California Gov. Gavin Newsom (D) has proposed tweaks to the state’s new passthrough entity workaround to the federal SALT cap and an accelerated restoration of scheduled business tax breaks that were suspended during the COVID-19 pandemic.
The governor included those and other tax provisions in his sizable $286.4 billion fiscal 2023 budget proposal, which he presented to lawmakers January 10. California is flush with revenue and federal aid dollars; notably, the state’s projected $45.7 billion surplus appears set to trigger the state’s “Gann limit,” a decades-old, voter-enacted limit on appropriations that would require the state to allocate excess revenues to schools and provide tax rebates to residents.
Newsom's budget proposes to modify the state's workaround to the Tax Cuts and Jobs Act's $10,000 cap on the federal state and local tax deduction, which allows eligible entities to elect to pay a 9.3 percent state tax on their owners' income at the entity level and allows owners to claim an equivalent tax credit against their California personal income tax. In response to complaints by businesses and tax experts that the workaround excludes taxpayers who own their share of passthrough businesses through disregarded entities, such as single-member LLCs, and that the credit can't be used to reduce a taxpayer's liability below the level of the tentative minimum tax, the budget proposes eliminating the tentative minimum tax limitation on the credit, calling the limitation unnecessary because "tax on the income has already been paid at the business entity level." The budget would also allow taxpayers who own their share of a passthrough entity through a disregarded entity to use the workaround.
“These changes should be enacted in time to assist businesses with their 2021 tax liabilities before the March 15, 2022 tax filing and payment deadline for pass-through business entities,” according to the budget summary.
Restoring NOLs and Credits
Noting that the state's "revenue picture has . . . improved dramatically," the budget also proposes an early end to the suspension of net operating loss deductions for businesses with more than $1 million in income and the $5 million cap on businesses using business tax credits, including the research and development tax credit, to offset their state tax liability. The NOL suspension and the tax credit cap applies to 2020, 2021, and 2022, but Newsom’s budget proposal would terminate it for this year, at a cost of $5.5 billion.
Notably, that reversal comes after legislators and life science companies in 2021 urged lawmakers and Newsom to exempt the life sciences industry from the policy.
Other Tax Proposals
Newsom’s budget contains several other tax policy proposals, including new tax credits to bolster business investment to combat climate change. An allocation of $250 million per year for three years would fund an “Innovation Headquarters Credit” to support in-state businesses that invest in "activities and technologies that mitigate climate change." The budget would also allocate $100 million per year for three years to fund a “Credit for Green Energy Technologies” to encourage development of technologies related to electric vehicle manufacturing, geothermal energy, battery manufacturing, energy storage, and emissions reductions, among others.
“The credit will be awarded by a newly created clean energy board at the Governor’s Office of Business and Economic Development (GO-Biz),” according to the budget summary. The program would also stipulate that as recipient businesses become profitable, some of their profits would be repaid to the state.
Newsom is also proposing to allocate $500 million over several years as tax relief for small businesses by conforming to federal law that provides tax exemptions for federal grants provided to businesses through the Restaurant Revitalization Fund and the Shuttered Venue Operators Grant program. “The Budget generally conforms California’s tax treatment of these grants to the federal treatment: exempting the grant amount from taxable income and allowing normal deductibility for the expenses related to those grants,” according to the proposal, which urges lawmakers to approve that conformity in time for businesses to use it when filing their 2021 tax returns.
Newsom’s budget also proposes expanding the state’s Young Child Tax Credit to include families with no income, indexing the credit for inflation, and establishing a refundable $1,000 tax credit for young adults aged 18 to 25 “who were former foster youth at age 13 or older.”
In a bid to provide relief to motorists, the budget also proposes to eschew the annual inflation adjustment to the state’s per-gallon excise tax on gas that’s set to take place in July. That would reduce state revenues by as much as $523 million in fiscal 2022–23 “based on an estimated 5.6 percent inflation rate,” according to the budget. Under the proposal, “the annual inflation adjustment will be resumed by 2023–24 with flexibility to delay the adjustment should economic conditions warrant it.”
Newsom is also proposing to work with lawmakers to modify the state’s taxes on legal marijuana, which the cannabis industry argues are hurting legal sellers and providing a price advantage to the state’s black market. California levies a weight-based cultivation tax with different rates for flowers, leaves, and fresh plant material, which was set to increase as of January to $10.08, $3.00, and $1.41, respectively. The state also imposes a 15 percent excise tax on the average market price of marijuana sold at retail.
“The Administration supports cannabis tax reform and plans to work with the Legislature to make modifications to California’s cannabis tax policy to help stabilize the market; better support California’s small licensed operators; and strengthen compliance with state law,” according to the budget summary. The administration also said it will explore ways to increase access to the legal marijuana market in the state, including through a grant program to provide assistance to local governments in order to facilitate legal sales in more jurisdictions.
Gann Limit
Notably, the governor’s budget predicts that the state’s sizable surplus puts it at risk of exceeding the Gann limit, a constitutional limit on appropriations that requires excess revenues to be split between schools and tax rebates to Californians when appropriations exceed a calculated limit over two consecutive years.
Lawmakers have some flexibility to appropriate money for purposes that don’t count toward the Gann limit. The budget advocates bolstering the state’s reserves using surplus dollars but notes that appropriating money to pad the state’s reserves would count toward the Gann limit.
“In addition to strengthening reserves, it is essential that one-time revenues be used for one-time expenditures in order to maintain fiscal stability. Maintaining a balanced budget over the long-term will minimize disruptions to core programs such as education and health care when revenues decline,” according to the summary.