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Pandemic Relief for Small Business

Posted on Jan. 11, 2021
Kathleen K. Wright
Kathleen K. Wright

Kathleen K. Wright is the director of the state and local tax program in the School of Taxation at Golden Gate University, San Francisco. She frequently presents seminars on SALT issues for the California CPA Education Foundation.

In this installment of States of Mind, Wright summarizes the tax relief measures provided by California during the pandemic.

The financial impact of the pandemic on small business is sobering. To put it in perspective, small businesses comprise 99.8 percent of the 4.1 million businesses in California and employ 48.5 percent of the state’s workforce. In an August 2020 survey, 44 percent of small businesses reported that they were at risk of shutting down. And from my own informal and unscientific survey, I have observed through my daily walks in San Francisco neighborhoods that restaurants, coffee bars, salons, and gyms have closed or are struggling.

Much has been written about federal assistance programs, so what is the state doing? Here is a summary of tax relief measures provided by California, which itself is looking to the federal government for financial assistance, as well as burdensome tax measures enacted as part of the budget process.

Tax Relief Measures

Payroll Protection Plan Loans

The Coronavirus Aid, Relief, and Economic Security Act created Payroll Protection Plan loans, which are designed to provide direct incentives for small businesses to remain open and retain workers on the payroll. The loan is administered by the Small Business Administration, which has the authority to forgive the loan if all employee retention criteria are met and the funds are used for eligible expenses. If the SBA forgives the loan, it then pays the lender the amount of debt forgiveness (and essentially, the debt is forgiven). No collateral or personal guarantees are required from the borrower.

The loans are forgiven for payroll costs, mortgage or rent obligations, and specific utility payments incurred between February 15, 2020, and December 31, 2020. The amount forgiven is excluded from the taxpayer’s gross income and not considered cancellation of debt income for federal income tax purposes.1

Although several issues have arisen regarding this transaction, the most controversial is the IRS position on deductibility of expenses paid with PPP loan proceeds. In Notice 2020-32,2 the IRS concluded that these expenses are not deductible under IRC section 265. IRC section 265(a)(1) states that “no deduction is allowed to a taxpayer for any amount otherwise allowable as a deduction to such taxpayer that is allocable to one or more classes of income . . . wholly exempt from taxes.” This was not what taxpayers expected; rather, during a crisis, they expected a “double dip.” This was followed by Rev. Rul. 2020-27,3 which prohibits the deduction of expenses paid with PPP loan proceeds that the taxpayer reasonably expects will be forgiven by the SBA.

Believing that this was an unintended consequence, some members of Congress are pushing legislation to reverse the IRS position and allow the expenses to be deducted. If their effort is successful, California would have to enact conformity legislation.

Gov. Gavin Newsom (D) did sign A.B. 1577 (CH 39-2020), which conforms California law to federal law by excluding from gross income the debt forgiveness related to the PPP loans. According to the Franchise Tax Board’s bill analysis, the FTB will follow the IRS guidance in Notice 2020-32 — which is consistent with California law generally as discussed in Information Letter 2010-5. This ruling clarified that when the Revenue and Taxation Code conforms to the IRC, federal administrative guidance applicable to the IRC governs the interpretation of conforming state statutes.

A second issue with PPP loans is whether the debt forgiveness will become part of qualified business income (QBI) for purposes of the IRC section 199A deduction. QBI is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business — including income from partnerships, S corporations, sole proprietorships, and some trusts — that serves as the base for computing the 20 percent section 199A deduction. There is no IRS guidance yet, but whatever it decides, there won’t be much impact on the California tax return in a state that did not conform to IRC section 199A.

The Main Street Hiring Tax Credit

S.B. 1477 (CH 41-2020) allows a small business hiring credit against state income taxes or sales and use taxes for specific California qualified small business employers that receive a tentative credit reservation.

The credit only applies to California small businesses that meet the following qualifications:

  • employed 100 or fewer employees as of December 31, 2019; and

  • suffered a 50 percent decrease or more in gross income tax receipts (generally, all income less returns and allowances), when comparing second quarter 2020 with second quarter 2019.4

Funding for the Small Business Hiring Tax Credit program totals $100 million. Generally, qualified employers may receive a credit of $1,000 for each net increase in qualified employees from April 1, 2020, through June 30, 2020, compared with July 1, 2020, through November 30, 2020. The total credits received cannot exceed $100,000 for each qualified California small business employer.

