Winners and Losses: Profitable Businesses Face Greater Tax Liability in California

When the California budget is in trouble, California seeks more tax from businesses, especially those that were profitable and have loss carryovers. On October 8, 2010, California Governor Arnold Schwarzenegger signed the state’s Budget Act of 2010. Under the Act, many companies that expected to pay little or no tax may be required to pay more California tax this year.

Significant Tax Changes

The Act implements several corporate income tax changes, including the following:

  • NOL usage is suspended for 2010 and 2011. (Note that when California suspended NOL usage for the 2008 and 2009 tax years, the use of credits were limited to 50% of the tax liability. But this tax credit limitation provision does not apply for 2010 and 2011.) Taxpayers with sufficient credits may be able to reduce income tax down to the minimum tax. In some cases, net tax may be lower because of NOL suspension if credits can eliminate minimum tax that would otherwise be due when NOLs are used.
  • 2011 NOL carrybacks are pushed back. When California suspended NOL usage for 2008 and 2009, it also said it would allow two-year NOL carrybacks starting in 2011. Now the carryback ability has been postponed until 2013.
  • State apportionment rules have changed for services and intangibles. The marketplace approach was to be adopted beginning in 2011. The new law abandons the market-based approach and retains the cost of performance rules for anyone using 3- or 4-factor apportionment.
  • Under current law, taxpayers can elect single sales factor apportionment beginning in 2011. For taxpayers that elect single-factor apportionment the market-based approach should be used. However, Proposition 24 — on the ballot for the November 2, 2010 elections — would change that rule. It calls for the repeal of the election to apply single sales factor apportionment. If Proposition 24 passes, single factor apportionment will not be allowed, so cost of performance will apply to everyone.
  • The market-based approach is to be used for determining whether a corporation has “economic nexus” in the state of California beginning in 2011. This may subject more taxpayers to California income tax.
  • Larger penalties were enacted for “large corporate underpayments” of tax.

Who Will be Affected

  • Companies with 2010 or 2011 profits and NOL carryforwards to those years. Note that the suspension does not apply if the business’s pre-apportionment income is $300,000 or less. (The 2008/2009 suspension applied if post-apportionment income was over $500,000, thus the new limit is lower.)
  • Taxpayers with credits (such as research credits) may still use those credits to reduce tax, and there is no 50% limitation on credit usage.
  • Taxpayers with sufficient credits may actually be able to avoid alternative minimum tax that would otherwise be due for 2010 or 2011 if NOLs were utilized.
  • Taxpayers with revenue from services or intangibles will need to apply the new apportionment rules. The impact will vary.

What To Do

  • Talk with your tax advisor to analyze the impact on your company’s 2010 tax liability. Consider tax planning to reduce taxable income. If you already planned in 2009 expecting 2010 NOL usage, you may need to dig deeper.
  • Review estimated tax rules to determine when any additional tax is due. Higher tax may be due at the next quarterly due date. Some companies may avoid paying tax until extension time (March 15, 2011 for calendar year-end corporations).