BILL ANALYSIS Ó
AB 2544
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Date of Hearing: May 9, 2016
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Sebastian Ridley-Thomas, Chair
AB 2544
(Travis Allen) - As Introduced February 19, 2016
Majority vote. Tax levy. Fiscal committee.
SUBJECT: Income taxes: limited liability company: qualified
investment partnership
SUMMARY: Exempts a limited liability company (LLC) classified
as a qualified investment partnership (QIP) from the annual tax,
equal to the minimum franchise tax (MFT), and annual fee by
excluding QIPs from the definition of a LLC. Specifically, this
bill:
1)Provides that a LLC classified as a QIP is not subject to the
annual tax, equal to the MFT, and annual fee.
2)Defines a "QIP" as a LLC that meets all of the following
requirements:
a) It is classified as a partnership for California income
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tax purposes;
b) No less than 90% of the costs of its total assets
consist of "qualifying investment securities" (QIS),
deposits at banks or other financial institutions, interest
or investments in a partnership, or office space and
equipment reasonably necessary to carry on its activities
as a QIP; and,
c) No less than 90% of its gross income consists of
interest, dividends, and gains from the sale or exchange of
QIS or investments in a partnership.
3)Defines "QIS" as having the same meaning as the same term in
Revenue and Taxation Code (R&TC) Section 17955(c)(3)(A).
4)Requires a QIP with a federal partnership return filing
obligation to also file a state partnership return for the
taxable year.
5)Requires a QIP without a federal partnership return filing
obligation to file an information return for the taxable year.
6)Takes immediate effect as a tax levy.
EXISTING LAW:
1)Imposes franchise tax on all corporations doing business in
California equal to 8.84% of the taxable income attributable
to California.
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2)Requires a corporation incorporated in California, doing
business in California, or qualified to transact intrastate
business in California to pay a MFT of $800 if that amount
exceeds its regular franchise tax liability. However, credit
unions and nonprofit cooperative organizations are exempt from
MFT, as is a corporation in its first taxable year (although
it will be subject to franchise tax in its first taxable year
based on its taxable income).
3)Requires a limited partnership (LP), limited liability
partnership (LLP), or LLC doing business in California,
registered or qualified to do business in California, or
formed in California to pay an annual tax equal to the MFT for
the privilege of doing business in this state. The tax is due
until a certificate of cancellation is filed with the
Secretary of State. 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)Exempts a corporation or LLC from MFT or annual tax,
respectively, until January 1, 2018 in taxable years when the
corporation or LLC is a small business solely owned by a
deployed member of the United States Armed Forces and operates
at a loss or ceases operation.
5)Requires a LLC subject to the annual tax but not classified as
a corporation to also pay an annual fee based on total income
from all sources derived from or attributable to this state
for the taxable year. Total income is calculated as gross
income plus the cost of goods sold that are paid or incurred
in connection with the trade or business of the taxpayer, but
excludes income of a subsidiary LLC if it is also subject to
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the annual fee. The fee schedule is as follows:
a) $900 for total income of $250,000 or more but less than
$500,000;
b) $2,500 for total income of $500,000 or more but less
than $1 million;
c) $6,000 for total income of $1 million or more but less
than $5 million; and,
d) $11,790 for total income of $5 million or more.
6)Requires a real estate mortgage investment conduit (REMIC),
financial asset securitization investment trust (FASIT), and
if organized as a corporation, a regulated investment company
(RIC) and real estate investment trust (REIT), to pay the MFT.
7)Defines "QIS" as all of the following:
a) Common stock, including preferred or debt securities
convertible into common stock, and preferred stock;
b) Bonds, debentures, and other debt securities;
c) Foreign and domestic currency deposits or equivalents
and securities convertible into foreign securities;
d) Mortgage- or asset-backed securities secured by federal,
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state, or local governmental agencies;
e) Repurchase agreements and loan participations;
f) Foreign currency exchange contracts and forward and
futures contracts on foreign currencies;
g) Stock and bond index securities and futures contracts,
and other similar financial securities and futures
contracts on those securities;
h) Options for the purchase or sale of any of the
securities, currencies, contracts, or financial instruments
described in clauses (a) to (g), inclusive; or,
i) Regulated futures contracts.
8)Requires every partnership or LLC classified as a partnership
to file a return stating gross income and deductions. The
return should include the names, addresses, and taxpayer
identification numbers of partners entitled to share in the
partnership's net income, along with each partner's
distributive share. An LLC not doing business in California,
but registered with the SOS and subject to MFT, must file an
information return in a manner prescribed by the Franchise Tax
Board (FTB).
