BILL ANALYSIS                                                                                                                                                                                                    Ó






                                                                     AB 612


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          Date of Hearing:  May 4, 2015





                     ASSEMBLY COMMITTEE ON REVENUE AND TAXATION


                                 Philip Ting, Chair





          AB 612  
          (Patterson) - As Amended March 12, 2015





          Majority vote.  Fiscal committee.  Tax levy. 


          SUBJECT:  Minimum franchise tax:  annual tax:  small business


          SUMMARY:  Reduces the minimum franchise tax to $400 in the  
          second taxable year for a new corporation, and reduces the  
          annual tax in the first taxable year for a new limited  
          partnership (LP), new limited liability partnership (LLP), and  
          new limited liability company (LLC) that is a small business.   
          Specifically, this bill:


          1)Provides, beginning on or after January 1, 2016, that every  
            new LP, LLC, and LLP defined as a small business shall pay an  
            annual tax of $400 for its first taxable year.











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          2)Provides, beginning on or after January 1, 2016, that every  
            new corporation defined as a small business shall pay a  
            minimum franchise tax of $400 for its second taxable year.

          3)Defines a "small business" as an LP or LLP that has gross  
            receipts, less returns and allowances, reportable to this  
            state for the taxable year of $5,000 or less. 

          4)Defines a "small business" as a corporation or an LLC that  
            reasonably estimates that it will have gross receipts, less  
            returns and allowances, reportable to this state for the  
            taxable year of $5,000 or less.

          5)Defines "gross receipts, less returns and allowances  
            reportable to this state" as, the sum of the gross receipts  
            from the production of business income, and the gross receipts  
            from the production of nonbusiness income. 

          6)Defines a "new LP" as, an LP that on or after January 1, 2016,  
            is organized under the laws of this state or has qualified to  
            transact intrastate business in this state that begins  
            business operations at or after the time of its organization.   
            A "new LP" does not include any LP that began business  
            operations as, or acquired its business operations from, a  
            sole proprietorship, a LLP, or any other form of business  
            entity prior to its organization.  This reduction in the  
            annual tax shall not apply to any LP that reorganizes solely  
            for the purpose of reducing its annual tax.

          7)Defines a "new LLC" as, an LLC that on or after January 1,  
            2016, is organized under the laws of this state or has  
            qualified to transact intrastate business in this state that  
            begins business operations at or after the time of its  
            organization.  A "new LLC" does not include any limited  
            liability company that began business operations as, or  
            acquired its business operations from, a sole proprietorship,  
            a limited liability company or any other form of business  
            entity prior to its organization. This reduction in the annual  











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            tax shall not apply to any LLC that reorganizes solely for the  
            purpose of reducing its annual tax.

          8)Defines a "new LLP" as, an LLP that on or after January 1,  
            2016, is organized under the laws of this state or has  
            qualified to transact intrastate business in this state that  
            begins business operations at or after the time of its  
            organization.  A "new LLP" does not include any limited  
            liability partnership that began business operations as, or  
            acquired its business operations from, a sole proprietorship,  
            a limited liability partnership, or any other form of business  
            entity prior to its organization.  This reduction in the  
            annual tax shall not apply to any LP that reorganizes solely  
            for the purpose of reducing its annual tax.

          9)Defines a "new corporation" as, a corporation that on or after  
            January 1, 2016, is incorporated under the laws of this state  
            or has qualified to transact intrastate business in this state  
            that begins business operations at or after the time of its  
            incorporation. "New corporation" does not include any  
            corporation that began business operations as, or acquired its  
            business operations from, a sole proprietorship, a corporation  
            or any other form of business entity prior to its  
            incorporation.  This reduction in the minimum franchise tax  
            shall not apply to any corporation that reorganizes solely for  
            the purpose of avoiding payment of its minimum franchise tax.

          10)Provides that reduction in the annual and minimum franchise  
            tax shall apply to corporations, LPs, LLCs, or LLPs only if  
            they file a timely return.