Taxpayers may claim the credit against their personal income tax, corporation income and franchise taxes, or sales and use tax liability. The credit against personal income taxes or corporation franchise taxes may only be claimed on a timely filed original return. Unused credits may be carried forward for up to five succeeding taxable years. Wage deductions claimed by the employer must be reduced by the amount of credit claimed.

On December 1, 2020 the California Department of Tax and Fee Administration (CDTFA) began accepting applications for tentative small business hiring credit reservation amounts. The credit is allocated on a first-come, first-served basis. Applications will be accepted until the earlier of (1) January 15, 2021, or (2) the date the maximum cumulative total allocation of $100 million is reached.

Other general credit restrictions will also apply to the Main Street Hiring Credit. One of those restrictions is the special provision that limits the S corporation use of any allowable credit to one-third of the credit amount. Also, credits that are allowed only under the corporation tax law may not be passed through to shareholders. However, regarding any credit allowed under both the corporation tax and personal income tax laws, shareholders may take the entire credit to which they are entitled under the personal income tax law, without the one-third limitation.5 The one-third restriction applies whether the S corporation elects to apply the credit against the sales and use tax or the franchise (income) tax.

Example. Il Vagabondo Inc., an old-fashioned Italian restaurant organized as an S corporation in Los Angeles, specializes in providing a dining experience of ethnic Italian food and even has an indoor bocce ball court. It caters to groups who want to have fun in an old-world environment. When the pandemic hit, Il Vagabondo’s business dried up.

The restaurant employed 15 employees at the end of December 2019. It temporarily closed because of COVID-19 on April 1, 2020 then reopened on August 1, 2020. Since Il Vagabondo was closed during the second quarter (April 1 to June 30, 2020) and laid off all of its workers, it had no employees.

From the period of August 1 to November 30, 2020 Il Vagabondo had five average monthly full-time equivalent employees. Because these five employees all counted as a net increase in full-time equivalent employees, the restaurant qualified for up to $5,000 in credits.

Il Vagabondo can also use $1,666 against the franchise tax imposed on the S corporation, and it will be able to pass through $5,000 of credit for use by its individual shareholders.

Example. Because of another surge in COVID-19 cases and limited hospital space, in December Il Vagabondo was again ordered to stop all indoor and outdoor dining and limit service to delivery and takeout. The business temporarily closed a second time and let all five employees go. Il Vagabondo still qualifies for the hiring credit in 2020, because there is no requirement that employees hired between July 1 and November 30, 2020 be retained for any specific period.

Filing Due Dates

In a March 18, 2020 news release, the FTB stated that it will conform to the federal July 15 extended due date for filing and payment of state income taxes for all taxpayers. The relief postpones the filing and payment of state income taxes related to:

  • 2019 tax returns;

  • 2019 tax return payments;

  • 2020 first- and second-quarter estimate payments;

  • 2020 limited liability company taxes and fees; and

  • 2020 non-wage withholding payments.

On May 30, 2020 the governor signed an executive order that allows the CDTFA to offer a 90-day extension for tax returns and tax payments for all businesses filing a return for less than $1 million in sales and use taxes. That means small businesses will have until the end of July to file their first-quarter returns.

On November 30, 2020 Newsom and a CDTFA press release announced that an additional three-month extension is automatically granted for sales and use tax payments and returns originally due between December 1, 2020, and April 30, 2021. The extension is automatic and applies to businesses that owe up to $1 million in sales or use tax. No word on any extension for state income tax returns.

Minimum Franchise Tax for New Businesses

LLCs, limited liability partnerships, and limited partnerships are now eligible for the tax holiday that has been available to corporations for many years.6 For years beginning on or after January 1, 2021, and before January 1, 2024, A.B. 85 provides a first-year exemption from the $800 annual tax imposed on an LLP or limited partnership that files a certificate of limited partnership or registers with the Office of the Secretary of State, or an LLC that organizes or registers with the secretary of state. The Legislature kept its hand on its purse strings by providing that the exemption will not be available unless at least $1 is appropriated in the California budget for FTB costs associated with administering the exemption. If no funds are allocated, no exemption is available.

