California NOL Deduction Limit Would Cause Startups to Suffer

California Gov. Gavin Newsom’s revised budget, which would suspend the net operating loss carryover tax deduction for businesses with California income over $1 million, is a bad idea for several reasons.

Newsom (D) estimates the proposal would generate about $16 billion in fiscal years 2024-2025 through 2027-2028. But to every taxpayer who has unused NOLs or tax credits, this might seem like the state is strong-arming them into lending about $16 billion without any interest for up to three years.

That’s because the proposal forces taxpayers with NOLs or tax credits to defer the use of those tax assets and pay $16 billion in the aggregate tax now instead of over the next three years. Denying a startup use of NOLs discourages companies from choosing to start their businesses in California.

Impact on Startups

Say a hypothetical company—we’ll call it PostPan—began developing data analytic tools in 2021 to predict snowbird migration patterns. It built a business plan around several estimates, including qualifying for $10 million in California research and development tax credits and accumulating an aggregate of $20 million of NOLs from 2021 to 2024.

PostPan anticipated using these tax assets to offset $15 million of California taxable income in each of 2025 and 2026. But Newsom’s proposal would pull the carpet out from under that plan and require PostPan and similarly situated real companies to pay $1.3 million (the 8.84% state tax rate on $15 million of income) in 2025 and 2026—a serious financial setback for a startup.

The proposal to suspend use of NOLs and tax credits, which would be capped at $5 million for several tax years, is a fiscal shell game that mandates taxpayers to extend an interest-free loan to the state.

How is this so? In our hypothetical example, California gets to use the $2.6 million of tax that the proposal forced PostPan to pay for 2025 and 2026. On the other side of the coin, PostPan must find another source for that total of $2.6 million before it can again have access to it after 2027, when the proposal will sunset and it will be able to use its NOLs and tax credits.

Yes, Newsom can try to take some of the sting out by saying this proposal is needed to patch a much larger budget shortfall. But whose fault is the large shortfall? Newsom also can say this proposal is only temporary. But what about the time value of money and business plans that were based on the state sticking to its word?

The NOL suspension doesn’t apply to a taxpayer with less than $1 million in taxable income, which may somewhat ameliorate the proposal’s pain. That probably doesn’t do much to appease a taxpayer with $1,000,001 of taxable income and $1 million of NOLs—a taxpayer who would have to pay more than it anticipated for the 2025 tax year (the first year NOLs and tax credits would be suspended under the proposal).

Newsom’s proposal would dial back the suspensions if California collects more revenue than it currently estimated. If California taxpayers end up paying more than anticipated, the NOL and tax credits would not be suspended for the full three years. But that’s like telling a baby that you might give back the piece of candy you took after you’ve taken a bite out of it.

Pennsylvania Contrast

Newsom should look at what’s being proposed on the other side of the country. The Pennsylvania General Assembly is considering increasing or eliminating that state’s NOL cap. They realize businesses want to invest in states that reward investment by allowing them to use the NOLs they incurred.

Pennsylvania lawmakers realize that their current NOL cap penalizes startup companies such as the hypothetical PostPan (as well as mature business with NOLs) that make investment decisions trusting that the state government will not play fiscal shell games.

Instead of decreasing the cap—which, like suspending NOLs and tax credits would force taxpayers to “lend” the state money—the Pennsylvania Senate has proposed the opposite: Allow taxpayers to use more of their NOLs sooner so they can reinvest that money to drive the state’s economy.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Mike Semes is of counsel at BakerHostetler and professor of practice at Villanova University School of Law’s graduate tax program.

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