          11)Provides that if the LLC or corporation's gross receipts  
            exceed $5,000, an additional tax in the amount equal to $400  
            shall be paid on the due date of its return for the taxable  
            year, without regard to extension.

          12)Takes effect immediately as a tax levy.

          EXISTING LAW:











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          1)Imposes franchise tax on all corporations doing business in  
            California equal to 8.84% of the taxable income attributable  
            to California.  A minimum franchise tax of $800 is imposed on  
            all corporations that are incorporated under the laws of  
            California, qualified to transact intrastate business in  
            California, or are doing business in California.  Taxpayers  
            must pay the minimum franchise tax only if it is more than  
            their regular franchise tax liability.<1>  

          2)Provides exceptions with respect to imposition of the minimum  
            franchise tax.  For instance, credit unions and nonprofit  
            organizations are not subject to the minimum franchise tax and  
            a corporation is not subject to the minimum franchise tax for  
            its first taxable year.  However, even though a corporation is  
            not subject to the minimum tax in its first taxable year, it  
            will be subject to franchise tax in its first taxable year  
            based on its taxable income.

          3)Provides that LPs, LLPs, and LLCs that are doing business in  
            California, registered or qualified to do business in  
            California, or formed in this state, are subject to annual tax  
            in an amount equal to the minimum franchise tax, currently set  
            at $800.  These entities (known as 'pass-through entities')  
            are not subject to any tax based on taxable income.  Rather,  
            the items of income, gain, loss, deduction and credit are  
            passed-through to the owners and reported on their respective  
            income or franchise tax returns.

          4)Provides that real estate mortgage investment conduits  
            (REMICs) and financial asset securitization investment trusts  
            (FASITs) are subject to and are required to pay the minimum  
            franchise tax.  Regulated investment companies (RICs) and real  
          ---------------------------
          <1> According to the Franchise Tax Board (FTB), for taxable  
          years beginning on or after January 1, 1997, only taxpayers with  
          net incomes of less than approximately $9,040 pay the minimum  
          franchise tax because the amount of measured tax owed would be  
          less than $800 ($9,039 x 8.84% = $799).










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            estate investment trusts (REITs) organized as corporations are  
            also subject to and are required to pay the minimum franchise  
            tax.  RICs, REITs, REMICs, and FASITs are entities authorized  
            by the federal government for special tax treatment.   
            California conforms in large part to federal tax provisions  
            but subjects each entity to payment of the annual minimum tax.

          5)Provides that LLCs and certain small corporations, solely  
            owned by a deployed member of the United States (U.S.) Armed  
            Forces, are exempted until January 1, 2018 from the $800  
            annual tax and minimum franchise tax

          FISCAL EFFECT:  The FTB estimates that this bill would reduce  
          the General Fund by $4 million in the fiscal year (FY) 2015-16,  
          $9.8 million in FY 2016-17, and $13 million in FY 2017-18.  


          COMMENTS: 


           1)Author's Statement  :  The author has provided the following  
            statement in support of this bill:



          California is consistently ranked as one of the worst states in  
            which to do business. Since 2012, the Tax Foundation has  
            ranked California as one of the worst states for taxes, and  
            publications such as Chief Executive Magazine  have named  
            California the most unfriendly state towards business for the  
            past four years running, citing the state's high taxes and  
            burdensome regulations on business as the main factor for this  
            ranking. Forbes magazine cites the cost of doing business in  
            California as 10.2% higher than the average cost of doing  
            business in other states. California's current regulatory and  
            tax environment is not friendly to small business growth,  
            which is an important factor in job creation. 

          "Current tax policy requires businesses in California to pay a  











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            minimum franchise tax of $800 even if they operate at a loss  
            for the fiscal year. By penalizing businesses $800 annually  
            simply for existing, the state discourages business investment  
            and can make it difficult for newly formed small businesses to  
            be able to afford to do business as they establish themselves  
            in the market. Reducing the minimum franchise tax to $400 for  
            the first year of operation for small partnerships, LLCs, and  
            LLPs and for the second year of a corporation's existence will  
            help to relieve the tax burden placed upon newly formed small  
            businesses, allowing them to retrain more capital up front for  
            growth, as opposed to the prepayment of future tax liability. 

