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This change aligns California with a wide range of federal provisions enacted over the past 10 years, while preserving California-specific deviations. Notably, the state does not conform to changes enacted under the mid-2025 “One Big, Beautiful Bill Act,” underscoring California’s selective approach to federal alignment.

Key Areas of Conformity and Non-Conformity

Depreciation and Expensing

California continues to diverge from federal depreciation rules. Bonus depreciation under IRC section 168(k) remains disallowed, and the state retains its own Section 179 expensing limits—$25,000 with a $200,000 phase-out threshold—far below federal levels.

Net Operating Losses

While California generally conforms to federal NOL rules, significant limitations remain. The state continues to suspend NOL deductions for taxpayers with taxable income of $1 million or more for tax years 2024 through 2026, reducing the value of loss carryforwards for larger businesses.

Interest Deductibility and CAMT

California does not conform to the federal Section 163(j) interest limitation, allowing full interest expense deductions at the state level. The state also does not adopt the federal corporate alternative minimum tax enacted under the Inflation Reduction Act, shielding large corporations from a parallel state-level minimum tax based on book income.

Pass-Through Owners

The state continues to disallow the federal Section 199A qualified business income deduction, resulting in higher California taxable income for pass-through owners despite federal relief.

Research Credit Changes

Elimination of Alternative Incremental Research Credit

Effective January 1, 2025, California repealed its alternative incremental research credit through SB 711. Taxpayers claiming research incentives must now elect either the regular incremental credit or the alternative simplified credit, using state-specific elections and forms. The change simplifies the credit structure but requires action by taxpayers that previously relied on the repealed method, particularly those with California-centric R&D operations.

Filing Changes

Mandatory Electronic Filing Expanded

Following IRC conformity, California now requires electronic filing for a broader set of business taxpayers, including:

• Corporations filing at least 10 returns of any type annually

• Partnerships filing at least 10 returns or with more than 100 partners

• Tax-exempt organizations with unrelated business income

The shift reflects the state’s push toward centralized compliance and audit efficiency.

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California imposes a corporate tax on net income of 8.84% for most businesses or 10.84% for financial institutions. SB 573 would revise that rate and tax publicly held corporations from 7% to 13% (9% to 15% for financial institutions) based on CEO-to-median-employee compensation ratio.

The applicable tax rate would increase by 50% if a company’s workforce in the United States decreases by more than 10% against an increase in contracted and foreign full-time employees. This could raise corporate taxes to as high as 19.5% for some corporations (22.5% for financial institutions). The new rates would begin for tax years beginning on and after January 1, 2026.

This bill would include a change in state statute that would result in a taxpayer paying a higher tax within the meaning of Section 3 of Article XIII A of the California Constitution. This would require the approval of 2/3 of the membership of each house of the legislature for passage.

Tax Rate and Compensation Ratio

The proposed tax rates on net income are as follows:

• 7% for compensation ratio is more than zero to 25

• 7.5% for compensation ratio of more than 25 to 50

• 8% for compensation ratio of more than 50 to 100

• 9% for compensation ratio of more than 100 to 150

• 9.5% for compensation ratio of more than 150 to 200

• 10% for compensation ratio of more than 200 to 250

• 11% for compensation ratio of more than 250 to 300

• 12% for compensation ratio of more than 300 to 400

• 13% for compensation ratio of more than 400.

The law would require that the revenues collected be deposited in the Gun Violence Prevention and School Safety Fund, which will be established in the State Treasury. The bill would require the funds to be used to fund various gun violence prevention, education, research, response, and investigation programs, as specified.

The bill would require each licensed firearms dealer, firearms manufacturer, and ammunition vendor to register with the department for a certificate, as specified. The bill would also provide procedures for the issuance, revocation, and reinstatement of a permit.

Retail sales to law enforcement agencies and active or retired peace officers, and sales that total less than $5,000 per quarter are exempt from this tax.

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The California Film Commission administers the California Motion Picture and Television Tax Credit program, which provides tax credits for feature films, independent films, and new, relocating, or recurring television shows, pilots, or miniseries made in California.

The law creates a California Motion Picture and Television Tax Credit Program 4.0 for five years starting in 2025-2026. The credit of 20% or 25% is available for tax years beginning on or after January 1, 2025 and can be allocated on or after July 1, 2025, and before July 1, 2030. The law also removes the tentative minimum tax limitation and allows the taxpayer to elect to make the credit refundable at a discounted amount. Newsom had proposed to make the credit refundable. Productions will have to meet new safety rules and new diversity requirements in order to receive a portion of the tax credits.

The law also revises the current Motion Picture and Television Tax Credit. This includes reducing the amount of qualified wages that are reduced to $5 million from $7.5 million and limiting the amount of credit that may be allocated to a television series to $750,000 per episode.

The credit was created in 2009 to encourage film productions to locate in California, as legislators were concerned that other states were making efforts to attract the industry. The legislature since extended and expanded the credit multiple times. Newsom views the credit as a way to make California a clear choice for film production over states that have recently passed restrictive abortion laws.

The Legislative Analysists Office (LAO) stated in a report that, while the tax credit may be helping the California film industry grow, its impact on the overall state economy is unclear, as funds dedicated to the film tax credit could have been spent on other activities. The LAO advised that the decision to extend the credit should depend on how the legislature prioritizes maintaining California’s centrality in the film industry rather than on promoting overall economic growth.

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Taxes Incomplete Non-grantor Trusts

S.B. 131 taxes incomplete non-grantor trusts beginning in 2023 if the grantor of the trust is a California resident. Newsom included the idea in his 2023-24 budget proposal. The California Franchise Tax Board made the same proposal in 2020.

An incomplete non-grantor trust is a tax strategy in which an individual transfers funds to a state that does not have a state income tax. A trust is “incomplete” if the grantor retains some power over the gift. A non-grantor trust is one in which the trust is its own taxable entity and that taxation occurs at the trust level rather than at the level of the individual grantor.

With a non-grantor trust, the tax laws in the state in which the trust is established apply. To use this tax strategy, a California resident would establish an incomplete non-grantor trust with an out-of-state trustee and transfer assets to that trust. The taxable income of the trust would then be taxed by the state that is the trustee’s commercial domicile rather than by California.

