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