The 2020-21 Budget: Expanding the Minimum Franchise Tax Exemption

The 2020-21 Budget: Expanding the Minimum Franchise Tax Exemption SUMMARY The 2020-21 Governor’s budget includes a proposal background information on the current tax expenditure to expand an exemption from the state’s $800 minimum and assess the merits of the administration’s proposal franchise tax, which the state annually imposes on many to expand it. We conclude that the Legislature should companies that do business here. The change would reject the Governor’s proposal. We further suggest the reduce General Fund revenue by about $100 million Legislature reconsider the current exemption. per year. In this budget analysis brief, we provide BACKGROUND Many California Businesses Pay a Minimum and the amounts of minimum franchise tax paid in 2017. Franchise Tax. Corporations doing business in Altogether, the state annually collects about $1 billion California must pay a state corporation tax (CT) on from the minimum tax. their net income. Many corporations have no net Corporations Exempted From Paying Minimum income in California, but are still required to pay an Franchise Tax in First Year of Business. Since 1998, annual minimum franchise tax of $800. Other types of newly formed corporations have been exempted from noncorporate businesses are not subject to the CT, paying the $800 minimum franchise tax in their first but many also are required to pay an annual minimum year of business. About 100,000 new corporations franchise tax of $800. (Businesses that are organized are formed each year. However, the Franchise Tax or located in other states are subject to the tax if their Board (FTB) reports that only about three-quarters of California sales, property, or payroll exceed certain new corporations claim the exemption because many thresholds.) The minimum franchise tax ensures that all new corporations do not understand their tax filing of these businesses pay a minimum amount of tax for requirements. Overall, the exemption reduced state the right to conduct business here and for the benefits revenue by $60 million in 2017 (the most recent year for of limited liability protection, meaning their owners which data are available). Other newly formed business are not personally liable for the business’s debts. The entities that are subject to the minimum franchise tax, most common noncorporate businesses subject to the such as LLCs and LPs, cannot claim this exemption. minimum franchise tax include limited liability companies Growth in Number of New Noncorporate (LLCs), limited partnerships (LPs), and limited liability Businesses Outpaces Growth in New Corporations. partnerships (LLPs). We describe these in the box on In recent years, new business formation in California has page 4. In 2017, 1.6 million businesses were subject grown steadily and kept pace with the rest of the country. to the minimum franchise tax. Figure 1 (see next page) In addition to new corporations, about 250,000 LLCs, shows the number of business tax filers of each type GABRIEL PETEK LEGISLATIVE ANALYST MARCH 2020 analysis full gutter 2020-21 BUDGET Figure 1 California Businesses Pay $1 Billion in Minimum Franchise Tax Per Year (Dollars in Millions) Subject to Minimum Total Pass- Limited Minimum Franchise Corporation Number of Through Liability Franchise Other State Tax Tax and Fee Business Structure Taxpayers Businessa Protection? Tax? Tax or Fee? Collections Collectionsb Corporations C corporation 342,000 x x 8.84 percent tax $173 $7,381 on income. S corporation 615,000 x x x 1.5 percent tax 305 1,502 on income. Partnerships Limited liability company 567,000 x x x Income-based 454 1,044 fee. Limited partnership 71,000 x x x 57 57 Limited liability partnership 6,000 x x x 5 5 Totals 1,601,000 $994 $9,990 a “Pass through” means that the business is not directly taxed under federal law. The business income instead passes through to the owner (or owners) of the business who pay personal income tax (PIT) on their business income. b These amounts do not include any additional state and local taxes and fees paid by the owners of these businesses including PIT, sales and use tax, and property tax. partnerships, and sole proprietorships are formed in • Many real estate leasing companies create California each year. Figure 2 shows that the rate of a new, legally independent company to hold growth in new business formations has increased by each property that they own. about 3 percent per year since 2007, according to U.S. Census data. New business formation has been strongest Figure 2 among noncorporate businesses, Growth in New Noncorporate despite these businesses not being Businesses Outpaces New Corporations eligible for the first-year exemption Quarterly New Business Formations (In Thousands) from the minimum franchise tax. In particular, FTB reports that new 70 LLC registrations with the Secretary of State have increase by about 60 7 percent per year since 2007. Many Business Entities 50 Noncorporate Exist to Manage Investments. A significant number of new 40 companies are formed each year to independently hold and manage 30 investments. For example: Corporate 20 • Energy and real estate development companies 10 commonly form new partnerships to attract financing for new projects. 