FISCAL EFFECT: The FTB estimates that this bill will result in
General Fund revenue losses of $1.7 million in fiscal year (FY)
2016-17, $1.8 million in FY 2017-18, and $1.9 million in FY
2018-19.
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COMMENTS:
1)Author's Statement : The author has provided the following
statement in support of this bill:
Innovation is the backbone to California's economy.
Silicon Valley is world renowned for its startup industry
and the ability of companies to think outside of the box to
create the next up and coming product that will change the
world around us as we know it. New innovation in
technology has gone into overdrive as the average cost
across the nation of starting new companies has dropped
from millions of dollars to less than $100,000. However,
as the cost of starting a company dropped, startups began
raising funds from smaller accredited investors who each
invest small amounts of capital.
The only effective way for a startup to accept this capital
is to pool the investors into a "Qualified Investment
Partnership" (QIP) that invests only in that startup. This
way, the startup can deal with a single QIP, rather than
many individual investors. The QIP also makes the startup
more attractive to investors who can now defer to the
partnership manager on major decisions, rather than
constantly getting involved in the business of the startup.
AB 2544 simply seeks to incentivize the creation of QIPs
in California to ensure that our small businesses have all
the tools available to them to succeed.
2)Arguments in Support : Proponents of this bill state the
following:
California has a franchise tax of $800 per year if an
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entity is defined as doing business in California. QIPs
don't, but we need to clarify that in law. There is
currently a carveout for companies that just own
securities, but that was written before LLCs existed. This
bill just clarifies that it also applies to LLCs. Since
investors don't use QIPs in California today, it doesn't
lose us any state revenues. In return, we get more jobs in
California from the new investments.
3)Arguments in Opposition : Opponents of this bill state the
following:
California law already treats LLCs very lightly, with fees
designed to replace the corporation tax lost when LLCs were
recognized. We see no evidence that the use of this
lightly-taxed form has discouraged the use of LLCs in many
forms, which are now widespread since their inception. It
is unclear what the benefit of such an exemption would be
to the state of California, insofar as investment funds
will, as a matter of course, be used for investment
opportunities anywhere in the country or the world.
4)What is a "Tax Expenditure" ? Existing law provides various
credits, deductions, exclusions, and exemptions for particular
taxpayer groups. In the late 1960s, United States Treasury
officials began arguing that these features of the tax law
should be referred to as "expenditures," since they are
generally enacted to accomplish some governmental purpose and
there is a determinable cost associated with each (in the form
of forgone revenues). This bill would enact a new tax
expenditure program by exempting QIPs from the annual tax and
fee required to be paid by LLCs.
5)Tax Expenditure vs. Direct Expenditure : As the Department of
Finance notes in its annual Tax Expenditure Report, there are
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several key differences between tax expenditures and direct
expenditures. First, tax expenditures are reviewed less
frequently than direct expenditures once they are put in
place. This can offer taxpayers greater certainty, but it can
also result in tax expenditures remaining part of the tax code
without demonstrating any 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.
This bill does not include a sunset date. The Committee may
wish to consider adding a five-year sunset date to this bill
in order to provide an opportunity to evaluate whether
exempting QIPs from an LLC's annual tax and fee stimulates
greater start-up investment in California, whether benefits
exceed costs, and if any unintended consequences arise.
6)Purpose of the MFT : The MFT or annual tax and fee was enacted
to ensure that all corporations and LLCs pay at least a
minimum amount of tax for the privilege of conducting business
in California, regardless of the business's income or losses.
Thus, the tax is not an "income tax," but rather it is a tax
on the right to exercise the powers granted to a corporation
conducting business in California. Even when a business earns
no income, it still receives the benefits of its corporate
status, including the limited liability protection under the
laws of this state.
7)Purpose of This Bill : According to the author's office, QIPs
are created strictly with the intention to invest in and grow
the startup company, and are not traditional businesses with
overhead, personnel, and annual incomes. However, due to
California's annual filing fees, small investors in California
cannot form QIPs, depriving the state of a rapidly growing
class of capital for new business formation. If a QIP forms
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to invest $80,000 in a startup, it would have to withhold $800
(10%) annually of that capital from the startup to pay filing
fees.
8)Limited Liability, Free of Charge : In general, LLCs provide
limited liability, avoidance of double taxation, flexibility
of income distribution, simplicity of formation and
procedures, and no restrictions on ownership. Generally,
members of an LLC are not liable for the debts, liabilities,
or obligations of the entity. Members are also not liable for
tort or contractual obligations of other members of the firm
even if incurred during the course of the firm's business<1>.
