California’s 2020 Legislative Session Offers Glimpse of Future State Tax Legislation Aimed at Filling Budget Gaps Created by COVID-19

Faced with a record budget shortfall as a result of the economic turmoil created by the COVID-19 pandemic, the California State Legislature adjourned its 2020 legislative session on August 31, 2020 after having enacted the state’s 2020‒2021 budget, which fully suspends net operating losses (NOLs) and limits the amount of tax credits that may be claimed by large to medium-sized businesses. California’s budget, other bills that were proposed but failed to pass during the state’s 2020 legislative session, and property tax ballot initiatives before voters in November may offer a preview of tax-hike proposals to come when the state legislature in the Golden State and in many other states convenes in January 2021.

Among the measures that did not pass was a bill to increase marginal income tax rates and another that would have exacted a first-of-its-kind net worth tax upon the wealthy. The sponsors of each of these proposals have indicated that they may reintroduce the bills in the next legislative session.

The action is not limited to the capitol in Sacramento. The November ballot will see a property tax initiative that would reassess commercial and industrial property values, and another that would remove exceptions to reassessment on transfers of real property between family members all in a bid to increase tax collections.

Below is a summary of the tax legislation enacted this summer, failed measures aimed at the wealthy that are likely to resurface when the legislature reconvenes in January as well as the property tax related ballot initiatives before California voters in November.

Enacted Laws ‒ California Suspends NOLs and Limits Credits to $5 million for 2020‒2022

On June 29, 2020, Governor Gavin Newsom signed the 2020 Budget Act, which also included budget trailer bills that sought to stimulate economic recovery in the midst of a $54 billion budget shortfall driven by the COVID-19 statewide shutdown. The California state legislature passed Assembly Bill (AB) 85, which is expected to generate over $9 billion in income tax revenue.

Key provisions of this bill suspend NOLs and limit credit usage.

Net Operating Losses Suspended for 2020‒2022

AB 85 suspends NOL use for corporations with $1 million or more of income subject to tax and individuals with $1 million or more of net business income or modified adjusted gross income subject to tax under California law. The AB 85 NOL suspension is operative for taxable years beginning on or after January 1, 2020, and before January 1, 2023. NOL carryover periods will be extended when the 2020–2022 suspension prevents the use of all or part of a prior year’s NOL, including a three-year extension for unexpired NOLs that were incurred before 2020, a two-year extension for NOLs incurred in 2020 and a one-year extension for NOLs incurred in 2021.

Credits Limited to $5 Million for 2020‒2022

AB 85 also imposes a credit utilization limit of $5 million. This credit limit applies to the “total of all business credits otherwise allowable” including carryovers. Corporations filing combined returns are limited to $5 million total for all taxpayers included in the combined report. The credit limitation does not apply to credits for earned income, young child, household/dependent care, adoption costs, renter’s tax credit, personal exemption, head of household, dependent parent, low-income housing, and unemployment insurance.

The AB 85 credit limitation is also operative for taxable years beginning on or after January 1, 2020, and before January 1, 2023, and, similar to the NOL suspension, the “carryover period for any credit that is not allowed due to application of this bill will be increased by the number of taxable years the credit or any portion thereof was not allowed.”

Taxpayers should consider options that may be available for the 2019 tax year that may ameliorate impacts to the 2020‒2022 years. For example, taxpayers might consider accelerating income in 2019 to use tax attributes that otherwise would be limited. Additionally, because California is unique among states allowing California-only elections and accounting methods, taxpayers might consider selecting accounting methods that ease the impacts of NOL suspension and credit limitation. Where methods depart from the federal income tax method, taxpayers may need the consent of the Franchise Tax Board.

Proposed Laws – California Income Tax Legislation Targets the Wealthy

California lawmakers also proposed revenue-raising bills taking aim at the wealthiest Californians. One measure (AB 1253) would raise marginal individual income tax rates and another (AB 2088) would implement a wealth tax. Neither measure made it out of committee before the session adjourned. However, sponsors of each bill have indicated that they may reintroduce the bills in the next legislative session (January 2021).

