California’s latest budget bill, SB 167, could pose challenges for startups and businesses with large start-up costs and initial losses by suspending the net operating loss deduction for tax years 2023, 2024, and 2025 and limiting the use of business tax credits to $5 million during the same period. The bill, which passed on June 13, awaits Governor Gavin Newsom’s (D) signature.
While these measures are intended to stabilize state revenues without raising taxes, in many cases they will lead to liquidity problems for businesses and reduce tax deferrals, impacting their ability to plan and invest. Businesses whose financial models depend on being able to carry forward these losses into future profitable years will face immediate cash flow problems if the bills become law.
California has used the net operating loss exemption since the early 1990s to cover budget deficits during economic downturns, such as the Great Recession of 2008 to 2011. Similarly, state limits on business tax credits, including the research and development tax credit, are intended to generate immediate revenue.
Technology and biotechnology companies likely experienced substantial financial strain during the shutdown period from 2008 to 2011, typically due to extended periods of R&D expenditures and initial losses. The inability to use R&D credits exacerbated these problems, reducing cash reserves and potentially reducing innovation investments.
SB 167 reflects California’s continuing strategy to address budget shortfalls in a variety of ways.
Increased tax burden. Companies will no longer be able to offset their taxable income with net operating losses, which could create a significant financial burden for companies with large accumulated losses.
It creates cash flow challenges. Those most affected will be start-ups and companies in the higher R&D expenditure stage. For many start-ups and R&D stage companies, access to losses and credits will allow these companies to continue investing in innovation. If funds originally allocated for innovation and new product development are now being diverted to California income and franchise taxes, these companies may need to divert funds from other sources to continue growing.
Tax credit deferral. While the tax suspension provides states with immediate revenue, companies may carry forward these losses and unused deductions, resulting in a backlog of deferred tax assets, which could impact future profitability and tax planning strategies.
It impacts investment and growth. Limitations on business tax credits, particularly the Research and Development Tax Credit, could reduce investment in innovation. Companies may scale back their research and development activities, affecting their long-term growth prospects and competitiveness.
Companies need to consider several aspects as they prepare for the bill’s passage.
Tax Planning and Cash Management. Companies may face cash flow and liquidity problems due to the inability to offset California income/franchise tax liabilities. Considering approaches to reduce their California tax base (such as apportionment studies) may alleviate short-term cash flow issues.
Accelerate your federal deductions using federal tax attributes and accounting methods. Companies should consider possible changes to their federal tax attributes and accounting methods that could reduce their federal taxable income. For example, accelerating the use of deductions through a federal election or a change in accounting methods could reduce federal taxable income and, therefore, reduce the company’s California tax liability.
Consider Future tax position. It is important to have a plan in place for the ultimate use of net operating loss deferrals and credits when the moratorium is lifted, including adjusting strategic forecasts and financial plans to optimize future tax benefits.
Future Suspensions and Restrictions. California has indicated its intention to periodically suspend tax attributes. Knowing this will allow businesses to be prepared for next time. Businesses may need to consider accelerating their use of California losses or credits after the current restrictions are lifted, given that these restrictions will likely be reimposed in the near future.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Shail P. Shah is a shareholder at Greenberg Traurig, a firm focused on complex California tax planning and representation.
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