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Home > ESOPs > Articles Online > ESOP Forum >
In light of severe budget constraints and deficits in California and throughout the United States, it is advisable for ESOP advocates to remain vigilant and protective of the legislation that has encouraged thousands of business owners to establish ESOPs for the benefit of hundreds of thousands of employee owners over the last 29 years. There is at least one piece of legislation, California Senate Bill 516, which threatens the overall positive legislative environment for ESOPs. This report summarizes current available information regarding S. 516.
On February 20, 2003, Senator Jackie Speier (D. San Francisco and San Mateo), introduced Senate Bill 516. This is an act to add Section 23820 to the Revenue and Taxation Code, relating to taxation, to take effect immediately, a tax levy.
The Corporation Tax Law allows certain small corporations to elect to be treated as "S corporations," whereby those corporations obtain the tax advantages of partnerships, including reduced taxation at the entity level, while retaining the all important corporate characteristic of limited liability. With a "C" corporation, the income of the corporation itself is subject to tax (for California, the tax rate is 8.84% of corporate income), and the dividends subsequently declared from after-tax income and paid to stockholders are taxed (again) at the stockholder level. The main benefit, therefore, of an S corporation election is that the corporation itself is not taxed at all for Federal purposes, or is taxed at the lesser of $800 or 1.5% of income for California purposes.
Senate Bill 516 would limit the use of "S corporation" status to only those corporations with less than $20,000,000 in total gross receipts for the taxable year. This bill would result in a change in California taxes for the purpose of increasing state revenues within the meaning of Section 3 of Article XIII A of the California Constitution. Therefore, Senate Bill 516 would require approval of two-thirds of the membership of each house of the California State Legislature. Upon approval, this bill would take effect immediately.
After introduction on February 20, 2003, Senate Bill 516 was delivered to the Senate Revenue & Taxation Committee (the "Senate Committee") on March 6, 2003. That committee set the first hearing for April 23, 2003.
At the Senate Committee hearing on April, 23, 2003, the FTB estimated that this proposal would increase General Fund revenues by $785 million in 2003-04, $655 million in 2004-05 and $705 million in 2005-06. The Senate Committee also noted that in 1987, when California's law was amended to conform with Federal S corporation law, the fiscal effect of conforming was estimated to be approximately $275 million annually. According to the Senate Committee, the current estimate of the revenue loss due to allowing S corporation status approaches $2 billion annually. Senate Bill 516 would "reel that revenue loss back by about one-third."
The Senate Committee indicated that Senate Bill 516 is intended to restrict S corporation status to those for whom it was arguably created - small business corporations that are actually "small" - using $20 million of gross income as the measure of "small." The Senate Committee noted that Senate Bill 516 is similar to a suggestion recently made by the Legislative Analyst.
The Senate Committee made one very interesting observation: "It is generally considered good tax policy for the state tax laws to mimic the Federal laws as closely as possibly (sic), so as to avoid undue confusion and error. The income tax laws are almost impossibly complex, and to allow two parallel but substantially different systems, Federal and stats, to evolve separately is considered the tax equivalent of deadly sin. The laws providing for S corporate status are among the most complex, and opponents would argue that this proposal will exacerbate that complexity." Please note, however, that California tax law does maintain some inconsistencies with Federal tax law (i.e., California law currently applies the unrelated business income tax to the taxable income of an S corporation that is 100% owned by an ESOP (whereas Federal law does not) so that such corporations are subject to a 1.45% tax rate and similarly situated corporations in other states that maintain conformity with Federal tax laws are not subject to the same taxation).
The Senate Committee also raised two other concerns regarding Senate Bill 516. First, corporations whose gross income is generally in the "about $20 million" range could be swung back and forth year by year from C corporation to S corporation status by virtue of relatively small revenue swings. This would create an unintended side effect at tax time for these corporations, "causing such corporations anguish at tax time…" Second, the California Legislature passed legislation last year that "required that any corporation with a Federal S corporation election must also be an S corporation for state purposes." Senate Bill 516 would create a conflict with that policy. The conflict would have to be resolved by creating an exception to the Federal/state conformity requirement of 2002.
The Senate Committee listed the California Tax Reform Association as being in support of Senate Bill 516. The Senate Committee listed as opposition to Senate Bill 516 "Unknown." This is really unfortunate in that it appears that no one showed up to the Senate Committee hearing on Senate Bill 516 to oppose the bill. Due diligence has revealed that that the Automobile Dealers Association in California is strongly opposed to Senate Bill 516. ESOP corporations, of course, are opposed to Senate Bill 516 for many reasons, including the fact that many ESOP corporations use the tax savings created by S corporation status to help fund repurchase obligations related to the maintenance of an ESOP.
For the current legislative session, Senate Bill 516 will not advance any further (and will have to be re-introduced in a subsequent session next year) because the bill did not come before the Senate Committee for a "second" hearing.
Copyright © 2003 by The National Center for Employee Ownership (NCEO) (phone 510/208-1300; email nceo@nceo.org; WWW http://www.nceo.org/). All rights reserved.
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