Friday, August 15, 2008

Businesses' loss could be state's gain

Budget proposal would suspend net operating loss tax deduction

Sacramento Business Journal - by Tanya Roscorla Correspondent

California legislators have created a potential money-saving solution to the state budget shortfall that could hurt many small businesses if it passes.

Current California tax law allows businesses to carry forward 100 percent of their losses and deduct them on their tax returns for up to 10 years. The deductions offset their taxable income in profitable years.

Budget Conference Committee members passed a state fiscal plan in July that would suspend net operating loss carryover for three years and increase revenue from other sources.

Committee members would like to reach a deal with the Republicans and Gov. Arnold Schwarzenegger before they bring the state budget plan to the legislative floor, said Lynda Gledhill, spokeswoman for Don Perata, Democratic Senate president pro tem.

The plan would help reduce the budget shortfall of $15.2 billion and generate $1.1 billion in revenue from the suspension of net operating loss carryover, committee members say.

The other proposals include:

* Reinstate the 10 percent and 11 percent tax brackets ($5.6 billion)

* Collect past due taxes ($1.5 billion)

* Suspend a tax adjustment for upper-income taxpayers ($815 million)

* Increase the franchise tax from a top rate of 8.84 percent to 9.3 percent ($470 million)

* Roll back the dependent tax exemption credit for taxpayers with more than $150,000 in adjusted gross income ($215 million).

Businesses could carry over their losses for 20 years once the state lifts the suspension.

If they have not deducted their first-year losses by the 20th year, they lose the opportunity to carry over the loss from the first year. Business owners must use the oldest deductions first and lose them a year at a time.

Exemption proposed

The proposed suspension would hurt small businesses, said Joe Greenstreet of Broadstreet Financial Group in Nevada City.

Startup businesses typically accumulate debt in the first three years before they become profitable, Greenstreet said. The net operating loss carryover gives them tax relief so they can focus on paying off debt.

The proposal would impact businesses that have been operating for two to five years more than it will impact businesses that start this year, Greenstreet said.

Scott and Karen Alvord opened a family-run tea and ice-cream parlor three years ago in downtown Roseville. Scott Alvord said he's been carrying over losses from A Dash of Panache on his tax returns for years.

"Our business is holding its own, but it's still not profitable after three years, and not being able to carry over a loss is definitely going to be difficult for us," Alvord said.

He said that it is depressing to figure out where the money will come from to pay taxes each quarter.

Small Business California proposes that legislators exempt small businesses that have less than $5 million in annual gross receipts, said Scott Hauge, president of the business advocacy organization. The suspension would discourage business owners from investing in their companies and creating new jobs.

"All you're doing is just delaying the payment of this money and making future budgets worse," Hauge said.

Exempting businesses with less than $5 million in gross receipts would not help Robert Deitz. His Shingle Springs-based corporation, Government Technology Solutions, brings in more than $5 million in gross receipts even though he has fewer than 10 employees.

The technology industry considers his business small, but Small Business California would not under the proposed exemption, Deitz said.

He calls the budget committee's proposal "horrible."

"It's one of the dumbest things I've ever seen," he said.The proposal tells businesses that they are not wanted in California, Deitz said.

He has carried over net operating losses for two of the 11 years that the company has existed.

Not all small businesses would be affected by the suspension of the net operating loss carryover.

Mary Griffin does not carry over losses on her contract lobbying firm Griffin & Associates in Sacramento. She operates on a cash-and-carry basis and does not have overhead, so she would not be affected by the proposal like a retail store would.

But most small businesses don't have the ability or the assets to survive a three-year period without carrying over their losses, said Michael Shaw, legislative director for the California office of the National Federation of Independent Business.

The federation does not want the net operating loss suspension to go forward, but it has created alternative ideas to improve it if it does. A small-business exemption would help the most vulnerable businesses, Shaw said.

"Larger businesses may need to make cuts to compensate for this; small businesses are more likely to shut their doors," he said.

History repeating

In past years, the suspension of net operating loss carry°©over did not appear to significantly impact the economy. This year, higher gas prices and a tightening credit market combined with the suspension would force small businesses to fight harder to survive, Shaw said.

The economy plays a significant role in the effectiveness of tax increases. If the economy is doing well, income and tax revenue increase. If the economy does not do well, revenue falls, and the state's natural reaction is to make up the difference by raising taxes, Shaw said.

Business owners typically pay less in taxes when the rates increase because they earn less income, causing the state to lose more tax revenue, Shaw said. They also do not invest as much and may not work as hard.

"If it's not going to increase their income, then they're going to stop doing it," Shaw said.

The Legislature did not allow businesses to deduct net operating losses in other difficult budget years, including 1991-1993 and 2002-2004. The Budget Act of 1991 suspended net operating losses for two years, increased the sales and use tax rate by 0.75 percent, and added 10 percent and 11 percent personal income tax brackets.

The total difference between the estimated revenue and the actual revenue in 1991-1992 from these actions was $807 million, about 20 percent lower than projected, according to the Legislative Analyst's Office.

The suspension of net operating losses did not bring in the projected revenue. In the first year, the actual revenue of $257 million was 54 percent less than estimates, according to the Legislative Analyst's Office. In 1992-1993, the actual revenue of $401 million was 12 percent less than estimates.

The year that the suspension ended, the state lost $317 million, which was 52 percent more than its predicted loss.

Suspension of net operating losses artificially inflates revenue, which drops back down after the suspension, Shaw said. If the state does not decrease spending to offset the drop, it could end up losing money.

"The problem we face in California and the nation is we typically have cut taxes, but we've increased spending," Shaw said.

The state's proposed suspension would adversely affect corporations, stockholders and small businesses, said Alvord of A Dash of Panache.

"They're trying to solve the problem by hurting us, and the economy is already killing us."

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