BILL ANALYSIS Ó AB 612 Page A 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. AB 612 Page B 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 AB 612 Page C 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: AB 612 Page D 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). AB 612 Page E 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 AB 612 Page F 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 AB 612 Page G 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.) AB 612 Page H 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, AB 612 Page I 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 AB 612 Page J 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 AB 612 Page K 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, AB 612 Page L 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 AB 612 Page M 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