BILL ANALYSIS Ó SENATE GOVERNANCE & FINANCE COMMITTEE Senator Lois Wolk, Chair BILL NO: AB 1143 HEARING: 6/5/13 AUTHOR: Skinner FISCAL: Yes VERSION: 4/22/13 TAX LEVY: No CONSULTANT: Grinnell TAX ADMINISTRATION: SUSPENSION OR FORFEITURE: LIMITED LIABILITY COMPANIES Applies contract voidability law that applies to foreign corporation to foreign LLCs. Background and Existing Law Corporations in California form by filing articles of incorporation with the Secretary of State. Before transacting intrastate business in California, a corporation formed elsewhere must first qualify and register with the California Secretary of State. A foreign business entity can also qualify and register to transact business in California by filing the appropriate forms with the California Secretary of State. California law requires corporations and limited liability companies to update the records of the California Secretary of State on an annual or biennial basis by filing a statement. Franchise Tax Board (FTB) or the Secretary of State can suspend a corporation for: Failure to pay an amount due, Failure to file a statement of information with the Secretary of State's office, or Failure to file any past due returns. A suspended or forfeited business entity loses the right to enforce its legal contracts, known as "contract voidability." The counterparty to a contract with a suspended entity may seek to void the contract by filing suit against the suspended corporation. If a business enters a contract while suspended or forfeited, and then revives its active legal status, the business still cannot enforce that contract unless it gets relief from contract voidability by applying to FTB. Contract voidability is only found in state law; federal law does not allow for it. AB 1143 - 4/22/13 -- Page 2 A limited liability company (LLC) is a hybrid between a corporation and a partnership. LLCs are generally a partnership for operational and taxation purposes, although California imposes a specific fee on LLCs, but its members enjoy the immunity provided by a corporation to its shareholders for contract debts or tort liability. The interest of a member in an LLC is an economic interest, in the same manner that a partnership interest or a corporate share is an economic interest, that may be transferred under terms and conditions provided by the LLC agreement, the partnership agreement, or the corporate structure. California first recognized LLCs in 1994 with the enactment of the Beverly-Killea Limited Liability Company Act which provided comprehensive provisions for the organization, management, and dissolution of LLCs (SB 469, Beverly, 1994). Foreign corporations are subject to contract voidability: if they have an FTB account number contract voidability commences within 60 days of FTB mailing a final notice, if not, it begins on the first day of the taxable year in which the foreign corporation failed to file a return. However, foreign LLCs are not subject to contract voidability at all. Proposed Law Assembly Bill 1143 adds foreign limited liability companies onto the list of corporations that are subject to contract voidability, and specifies that it commences identically to current treatment of foreign corporations. The measure also makes a technical and conforming change. State Revenue Impact According to FTB, AB 1143 results in revenue increases of $50,000 in 2013-14, $30,000 in 2014-15, and $50,000 in 2015-16. Comments AB 1143 - 4/22/13 -- Page 3 1. Purpose of the bill . According to the author, "In 1994, the Legislature authorized the formation of limited liability companies (LLCs) in California by enacting the Beverly-Killea Limited Liability Company Act. LLCs organized within California are required to register with the Secretary of State (SOS) and to pay taxes to the Franchise Tax Board (FTB). Out-of-state LLCs who do business in California are supposed to register with the SOS and pay taxes to the FTB. However, out-of-state LLCs do not always register with the SOS and do not always pay taxes to the FTB. In these cases, the penalties for not paying taxes cannot be enforced because of a loophole in the law. AB 1143 would close this loophole. Companies organized within California are termed "domestic," while companies organized beyond California are termed "foreign." Companies that are registered with the SOS are termed "qualified," while companies that are not registered with the SOS are termed "nonqualified." All domestic LLCs are qualified, but not all foreign LLCs are qualified, though they are supposed to be. Foreign nonqualified LLCs can still pay taxes to the FTB even if they are not registered with the SOS, but not all of them do. When domestic and foreign qualified LLCs fail to pay taxes, penalties, fees, or interest, or when they fail to file required tax returns, they are subject to "contract voidability." When an entity is subject to contract voidability, any contract entered into may be voided by another party to the contract, which is a significant penalty for any business. While domestic and foreign qualified LLCs are subject to this penalty, foreign nonqualified LLCs were inadvertently not included. This contract voidability penalty is also applied to all corporations under the same tax situations. Contract voidability even applies to foreign nonqualified corporations. In fact, foreign nonqualified LLCs are the only group of LLCs or corporations that is excluded from the contract voidability penalty. The law does not treat foreign nonqualified LLCs in the same manner as it treats other LLCs and corporations in regards to contract voidability, resulting in inequitable treatment between similarly situated business entities." 2. Equity . AB 1143 advances horizontal equity by applying the same rules of contract voidability to foreign LLCs that currently apply to foreign C-Corporations. Horizontal equity is one of the key values of any tax system: AB 1143 - 4/22/13 -- Page 4 taxpayers with the same amount of income should pay the same tax, and be subject to the same rules. Without horizontal equity, tax systems distort economic decisions as taxpayers make different decisions that they would have to take advantage of differences. When California created LLCs in 1994, the Legislature was concerned that taxpayers would choose to form them instead of C-Corporations because of tax and corporate reasons, and imposed a fee on LLCs that sought to equalize the tax difference. While the Legislature subsequently abandoned horizontal equity for LLCs when it changed the fee to eliminate this equalization, taxpayers are choosing the LLCs form instead of C-Corporations: LLCs have grown in number from 26,186 in 2000-01 to 75,018 in 2012-13, and while S-Corporations have also grown, fewer C-Corporations file returns today than they did in 2000, suggesting that the California Corporation Tax lacks horizontal equity as taxpayers find an advantage in forming LLCs. 3. Urgency . AB 1143 is an urgency measure that takes effect immediately. As such, Legislative Counsel has assigned the measure the 2/3 vote key under Section 8(d) or Article IV of the California Constitution. Assembly Actions Assembly Revenue and Taxation8-0 Assembly Appropriations 17-0 Assembly Floor 73-0 AB 1143 - 4/22/13 -- Page 5 Support and Opposition (05/30/13) Support : Franchise Tax Board, California Federation of Teachers, California Tax Reform Association, SEIU California. Opposition : None received.