February of 2022 brings a variety of noteworthy California income tax developments, including:
- A largely taxpayer-friendly bill signed by Governor Newsom.
- A significant policy change by the Franchise Tax Board (FTB) regarding nexus that could negatively impact retailers selling products online to California customers.
- Issuance of 2021 form by the FTB requiring the reporting of tax basis capital on a California basis and disclosures related to unclaimed property compliance.
Below, we dive into each California income tax development and what it could mean for taxpayers.
Senate Bill 113: Business Friendly Tax Legislation Enacted
On February 9, 2022, Governor Newsom signed Senate Bill 113 (SB 113). The bill contains taxpayer-friendly provisions lifting early pandemic restrictions on net operating losses (NOLs) and expanding the scope of the Pass-through Entity Tax regime enacted in 2021.
Reinstatement of NOL and Certain Credit Usage
At the beginning of the pandemic, California suspended NOL use for taxpayers with net business income of $1 million or more and limited the use of tax credits to $5 million. The suspensions were originally applicable to calendar tax years 2020, 2021 and 2022.
The limitations were put in place to raise revenue when state policymakers projected significant revenue reductions associated with the pandemic. Today, with the state budget picture considerably better than expected (due to revenue growth and federal government COVID-19 relief funding), the NOL/Credit suspensions are lifted one year early and will no longer apply starting with the 2022 tax year.
Amendments to the Pass-through Entity Tax
In 2021, California enacted AB 150, implementing a new passthrough entity level tax election as a workaround to the federal $10,000 limitation on state and local tax (SALT) deductions for individuals. Several provisions of the original legislation were criticized as overly restrictive. For example, the original legislation limited the range of entities and owners who could participate in the SALT Cap workaround. SB 113 addresses many of these criticisms:
- Pass-through entities having a partnership as a partner can now make the election. This was not permitted under the original legislation.
- Owners of pass-through entities can now hold their membership interests through a limited liability company that is disregarded for federal income tax purposes. Under the original bill, an owner holding their interest through a disregarded LLC could not participate as a qualifying electing taxpayer.
- Guaranteed payments to owners may now be included in the qualified entity’s pass-through entity tax base. This provision overturns previously issued FTB guidance that guaranteed payments were not included in the net income of a qualified entity.
- Owners of electing pass-through entities may now use their PTET credits to reduce regular tax below the tentative minimum tax.
Taxpayers who concluded that an election was not permissible or feasible under the original legislation may wish to reconsider an election in light of SB 113.
TAM 2022-01: FTB Restricts Applicability of PL 86-272 for Internet Retailers
On February 14, 2022, the FTB issued Technical Advice Memorandum 2022-01 (TAM 2022-01). The guidance limits the protection of Public Law 86-272 for internet retailers who sell products to California customers.
Public Law 86-272 (PL 86-272) is a 63-year-old federal law prohibiting the states from imposing net income taxes on sellers of tangible property when the activities of the seller are limited merely to solicitation. Many internet retailers have claimed exemption from California’s income tax because their online presence has previously been deemed to be mere solicitation.
The FTB’s new guidance limits PL 86-272 protection for online retailers. The TAM expands the list of “unprotected activities” to include many common aspects of internet retail sites, such as:
- Providing post-sale assistance regarding products via electronic chat or e-mail customers initiate by clicking on an icon on the website
- Placing of certain “cookies” onto the computers or other electronic devices of California customers
- Transmitting code to a California customer to upgrade or repair previously purchased products
- Selling extended warranties over the internet site
- Maintaining the taxpayer’s inventory at the warehouse of a marketplace facilitator (such as Amazon)
- Selling digital video and streaming services
Many of these activities are integral to the operation of a retail internet site. In light of this guidance, taxpayers should review TAM 2022-1 to consider impacts to their California PL 86-272 positions.
California’s guidance closely follows the Multistate Tax Commission’s updated guidance regarding internet selling, which was issued last August. We expect many additional states to adopt similar guidance going forward. Internet retail businesses should closely monitor this activity across the states and continue to review PL 86-272 positions.
FTB Requires Tax Basis Capital Reporting Beginning With 2021 Partnership and LLC Returns
Beginning with the 2021 tax returns for partnerships (Form 565) and limited liability companies (Form 568), the FTB now requires tax basis capital to be reported on Schedules M-2 and the partner/member K-1s. This is similar to the capital reporting requirement mandated by the IRS beginning with the 2020 returns. The FTB refers 2021 filers to the Federal Form 1065 instructions for further information.
Although not directly stated by the FTB within the instructions, it appears California (rather than federal) tax basis capital should be reported because the words “Use California amounts” appear at the top of Schedule M-2 for both the partnership and LLC forms.
FTB Requires Disclosure of Unclaimed Property Tax Compliance on Certain Income Tax Returns
Certain California returns also contain new questions related to unclaimed property compliance. Last July, California adopted legislation authorizing the FTB to share taxpayer information with the State Controller’s Office. The Controller’s office administers the state’s unclaimed property program. Pursuant to the new legislation, California’s corporation, partnership, and LLC returns will now contain the following questions:
- “has the business entity previously reported unclaimed property Holder Remit Report with the State Controller’s Office? [Yes/No]
- “if “yes”, when was the last report filed?
- “amount last remitted?”
The FTB may share the responses with the Controller’s office resulting in notices or inquiries. The new inquiries reflect an increasing aggressiveness across the states related to unclaimed property non-compliance. California has a 10-year unclaimed property lookback period and a 12% interest rate applicable to unremitted items. Furthermore, California does not have a voluntary disclosure program for unclaimed property. In light of these developments, California companies should consider their historic compliance and internal controls related to unclaimed property.
Each of these new developments could have significant consequences to California income taxpayers and those looking to do business in the state of California.
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