BILL ANALYSIS Ó AB 2544 Page A 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 AB 2544 Page B 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. AB 2544 Page C 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 AB 2544 Page D 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, AB 2544 Page E 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. AB 2544 Page F 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 AB 2544 Page G 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 AB 2544 Page H 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 AB 2544 Page I 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. AB 2544 Page J 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 AB 2544 Page K 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, AB 2544 Page L 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 AB 2544 Page M Analysis Prepared by:Irene Ho / REV. & TAX. / (916) 319-2098