BILL ANALYSIS �
AB 2428
Page A
Date of Hearing: May 5, 2014
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
AB 2428 (Patterson) - As Amended: April 10, 2014
Majority vote. Fiscal committee. Tax levy.
SUBJECT : Income taxes: minimum franchise tax: annual tax:
deductions: exemptions
SUMMARY : Provides a deduction in the amount of qualified income
earned or received by a qualified taxpayer from a qualified
business, eliminates the minimum franchise tax for limited
partnerships (LP), limited liability companies (LLC), limited
liability partnerships (LLP), and corporations for the first
five consecutive years, eliminates the annual fee imposed on
LLCs for the first five taxable years, and provides other tax
relief. Specifically, this bill :
1)Provides, beginning on or after January 1, 2015, that the
following entities will not be subject to the minimum
franchise tax for the first five consecutive taxable years:
a) LPs that file a certificate of limited partnership with
the Secretary of State (SOS);
b) LLCs that file articles of organization with the SOS;
c) LLPs that file a certificate of limited partnership with
the SOS; and,
d) Corporations that incorporate in California.
2)Provides that an LLC that files articles of organization with
the SOS on or after January 1, 2015, shall not be subject to
the annual fee for the first five consecutive taxable years.
3)Allows a deduction, beginning on or after January 1, 2015, for
the amount of qualified income earned or received by a
taxpayer from a qualified business. The deduction shall be
available for the first five consecutive taxable years in
AB 2428
Page B
which the business is a qualified business.
4)Defines a "qualified business" as a business that, on or after
January 1, 2015, is either a sole proprietorship, a general
partnership that commences business within this state, a
limited partnership, or a limited liability partnership, that
files the applicable document or form with the SOS, and does
business in California during the period in which the
deduction allowed.
5)Defines "qualified income" as any income attributable to a
taxpayer's status as a partner in or sole proprietor of a
qualified business.
6)Extends the sunset date for the provision allowing an
exemption from the minimum franchise tax for a small business
wholly owned by a deployed member of the United States (U.S.)
Armed Forces from January 1, 2018, to January 1, 2019.
7)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>
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.
---------------------------
<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 2428
Page C
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.
6)Provides that LLCs that are doing business in California are,
in addition to the minimum franchise tax, subject to an annual
fee based on the total income from all sources derived from or
attributable to California. The fee is determined as follows:
a) If total income is more than $250,000, but less than
$500,00, the fee is $900;
b) If total income is more than $500,000, but less than $1
million, the fee is $2,500;
c) If total income is more than $1 million, but less than
$5 million, the fee is $6,000; and,
d) If total income is more than $5 million, the fee is
$11,790.
7)Provides that under current federal and state law, a
AB 2428
Page D
partnership computes its income, gain, loss, deduction, and
credit at the partnership level and allocates these items
among its partners. The partners report their distributive
share of these items on their own tax returns to be included
in taxable income. There is no federal or state law that
allows shareholders or members to deduct all income received
from a qualified business from their gross income.
8)Provides that partners are generally allowed to allocate
partnership items of income, gains loss, deduction, or credit
among themselves based on their partnership agreement.
Allocation of the partnership tax items must be consistent
with underlying economic arrangement among the partners.
FISCAL EFFECT : The FTB estimates that this bill will reduce
general fund revenue by $6 billion in fiscal year (FY) 2014-15,
$13 billion in FY 2015-16, and $15 billion in FY 2016-17.
COMMENTS :
1)Author's Statement . The author has provided the following
statement in support of this bill:
California is often known as the "first in the nation"
state that leads the way for other state to follow. While
it rightly deserves its place at the forefront in terms of
innovation, unfortunately California comes in dead last in
what matters most: providing a friendly climate for
businesses to establish themselves and flourish. Named the
worst state to do business in by Chief Executive Magazine,
and the 48th worst state for business by the Tax Foundation
for the past three years running, California has a long way
to go to attract business and create jobs once again.
California currently imposes multiple taxes and fees on all
businesses in the state. Businesses must pay an $800 fee
per year simply for operating in the state, whether or not
the business is actually making a profit. For [LLCs] that
do turn a profit, the state imposes a minimum franchise fee
that must be paid each year. Corporations must also pay an
8.84% tax rate per year on income earned in the state.