California now follows New York as the only states targeting this tax planning strategy. The proposal is projected to raise only $30 million in revenue during the first year with a significant reduction in revenue in later years. The retroactive effective date of January 1, 2023 could bring constitutional challenges.

The proposal can be viewed as closing a tax “loophole” for wealthy taxpayers. According to the governor’s budget summary, the proposal “mitigates a tax strategy which allows California residents to transfer assets into out-of-state incomplete non-grantor trusts and potentially avoid state taxation.”

Excludes Settlement Payments from Taxation

S.B. 131 also excludes from taxation amounts received in settlements associated with either the 2019 Kincade Fire in the County of Sonoma, or the 2020 Zogg Fire in the Counties of Tehama and Shasta. The exclusion is for tax years beginning on or after January 1, 2020, and before January 1, 2028.

Eliminates Employment Tax Credit Requirements for Semiconductor, Lithium Battery, or Electric Airplane Manufactures

S.B. 131 also eliminates the requirement in the employment tax credit that the new employment be located within a designated census tract or economic development area if the qualified taxpayer is engaged in semiconductor manufacturing or semiconductor research and development, lithium production, manufacturing of lithium batteries, or electric airplane manufacturing. This is effective for tax years beginning on or after January 1, 2023 and before January 1, 2026.

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The bill excludes discharged unpaid community college fees from an individual’s taxable income for state tax purposes for tax years beginning during 2022–2026. It also excludes higher education emergency grants for tax years beginning during 2020–2027. Lastly, the bill conforms to federal law on student loans by excluding loans discharged during 2021–2025 from taxable income for tax years beginning during 2021–2025.

Generally, debt that is canceled, forgiven, or discharged for less than the amount owed is taxed as income. The American Rescue Plan of 2021, however, exempted forgiven student debt from federal taxation through 2025. AB 111 clarifies that California’s tax treatment for loan forgiveness will conform to federal law.

The bill is not expected to impact state revenue, as California did not project or anticipate that individuals receiving fee or student loan forgiveness would be taxed by the state. Legislative staff analysis projected that the taxation of loan forgiveness could have raised up to $850 million in 2023–2024 and $450 million in 2024–2025. The taxation of forgiven community college fees was projected to have generated tens of millions of dollars in revenue.

The bill comes amid uncertainty surrounding President Biden’s student loan debt relief plan, which includes up to $20,000 in student loan forgiveness. The plan is on hold due to legal challenges. The U.S. Supreme Court is expected to issue a decision by the end of June.

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The Keep Groceries Affordable Act, also known as AB 1838, was passed in 2018 to ban the imposition of special taxes on sodas and sugar-sweetened drinks until 2031. The law required the California Department of Tax and Fee Administration to withhold the administration of any local sales or use tax if that local agency “imposes, increases, levies and collects, or enforces any tax, fee, or other assessment” on groceries. (Local governments in California are allocated 1 percent of the state sales tax assessed in their jurisdiction.) Localities that had a soda a tax in place on or before January 1, 2018 were exempted.

The law was passed as part of a deal between business groups and labor unions to ban soda taxes for 12 years in exchange for the withdrawal of a voter initiative that would have curtailed the ability of local governments to raise taxes. The initiative, known as the “Tax Fairness, Transparency and Accountability Act of 2018,” would have amended Section 3 of Article XIII A of the California Constitution to raise the voter requirement from a simple majority to two-thirds voter approval of any local tax, fee, or assessment.

The voter initiative arose in response to the implementation of soda taxes in several cities, beginning with Berkeley in 2014, as part of a public health effort to reduce demand for sugar-sweetened drinks. As more cities considered imposing these taxes, the beverage industry helped to place the initiative on the ballot. Labor unions and local governments groups opposed it, leading to the deal that resulted in the passage of AB 1838. The law proved effective, as efforts to enact a soda tax in several charter cities were abandoned soon after its passage.

Constitutional Challenge

In 2020, a nonprofit health advocacy organization and a city council member challenged the law, arguing that it wrongly penalizes charter cities that lawfully exercise their constitutional rights under the home rule doctrine. They believed that the legislature probably understood that the home rule doctrine prevented the state from banning charter cities from taxing sugar-sweetened drinks and created the law’s penalty provision as a workaround to discourage charter cities from doing so. The trial court agreed and held that the penalty provision was unlawful and unenforceable.

The appeals court affirmed the trial court’s decision and held that the penalty provision of the law “improperly uses the threat of crippling penalties to chill charter cities from exercising their constitutional rights.” Citing California Supreme Court precedent, the court stated that if a law has “no other purpose . . . than to chill the assertion of constitutional rights by penalizing those who choose to exercise them, then it [is] patently unconstitutional.” The court stated that the penalty provision in the grocery act “serves to penalize a charter city only when its tax, fee, or other assessment on groceries ‘is a valid exercise of [the] city’s authority under Section 5 of Article XI of the California Constitution with respect to the municipal affairs of that city.’”

Tax Politics

While the decision centers on the current conflict over soda taxes, it also provides insight into tax politics in California. During debate over the bill in 2018, the beverage industry argued that soda taxes would disproportionately harm lower-income individuals. Labor leaders and Governor Jerry Brown, however, took a less democratic direction and supported the ban on soda taxes in order to prevent California voters from possibly increasing the voter threshold to raise local taxes.

Labor leaders argued that the two-thirds voter threshold would prevent the passage of about half of local tax measures. This restriction, they argued, would outweigh any benefits of implementing a soda tax. Brown, meanwhile, noted that the “far reaching initiative” would “restrict the normal regulatory capacity of the state by imposing a two-thirds legislative vote on what is now solely within the competency of state agencies.” This, Brown said, “would be an abomination.”

The labor interests that supported AB 1838 face another voter initiative to increase voter thresholds for tax increases. In an initiative similar to the 2018 measure, the Taxpayer Protection and Government Accountability Act would amend Article XIII of the California Constitution to reverse a series of recent court decisions that interpreted the voter approval thresholds for tax-related citizen initiatives and would expand the definition of “taxes” to include certain regulatory fees. The initiative qualified for the November 5, 2024 ballot.

