California Startups, R&D Centers Must Prepare to Lose Tax Breaks

California’s latest budget bill, SB 167, could pose challenges for startups and companies with large upfront costs and initial losses by suspending net operating loss deductions for taxable years 2023, 2024, and 2025, and limiting use of business credits to $5 million for the same period. The bill, passed June 13, awaits Gov. Gavin Newsom’s (D) signature.

While these measures intend to stabilize state revenues without increasing taxes, they often translate to liquidity challenges and deferred tax relief for businesses, affecting their financial planning and investment capabilities. Companies whose financial model hinges on being able to carry forward these losses to future profitable years would face immediate cash flow issues if the bill becomes law.

Since the early 1990s, California has implemented net operating loss suspensions during economic downturns to bridge budget deficits, such as during the Great Recession in 2008-2011. Similarly, state-imposed limitations on business credits, including the research and development tax credit, seek to generate immediate revenue.

Technology and biotechnology businesses, which typically have prolonged phases of R&D expenditure and initial losses, likely experienced substantial financial strain during the 2008-2011 suspension. The inability to use R&D credits exacerbated these challenges, leading to reduced cash reserves and potential cutbacks on innovation investments.

SB 167 reflects California’s ongoing strategy to address budgetary shortfalls in several ways.

Increasing tax liabilities. Businesses won’t be able to offset their taxable income with net operating losses. This could create a significant financial burden for companies with substantial accumulated losses.

Creating cash flow challenges. Startups and companies in high R&D expenditure phases are likely to be the most affected. For many startups and R&D phase companies, use of losses and credits allows these companies to continue investing in innovation. If funds originally earmarked for innovation or development of a new product are now diverted to California income/franchise taxes, these companies may need to divert funds form another source to continue to grow.

Deferring tax relief. While the suspensions create immediate revenue for the state, businesses will carry forward these losses and unused credits, potentially creating a backlog of deferred tax assets. This could impact future profitability and tax planning strategies.

Impacting investment and growth. The limitations on business credits, particularly the R&D credit, may lead to reduced investments in innovation. Companies may scale back on research and development activities, affecting long-term growth prospects and competitiveness.

Businesses should consider several aspects when preparing for the bill’s potential enactment.

Tax planning and cash management. Businesses may experience cash-flow and liquidity issues given the inability to offset the California income/franchise tax liability. Thinking through approaches to decrease the California tax base (such as apportionment consideration) may alleviate some short-term cash flow issues.

Using federal tax attributes and accounting methods to accelerate federal deductions. Companies should explore the availability of federal tax attributes and accounting method changes that may lower federal taxable income. For example, accelerating use of deductions through a federal election or an accounting method change would decrease federal taxable income and consequently decrease a company’s California tax liability.

Considering future tax positioning. Planning for the eventual use of deferred net operating losses and credits when the suspensions are lifted will be essential. This includes strategic forecasting and aligning financial planning to optimize future tax benefits.

Future suspensions and limitations. California has shown it’s willing to suspend tax attributes periodically. Knowing this can help businesses prepare for the next time. Companies may want to consider accelerating use of California losses or credits after current limitations are lifted, with the thought that these limitations will likely be imposed again in the near future.

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

Shail P. Shah is shareholder at Greenberg Traurig with focus on complex California tax planning and representation.

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