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET • Financial companies primarily Figure 3 exist to manage their owners’ Many LLCs and Partnerships Manage Investments investments and assets. The Internal Revenue Service Real Estate Health Care reports that half of all LLCs and Finance Manufacturing partnerships in the U.S. are Professional and Other real estate rental and leasing Technical Services businesses and 10 percent are financial companies. (FTB does Number of LLCs and Partnerships Compensation to Employees not provide similar statistics on LLCs and partnerships in California.) As shown in Figure 3, these businesses create relatively few jobs compared to companies in other industries. Nonetheless, finance and real estate companies often hold significant assets. Figure 3 shows that financial companies own 55 percent— nearly $18 trillion in 2017—of the total assets owned by all LLCs and Real estate LLCs and partnerships partnerships. account for relatively few jobs. Assets Income Distributed to Partners GOVERNOR’S PROPOSAL Extend the First-Year Minimum Franchise Tax Exemption to Noncorporate Businesses. The administration has proposed to extend the first-year exemption from the $800 minimum franchise tax to LLCs, LPs, and LLPs. The Finance LLCs and partnerships own $18 trillion Governor’s budget assumes the in assets and generate 83 percent of income distributed to partners. expansion of the exemption will result in a reduction of $50 million LLCs = limited liability companies. in General Fund revenues in 2020-21 and $100 million in 2021-22 and out-years. This estimate assumes that about 125,000 new eligible and LLPs would sunset on January 1, 2026. The noncorporate taxpayers claim the exemption each FTB also would be required to annually report the year. (The revenue assumption also makes a rough number of first-year businesses that are affected by adjustment for the timing of the revenue effect the exemption. in the first year.) The exemption for LLCs, LPs, www.lao.ca.gov 3 analysis full gutter 2020-21 BUDGET ASSESSMENT Tax Exemption Lacks a Strong Policy sunset date, and its effectiveness has never been evaluated. In our 2019 post on evaluating tax Justification expenditures, we explain that periodically reviewing The Minimum Franchise Tax Exemption Has tax expenditures is important because, like direct Not Been Closely Reviewed. Like many of the state expenditures, they have budgetary costs. state’s tax expenditures, the minimum franchise Such reviews can help policymakers assess tax exemption is not regularly reviewed, has no Types of Businesses Businesses Are Organized In Different Ways. Businesses take a variety of forms depending on the complexity of their ownership and management structure. The organizational form of a business determines how the federal and state governments tax the business and its owners. The primary considerations for determining which form to take include the number of owners, whether the owners are all actively involved in managing the business, and whether the owners need or want protection from financial liabilities. Sole Proprietorships and General Partnerships Are Owned and Principally Managed by Individuals. A sole proprietorship, owned and managed by an individual, is the most basic and most prevalent form of business entity. As we show in the nearby figure, nearly 70 percent of California’s 5 million businesses are sole proprietorships. When two or more individuals decide to jointly Number of Businesses in own and operate a business, they form a California by Entity Type partnership. A general partnership is similar to a sole proprietorship in that the owners are equally responsible for any debts or other liabilities of the business. Limited Liability Protection for Business Corporation 900,000 Owners. Unlike general partnerships, limited partnerships (LPs) and limited liability partnerships (LLPs) provide business owners Partnership or Limited Liability Company with limited liability protection. This means 700,000 Sole Proprietorship that the owners are not personally liable for 3.4 million the business’s debts. An individual or another company may be a partner in an LP or LLP. Corporations and Limited Liability Companies (LLCs) Are Legally Distinct Business Entities. An LLC is a business that is legally distinct from its owners (members). An LLC may not provide professional services or be a bank, insurer, or trust company. A professional services business is one owned by one or more individuals who have a state professional license, such as an engineer, accountant, or chiropractor. A corporation also is a business that is legally distinct from its owners (shareholders). Individuals or companies may own an LLC or a corporation. An LLC or a corporation may have just a single member or shareholder. 