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In January, a group of property owners challenged the constitutionality of the tax in federal court, arguing that it violates their equal protection rights under the 14th Amendment of the U.S. Constitution and the equal protection clause of the California Constitution. (see Property Owners Challenge Constitutionality of Los Angeles Real Estate Tax.)

The city, in a motion to dismiss filed on March 15, 2023, argued that the Tax Injunction Act and comity principles prohibit challenges to state and local taxes in federal court unless the state courts do not provide an adequate forum.

The city argued that the Los Angeles County Superior Court obtained jurisdiction over the parties and the subject matter in February in a separate suite filed by the Howard Jarvis Taxpayers Association. (see Legal Challenge Filed against Los Angeles Real Estate Tax.) The city argued that Superior Court provides a “more-than-adequate forum – indeed, the only proper forum – for the challengers to seek to litigate their claims.” The fact that the case involved a constitutional challenge was “immaterial,” as California courts “regularly decide cases in which plaintiffs allege equal protection, due process, and takings challenges to taxes and other charges.”

The city also argued that, under the Colorado River doctrine, the plaintiffs “may not invoke this Court’s jurisdiction to litigate claims for which the Superior Court already has jurisdiction.”

Motion To Dismiss Newcastle v. Los Angeles

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Los Angeles motion to dismiss Newcastle v. Los Angeles, filed March 15, 2023.

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The BOE was stripped of most of its powers and duties in 2017 amid controversies and scandals. Proponents of abolishing the BOE argue that other tax agencies can perform its remaining tax functions. Opponents, however, argue that the state needs property tax administration that is directly accountable to voters.

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Constitutional Responsibilities

The BOE was established under the California Constitution of 1879 as the agency responsible for ensuring that county property tax assessment practices were equal and uniform throughout the state. The legislature expanded its role to include the administration of most California taxes other than income taxes, amounting to the collection of about 30% of state revenue. This included more than 30 taxes and fees and, including sales and use taxes and property taxes. The BOE also became responsible for auditing taxpayers and hearing tax appeals. The five-member board, which is composed of four members elected by regional districts and the state controller, is unique as the only tax board in the United States under which elected officials administer tax programs and adjudicate tax appeals.

Controversies

In March 2017, the California Department of Finance published a report on the BOE’s misuse of public funds, leading Governor Jerry Brown to request the California Department of Justice to investigate the agency. The audits and investigations found that the board failed to report tax information accurately, elected board members were misusing staff and public funds for political purposes, members were subject to undue influence of BOE and political interference, and there were conflicts of interest among BOE members.

In response, Governor Jerry Brown signed into law AB 102, known as the Taxpayer Transparency and Fairness Act of 2017, which reduced the BOE’s responsibilities to its constitutional duties of administering property taxes, alcohol excise taxes, and taxes on insurers. The law also established the California Department of Tax and Fee Administration (CDTFA), which became responsible for administering the taxes that are not mentioned in the state constitution, including sales and use, fuel, and cigarette taxes. The CDTFA later became the auditor of all state taxpayers. The law also established the Office of Tax Appeals (OTA), which adjudicates state income and franchise tax appeals from the Franchise Tax Board (FTB) as well as sales and use taxes appeals from the CDTFA.

Brown was not the first governor to call for changes to the tax board, however. In 1928, some tax duties were transferred from the BOE to the agency that later became the modern-day California Franchise Tax Board in response to calls to overhaul or dissolve the board. In 1949, the Legislative Analyst’s Office criticized the board for poor revenue management and the lack of uniform policy. More recently, the BOE was the target of unsuccessful change efforts during the 1990s, when Gov. Pete Wilson proposed to merge the state’s two tax boards and, and during the 2000s, when Gov. Arnold Schwarzenegger proposed changes the state tax system.

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The California Film Commission administers the current program, which provides tax credits for feature films, independent films, and new, relocating, or recurring television shows, pilots, or miniseries made in California. Funding for the program is limited to $330 million a year through 2025, and the funding is divided between the different production categories.

The credit was created in 2009 to encourage film productions to locate in California, as legislators were concerned that other states were making efforts to attract the industry. The legislature since extended and expanded the credit multiple times. Newsom views the credit as a way to make California a clear choice for film production over states that have recently passed restrictive abortion laws.

LAO Doubts Benefit to Economy but Recommends Refundability

The Legislative Analysists Office (LAO) stated in a report that, while the tax credit may be helping the California film industry grow, its impact on the overall state economy is unclear, as funds dedicated to the film tax credit could have been spent on other activities. The LAO advised that the decision to extend the credit should depend on how the legislature prioritizes maintaining California’s centrality in the film industry rather than on promoting overall economic growth.

The LAO also advised that the program should be fully refundable with some modifications to improve taxpayer equity in the program and to make it easier to administer. These modifications include specifying a schedule for the credit to be claimed over a period of years, reducing the annual allocation cap, and limiting other flexibilities in the use of the credit by production companies.

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An incomplete non-grantor trust is a tax strategy in which an individual transfers funds to a state that does not have a state income tax. A trust is “incomplete” if the grantor retains some power over the gift. A non-grantor trust is one in which the trust is its own taxable entity and that taxation occurs at the trust level rather than at the level of the individual grantor. With a non-grantor trust, the tax laws in the state in which the trust is established apply. To use this tax strategy, a California resident would establish an incomplete non-grantor trust with an out-of-state trustee and transfer assets to that trust. The taxable income of the trust would then be taxed by the state that is the trustee’s commercial domicile rather than by California.

If approved, California would follow New York in ending this tax planning strategy. The retroactive effective date of January 1, 2023 of the proposed legislation would be controversial and would most likely bring constitutional challenges. The proposal is projected to raise only $30 million in revenue during the first year with a significant reduction in revenue in later years.

While the proposal can be viewed as closing a tax “loophole” for wealthy taxpayers, Newsom has opposed other proposals to increases taxes on the wealthy, including a wealth tax and a surtax on high incomes.

California legislators have made efforts in the past few years to increase taxes on the wealth, including proposed legislation in 2023 to impose a 1.5% state tax on the worldwide wealth of California residents. (California Legislators Reintroduce Wealth Tax for 2023 Legislative Session.)