Net Worth Tax (AB 2088)

AB 2088 proposes a wealth tax of 0.4% imposed annually upon worldwide net worth in excess of $30 million (or $15 million if married filing separately). Taxable net worth would be the same as a taxable estate for federal estate tax purposes. The proposal provides an exception for real property owned directly by an individual but does not allow such exclusion for property owned by any form of entity. While long-time California residents may be subject to the proposed tax in its entirety, AB 2088 also imposes the tax upon new residents in proportion to the number of years such individual is a resident of California during the last 10 years. In addition, the bill attempts to implement a long-arm statute aimed at residents who leave California with no intention of returning. Under this provision, a former California resident would remain subject to tax for a period of 10 years following a departure from California. The tax would apply in proportion to the time the individual was a resident of California for the 10-year period ending with the most recent year.

The bill also extends beyond residents. Individuals who spend more than 60 days in the state in any given year are treated as temporary residents and would be subject to the tax in proportion to the number of days spent in California.

Increased Marginal Income Tax Rate (AB 1253)

California currently imposes the highest marginal individual income tax rate of any U.S. state. AB 1253 proposes to raise the income tax rate on individuals, estates and trusts with income above $1 million per year indexed for inflation. The bill proposes a retroactive increase for taxable years beginning on or after January 1, 2020:

• 1% on income over $1,181,484, but not over $2,362,968;
• 3% on income over $2,362,968, but not over $5,907,420; and
• 3.5% on income over $5,907,420.

AB 1253 would raise California’s individual income tax rate from 13.3% on taxable income over $1,181,484 and hike the maximum individual income tax rate to a staggering 16.8%.

Ballot Initiatives for November 3 – Propositions (Props) 15 and 19

In addition to the new and proposed income tax laws, proponents of two property tax measures celebrated their qualification to appear on the California statewide general election ballot scheduled for November 3, 2020.

Proposition 15

Proposition 15 seeks to partially overturn 1978’s Proposition 13, which limits property value reassessments to 2% per year for real property tax purposes. Property may be reassessed to fair market value only following a change in ownership. Enacted during Governor Jerry Brown’s first stint as California’s governor, Prop 13 was broadly hailed as a fair limit on the ever-increasing tax burdens placed by the state upon its citizens. However, Prop 13 limited revenue increases to local county property tax assessors, hindering local city and county balanced budgets across the state for decades.

As a result, during the last decade or so, legislators have periodically proposed rolling back Prop 13 for specified properties. Prop 15 is the latest assault on Prop 13, but with a twist. In an effort to garner voter support, this measure is targeted at commercial and industrial real property, excluding property zoned as commercial agriculture and residential property.

Prop 15 would amend the California Constitution to require reassessment at present fair market value (FMV) of commercial and industrial properties for property tax, while continuing to assess taxes on residential properties based on the most recent purchase price as between unrelated parties (as limited by Prop 13). This is why Prop 15 is also referred to broadly as the split-roll tax or initiative.

A Yes vote for Prop 15 by a simple majority of the voters will result in a significant change to California’s property tax regime, the impact of which would be broadly shouldered by owners and lessors of commercial and industrial properties.

Proposition 19

Similarly, Proposition 19 would upend a decades-long exception to property reassessment upon a transfer between parents and children. In 1986, voters overwhelmingly voted for Prop 58, which ensured no reassessment of transfers between parents and children of any home and up to $1 million dollars of assessed value of other property.

Prop 19 seeks to repeal Prop 58, thereby removing the family exemption. Inherited or transferred real property within families would be subject to reassessment above $1 million except where the recipient uses the property as their primary residence.

If passed, Prop 15 and 19 are expected to generate from $8 billion to $15 billion in revenue for local California governments annually.

The Takeaway

In response to the COVID-19 pandemic’s economic toll, California’s 2020‒2022 budget will fully suspend NOLs and limit the amount of tax credits that may be claimed by large to medium-sized businesses. Other states may take similar action, such as decoupling from some or all of the tax benefits under the federal Coronavirus Aid, Relief, and Economic Security Act (CARES) Act. While California may present unique planning options, the changing state and local tax landscape highlights the need to periodically review a taxpayer’s overall footprint. The likelihood of AB 2088 (wealth tax) or AB 1253 (increased individual marginal income tax rate) gaining greater legislative support may be dependent upon the fate of Propositions 15 (assessments on commercial and industrial properties) and 19 (removing the family exemption), state tax collections and other proposals to fill the state budget gap. While it is too early to discern whether voters will pass either or both Prop 15 and Prop 19, taxpayers with commercial and industrial real property in California and those contemplating inter-family transfers should keep a very close eye on polls as passage could result in significant future local property tax increases for owned or leased real property in California.

Andersen will continue to monitor all legislative action and provide updates as new matters arise.