Before the advent of LLCs, investors would have likely
organized as a partnership, if at all, which would have
allowed creditors and tort victims to go after the personal
assets of the investors.
As a public policy, providing limited liability appears to
further the goal of promoting investment by transferring risk
from investors to creditors. Providing limited liability to
small businesses, presumably with limited assets, may cause
owners of the LLC to consider only those marginal costs and
benefits associated with the investments that they will
internalize. In other words, "limited liability allows
investors to pursue extremely risky projects and to profit
from the pursuit of a 'heads I win; tails you lose' strategy
of project finance."<2> LLCs allow investors the benefit of
taking greater investment risks without necessarily
shouldering the burden of the costs if the financial gamble
--------------------------
<1> Jonathan Macey, The Limited Liability Company: Lessons for
Corporate Law, Washington University Law Review, Vol. 73, Issue
2, 1995.
<2> Id.
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proves unsuccessful.
Investors who believe that the annual tax is too costly have
the option of pooling their money and doing business as a
general partnership, which is not subject to the $800 annual
tax. In this scenario, however, investors could be subject to
lawsuits by the underlying business start-up and held
personally liable for the actions of other partners. In
exchange for the benefits that organization as an LLC
provides, the state requires payment of the annual tax.
9)Angel Investors : Investors who provide financial backing for
small startups or entrepreneurs are referred to as "angel
investors." According to the Center for Venture Research at
the University of New Hampshire, $10.5 billion in angel
investments were made in the first two quarters of 2015, a
4.1% increase over the first two quarters of 2014 (total
investments in 2014 were $24.1 billion). Furthermore, the
2015 Halo Report published by the Angel Resource Institute at
Willamette University, found that the median pre-money
valuation of seed deals reached $4.6 million, a 53% increase
from 2014 and the highest valuation in the report's history.
The Halo Report also found that while most angel investment
groups invest close to home, investors in California are the
most likely to invest out-of-region, with 34.2% of deals
occurring out-of-region. In light of natural incentives to
invest in a growing market, the Committee may wish to consider
whether additional incentives are needed to stimulate
investment, especially investment that may be supporting
out-of-state businesses.
Additionally, although this bill is intended to help small
investors, any QIP doing business in California would benefit
from the annual tax and fee exemption, including out-of-state
QIPs formed to invest millions of dollars. Although such
investment may potentially benefit California startups, the
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Committee may wish to consider whether General Fund money
should be used to subsidize well-financed investors located
outside of California that may be able to easily absorb an
$800 tax and fee and in exchange for liability protections.
10)Exemption from the Annual Fee : In addition to exempting QIPs
from the $800 annual tax, this bill exempts QIPs from the
annual fee imposed on LLCs, as payment of the fee is imposed
on every LLC subject to the annual tax. The annual fee is
based on a scale of the LLC's total income derived from or
attributable to the state - LLCs with total income under
$250,000 pay no fee, while LLCs with total income over $5
million must pay $11,790. In order to provide more targeted
relief to small investors, the Committee may wish to consider
simply reducing the annual tax for QIPs as an alternative to
exempting QIPs from the annual tax, and therefore the annual
fee. Reducing the tax would provide relief to small investors
pooling together as a QIP, and any QIP with total income under
$250,000 is already exempt from the annual fee.
11)Related Legislation :
a) AB 2625 (Lopez) would reduce the MFT or annual tax
according to gross receipts if the corporation or LP, LLP,
or LLC, respectively, qualifies as a new microbusinesses.
AB 2625 is scheduled to be heard in this Committee along
with this bill.
b) AB 799 (Travis Allen and Quirk) was substantially
similar to this bill. AB 799 was held under submission in
this Committee.
c) AB 612 (Patterson) would have reduced the MFT or annual
tax to $400 if the corporation or LP, LLP, or LLC,
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respectively, qualified as a new small business. AB 612
was held under submission in this Committee.
d) AB 328 (Grove) would have eliminated the MFT or annual
tax if the corporation or LLC, respectively, qualified as a
new veteran-owned small businesses. AB 328 was held under
submission in this Committee.
REGISTERED SUPPORT / OPPOSITION:
Support
AngelList
Kapor Capital
TechNet
101 Individuals
Opposition
California Tax Reform Association
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Analysis Prepared by:Irene Ho / REV. & TAX. / (916) 319-2098