          "AB 612 will reduce the tax burden imposed upon newly formed  
            businesses in California during their critical start-up years  
            and is an important step in making California more  
            business-friendly. 
           2)Arguments in Support  : The National Federation of Independent  
            Business (NFIB) states, "[o]ne significant hurdle and  
            inhibitor for many entrepreneurs is the California minimum  
            franchise tax of $800 per year. Many individuals consider this  
            a game-ender, as they do not have the resources to pay that  
            amount to get their business going."  NFIB continues on to  
            say, "[s]mall business owners are willing to comply with and  
            pay the right taxes, abide by the right regulations and  
            requirements and permits, but these entrepreneurs first need  
            to know they have support and opportunity to open their doors.  
            AB 612 helps to show a good-faith effort by the State that  
            there is support of a growing and thriving 'Main Street' and  
            the opportunity to put more people to work. It is fair, sounds  
            policy that is a win-win for out state economy and those  
            wishing to pursue their entrepreneurial dreams." 


           3)Committee Staff Comments  :


              a)   Minimum Tax  :  The MFT, the AT, and annual fee were  
               enacted to ensure that all corporations and LLCs pay at  
               least a minimum amount of tax for the privilege of doing  











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               business in California, regardless of the businesses income  
               or loss.  The minimum tax is not a tax on income.  Rather,  
               it is a tax on the right for a corporation doing business  
               in California to exercise the powers granted to them.   
               Irrespective of whether a business generates taxable  
               income, it continues to receive the benefits of its  
               corporate status, namely limited liability protection.   
               Requiring corporations to pay the MFT or AT, regardless if  
               the entity generates taxable income, is not a penalty but  
               rather a payment made in exchange for the benefit of  
               limited liability and the right to exercise corporate  
               powers.  If paying either the MFT or the AT is overly  
               burdensome, there is always the alternative of establishing  
               a sole proprietorship or general partnership.  However,  
               whereas both entities are not liable for either tax, they  
               are also ineligible to receive the benefits of limited  
               liability.


              b)   Small Businesses in California .  According to the U.S.  
               Small Business Administration 2014 report, in 2012  
               California's small businesses employed 6.5 million of the  
               state's private workforce.  In 2012, small businesses in  
               California created 271,515 net new jobs.  Additionally,  
               California's private-sector employment growth increased by  
               2.6% by the end of October 2014, whereas the national  
               average was 2.3%.  In 2010, 59,314 businesses opened in  
               California.  Of those businesses, 67.7% remained in  
               business through 2012.  In 2013, 109,395 opened in  
               California.  Of those businesses, 79.4% remained in  
               business through 2014.  According to the U.S. Department of  
               Labor, 62,938 new businesses opened in the first quarter of  
               2014, whereas 58,205 closed in California.  However,  
               businesses filing bankruptcies have declined during the  
               periods from 2010 to 2014, implying a healthier state  
               economy.  (U.S. Small Business Administration, Office of  
               Advocacy. California Small Business Profile. 2015.) 













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              c)   Is the MFT or AT the Problem  ?  According to Forbes.com,  
               the top five reasons why small business fail is because  
               business owners:  (a) did not know what their customers  
               wanted/thought, (b) lacked a unique proposition, (c) failed  
               to communicate that propositions appropriately, (d) lacked  
               leadership ability/management skills, and (e) lacked a  
               sufficient/proven business model.  (Eric T. Wagner. Five  
               Reasons 8 out of 10 Businesses Fail. Forbes. 2015.)   
               Whereas state taxes and regulations may make it more  
               difficult for a new business owner to enter into the  
               market, generally they are not a major cause for business  
               failure.  Additionally, according to an article published  
               by the Consumer News and Business Channel (CNBC), the 11  
               most common reasons why small businesses fail are:  (a)  
               lack of funding, (b) overconfidence, (c) poor pricing  
               strategy, (d) dueling partners, (e) burnout, (f) stale  
               marketing message, (g) failure to join the digital  
               revolution, (h) cybertheft, (i) underestimating the  
               competition, (j) overreliance on one customer, and (k)  
               disgruntled employees.  (Peter Dazeley. 11 Common Reasons  
               Small Businesses Fail. CNBC. 2015.)  Therefore, it would  
               behoove the state to focus on these concerns if it wants to  
               encourage new businesses and their success.  


