and business requirements.
The maximum tax rate on any remaining gain is 28% under
the income tax, and under the alternative minimum tax,
which would normally apply a higher rate.
The American Recovery and Reinvestment Act, enacted in
March, 2009, increased the exclusion to 75%. The Small
Business Jobs Act, enacted in June, 2010, hiked the
exclusion to 100% for qualified small business stock
acquired between September 27, 2010 and January 1, 2011,
and the Tax Relief, Unemployment Insurance Reauthorization,
and Job Creation Act, enacted in December, 2010, extended
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the exclusion on stock purchased until December 31, 2011.
State law provides its own personal income tax exclusion
for qualified small business stock that largely mirrors
federal law (SB 671, Alquist, 1993). Taxpayers may exclude
the capital gain up to the lesser of ten times the stock's
basis, or $10 million, issued by any corporation:
With total assets of $50 million or less, and
Has 80% of its payroll in California, and
Uses at least 80% of its assets in the active
conduct of one or more qualified trades or businesses.
California does not apply a differential rate to gains
above that amount, as California taxes all income at the
same rate regardless of source. However, California does
provide a similar AMT preference than federal law, taxing
the gain at a maximum of 7%. California does not
automatically conform to federal changes in the exclusion,
and does not conform to IRS regulations it issues for the
exclusion.
Proposed Law
Senate Bill 560 increases the income exclusion for
qualified small business stock from 50% of the gain to 100%
for stock acquired during the 2011 year only. The measure
maintains the preferential Alternative Minimum Tax rate.
State Revenue Impact
No estimate.
Comments
1. Purpose of the bill . According to the Author, "This
bill will stimulate small business investment and job
creation in California. Investments made into qualified
California small business during 2011, then held for five
years, will not be subject to California capital gains tax.
This bill closely conforms to existing federal tax law and
will provide investors with an incentive to put their
capital to work in our state."
2. The right tool for the job ? Providing an exclusion for
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the gain in qualified small business stock may sound like
it will bring more investment capital to small businesses,
but what evidence exists that it will lead to the promised
employment gains?
No clear data exists demonstrating the positive
effect of lower state tax rates, specific tax
benefits, or enhancements to state tax benefits on
state employment.
Should the measure result in equity finance that
would not exist but for the increased exclusion, firms
will not likely add employees unless demand for their
product or service grows. Nationally, corporate
profits are at all-time highs, federal corporate
income taxes at all-time lows, and stock market
valuations have roughly doubled in slightly over a
year, yet high unemployment rates persist.
Small businesses don't always access public equity
markets. Issuing stock means conceding ownership of
the business. Additionally, with the enactment of
Sarbanes-Oxley, and the benefit of interest expense
deductions, creditworthy firms increasingly use debt
finance such as credit cards and bank loans instead.
According to the National Venture Capital Association,
venture capital involvement is at its lowest both in
number and as a percentage of the whole in 2009 and
2010 than in any year since 1998-99.
The exclusion only applies to stock in
C-Corporations, when firms increasingly form as
Limited Liability Companies, which offer many of the
liability protections of the corporate model without
the entity level tax of 8.84% of apportioned net
income. The exclusion would also not apply to
businesses that are partnerships,
sole-proprietorships, or S-Corporations.
Additionally, investors are increasingly purchasing
assets, not stock, for tax reasons. In testimony
before Congress on March 3, 2011, Patricia Thompson of
the American Institute of Certified Public Accountants
stated that the recently increased federal exclusion
which SB 556 conforms to would not likely benefit
small businesses:
"The problem is that the majority of small
businesses are not conducted as C corporations.
They are operated as pass-through entities. In
addition, many buyers prefer to purchase the
assets of a company rather than the stock. If the
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assets of the company are sold, any portion of
the gain relating to capital assets would be
taxed at ordinary income tax rates which would be
a maximum of 35%. The corporation would be
liquidated and no additional tax would be due if
the conditions relating to this provision were
met. If those same assets were sold by a
pass-through entity, the gain relating to capital
assets would be taxed to the individual using
capital gain tax rates, currently 15%. The result
of the sale of the assets would increase the tax
liability by 20% by taking advantage of the gain
exclusion provision."
The measure provides conformity to federal law for
the 2011 year. While conformity usually benefits
taxpayers and tax agencies alike, California rarely
conforms to federal credits and deductions for
economic development purposes because taxpayers are
more likely to act in response to federal incentives
because federal taxes are generally three times
higher. Conforming state law to federal incentives
may make things easier for taxpayers, but it functions
as a costly reward for taxpayers that would have done
the same without the state tax change.
The Committee may wish to consider whether this bill will
have the intended consequences or if it will only be a
monetary benefit without the promised employment gains.
3. Of breadboxes and elephants . Tax law distinguishes
small businesses from larger ones in different ways. The
qualified small business stock exclusion is based on the
federal standard of $50 million in assets. However, the
Legislature has provided smaller exclusions when it's
enacted statutes differentiating small from large. When
the Legislature provided a small business exclusion from
the 2008 and 2009 taxable years net operating loss (NOL)
suspension, it defined small businesses as those with less
than $500,000 in net business income. When it again
suspended NOLs for the 2010 and 2011 taxable years, it
redefined small businesses as those with $300,000 of
"modified adjusted gross income" for personal income
taxpayers and "pre-apportioned income" for corporate
taxpayers. Additionally, the Sales and Use Tax Law
requires firms with $17,000 in monthly sales to prepay
taxes. Are firms with $50 million in assets truly "small"
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businesses, especially given definitions in other areas?
The Committee may wish to consider whether the existing
definition accurately targets the firms it wants to
benefit.
4. Timing is everything . Congress increased the exclusion
to 100% for stock acquired in 2011, it did so in December,
2010, hoping to spur investors to provide equity finance in
the forthcoming year. However, most of the year will have
passed by the time SB 556 is enacted, dulling most of any
possible incentive effect, functioning more as a reward for
investments already made. The Committee may wish to
consider whether SB 556 is worth its cost given its awkward
timing.
Support and Opposition (5/12/11)
Support : California Taxpayers' Association.
Opposition : Unknown.