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET whether a tax expenditure is effective and merits by instead targeting benefits at newly formed continued financial support from the taxpayers. companies. This strategy poorly targets small Good Tax Policy Should Treat Similar business. Benefits from the exemption go to Taxpayers Similarly. In general, the state’s tax many companies that do not seem to meet any laws should treat businesses differently only to reasonable definition of a small business. For serve a clear policy goal. We see no obvious public example, major companies routinely form new policy benefit for the status quo of exempting corporations to facilitate financial transactions, raise a newly formed corporation from the minimum capital, and manage risk. Distinguishing between franchise tax, while a newly formed LLC, LP, or these new entities and actual small businesses LLP must pay the minimum franchise tax. That often is not possible from the information currently being said, there are two ways for the Legislature reported on tax forms. Similar problems would exist to address this unequal treatment: (1) extend if the exemption were expanded to LLCs, LPs, and the exemption to LLCs, LPs, and LLPs as the LLPs. About one-third of LLCs, LPs, and LLPs Governor proposes or (2) eliminate the exemption are owned by corporations or other companies entirely. We suggest that the Legislature consider and not by individuals. In addition, as discussed whether the exemption achieves a clear policy earlier, many new LLCs, LPs, and LLPs are formed goal. If the exemption does achieve a clear policy to hold and manage real estate property and goal, extending it is reasonable. Otherwise, other investments. Many of these companies have the Legislature should consider eliminating the significant assets, but generate comparatively little exemption for all businesses. economic activity in the way of buying and selling goods or employing workers. Current Exemption and Proposal Lack a Strong Policy Justification. The stated Legislative Provides Limited Relief to Businesses. intent of the current first-year minimum franchise Many businesses undoubtedly consider the tax exemption is to promote small businesses by $800 minimum franchise tax an unwelcome cost reducing the burden of the minimum franchise tax. of doing business in California. In most cases, The Governor’s proposal to extend the exemption however, the one-time tax exemption provides a to new noncorporate businesses uses similar relatively limited amount of financial assistance language. There are several reasons to think the to new businesses relative to the overall cost of exemption is an ineffective and poorly targeted starting a new business. These costs—such as means of promoting small business, which we equipment, construction costs, employee salaries, discuss below. and rent—often sum to tens of thousands of dollars, or considerably more. The number of LLCs Difficult to Identify Small Businesses. Small (which do not receive an exemption) has grown businesses are difficult to target in the tax code. more quickly than the number of corporations In large part, this is because a “small business” is (which do receive an exemption) in recent years. difficult to define and the definitions that currently While not conclusive, this suggests that the lack are used can vary across different industries. of the first-year minimum franchise tax exemption In addition, definitions typically rely on simple has not significantly hindered the formation of new thresholds, such as the number of employees businesses. or annual revenue, for practical reasons. These thresholds may not always reliably distinguish Other Issues small businesses. For example, a small business in a labor-intensive industry, such as a retailer Current Exemption May Obfuscate Tax or restauranteur, will employ many people, while Filing Requirements. About 25 percent of new a large financial investment firm with significant companies do not file a timely corporate tax return assets might employ far fewer staff. in their first year of business. We are concerned that the exemption itself may be confusing new Exemption Poorly Targets Small Business. companies that might infer that they are not The exemption attempts to avoid the challenge required to file a tax return