California AB 85: Key Business Tax Changes

California Assembly Bill 85 (AB 85) introduced several tax adjustments for individuals and businesses. The bill created a distinct set of rules for taxpayers in the state by not fully conforming to federal changes, impacting the taxability of federal relief funds, business deductions, and credits. The legislation addressed immediate fiscal needs while also providing targeted relief to new business ventures.

Paycheck Protection Program Loan Conformity

The tax treatment of Paycheck Protection Program (PPP) loans in California evolved significantly. Initially, AB 85 made the forgiven portion of a PPP loan taxable state income and disallowed deductions for expenses paid with those funds. This position was later reversed by subsequent legislation, including Assembly Bill 80 and Senate Bill 113, which retroactively aligned California with federal rules for eligible taxpayers.

For tax years beginning on or after January 1, 2019, forgiven PPP loan amounts are not included in taxable gross income. Additionally, the ordinary and necessary business expenses paid for with those forgiven funds are fully deductible for state income tax purposes. This conformity simplifies tax preparation for many California businesses.

To benefit from this treatment, a business must be an “eligible taxpayer.” This excludes publicly traded companies and businesses that cannot demonstrate a 25% or greater reduction in gross receipts. The gross receipts test requires a comparison of a calendar quarter in 2020 to the same quarter in 2019. Businesses should use their total sales, not just California sales, to determine if they meet this threshold.

Net Operating Loss Suspension

A Net Operating Loss (NOL) occurs when a business’s allowable tax deductions exceed its taxable income for a given year. AB 85 suspended the ability for certain taxpayers to use their NOL carryover deductions for the 2020, 2021, and 2022 tax years. This measure was aimed at increasing state revenues.

The NOL suspension was targeted at higher-income taxpayers. The limitation applied to corporations and individual taxpayers with net business income of $1 million or more. Taxpayers with income below this threshold were unaffected and could continue to use their available NOLs.

The suspended losses were not forfeited. AB 85 extended the carryover period for any NOLs that were denied due to the temporary suspension. The carryover period was extended by three years for losses incurred before 2020, two years for 2020 losses, and one year for 2021 losses. This ensures that businesses can eventually utilize the full value of their losses.

Business Tax Credit Limitations

AB 85 also placed a temporary cap on the use of various business tax credits for the 2020, 2021, and 2022 tax years. The law limited the total amount of business tax credits a taxpayer could claim to offset their liability to $5 million per year. This cap applied to the aggregate amount of credits claimed by all members of a combined reporting group.

This $5 million limitation affected a broad array of credits, including the Research and Development (R&D) credit, the California Competes Tax Credit, and the New Employment Credit. The restriction applied to both new credits earned during the year and any credit carryovers from previous years.

Any business tax credits that could not be used because of the $5 million annual cap were not lost. The law stipulated that the carryover period for these excess credits would be extended, preserving their value for use in future tax years once the temporary cap expired.

First Year Limited Liability Company Fee Exemption

Most business entities in California are subject to an annual minimum franchise tax of $800, payable to the Franchise Tax Board regardless of business activity or profitability. A relief measure within AB 85 was the reinstatement of a first-year fee exemption for certain new businesses.

AB 85 extended this first-year exemption to new Limited Liability Companies (LLCs), Limited Liability Partnerships (LLPs), and Limited Partnerships (LPs). Any of these entities that organized, registered, or filed with the California Secretary of State between January 1, 2021, and January 1, 2024, were exempt from paying the $800 annual tax for their first taxable year.

This provision was intended to encourage new business formation by reducing startup costs. The exemption was automatic for qualifying entities. The requirement to pay the annual tax commenced in their second taxable year of operation. This exemption expired at the end of 2023, and new entities formed on or after January 1, 2024, are now required to pay the $800 minimum franchise tax during their first year.