              d)   Supply-Side Economics  :  Generally, advocates for tax  
               incentives, such as Arthur Laffer and N. Gregory Mankiw,  
               argue that reduced taxes allow taxpayers to invest money  
               that would otherwise be paid in taxes, thereby creating  
               additional economic activity.  "Supply-siders" posit that  
               higher taxes do not result in more government revenue;  
               instead, they suppress additional innovation and investment  
               that would have led to more economic activity and,  
               therefore, healthier public treasuries, under lower  
               marginal tax rates.  Critics, however, assert that tax  
               incentives rarely result in additional economic activity.   
               Companies conduct business in California because of its  
               competitive advantages, namely its environment;  
               transportation infrastructure; access to ports, highways,  











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               and railroads; as well as its highly skilled workforce and  
               world-class higher education system.  $800 is a nominal  
               amount in light of the benefits that are conferred.  


              e)   LLCs  :  For most of American history, business owners had  
               a choice of either a partnership or a corporation.   
               Relatively recently, however, the LLC business structure  
               has become one of the most popular choices for starting a  
               new business because it provides owners with the limited  
               liability of "C" corporations and the flow through tax  
               status of partnerships.  In 2007, formation of LLCs in the  
               U.S. outpaced the number of corporations by a margin of  
               two-to-one.  As a result, the number of new partnerships,  
               although difficult to track, has also substantially  
               decreased.  According to Professor Howard Freidman, the  
               general partnership can easily be replaced by an LLC,  
               providing the informal benefits of a partnership along with  
               limited liability.  General partnerships that exists today  
               are either those that exist from the pre-LLC days or are  
               informal agreements that by default fall within the Uniform  
               Partnership Act.  Professor Howard Freidman went on to say  
               that "[t]he once-elaborately drafted partnership agreement  
               has gone the way of the buggy whip and slide rule.  It has  
               been replaced by the LLC operating agreement."  (Rodney D.  
               Chrisman, LLCs are the New King of the Hill, Fordham  
               Journal of Corporate and Financial Law, Vol. 15, Issue 2,  
               2009.)



             In general, LLCs provide limited liability, avoidance of  
               double taxation, flexibility of income distribution,  
               simplicity of formation and procedures, and no restrictions  
               on ownership.  For a small business owner who has never  
               considered forming as a "C" corporation, the major benefit  
               of an LLC is the limited liability.  Generally, members of  
               the LLC are not liable for the debts, liabilities, or  
               obligations of the firm.  (Jonathan Macey, The Limited  











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               Liability Company: Lessons for Corporate Law, Washington  
               University Law Review, Vol. 73, Issue 2, 1995.)  The goal  
               of providing limited liability appears to be the state's  
               need to promote investment by transferring risk from  
               investors to creditors.  (David Millon, Piercing the  
               Corporate Veil, Financial Responsibility, and the Limits of  
               Limited Liability, Emory Law Journal, Vol. 65, Number 5,  
               2007.)  Therefore, LLCs and other limited liability  
               structures provide a substantial benefit to entrepreneurs  
               at a nominal cost of $800 per year, even when their  
               businesses are insolvent or operating at a loss.
              f)   How is a tax expenditure different from a direct  
               expenditure  :  As the Department of Finance notes in its AT  
               Expenditure Report, there are several key differences  
               between tax expenditures and direct expenditures.  First,  
               once they are put in place, tax expenditures are reviewed  
               less frequently than direct expenditures.  Although this  
               creates greater certainty for taxpayers regarding the  
               applicable tax laws (because the tax expenditure will  
               remain on the books for longer periods of time), it may  
               also result in arbitrary tax expenditures that do not serve  
               a public benefit.  Second, there is generally no control  
               over the amount of revenue losses associated with any given  
               tax expenditure.  Finally, it should also be noted that  
               once enacted it takes a two-thirds vote to rescind an  
               existing tax expenditure absent a sunset date.  For this  
               reason, the author may wish to include a five-year sunset  
               date for this deduction, to provide the opportunity for  
               future legislative review.


