Preparing for potential California tax changes

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May 2020

UPDATE: Enacted on June 29, 2020, A.B. 85 provides the following:

2020-2022 NOL suspension

The use of NOLs are suspended for the 2020 - 2022 tax years for taxpayers with net business income of $1 million or more.

For any net operating loss or carryover of a net operating loss for which a deduction is denied per the above, the carryover period under Section 172 of the Internal Revenue Code shall be extended as follows:

  • By one year, for losses incurred in taxable years beginning on or after January 1, 2021, and before January 1, 2022.
  • By two years, for losses incurred in taxable years beginning on or after January 1, 2020, and before January 1, 2021.
  • By three years, for losses incurred in taxable years beginning before January 1, 2020.

Credits cap

Business incentive tax credits cannot offset more than $5 million of a separate taxpayer or a combined group’s annual liability for the 2020 - 2022 tax years.  The carryover period for any credit that is not allowed due to the application of this section shall be increased by the number of taxable years the credit or any portion thereof was not allowed.

The credits included in this are those allowable under any provision of Chapter 3.5 (commencing with Section 23604), including: research and development credit, jobs tax credit, California Competes credit, and certain motion picture credits.

Overview

California faces an unprecedented $54 billion budget deficit as a result of the coronavirus pandemic. Before the pandemic, California enjoyed a budget surplus and had built approximately $21 billion of reserves over the last six years. These reserves are projected to cover less than half the deficit the state now faces. 

Facing a sharp decline in tax collections, California may look for ways to raise revenue in addition to spending cuts and borrowing in order to balance the budget as mandated by California’s constitution. As with the 2008-2009 Great Recession and other recessions, businesses may face tax increases and additional fees and penalties. Further, unlike with previous budget deficits, because California adopted mandatory single sales factor apportionment for most businesses and market-based sourcing for tax years beginning on or after January 1, 2013, businesses that wish to reduce their footprint in the state may find it difficult to mitigate the impact of such measures.

The takeaway

Steps can be taken by businesses to prepare for the changes proposed in the May Revise of the California budget and other potential revenue-raising ideas.  Businesses should model these scenarios before filing their 2019 return or in preparation for their 2020 filing. 

If the state’s proposed responses to prior fiscal crises offer any guide, in addition to the May Revise measures, California might consider other revenue-raising proposals if the downturn proves extended and severe, such as:

  • expanding the reach of sales and use tax to services
  • aggressive audits at the state and local levels
  • higher tax rates
  • implementing a gross receipts tax (LLCs are subject to a gross receipts tax in California, and other states have adopted a gross receipts tax in lieu of or in addition to a corporate income tax)
  • prepayment of future taxes, offering in exchange a voucher with a higher face value than the prepayment amount. Senate President Pro Tem Toni Aktins has announced a proposal to create a $25 billion Economic Recovery Fund through the establishment of prepaid future tax vouchers from 2024 through 2033. 

In light of the COVID-19 economic impact and possible tax law changes, businesses may wish to consider several options on their 2019 return if it has not yet been filed, as well as planning ahead for the 2020 return, where appropriate:

  • California separate elections
  • California-only accounting method changes
  • applying for California Competes Tax Credit (potentially, not subject to the $5 million limitation discussed above)
  • reviewing sourcing of sales – due to California’s single sales factor and market-based sourcing provisions, businesses cannot readily reduce liability without abandoning California as a market for their goods and services.  That said, businesses may be able to revisit supply chain alternatives with distributors in particular.  In addition, the market-based sourcing rules should be re-examined as to their operation and impact.

Contact us

Peter Michalowski

State and Local Tax Leader, PwC US

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