Existing law imposes an annual tax in an amount equal to the minimum franchise tax, which is $800, on every limited liability company that is doing business in this state. Existing law also exempts, until taxable years beginning on or after January 1, 2018, a limited liability company that is a small business solely owned by a deployed member of the United States Armed Forces from paying the annual tax for any taxable year the owner is deployed and the limited liability company operates at a loss or ceases operation.

This bill would reduce to $100 the annual tax for microbusinesses, as defined, and would extend indefinitely the exemption for a limited liability company that is a small business solely owned by a deployed member of the United States Armed Forces.

This bill would take effect immediately as a tax levy.

Date of Hearing: April 2, 2018

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Autumn R. Burke, Chairwoman

ABPCA Bill Id:AB 2510 (

Author:Muratsuchi) – As Introduced Ver:February 14, 2018

Majority vote. Tax levy. Fiscal committee.

SUBJECT: Limited liability companies: annual tax: microbusinesses

SUMMARY: Reduces the annual tax to $100 for a limited liability company (LLC) that is a microbusiness, and reinstates and makes permanent the $800 annual tax exemption for an LLC that is solely owned by a deployed member of the Armed Forces. Specifically, this bill:

1. Reduces, for taxable years beginning on or after January 1, 2018, the annual tax to $100 for a microbusiness.
2. Defines "microbusiness" as an LLC with total income from all sources derived from, or attributable to, the state of $150,000 or less.
3. Reinstates and makes permanent the annual tax exemption provided to an LLC that is solely owned by a deployed member of the Armed Forces.
4. Takes effect immediately as a tax levy.

EXISTING LAW:

1. Imposes a 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 limited partnerships, limited liability partnerships (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. Every LLC subject to the annual tax is also required to pay an annual fee based on the total income from all sources derived from or attributable to the state. The fee is determined as follows:
   1. If total income is more than $250,000, but less than $500,000, the fee is $900;
   2. If total income is more than $500,000, but less than $1 million, the fee is $2,500;
   3. If total income is more than $1 million, but less than $5 million, the fee is $6,000; and,
   4. If the total income is more than $5 million, the fee is $11,790.

FISCAL EFFECT: The Franchise Tax Board estimates General Fund revenue losses of $500 million in fiscal year (FY) 2018-19, $360 million in FY 2019-20, and $390 million in FY 2020-21.

COMMENTS:

1. The author has provided the following statement in support of this bill:

Business owners, especially very small businesses, face many challenges in ensuring that their businesses are successful. In an effort to help "microbusinesses" grow, this bill reduces the amount in annual minimum franchise tax. Additionally, for those business owners who are deployed oversees in defense of our nation, waiving the tax on their business is one small way that the state can assist.

In both cases, it is of benefit to both the state and the owner to have successful outcomes for these businesses. If a recognition on the part of the state that a reduction in this tax will help these businesses succeed, then we should make every effort to address it.

1. Proponents state that the "requirement for small business to pay the annual minimum franchise tax does pose a substantial cost to every small business."
2. Committee Staff Comments:
   1. Not all deployed members will be included: Prior to January 1, 2018, existing law allowed LLCs or corporations owned solely by a deployed member of the Armed Forces to be exempt from the $800 annual tax and minimum franchise tax. This bill deletes the January 1, 2018 sunset date for the annual tax exemption but maintains the sunset date for the minimum franchise tax exemption under Revenue and Taxation Code (R&TC) Section 23153. Without making similar changes to R&TC Section 23153, certain entities solely owned by a deployed member of the Armed Forces would still be subject to the $800 minimum franchise tax.
   2. A person does not need to pay $800 to conduct business in California: California allows an individual to open a business as a sole proprietor. A sole proprietorship is an unincorporated business that is owned by one person and is the simplest form of business organization to start and maintain. The business has no existence apart from the owner; its liabilities are the owner's personal liabilities; and the owner undertakes the risks of the business for all assets owned, whether used in the business or personally owned. The owner includes the income and expenses of the business on the owner's tax return. Formation documents are not required to be filed with the California Secretary of State's (SOS) office, but other state filings may be required depending on the type of business. General partnerships are treated very similarly but are required to file a statement of partnership authority with the SOS. Although the structure and liabilities are different from other business entities, sole proprietorships and general partnerships can engage in business without having to pay the minimum franchise tax or the annual tax.
   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 losses. 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 California law.
   4. $800 for Limited Liability: By providing limited liability to certain entities, (e.g., LLCs, LLPs, and corporations), California is essentially allowing a business owner to transfer part of the cost of conducting business onto creditors and tort victims. (Jonathan Macey, The Limited Liability Company: Lessons for Corporate Law, Washington University Law Review, Vol. 73, Issue 2, 1995.) As an example, if an owner of a construction company, having limited liability, injures an individual during the course of business, the victim's redress is limited to the assets of the company. If the company is insolvent, part of the cost of the injury is borne by the victim. Before the advent of LLCs and LLPs, that small business owner would have likely started the company as a sole proprietorship or general partnership, allowing the victim to go after the personal assets of the owner.

As a public policy, California has decided that the risk borne by creditors and potential tort victims is outweighed by the need to encourage investment. Providing limited liability to small businesses, presumably with few or no assets, may cause owners of the business to only consider 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." (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.) It may be argued that creditors, knowing that LLCs have limited liability, will require higher borrowing costs or ask for personal guarantees from the individual owners. However, the person hit by a taxi cab or the victim of a toxic spill did not assume the potential risk of the company's insolvency and the owner's limited liability. (David Millon, Piercing the Corporate Veil, Financial Responsibility, and the Limits of Limited Liability, Emory Law Journal, Vol. 65, Number 5, 2007.) The goal of providing limited liability appears to be the state's need to promote investment by transferring risk from investors to creditors. (Id.) Therefore, LLCs and other limited liability structures provide a substantial benefit to entrepreneurs at a nominal cost of $800 per year, even when insolvent or operating at a loss.

• 1. Inflation: California's minimum franchise tax was increased to $800 in 1990, and has remained at $800 since then. Due to inflation, the cost of the minimum franchise tax has been significantly reduced. The $800 minimum franchise tax in 1990 would cost 1,556.46 in January 2018 dollars.^[2] Because the minimum franchise tax is not indexed for inflation, it has functionally been lowered by 2.35% per year. Therefore, the minimum franchise tax has effectively been cut in half since it was imposed in 1990.
  2. Cash Flow Problems: Both startups and established companies may, at some point, face cash flow problems. A number of things can put a strain on a business' cash flow: customers can choose not to pay or pay late, the cost of materials can skyrocket, unforeseen acts can delay production, and changes in interest rates can increase the costs of capital. Additionally, once a business realizes that it is unable to pay current debts, it may be difficult, if not impossible, to secure additional funding. It appears that this bill could aid new businesses as they struggle to become profitable. However, as noted earlier, $800 is a nominal amount, and it is unclear if the elimination of the minimum tax would help struggling businesses succeed.
  3. How is a tax expenditure different from a direct expenditure: As the Department of Finance notes in its Tax 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 Committee may wish to include a five-year sunset date for both the reduction in the annual tax and the exemption for deployed members of the Armed Forces to provide for future legislative review.

REGISTERED SUPPORT / OPPOSITION:

Support

Small Business California

Opposition

None on file

Analysis Prepared by: Carlos Anguiano / REV. & TAX. / (916) 319-2098

1. According to the 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). ↑

2. Consumer Price Index, Inflation Calculator, Bureau of Labor Statistics, https://www.bls.gov/data/inflation_calculator.htm ↑