On May 10, 2024, California Governor Gavin Newsom released a revised budget for 2024-2025 that includes, among other changes, a temporary suspension on the use of net operating losses (NOLs) for businesses with California income in excess of $1 million and limitations on business incentive tax credits for tax years 2025, 2026, and 2027. On May 29, 2024, California Senate and Assembly leaders announced a budget agreement that includes these changes but accelerates the suspension on the use of NOLs and limitations on tax credits by one year, for tax years 2024, 2025, and 2026. Notably, since these rules would be in effect for the entire 2024 taxable year, taxpayers may have already concluded transactions that would implicate these rules. While the budget has not been finalized, the similarity between the Governor’s proposal and the budget agreement released by the Legislature suggests that these provisions are likely to be included in the final budget in some form. Companies with California source income should be aware of the impact to them of these potential changes.
Under the temporary suspension on the use of NOL deductions, taxpayers who have historically operated at a loss, but who have business income in excess of $1 million in any of the affected years, will not be able to use their historical NOLs to offset income for California tax purposes. This provision could implicate companies that have a significant increase in business income from year to year, e.g., as a result of a one-time sale of assets or cancellation of debt income arising from restructuring debt or that enter into large, milestone-based contracts with a substantial upfront payment. These taxpayers may now be faced with California tax on income recognized in the affected years that is apportioned to California, even though NOLs are largely available to offset the income for federal tax purposes. California previously implemented a similar temporary suspension on the use of NOL deductions in 2008 and 2020.
The budget agreement also limits the use of business incentive tax credits, including R&D tax credits, to offset no more than $5 million of tax liability in the affected years. The Low-Income Housing tax credit and the Pass-Through Entity Elective tax credit are exempt from this limitation.
Further, Governor Newsom’s budget proposal included a provision intended to “clarify” existing law such that a corporation that receives income that is excluded from taxable business income must exclude this income from its apportionment factor. This provision appears to target the Office of Tax Appeals’ holdings in two recent cases1 that income that is deductible from a taxpayer’s tax base is nevertheless included in the sales factor numerator and denominator for California state apportionment purposes.
Business taxpayers who have recognized or anticipate recognizing significant California income (including as a result of debt restructuring) in 2024 and subsequent years should consult a Wilson Sonsini tax attorney or other tax adviser regarding the impact of these rules. Wilson Sonsini will continue to monitor the California budget process and will post updates as the provisions are finalized.
[1] In The Matter of the Appeal of Microsoft Corporation and Subsidiaries, 2024-OTA-130 (Cal. OTA July 27, 2023) and In the Matter of the Appeal of Southern Minnesota Beet Sugar Co-op., 2023-OTA-342P (Cal. OTA March 17, 2023).
