California restricts NOLs, credits for three years

On June 29, 2020, California Gov. Gavin Newsom signed Assembly Bill 85, which is expected to raise $9.2 billion in taxes over a three-year period by amending the California Revenue and Taxation Code to suspend the use of net operating losses (NOLs) for most taxpayers, and limit the utilization of most business credits to $5 million for taxable years beginning in 2020, 2021, and 2022.¹

A.B. 85’s NOL suspension

A.B. 85 adds Cal. Rev. & Tax. Code Sec. 24416.23 to California’s Corporation Tax Law and Cal. Rev. & Tax. Code Sec. 17276.23 to California’s Personal Income Tax Law, which together suspend the use of NOLs for most California taxpayers for tax years beginning in 2020, 2021, and 2022 unless they can qualify for limited small business exceptions, as described below.

For purposes of the Corporation Tax Law, under Cal. Rev. & Tax. Code Sec. 24416.23, the NOL suspension does not apply if a corporate taxpayer has income subject to tax under the Corporation Tax Law of less than $1 million for the taxable year.² Additionally, to the extent that the NOL utilization is denied by Cal. Rev. & Tax. Code Sec. 24416.23, a corollary extension of the NOL carryover period is provided for each year of disallowance.³

Somewhat similar to the Corporation Tax Law’s NOL suspension, the Personal Income Tax Law’s NOL suspension does not apply if a taxpayers has either “net business income” or “modified adjusted gross income” of less than $1 million for the taxable year.⁴ To the extent that the NOL utilization is denied by Cal. Rev. & Tax. Code Sec. 17276.23, a corollary extension of the NOL carryover period is provided for each year of disallowance.⁵

A.B. 85’s Credit Limitation

A.B. 85 seeks to raise additional tax revenue by adding Cal. Rev. & Tax. Code Sec. 23036.3 to the Corporation Tax Law and Cal. Rev. & Tax. Code Sec. 17039.3 to the Personal Income Tax Law, both of which limit the utilization of tax credits in tax years beginning in 2020, 2021, and 2022.

Concerning the credit limitation added to the Corporation Tax Law, for taxpayers not included in a combined report, the total of all credits otherwise allowable under the tax credit provisions of the Corporation Tax Law, including the carryover of any credit, is not allowed to reduce tax by more than $5 million in tax years beginning in 2020, 2021, and 2022.⁶ The same dollar limitation applies to combined groups, which for the same period cannot use credits to reduce the aggregate amount of tax for all combined reporting group members by more than $5 million per year.⁷ This limitation applies to all credits allowed under the tax credit provisions of the Corporation Tax Law, with the exception of the low-income housing credit, which is specifically excluded from the limitation.⁸ Any amount of credit that would have been allowed under Cal. Rev. & Tax. Code Sec. 23036 that is not utilized as a result of the limitation on credits will be included in the total credit carryover to the following taxable year.⁹ In addition, the credit carryover period will be increased by the number of years in which the credit (or portion of the credit) was not allowed due to the limitation.¹⁰

With respect to the Personal Income Tax Law credit limitation, similar to corporations, individuals cannot reduce net tax with “business credits” by more than $5 million.¹¹ Cal. Rev. & Tax. Code Sec. 17039.3 defines “business credits” broadly to be any credit allowable under any provision of Chapter 2 of the Cal. Rev. & Tax. Code other than listed exclusions such as the earned income tax credit,¹² the young child credit,¹³ the dependent care credit,¹⁴ the credit for adoption costs,¹⁵ the renter’s tax credit,¹⁶ and others.¹⁷ Like the credit limitation in the Corporation Tax Law, Cal. Rev. & Tax. Code Sec. 17039.3 provides that the credit carryover period will be increased by the number of years the credit (or portion of the credit) was not allowed due to the limitation.¹⁸

A.B. 85 also imposes a parallel $5 million limitation on certain credits (other than low-income housing credits) that may be claimed against the insurance premiums tax imposed by Cal. Rev. & Tax. Code Sec. 12201.¹⁹

Initial year minimum tax exemption for partnerships

A.B. 85 also amends Cal. Rev. & Tax. Code Sec. 17941 to provide that limited partnerships, limited liability companies, and limited liability partnerships doing business in California that organize or register with the California Secretary of State in 2021, 2022, and 2023 are not subject to the $800 minimum tax for the first taxable year.²⁰

Commentary

A.B. 85 contains significant limitations on the utilization of tax attributes for purposes of both California’s Corporation Tax Law and Personal Income Tax Law. As noted above, these changes are intended to raise an additional $9.2 billion in estimated tax revenue to help close California’s sizable projected budget shortfall due to the economic impact of the COVID-19 pandemic. Since A.B. 85’s revisions to the utilization of NOLs and credits are effective for tax years beginning on or after January 1, 2020, they will not apply for the purposes of the 2019 tax year return compliance season. However, these changes may need to be considered for second quarter 2020 income tax provision planning.