because they are of defining which taxpayers are small businesses www.lao.ca.gov 5 analysis full gutter 2020-21 BUDGET exempt from the minimum franchise tax in their first corporations pay the CT four months after the end year. Taxpayers who do not file a timely tax return of the tax year, corporations and noncorporate may be subject to penalties and interest. Such businesses must pay the minimum franchise tax treatment of new businesses seems to be at odds during the taxable year. (For corporations, the with the intent of assisting small businesses that minimum franchise tax affects the amount of their are less likely to have access to experienced state first estimated tax payment.) The DOF appears to tax advisors. have based their assumption about when the state Proposed Reporting Requirements Add Little collects the minimum franchise tax on guidelines Value. The proposal would require FTB to report used for estimating the CT. This likely understates the number of first-year businesses claiming the the cost in 2020-21. FTB estimates the proposal exemption, including corporations. The Department will cost up to $110 million in 2020-21. of Finance (DOF) already is required to report this Out-Year Cost May Be More or Less Than information in its annual tax expenditure report. $100 Million Per Year. The DOF has assumed the Simply reporting the number of total exemption proposal would cost $100 million annually in the claims would not help the state to understand how out-years. This assumption is based on a 9 percent many small businesses specifically would benefit annual rate of growth in the formation of new LLCs. from the provision, nor to estimate the effectiveness This assumption may be reasonable, given the of the provision in stimulating new business amount of uncertainty regarding the future rate of formation. business formations, but it is somewhat faster than Budget Year Cost Likely More Than the historical average of 7 percent. A slower rate of $50 Million. The proposal likely will cost LLC formation would result in the proposal having somewhat more than $50 million in 2020-21. While a somewhat lower cost, while a faster rate of LLC formation would result in a higher cost. RECOMMENDATIONS Reject Proposal To Extend First-Year targeting small businesses, we recommend the Minimum Franchise Tax Exemption. We Legislature at some point consider addressing this recommend rejecting the administration’s proposal differential treatment by ending the exemption for to exempt LLCs, LPs, and LLPs from paying the corporations. $800 minimum franchise tax in their first year of Fiscal Effect of Our Recommendations. The business. Extending the exemption appears to be budget assumes the Governor’s proposal would an inefficient way to promote small businesses. have reduced General Fund revenues by $50 million Reconsider Current Exemption for in 2020-21 and $100 million in 2021-22 and Corporations. Although we recommend rejecting out-years. Ending the exemption for corporations an extension of the first-year exemption to LLCs, would increase General Fund revenues by more LPs, and LLPs, there could be merit in eliminating than $60 million. Relative to the Governor’s the current differential tax treatment of these budget, these two actions would increase revenues businesses. Given the limited benefit of the current by about $110 million in 2020-21 and about exemption for corporations and the difficulty of $160 million per year thereafter. 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET CONCLUSION Two decades ago, the Legislature adopted an problem the provision would solve. We, therefore, exemption from the state’s minimum franchise tax recommend the Legislature reject the Governor’s for corporations in their first year of business with proposal. Furthermore, we recommend at some the stated intent to provide financial assistance to point reconsidering the existing exemption for small businesses. This provision instead provides corporations. We recognize that, especially in limited, broad-based tax relief to nearly all new light of the growing economic impact of the corporations, including many that probably do COVID-19 outbreak, there is a general interest in not meet any reasonable definition of a small supporting small businesses. However, expanding business. The Governor’s proposal would expand this poorly targeted tax expenditure is not a good this poorly targeted tax expenditure to LLCs, LPs, option for achieving this goal. We suggest the and LLCs, without articulating a specific policy Legislature explore other options. www.lao.ca.gov 7 analysis full gutter 2020-21 BUDGET LAO PUBLICATIONS This report was prepared by Brian Weatherford, and reviewed by Brian Uhler and Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 8 LEGISLATIVE ANALYST’S OFFICE