The initiative would require any “new or higher tax” to be approved by two-thirds of the legislature and a majority of the voters. For local taxes, it would require any increase in general taxes to be approved by the majority of voters and any special tax to be approved by a two-thirds majority of voters. The initiative also provides that any tax increases passed after January 1, 2022 but prior to the effective date of this act would be void 12 months after the act becomes effective unless the tax is reenacted in compliance with the requirements of the initiative.

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The authors of the initiative characterized it as a way for voters to “reassert their right to a voice and a vote on new and higher taxes” and fees. The stated purpose of the initiative is to require “any new or higher tax” to be submitted for voter approval, to increase “transparency and accountability over higher taxes and charges,” and to “clarify that any new or increased form of state government revenue” is authorized through the legislative process.

Approval for New or Higher State Taxes

The initiative would amend Section 3 of Article XIII of the California Constitution to state that “every levy, charge, or exaction of any kind imposed by state law is either a tax or an exempt charge.” Any “new or higher tax” must imposed by an act passed by at least two-thirds of legislature in both houses and approved by a majority of the voters.

The initiative also requires that each tax bill to include specific information on the tax, including the type and amount or rate of the tax, the duration of the tax, the annual revenue expected to be derived from the tax, and the use of the revenue derived from the tax. Any proposed change to the use of the revenue from the tax must be adopted by a separate act that is passed by at least two-thirds of legislature in both houses and approved by a majority of the voters.

Additionally, any change in state law that results in any taxpayer paying a new or higher exempt charge must be imposed by an act passed by each legislative chamber. An act must also specify the type of exempt charge, and the amount or rate of the exempt charge to be imposed.

Approval for New or Higher Local Taxes

The initiative would also amend Section 2 of Article XIII C to state that “[e]very levy, charge, or exaction of any kind imposed by local law is either a tax or an exempt charge.” It would require that any local law that increases any general tax, “whether proposed by the governing body or by an elector,” be approved by the majority of voters. It would also require that any special tax, “whether proposed by the governing body or by an elector,” be approved by a two-thirds of the voters.

In keeping with the proposed changes to state tax law, the initiative would also requires each local tax bill to include specific information on the tax, including the type and amount or rate of the tax, the duration of the tax, the annual revenue expected to be derived from the tax, and the use of the revenue derived from the tax.

Overturn Recent Cases

The initiative states that it is “intended to reverse a series of court decisions that have weakened the legislative two-thirds vote and voter approval requirements for government revenue increases.” The most notable of these cases was California Cannabis Coalition v. City of Upland, which involved a dispute over a voter initiative to allow marijuana dispensaries in the city and charge an annual fee on each dispensary. The City of Upland determined that the fee was a general tax and ordered the initiative to be placed on the ballot at the next general election. The court ruled that only a majority of voters rather than two-thirds of voters was required to approve the citizen-initiated measure. The court held that a citizen initiative is not subject to the two-thirds majority requirement that applies to tax increases proposed by local governments.

While Upland involved a general tax, it became unclear whether a two-thirds majority was required to pass voter initiatives that implement special taxes. Courts of Appeal decisions have since concluded that special taxes put up in a citizen initiative can be approved by simple majorities of voters. In April 2021, the California Supreme Court declined to review that decision. By declining its review, the California Supreme Court settled the law that special taxes proposed by initiative required only simple majority voter approval.

Support and Opposition

California business groups support the initiative while labor unions, including public employee unions, and local governments groups oppose it. A similar initiative qualified for the ballot in 2018 but was withdrawn in an agreement to pass AB 1838, which banned local soda taxes until 2031. In the most recent attempt, in 2022, the initiative did not receive enough votes to qualify for the ballot.

The California Special Districts Association (CSDA), a local government group, called the initiative the “most consequential proposal to limit the ability of the state and local governments to enact, modify, or expand taxes, assessments, fees, and property-related charges since the passage of Proposition 218 (1996) and Proposition 26 (2010).” The CSDA said “public agencies would face a drastic rise in litigation that could severely restrict their ability to meet essential services and infrastructure needs.”

AB-362, introduced February 1, 2023, would require the California Department of Tax and Fee Administration to conduct or commission a study on the efficacy of a statewide land value taxation system as an alternative to the current property tax appraisal methods. The bill would require the study to be completed by January 1, 2025.

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The bill defines a “land value tax” as a levy on the value of land without regard to buildings, property, or other improvements. It states that such a system will make more land available for “productive uses” by removing the financial incentives to hold unused land solely for price appreciation.

The bill notes that a land value system is in place in Denmark, Estonia, Lithuania, Russia, Singapore, and Taiwan and in parts of Australia and Mexico. The bill reports that Allentown, Pennsylvania adopted a land value tax through a split-rate system in 1996, and the number of building permits has since increased by 32%. It also reports that California considered such a system in 1918 under Proposition 19, which would have required all public revenues to be raised by land value taxation.

The bill credits Henry George for developing the idea of the “land value tax” in 1879 and for the development of the political philosophy of “Georgism.” Although not defined in the bill, the philosophy of Georgism holds that the economic value of land and natural resources should be shared equally among members of society. George believed that a tax on land, rather than on labor, would increase productivity and reduce poverty.

The bill was introduced on January 19, 2023 along with similar proposals in Connecticut, Hawaii, Illinois, Maryland, Minnesota, New York, and Washington. Supporters of the tax say it would raise more than $21 billion in annual revenue and help address income inequality in the state. As a tax increase, the bill would require the approval of two-thirds of each house of the legislature.

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2023 Wealth Tax Legislation

AB 259 would impose an annual tax of 1.5% on a California resident’s worldwide net worth in excess of $1 billion (or in excess of $500 million for married taxpayers filing separately) for tax years beginning on or after January 1, 2024 and before January 1, 2026. The reach of the tax would be expanded after 2026, with a separate tax rate for taxpayers with a lower wealth threshold. The law would impose an annual tax of 1% on a California resident’s worldwide net worth in excess of $50 million (or $25 million for married taxpayers filing separately). It would maintain the 1.5% tax rate on wealthier taxpayers by imposing an additional tax of 0.5% tax on a resident’s worldwide net worth in excess of $1 billion ($500 million for married taxpayers filing separately). To prevent taxpayers from avoiding the tax by leaving the state, the tax would reach transactions made during the previous four tax years.

