BILL ANALYSIS �
AB 1778
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Date of Hearing: May 13, 2014
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
AB 1778 (Allen) - As Amended: April 1, 2014
Majority vote. Fiscal committee. Tax levy.
SUBJECT : Corporation taxes: minimum annual tax: limited
liability company: exemption
SUMMARY : Excludes from the definition of a "limited liability
company" (LLC) a LLC formed exclusively for the purpose of
acquiring and holding title to intangible personal property in a
single other corporation, LLC, or partnership. Specifically,
this bill :
1)Excludes from the definition of LLC a LLC formed exclusively
for the purpose of acquiring and holding title to intangible
personal property constituting equity or debt interests, or
both, in a single other corporation, limited liability
company, or partnership, collecting income therefrom, and
turning over the entire amount to its members.
2)Takes effect immediately 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. 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>
---------------------------
<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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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
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 will reduce
General Fund revenue by $2.6 million in fiscal year (FY)
2014-15, $2.9 million in FY 2015-16, and $3.1 million in FY
2016-17.
COMMENTS :
1)Author's Statement . The author has provided the following
statement in support of this bill:
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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.
Investment LLC's are created strictly with the intention to
invest and grow the startup community. The financial
assistance provided by these Investment LLC's allow
countless of innovative ideas to become a reality, while
offering startups a kick start in capital to allow them to
drive our economy and create jobs for all Californians.
2)Arguments in Support . Supporters of this bill state that
"[s]mall companies are often financed by groups of individual
investors - our members. In many states, the angel investor
group forms an 'investment LLC'. The Investment LLC benefits
young companies, since it has one investor to deal with for
administrative approvals. It also benefits the investors, who
can designate a single person to oversee the administration
rather than each having to deal with the same paperwork."
Supporters go on to say that the LLC structure does not work
in California because of the $800 minimum franchise tax. AB
1778 would address the issue by eliminating the minimum
franchise tax for an investment LLC "created for the sole
purpose of investing in a single company."
3)Minimum Tax . The minimum franchise tax, the annual tax, and
annual fee were 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
businesses income or loss. Thus, the minimum 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.
4)What does this bill do ? This bill would specify that a LLC
created for the exclusive purpose of acquiring and holding
title to intangible personal property constituting equity or
debt interest in a single other business entity is exempt from
the minimum franchise tax. According to the author's office,
LLCs can be used to pool funds together from individual
investors, known as "angel investors," for funding small,
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start-up companies. However, the imposition of the minimum
franchise tax impedes many investors from forming an
investment LLC, especially true for pooled funds under
$250,000 because angel investors typically have to wait about
10 years before start-up companies become profitable. An LLC
must pay the minimum franchise tax for each of those 10 years,
which would be $8,000. If pooled funds are $250,000 and the
partners pay $8,000 over the course of 10 years, the LLC would
have to withhold about 3.2% of the funds to pay for the
minimum franchise tax. That percentage would increase or
decrease depending on the amount of pooled funds over the same
10 year period of time.
As a way of getting around the $800, individual investors
could instead form a general partnership, which is not subject
to annual minimum franchise tax. However, supporters of this
bill believe that forming a general partnership is a
non-starter. There may be situations where the underlying
business start-up sues its own investors. If formed as a
general partnership, individual owners would be personally
liable. Individual owners may also be personally liable for
the actions of other partners, potentially creating litigation
among the members. Pooling the funds together under an LLC
would remove a lot of the liability impeding investment.
5)LLCs . 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 firm. (Jonathan
Macey, The Limited Liability Company: Lessons for Corporate
Law, Washington University Law Review, Vol. 73, Issue 2,
1995.) 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. (Id.) Before the
advent of LLCs, angel investors would have likely formed as a
partnership, if at all, allowing creditors and tort victims to
go after the personal assets of the partners.
As a public policy, the goal of providing limited liability
appears to be the state's need to promote 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 only consider those
marginal costs and benefits associated with the investments
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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." (Id.) The idea that
people will take on greater risk because someone else will pay
for the costs is known as "moral hazard." (Id.) This tends
to occur when businesses are shielded from liability, but also
when businesses lack financial resources to provide adequate
compensation to creditors. (Id.) Clearly, as noted by
supporters of this bill, angel investors are unlikely to pool
funds without the protection of limited liability. Investors
are also unwilling to pool funds without the elimination of
the $800 minimum franchise tax. In essence, this bill will
provide angel investors the benefits of limited liability free
of charge.
6)Unforeseen Consequences . This bill provides the exemption by
carving out investment LLCs from the definition of LLCs for
the purpose of imposing the minimum franchise tax. This bill
would also eliminate the annual fee since investment LLCs
would no longer be subject to Revenue and Taxation Code (R&TC)
Section 17941. Unfortunately, this bill could potentially
eliminate the minimum franchise tax imposed on an out-of-state
LLC that is a sole proprietor or partner in a California
investment LLC as the change in law could be interpreted to
mean that an-out-of state LLC is no longer conducting business
in the state.
Additionally, the language in this bill states that the LLC
must be formed for the exclusive purpose of acquiring and
holding title to intangible personal property in a business
entity. The language, however, does not require that the LLC
continue to operate for that exclusive purpose of holding
title to intangible personal property. Theoretically, the
owner can change the operation of the company after its
formation and never have to pay the minimum franchise tax.
7)Related Legislation .
a) AB 1889 (Hagman) would reduce the minimum franchise tax
in the second taxable year for a new corporation, and in
the first taxable year for a limited partnership, new
limited liability partnership, and new LLC with gross
receipts of $5,000. AB 1889 is currently on this
Committee's Suspense File.
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b) AB 2244 (Chau) would reduce the minimum franchise tax to
$200 for a dormant business entity and to $50 for an
inactive business entity. AB 2244 is currently on this
Committee's Suspense File.
c) AB 2428 (Patterson) provides 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 is currently on this Committee's Suspense File.
d) AB 2466 (Nestande) reduces the minimum tax for new
veteran-owned businesses and eliminate the tax if the
business operates at a loss or ceases operation. AB 2466
is currently on this Committee's Suspense File.
e) AB 2495 (Melendez) exempts new qualifying corporations,
limited partnerships, limited liability partnerships, and
limited liability companies from the annual minimum tax for
the first five consecutive taxable years. AB 2495 is
currently on this Committee's Suspense File.
8)Prior Legislation .
a) AB 2671 (Cook), Chapter 394, Statutes of 2010, exempts,
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.
b) 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.
c) 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.
d) AB 1179 (Garrick), of the 2007-08 Legislative Session,
is similar to AB 327. AB 1179 was held on this Committee's
Suspense File.
e) 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
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passage in the Senate Revenue and Taxation Committee
REGISTERED SUPPORT / OPPOSITION :
Support
AngelList
Angel Capital Association
Fastly
Kapor Capital
National Federation of Independent Business
San Jose Silicon Valley Chamber of Commerce
4 individuals
Opposition
None on file
Analysis Prepared by : Carlos Anguiano / REV. & TAX. / (916)
319-2098