           4)Prior Legislation  :  


             a)   AB 1889 (Hagman), of the 2013-14 Legislative Session,  
               would have reduced the minimum franchise tax to $400 for a  
               new corporation in the second taxable year, and reduces the  
               annual tax to $400 for new LPs, new LLPs, and new LLCs  
               defined as small businesses in the first taxable year.  AB  











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               1889 was held on this Committee's Suspense File.  


             b)   AB 2086 (Calderon), of the 2013-14 Legislative Session,  
               would have allowed LLCs to pay the annual minimum tax, fee,  
               and estimated tax over time.  AB 2086 failed passage in the  
               Assembly Appropriations Committee. 


             c)   AB 2244 (Chau), of the 2013-14 Legislative Session,  
               would have reduced the minimum franchise tax to $200 for a  
               dormant business entity and to $50 for an inactive business  
               entity.  AB 2244 failed passage in the Assembly  
               Appropriations Committee. 


             d)   AB 2428 (Patterson), of the 2013-14 Legislative Session,  
               would have provided a deduction for income derived from a  
               qualified business, provides an exemption from the minimum  
               franchise tax, and extends the sunset date of the minimum  
               franchise tax for deployed armed forces.  AB 2428 was held  
               on this Committee's Suspense File. 


             e)   AB 2466 (Nestande), of the 2013-14 Legislative Session,  
               would have reduced the minimum tax for new veteran-owned  
               businesses and eliminate the tax if the business operates  
               at a loss or ceases operation.  AB 2466 failed passage in  
               the Assembly Appropriations Committee. 


             f)   AB 2495 (Melendez), of the 2013-14 Legislative Session,  
               would have exempt new qualifying corporations, LPs, LLPs,  
               and LLCs from the annual minimum tax for the first five  
               consecutive taxable years.  AB 2495 was held on this  
               Committee's Suspense File. 


             g)   AB 2671 (Cook), Chapter 394, Statutes of 2010, exempts,  











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               until 2010, certain small corporations and LLCs solely  
               owned by a deployed member of the U.S. Armed Forces from  
               the annual minimum franchise tax.


             h)   AB 327 (Garrick), of the 2009-10 Legislative Session,  
                  would have reduced the minimum franchise tax from $800 to  
               $100.  AB 237 was held on this Committee's Suspense File.


             i)   AB 2178 (Garrick), of the 2007-08 Legislative Session,  
               would have reduced the minimum franchise tax from $800 to  
               $200.  AB 2178 was held on this Committee's Suspense File. 


             j)   AB 1179 (Garrick), of the 2007-08 Legislative Session,  
               is similar to AB 327.  AB 1179 was held on this Committee's  
               Suspense File.   


             aa)  AB 1419 (Campbell), of the 1997-98 Legislative Session,  
               would have reduced the minimum franchise tax for a  
               qualified corporation from $800 to $100.  AB 1419 failed  
               passage in the Senate Revenue and Taxation Committee


          


          REGISTERED SUPPORT / OPPOSITION:




          Support


          Fresno Chamber of Commerce












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          National Federation of Independent Business 


          State Board of Equalization, 4th District, Board Member


          State Board of Equalization, 1st District, Vice Chair




          Opposition




          None on file




          Analysis Prepared by:Paul Kim / REV. & TAX. / (916) 319-2098