Wealth Tax Bills since 2020

AB 259 is the latest attempt by California lawmakers to impose a wealth tax after previous attempts—in 2020, 2021, and 2022—failed with limited support. A change in the state’s fiscal outlook, from record surpluses to a projected budget deficit of more than $22 billion, could factor into the debate.

In 2020, legislators introduced AB 2088, which would have imposed an additional 0.4 percent tax on net worth of more than $30 million or more than $15 million if married filing separately. Governor Gavin Newsom opposed AB 2088, stating: “In a global, mobile economy, now is not the time for the kind of state tax increases on income we saw proposed at the end of this legislative session and I will not sign such proposals into law.”

In March 2021, during the 2021-2022 legislative session, Lee introduced the California Tax on Extreme Wealth, a legislative package similar to the current bill but with a more aggressive timeline. AB 310 would have imposed a tax of 1% on “worldwide net worth” on California residents with more than $50 million in net worth, or more than $25 million for married taxpayer filing separately, for tax years beginning after January 1, 2022. To achieve the same results as the current bill, the 2021 bill would also have imposed an additional tax of 0.5% on worldwide net worth on California residents with more than $1 billion in net worth or more than $500 million for married taxpayer filing separately. AB 310 also required the passage of ACA 8, a resolution to propose to voters a constitutional amendment that would authorize the legislature to impose a wealth tax. The 2021 bill, however, failed to advance out of its committee.

In 2022, Lee introduced AB 2289, a bill nearly identical to the current legislation that would have imposed a 1.5% tax on an individual’s worldwide net worth greater than $1 billion, beginning in 2023. As with the current bill, this would have expanded in 2025 to impose an annual tax of 1% of a resident’s worldwide net worth in excess of $50 million ($25 million for a married taxpayer filing separately) along with an additional tax of 0.5% of a resident’s worldwide net worth in excess of $1 billion ($500 million for a married taxpayer filing separately).

Additional Details in 2023 Legislation

AB 259 would define worldwide net worth with reference to specific federal provisions and would provide that the definition does not include specific assets, including out-of-state personal property, directly held real property, or liabilities related to directly held real property. The bill would authorize the Franchise Tax Board to adopt regulations to carry out the tax provisions, including regulations on the valuation of certain assets that are not publicly traded. This bill would also establish the Wealth Tax Advisory Council, which would determine an adequate level of annual funding and staffing for the administration and collection of the wealth tax.

False Claims Act

This bill would also apply the provisions of the False Claims Act to claims, records, or statements made in relation to the wealth tax. The False Claims Act makes any person who makes a false or fraudulent claim for payment or approval liable to the state for triple the damages that the state or political subdivision sustained because of the false claim. California legislators have recently made several legislative proposals to include tax issues under the False Claims Act.

Information Disclosure

The bill would also create an exception to existing laws against information discloser as long as the information is related to the wealth tax. Under existing law, it a misdemeanor for specified persons, including, among others, officers or employees of the state or its political subdivisions, to disclose information set forth or disclosed in returns, reports, or documents required to be filed under the franchise and income tax laws. AB 259 would provide an exception to this law for information related to the wealth tax and as long as certain information privacy protections are in place and the request is for a specified purpose.

Constitutional Amendment

The tax imposed by AB 259 would become effective only if the voters approve a specified constitutional amendment that would extend the state’s taxing authority to “all forms of personal property or wealth, whether tangible or intangible…” The amendment would also reduce the two-thirds majority threshold to a simple majority to “classify any form of personal property or wealth for differential taxation or for exemption.”

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Measure ULA increases the city’s transfer tax from 0.45% on all property sales to 4% on sales of property between $5 million and $10 million and 5.5% on sales of property of $10 million or more. The tax, which was approved by voters in November, would raise funds for housing and homeless services.

In citing Stewart Dry Goods Co. v. Lewis, 294 U.S. 550 (1935), the plaintiffs argued that “a tax, as here, based on gross sales rather than net income is an arbitrary and irrational metric for determining the ability to pay a tax.” The plaintiffs contended that the transfer tax in the ULA “may well be better legally characterized as an unconstitutional and illegal monetary exaction or an illegal special assessment, rather than a ‘tax,’ if it is a ‘transfer tax,’ it is an unconstitutional one.”

The plaintiffs also argued that the ULA violates the equal protection requirements of uniformity and apportionment under both the U.S. Constitution and the California Constitution. The petitioners cited City of Santa Cruz v. Patel, 155 Cal.App.4th 234 in arguing that “[i]n considering whether a tax is consistent with equal protection principles, ‘courts will look for a rational basis for the class of persons selected to pay the tax.’”

They argued that there is “no rational basis under the ULA to require the $5,000,001 sub-class to pay at least $200,000 (and possibly millions of dollars) in ULA taxes on a sales transaction while the $4,999,999 sub-class, and, indeed, all other members of society who do not even own property, pay nothing at all to accomplish the stated purpose of the ULA (i.e., to reduce the societal problem of homelessness).”

The lawsuit is the second challenge against the law in as many months. In December, the Howard Jarvis Taxpayers Association (HJTA) and the Apartment Association of Greater Los Angeles filed a lawsuit contending that Measure ULA violates the state constitution and the Los Angeles city charter. In its challenge under the state constitution, the lawsuit contends that it violates Article XIII A, section 4 of the California Constitution, which generally prohibits transfer taxes. (see Legal Challenge Filed against Los Angeles Real Estate Tax.)

Newcastle v Los Angeles complaint

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Complaint filed on January 6, 2023.

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Measure ULA increases the city’s transfer tax from 0.45% on all property sales to 4% on sales of property between $5 million and $10 million and 5.5% on sales of property of $10 million or more. The measure was certified as passed after receiving 58% of the vote. (see Los Angeles Approves Real Estate Transfer Tax.)