Burdensome Tax Measures

Net Operating Losses

Although any assistance is welcome relief for the many struggling businesses hit by the pandemic, two tax measures enacted as part of the 2020 budget stand out: restrictions on use of net operating losses and tax credits.

NOLs are suspended for tax years beginning on or after January 1, 2020, and before January 1, 2023.7 This is a favorite revenue raiser of lawmakers, who have used NOL suspensions several times to balance past budgets. But with so many small businesses on the brink of failure and needing every penny of tax savings thrown their way, it’s not a wise policy choice in 2020.

Very small businesses will get some relief from the suspension that does not apply to businesses:

  • subject to the personal income tax if they have net business income or modified adjusted gross income of less than $1 million; and

  • subject to the corporation income tax if their business income subject to California tax is less than $1 million.

Modified AGI means the taxpayer’s federal AGI without regard to the NOL deduction.

Business income is defined to include income:

  • from a trade or business, whether conducted by the taxpayer, partnership, or S corporation owned directly or indirectly by the taxpayer;

  • from a rental activity; or

  • attributable to a farming business.

As in prior years, any NOL or NOL carryover disallowed as a result of the NOL suspension will result in an extension of the 20-year maximum carryover period. Therefore, NOLs suspended during the 2021 tax year will get one year added to the carryover period. NOLs suspended during the 2020 tax year will get two years added to the carryover period.

Tax Credits

For tax years beginning on or after January 1, 2020, and before January 1, 2023, the business credits that can be applied against the personal income, corporation franchise, and income taxes are limited.8 For those years, business credits may not reduce a taxpayer’s net tax by more than $5 million. The limitation applies to the research and development credit, the film and television tax credit, the new jobs credit, and the California Competes Tax Credit. The limitation also applies to taxpayers who use the film and television credit against their sales or use tax liabilities. For unitary businesses, the limitation is applied on a combined reporting group basis. The carryover period for any credit not used as a result of this limitation increases by the number of tax years the credit was not allowed.

Example. ABC Corp. is a unitary business group consisting of more than 100 corporations. ABC is a large pharmaceutical company engaged in extensive R&D activities related to several drugs under development. Only 38 members of the group incurred a 2020 California tax liability. Three of these subsidiaries generated approximately $9 million in research credits ($3 million attributed to each of the three subsidiaries).9

After filing a combined report for the unitary group in 2020, ABC determines that it has a $15 million tax liability in California. The liability of the three subsidiaries that generated R&D tax credits is $6 million — or approximately $2 million attributed to each subsidiary. Therefore, under prior case law, the ABC group can only use $6 million of the $9 million credits. In General Motors Corp. v. FTB,10 the California Supreme Court made clear that credits can only be used by the entity that generates the credit.

The $5 million limitation, however, applies to the unitary group as a whole (despite the fact that the credit can only be used by the member that generated it). Since the total amount of credits used by the group against its California tax liability is $6 million, the credit limitation applies — reducing the total credit allowed to $5 million. There is no guidance yet on how to allocate the $1 million reduction amongst the unitary group members.

Conclusion

As California enters a second round of lockdown and curfews, the light at the end of the tunnel for small businesses seems distant. California — and all the other states — must operate within budgetary constraints, so only so much can be expected from the state. More federal help is desperately needed because we are only in the second stage of this virus. Looking forward, 2021 will ideally bring enough vaccine to halt the deadly spread of COVID-19 and bring us back to some semblance of a normal lifestyle and spending habits. But history suggests extreme caution, because the 1918 pandemic lasted over three years with four stages of outbreak.

FOOTNOTES

2 Notice 2020-32, 2020-21 IRB 837.

3 2020-50 IRB 1552 (Nov. 18, 2020).

4 Rev. and T.C. section 17053.72 and 23627.

5 Rev. and T.C. section 23803.

6 A.B. 85 (CH-8, June 29, 2020) amending Rev. and T.C. section 17935, 17941, and 17948.

7 Rev and T.C. section 17276.23 and 24416.23.

8 Rev. and T.C. section 17039.3 and 23036.3.

9 Rev. and T.C. section 23609.

10 39 Cal. 4th 773, 47 Cal. Rptr. 3d 233, 139 P. 3d 1183 (Aug. 18, 2006).

END FOOTNOTES

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