These fees and taxes may not seem like a lot, but for a
small business trying to get ion its feet, they can
represent a serious financial hardship. If California
AB 2428
Page E
wants to lower its 7.9% unemployment rate and encourage
more businesses to set up shop in the state, it must put
more business-friendly policies in place and draw in
businesses, rather than drive them away.
AB 2428 will do just that. By exempting newly formed
businesses from all corporate taxes and franchise taxes and
fees for the first five years of being established in the
state of California, this bill will make it easier for
businesses to establish themselves and will give them a
chance to get on their feet before being subject to state
taxes and fees. It will be a long road for California to
break into the top ranks of most business-friendly states.
But this bill is a step in the right direction towards job
creation and encouraging entrepreneurs in their business
ventures.
2)Purpose of this Bill . This bill would eliminate the minimum
franchise tax, the annual fee paid by LLCs, and provide a
deduction for the amount of income received by a partner or
sole proprietor in a qualified business for the first five
taxable years. The purpose, as explained by the author, is to
reduce the unemployment rate in California by allowing
companies to get on their feet before being subject to any
tax. However, as noted in the FTB's staff analysis, this bill
does not prevent an existing company from reorganizing solely
for the purpose of taking advantage of these tax exemptions,
potentially allowing an extremely profitable company to take
advantage of the tax savings outlined in this bill.
Furthermore, it unclear if a company may be prevented from
reorganizing after the initial five years to again take
advantage of the tax exemptions. Under the provisions of this
bill, business entities may be allowed to continually
reorganize and avoid payment of taxes indefinitely. Such a
scenario could lead to a large number of businesses taking
advantage of local and state services without ever
contributing to California. As explained by former Supreme
Court Justice, Oliver Wendell Holmes Jr., "[t]axes are what we
pay for civilized society." (Compania General de Tabacos v.
Collecto, 275 US 87 (1927).) The idea being that we must all
contribute for the enjoyment of a functioning government.
Additionally, in 1851, the Journal of the House of
Representative of the State of Vermont stated that "[t]axation
is the price which we pay for? social, civil and political
institutions, for the security of life and property, and
AB 2428
Page F
without which, we must resort to the law of force."
Therefore, it seems appropriate that entities conducting
business in California be subject to some level of taxation.
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
doing business in California, regardless of the businesses
income or loss. Thus, the minimum tax is not an "income tax",
but rather a tax on the right to exercise the powers granted
to a corporation doing 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 California law.
4)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 do business in California
because of its competitive advantages, namely its environment,
transportation infrastructure, access to ports, highways, and
railroads, as well as its highly skilled workforce and
world-class higher education system. As explained earlier,
this exemptions outlined in this bill can potentially apply to
existing companies. Therefore, it is uncertain if the
exemptions would generate additional economic activity or
provide a windfall to current businesses.
5)Helping Profitable LLCs . This bill eliminates the annual fee
imposed on extremely profitable LLCs. Unlike the minimum tax,
the annual fee is only paid by LLCs with income of more than
$250,000. Those making more than $250,000 but less than
$500,000 pay an annual fee of $900. The fee increases to a
maximum of $11,790 for LLCs making more than $5 million in
income per year. It is unclear to Committee staff if a tax
savings of $900 for LLCs with more than $250,000 in income
would substantially increase economic activity.
AB 2428
Page G
6)Related Legislation :
a) AB 2086 (Calderon) provides LLCs with several options to
pay the minimum franchise tax and the annual fee, and
provides corporations with similar options to pay the
estimated minimum franchise tax. AB 2086 will be heard in
this Committee today.
b) 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 will be heard in this
Committee today.
c) 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 will be heard in this
Committee today.
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
will be heard in this Committee today.
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 will be
heard in this Committee today.
7)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 under submission in this Committee.
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 under submission in this Committee.
AB 2428
Page H
d) AB 1179 (Garrick), of the 2007-08 Legislative Session,
is similar to AB 327. AB 1179 was held in this Committee.
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
passage in the Senate Revenue and Taxation Committee.
REGISTERED SUPPORT / OPPOSITION :
Support
Nine private individuals
Opposition
None on file
Analysis Prepared by : Carlos Anguiano / REV. & TAX. / (916)
319-2098