Lawsuit

The lawsuit contends that the tax is unconstitutional. The groups argue that Article XIII A, section 4 of the California Constitution, which was implemented by Proposition 13, generally prohibits transfer taxes. The complaint notes that case law has permitted charter cities, which have greater authority in their own governance, to impose transfer taxes that are undedicated “general taxes,” but transfer taxes that are “special taxes” are “prohibited for all local governments, including charter cities.” (Cohn v. City of Oakland (1990) 223 Cal.App.3d 261; Fielder v. City of Los Angeles (1993) 14 Cal.App.4th 137; Fisher v. County of Alameda (1993) 20 Cal.App.4th 120.)

The California Supreme Court has defined term “special taxes” refers to taxes that are “levied for a specific purpose rather than … a levy placed in the general fund to be utilized for general governmental purposes.” The complaint argues that the tax increase would be a “special tax” rather than a “general tax,” as the funds raised by the tax would be dedicated to housing and homeless services.

The complaint states that if the “Measure ULA tax increase is imposed as scheduled on April 1, 2023, great and irreparable harm will result to plaintiffs, and to all Los Angeles property owners in being required to pay unconstitutionally imposed taxes. Similar harm will occur to all Los Angeles residents in the form of increased rent and consumer prices resulting from the tax increase on all property sold (or value transferred) above $5 million.”

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Proposition ULA increases the city’s transfer tax from 0.45% on all real estate sales to 4% on sales of property between $5 million and $10 million and 5.5% on sales of property of $10 million or more. The property value is the gross sales price, which includes the value of any lien or encumbrance on the property at the time of the sale. The existing documentary transfer tax excludes these values.

One study estimated that the measure would raise $923 million a year to develop affordable housing and to provide rent relief, income support, and legal counsel for tenants. The higher tax takes effect on April 1.

Exemptions

The ordinance exempts certain sales from the tax. These include transfers to non-profit entities, community land trusts, limited-equity housing cooperatives, or a limited partnership or limited liability company in which only bona fide nonprofit corporations, community land trusts, and/or limited-equity housing cooperatives are the general partners or managing members. It is unclear whether existing exemptions provided by Los Angeles city ordinance or state exemptions, including foreclosures, would apply.

Other transfer taxes

The City of Santa Monica approved Measure GS, which increases the city’s real estate transfer tax from 0.6% to 5.6% on sales of properties valued at more than $8 million, beginning on March 1, 2023. Voters in the City and County of San Francisco approved Measure M, which imposes a vacancy tax on landlords that own three or more residential units. In Palo Alto, voters approved Measure K, which imposes a monthly tax of 7.5 cents for each square foot of real estate occupied by a business over 10,000 square feet.

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The bill has two other components:

• The bill extends the existing wage replacement rates for the State Disability (SDI) and Paid Family Leave (PFL) programs. The current wage replacement of 60-70% was scheduled to expire January 1, 2023 but will now expire January 1, 2025.

• The bill also revises the formulas for determining benefits under both programs to provide an increased wage replacement rate ranging from 70-90% based on the individual’s wages earned, as specified. This take effect on or after January 1, 2025.

The current tax rate of 1.1% is subject to annual adjustment based on program need and is authorized to increase to a maximum of 1.5 percent. With the elimination of the cap, California’s top marginal rate on wage income increases from 13.3% to 14.4%.

The extension of the payroll tax to all wages a significant departure from the federal practice of capping the income subject to Social Security taxes.

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“No other state in American history has ever experienced a surplus as large as this,” Newsom said while introducing his revised $286.4 billion budget in May. The massive windfall shows “the concentration of wealth and success in the hands of a few that are enjoying abundance in historic and unprecedented ways,” he said. “I am proud of California’s progressive tax system…and we’re the beneficiary of that.” Embedded in this progressive tax system is dependence on capital gains, a volatile source of tax revenue that could decline sharply and turn the surplus into a massive deficit.

California’s progressive tax system is largely dependent on revenue from the personal income tax, which is the state’s largest source of funding at more than two-thirds of the general fund revenue. The state’s income tax now relies disproportionately on the wealthiest taxpayers and a significant portion of tax revenue comes from capital gains, which are largely from record stock market returns and initial public offerings (IPOs) in Silicon Valley.  California’s dependence on the personal income tax is a relatively recent phenomenon. In 1990, for example, the state’s revenues depended on relatively equal shares of revenue from personal income taxes, corporate income taxes, and sales taxes.

Additionally, a small number of taxpayers are providing an increasing share of tax revenue. Approximately 0.5% of taxpayers provides about 40% of the state’s personal income tax revenue, according to the Los Angeles Times.  (This is about 100,000 people with incomes of more than $1 million.)  About 17% of taxpayers, which expands the group to people with incomes of more than $500,000, pay more than half of the state’s personal income tax revenue. 

This reliance on high-earners and their capital gains means that the state has tax revenues that are higher than other states when the economy or the stock market are doing well but experiences a disproportionate downturn when the economy or the stock market decline.  The Legislative Analyst’s Office (LAO) estimated in 2017 that the income for the top 10 percent of earners in California is seven times as volatile as the remaining 90 percent.  By contrast, the corporate income tax and the sales tax also fluctuate with the economy, but they are less volatile and contribute to a smaller share of the general fund.

Past economic downturns and financial market declines have caused dramatic drops in tax revenue that led to spending cuts, tax increases, and borrowing to balance the state’s budget.  California has also experienced cyclicality in economic activity that is greater than that of other states.  For example, in 2010, California revenue fell by 20% with a drop in state GDP of less than 2%.  To counteract these falls requires the state government to enact countercyclical fiscal policy through a “rainy day” fund, raise taxes, or cut spending.

Governor Newsom, to his credit, recently outlined the risks that California faces, noting that that the budget “must continue to be prudent and the state must be prepared for an uncertain future.”  The May revision noted that revenue from capital gains “as a percent of the state's personal income are at levels last seen in 1999—just before the dot-com bust,” a market crash led to state budget deficits for more than a decade. “For those that are concerned about that, they are right to be concerned about that. We are deeply mindful of that,” Newsom said.  

