It’s Not PersoNOL – California Enacts Tax Changes to NOL Deductions, Credit Utilization, and Apportionment – It’s Time to Revisit Yours

Issue No: 2024-30

Summary

California has passed legislation with immediate implications for businesses subject to tax in the state. Under the new law, businesses with over $1 million in taxable income will not be allowed to deduct net operating losses (NOLs) to decrease their taxable income for the tax years 2024, 2025, and 2026. Additionally, California has authorized a limitation to the amount of certain business tax credit deductions that businesses can take, capping it at $5 million per tax year. Businesses will have the opportunity to carry forward the NOLs and capped credits, and California is offering taxpayers the opportunity to take an “irrevocable election” entitling them to a partial refund of certain credit amounts. Additionally, the legislation amended the state’s apportionment rules by disallowing the inclusion of “amounts that do not give rise to apportionable income” in the sales factor. This is the time to revisit your California apportionment methodologies to reduce your expected increase in California cash tax liabilities in 2024, 2025, and 2026.

In Detail

Prior to the passing of its new fiscal year 2025 budget, the state of California reported a deficit of an estimated $46.8 billion. In response to this, the state adjusted its proposed budget to introduce multiple new tax laws that could increase the tax liability of many businesses that operate in California. On June 27, 2024, and June 29, 2024, California enacted bills containing material amendments to the Revenue and Taxation code, which are highlighted below:

Suspension of NOL Deductions

Similar to the NOL deduction suspensions previously seen in the early and late 2000s, and most recently in 2020 and 2021, California is suspending NOL deductions in 2024, 2025, and 2026. This limitation applies to businesses with more than $1 million of net business income during the taxable year. They will be unable to utilize their California NOLs to reduce taxable income during these tax years. NOLs carried into these disallowance years will have their carryover periods extended by up to three years.

Limitation on Business Tax Credits and Election for Refund

Similar to the tax credit limitations in 2020 and 2021, business tax credits will also face significant limitations going forward. Certain business tax credit utilization will be subject to a $5 million limitation in 2024, 2025, and 2026. Taxpayers will be offered the option of an irrevocable election that will entitle them to a future partial refund of the capped credits.

With potentially large California tax outlays on the horizon, now is the time to revisit California apportionment to determine whether there are more accurate and beneficial methods of sourcing receipts from sales of services, intangibles, and/or tangible personal property. Our National State & Local Tax (“SALT”) Team has extensive experience working with clients to identify and pursue such apportionment opportunities.

Amendment to the Sales Factor

In addition to the NOL and credit limitations discussed above, the bill retroactively amends the California apportionment formula used by businesses, excluding some forms of income from the sales factor computation. Specifically, according to Revenue and Taxation Code section 25128.9, businesses will not be allowed to include amounts that are “not included in net income.” These amounts may consist of deductions, eliminations, and non-recognized income. This amendment was passed in response to a decision by the California Office of Tax Appeals that ruled in favor of Microsoft Corporation. Microsoft argued that it should be allowed to include gross foreign dividends in its sales factor calculation for California apportionment, even though 75% of the dividends qualified for a dividend received deduction.

The favorable decision entitled Microsoft to claim a refund of over $94 million in prior year taxes paid and exposed California to $1 billion in potential refunds filed by other taxpayers. With the amendment to its sales factor computation, California is attempting to retroactively reduce its liability on this front and reduce the opportunity for taxpayers to claim refunds.

Insights

As a result of California’s NOL deduction suspensions and business tax credit limits, many taxpayers who previously relied on these tax attributes to reduce or eliminate California taxes may be surprised with significant cash tax liabilities. This is the time to revisit California apportionment to determine whether there are more accurate and beneficial apportionment sourcing methods to reduce anticipated California cash tax liabilities in 2024, 2025, and 2026.

Contact the National SALT team today to speak with one of our state tax professionals to determine whether you can benefit from one of the California apportionment opportunities we have successfully pursued for other clients.

NOW! Expertise

Yoni Fix

Mike Shaikh