Concerning A.B. 85’s NOL suspension, the small business exemptions in Cal. Rev. & Tax. Code Sec. 24416.23(c) and Cal. Rev. & Tax. Code Sec. 17276.23(c) are extremely narrow because both appear to be based on pre-apportioned income, rather than apportioned state taxable income. In addition to being relatively low income thresholds for exemption, A.B. 85’s approach to defining the $1 million exemption threshold does not appear consistent with California’s historical approach to computing NOLs, which under Cal. Rev. & Tax. Code Sec. 24416 has traditionally proceeded on a post-apportioned basis for each taxpayer.

As for A.B. 85’s incorporation of a $5 million ceiling for the utilization of certain credits, when viewed on an individual or single corporate taxpayer basis, a significant amount of state taxable income would appear to be needed before this threshold is met. For example, under the 8.84% corporate tax rate, apportioned income from California sources in excess of $56.5 million would be needed before the limitation is triggered. However, in the context of a combined group of corporations, it is expected that the $5 million threshold may be more commonly triggered once spread across multiple taxpayer members of a combined reporting group. For affected corporate taxpayers, A.B. 85’s credit limitations may have wide-ranging impact due to the breadth of frequently utilized credits included in the $5 million annual limitation, such as the research and development credit²¹ and the new employment credit.²²

1 Ch. 8 (A.B. 85), enacted June 29, 2020.
2 A.B. 85, § 16, enacting CAL. REV. & TAX. CODE § 24416.23(c).
3 A.B. 85, § 16, enacting CAL. REV. & TAX. CODE § 24416.23(b).
4 A.B. 85, § 8, enacting CAL. REV. & TAX. CODE § 17276.23(c). Definitions of “business income” and “modified adjusted gross income” are provided in CAL. REV. & TAX. CODE § 24416.23(d)(1)-(2).
5 A.B. 85, § 8, enacting CAL. REV. & TAX. CODE § 17276.23(b).
6 A.B. 85, § 14, enacting CAL. REV. & TAX. CODE § 23036.3(a).
7 A.B. 85, § 14, enacting CAL. REV. & TAX. CODE § 23036.3(b).
8 A.B. 85, § 14, enacting CAL. REV. & TAX. CODE § 23036.3(d).
9 A.B. 85, § 14, enacting CAL. REV. & TAX. CODE § 23036.3(e).
10 A.B. 85, § 14, enacting CAL. REV. & TAX. CODE § 23036.3(f).
11 A.B. 85, § 6, enacting CAL. REV. & TAX. CODE § 17039.3(a).
12 See CAL. REV. & TAX. CODE § 17052.
13 See CAL. REV. & TAX. CODE § 17052.1.
14 See CAL. REV. & TAX. CODE § 17052.6.
15 See CAL. REV. & TAX. CODE § 17052.25.
16 See CAL. REV. & TAX. CODE § 17052.5.
17 See A.B. 85, § 6, enacting CAL. REV. & TAX. CODE § 17039.3(c)(1)-(10), for a full list of the exclusions from the definition of “business credit.”
18 A.B. 85, § 6, enacting CAL. REV. & TAX. CODE § 17039.3(f).
19 A.B. 85, § 5, enacting CAL. REV. & TAX. CODE § 12209 to limit the credits that may be claimed under CAL. REV. & TAX. CODE §§ 12207 and 12208 in tax years beginning in 2020, 2021, and 2022.
20 A.B. 85, §§ 9-11, enacting CAL. REV. & TAX. CODE §§ 17935(f)(1); 17941(g)(1); 17948(e)(1).
21 CAL. REV. & TAX. CODE § 23609.
22 CAL. REV. & TAX. CODE § 23626.

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