The record stock market returns and IPOs that have pumped of California’s tax revenue are a result of the dramatic monetary inventions of the Federal Reserve, as continued low interest supported financial markets. With increasing economic uncertainty and the highest inflation rates since the early 1980s, the Federal Reserve seems likely to continue to raise interest rates. Increased rates would bring falls in financial markets and a likely disproportionate fall in California tax revenue. The LAO in its comments on the May budget warned of a “heightened risk of a recession within two years,” and urged the governor and legislature to add to California’s budget reserves.

Newsom “Leans In”, then Out, on Tax Reform

Newsom acknowledged the dependence on stock market gains and interest rates back in 2018, when he said the California tax system is “too reliant on what Janet Yellen does.”  Newsom said then that he believes in a progressive tax code, and wants to avoid a repeat of the cuts that occurred during the recession in 2010, as those cuts fell the hardest on people who rely on social services. 

During his campaign for governor in 2018, Newsom said he wanted to reform the tax system but noted the political challenge.  “Nothing, nothing, no issue more vexing than this one, because everyone has a trophy on the wall,” Newsom said before the election.  “Governor Brown had no interest in pursuing it. And I would argue there’s no greater political mind in our lifetime than Governor Brown,” he said.  “So I’m not naive about this, but I am not going to neglect this issue, and I’m going to lean into it and express a desire to see if we can possibly come together across our differences.” 

In 2019, Newsom spoke of “broadening the tax base, addressing the issue of volatility” in tax reform.  “I want to convene an effort to more broadly look at our tax code. Modernize it,” he said.  Newsom again discussed tax reform while introducing his budget proposal in January 2019. “This economy is radically different than it was 100 years ago,” he said.  “And we're not taxing the modern economy, we're taxing the old economy,” he said.  “This is the good times,” Newsom said.  “But the key in a progressive tax system with the volatility that we experience — that needs to be addressed, but will not be a short-term endeavor — is to stack away as much money as you can and pay down as much debt as you can.”

Newsom’s shift from lamenting being “too reliant on what Janet Yellen does” in 2018 to trumpeting the results of Federal Reserve policy in 2020 began with the state’s dramatic fiscal turnaround in 2020. In May and June 2020, amid the COVID-19 economic downturn, California projected a $54 billion deficit—the largest in state history. Newsom declared a budget emergency in June 2020 that allowed him to access the state’s rainy day fund. 

By October 2020, California had regained nearly 44% of the more than 2.6 million jobs lost during the previous March and April.   In November 2020, the LAO projected a one-time surplus of $26 billion, as revenues were anticipated to fall but actual tax collections remained steady.  The LAO then projected a balanced budget for 2021.

In explaining why revenue did not drop as anticipated, the LAO noted that high-income taxpayers did much better during the COVID-19 pandemic than did less-educated and lower-wage workers.  High-income taxpayers had fewer job losses and benefited from a strong stock market.  As of the end of November 2020, year-to-date revenue was $74.4 billion, with $52.5 billion, or 72%, coming from the personal income tax.  A year later, year-to-date revenue was $66.8 billion, with $45.2 billion, or 68%, coming from the personal income tax.  The LAO reports make clear that the multiyear surpluses are a result of California’s dependence on that single source of tax revenue.

Facing criticism for California’s increasing business tax burden, Newsom noted “all the new billionaires” created by IPOs.  The stock market boom in late 2020, caused partly by the Federal Reserve’s unprecedented monetary interventions during the COVID-19 pandemic, led many firms to the IPO market to take advantage of historical highs.  As a result, collection of capital gains tax from the stock market and IPO boom drove the state’s budget from deficit to surplus.

In January 2021, Newsom introduced a record $227 billion budget proposal that increased spending.  “While we are enjoying the fruits of a lot of one-time energy and a surplus… it’s not permanent,” he said.  “We have to be mindful of over-committing.”  Newsom said calls for new taxes on the wealthy were “not part of the conversation” and proposed more tax credits for businesses that stay in California and create full-time jobs.  Newsom also noted that the state was on track to exceed the Gann Limit by about $52 billion. Under the Gann Limit, the state cannot exceed its 1978 spending level, per resident, as adjusted for inflation.  

In May 2021, Newsom reported a projected $75.7 billion budget surplus and proposed direct stimulus payments to taxpayers (the LAO put its estimate the at $38 billion).  There were repeated concerns about “over-committing” to new recurring spending commitments.  The budget largess continued into 2022, when in January 2022 Newsom introduced a record $286.4 billion budget proposal for 2022-2023. 

Brown’s Budget Reforms

The current budget surplus is largely a result of reforms implemented under Governor Jerry Brown. In 2011, Brown took office with a $27 billion deficit.  Brown helped pass several measures to stabilize the state’s finances, including a ballot initiative to increase taxes on the state’s highest earners.  During his term, California paid down debt, made contributions to pension funds, and passed a constitutional amendment to shore up its rainy-day fund.   Brown left office with an estimated $21.6 billion surplus.  

Brown’s final budget proposed $190.3 billion in spending for the 2018-19 fiscal year and included an increase in the rainy day fund by more than $5 billion, to a total of $13.5 billion.  During this time, California was experiencing one of the longest periods of economic expansion in U.S. history following the Great Recession.  With strong job growth and tax revenue exceeding projections, the state’s fiscal position was vastly improved.

Nonetheless, Brown warned that the expansion would someday come to an end.  “It’s so important we prepare for the recession not when it comes but years before,” he said.  Brown captured the issue succinctly in 2018, after releasing his final budget, which had a nearly $9 billion surplus.  “We have a whole political system that judges our executives by the state of the economy, over which they have virtually no impact,” Brown said.  “The next governor is going to be on the cliff,” he said.  “What’s out there is darkness, uncertainty, decline and recession. So good luck, baby.”  

On the Cliff

With worsening economic conditions, the outlook for the state’s finances are uncertain. Newsom noted in his May 2022 budget proposal that 94% of the surplus will be spent on one-time expenditure. However, a downturn could bring a budget deficit similar to the projected $54 billion deficit in 2020 that would easily overwhelm the state’s reserves and make the $23.3 billion set aside for the rainy day fund look meager.

Instead of looking to increase tax and spending, even one-time expenditures, California should be preparing for worsening economic conditions and the likelihood of budget deficit. Part of preparing for a downturn should include tax reform that involves “broadening the tax base, addressing the issue of volatility” and promoting broader economic growth. Such broadening of the tax base would reduce state dependence on “all the new billionaires” created by IPOs. As observed since 2020, these high earners are highly mobile, and California has seen an increasing number of individuals and businesses leaving for states with lower taxes.

In the meantime, state lawmakers are doubling down on California’s dependence on high earners through such proposed measures as Proposition 30, a ballot initiative to impose a 1.75% tax on incomes of more than $2 million a year to fund zero emissions vehicles. In registering his opposition to Proposition 30, Newsom again noted the central problem. “California’s tax revenues are famously volatile, and this measure would make our state’s finances more unstable — all so that special interests can benefit,” he said. “Prop. 30 is fiscally irresponsible and puts the profits of a single corporation ahead of the welfare of the entire state.”

Along with reducing volatility, tax reform presents Newsom with an opportunity to show that he is a national leader willing to address tough political challenges. Not just as an academic exercise during the boom times of 2018 but as an exercise in preparing California for the future. Newsom may not be “on the cliff” yet, but the “darkness, uncertainty, decline and recession” that Brown warned against is surely coming.

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Annual Tax on Corporations and Pass-Through Entities

California imposes an annual fee of $800 on limited partnerships (LPs), limited liability partnerships (LLPs), and limited liabilities companies (LLCs) that are organized under California laws, registered to do business in California, or “doing business” in the state. (Section 23153 of the California Revenue and Taxation Code (R&TC) imposes the $800 minimum franchise tax on corporations, and Section 17941 of the R&TC applies Section 23153 to LLCs in addition to an LLC fee).

The “doing business” element widens the reach of the tax to apply to businesses that are not organized or registered under California law. R&TC Section 23101 provides two alternative standards for determining whether an entity is “doing business” in California.

Standards for “Doing Business” in California

Section 23101(a) provides the general rule under which a company is “doing business” in the state if it is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Section 23101(b) adds four factor presence nexus standards for “doing business” for taxable years beginning on or after January 1, 2011: (1) the company is organized or domiciled in California; (2) its sales in California for the taxable year exceed the lesser of $500,000 or 25 percent of its total sales; (3) its real property and tangible personal property in California exceed the lesser of $50,000 or 25 percent of its total real property and tangible property; or (4) the compensation it paid in California exceeds the lesser of $50,000 or 25 percent of the its total compensation paid. (The California Franchise Tax Board (FTB) adjusts the threshold amounts for inflation.) The FTB’s broad interpretation of Section 23101(a), and the factor presence nexus standards in Section 23101(b), have led to some confusion about the “doing business” standard among taxpayers with small, passive interests in pass-through entities.

Generally, whether an out-of-state owner is “doing business” under Section 23101(a) depends on its degree of control over the in-state business. This determination is not made based on an ownership share only, but also depends on the relationship between the out-of-state owner and the in-state entity. Under the Section 23101(b) factor presence nexus standards, an out-of-state owner is doing business if it meets the “bright-line” ownership thresholds under the statute through its pro rata or distributive shares of the entities. This “bright-line” threshold applies no matter how small the ownership share or the degree of control over the entity. These general rules are derived from several recent OTA decisions.

Degree of Control over a California Business under Section 23101(a)

In Swart Enterprises, Inc. v. Franchise Tax Board, a California court of appeals held that an out-of-state corporation whose only connection with California was a 0.2 percent ownership interest in a manager-managed (rather than a member-managed) California LLC investment fund was not “doing business” in the state. The court held that “passively holding a 0.2 percent ownership interest, with no right of control over the business affairs of the LLC, does not constitute ‘doing business’ in California” under Section 23101(a).

While the FTB interpreted the decision in Notice 2017-01 as a “bright-line” threshold of 0.2 percent for a passive interest in a California LLC, the OTA rejected that interpretation in the 2019 case In the Matter of the Appeal of Jali LLC, which involved an out-of-state LLC with an interest in a manager-managed California LLC of 4.75 percent, 3.19 percent, and 1.12 percent in different years. The taxpayer was not personally liable for any debt, obligation, or liability of the LLC; had no power to participate in its management, or bind or act on behalf of it in any way; and had no interest in any specific property of the LLC. The OTA applied the Swart analysis and decided that the taxpayer was not doing business in California due to its lack of control over the in-state LLC. The OTA stated that “[w]hile ownership percentages may be a factor in nexus determinations, it is not necessarily dispositive, as one must still generally conduct a fact-intensive inquiry into the relationship between the out-of-state member and the in-state LLC.”

Furthering the emphasis on degree of control, the OTA found in Wright Capital Holdings, LLC, another case that a disregarded entity that was a single-member, out-of-state LLC with a 50 percent interest in a California LLC was doing business in the state. The OTA noted that although 50 percent was not a controlling interest, it was the largest interest in the LLC and the taxpayer would have had “significant authority over the activities” of the entity.

“Bright-line” Ownership Thresholds in a California Business under Section 23101(b)

Most recently, the OTA established that the Section 23101(b) factor presence nexus standards established “bright-line” ownership thresholds for “doing business” no matter how small a member’s ownership share and without distinction between active versus passive ownership interests. In the 2021 case In the Matter of the Consolidated Appeals of: La Hotel Investments #3, LLC and La Hotel Investments #2, LLC, a Louisiana LLC owned a 5.41 percent interest in a California LLC that owned $25.3 million in buildings and other depreciable assets in California. A second Louisiana LLC owned a 2.56 percent interest in one year and a 5.13 percent in two additional years in a different California LLC that owned $51.4 million in land, buildings, and depreciable assets in California. Considering the owners’ pro rata or distributive share of the entities under Section 23101(d), the OTA found that it was “doing business” in California because its distributive share of its investment in California property through a lower tier-company exceeded the $50,000 statutory threshold under Section 23101(b)(3).

What Can Out-of-State Members in California LLCs Do?

Out-of-state taxpayers with an ownership interest in a California LLC should understand these cases to determine whether they are required to file a California tax return and pay California taxes, or whether they may qualify for a refund. They should also continue to monitor these OTA decisions as these nexus rules continue to develop.