California Enacts Significant Changes, Including NOL Suspension and Credit Limitation

California has enacted two important pieces of legislation that may prove adverse to businesses and individuals. The first, S.B. 167, suspends the use of net operating losses (NOLs) by businesses and individuals for tax years 2024 through 2026, limits the use of tax credits by businesses and individuals to $5 million for tax years 2024 through 2026, and clarifies that income not included in apportionable business income is excluded from the sales factor of the apportionment formula. The second, S.B. 175, provides some relief from the $5 million credit limitation in S.B. 167 by allowing taxpayers subject to the limit to elect to later receive a refund of credits they would have otherwise used to reduce tax liabilities during the limitation period.

Although many of the new California provisions adversely affect taxpayers, now is the time to closely examine the manner in which you reported items on your California tax returns. Moreover, taxpayers seeking to qualify for the refundable credits under S.B. 175 should be aware that there are timing considerations that require upfront planning to secure the credits. BDO’s California specialists can help you understand how the new provisions will affect your California tax liabilities and how to mitigate any related impact.  

Suspension of NOLs Under S.B. 167

For tax years beginning on or after January 1, 2024, and before January 1, 2027, S.B. 167 prohibits the use of NOLs for businesses with California-apportioned income and individuals with income of at least $1 million or more. For NOL deductions that were denied as a result of this provision, S.B. 167 extends by one year the carryover period for losses incurred in tax years beginning on or after January 1, 2025, and before January 1, 2026; by two years for losses incurred in tax years beginning on or after January 1, 2024, and before January 1, 2025; and three years for losses incurred before January 1, 2024.

Limitation on Use of Tax Credits Under S.B. 167

For tax years beginning on or after January 1, 2024, and before January 1, 2027, S.B. 167 limits the use of tax credits to $5 million for businesses and individuals.

For personal income tax law (PITL) purposes, all credits allowable under Chapter 2 of the PITL are subject to this $5 million limitation, with the exception of 12 enumerated credits that include those relating to the pass-through entity tax election and low-income housing. 

For corporation tax law (CTL) purposes, all credits allowable under Chapter 3.5 of the CTL — other than the low-income housing credit — are subject to the $5 million limitation.  

Among the most important credits subject to the $5 million limitation for both PITL and CTL purposes are the research tax credit and the California Competes credit.

Any credit that is not allowed under the new California provisions will remain a credit carry over, and the carryover period is increased by the number of tax years that the credit or any portion thereof was not allowed.

S.B. 175 Changes NOL Suspension and Credit Limitation in S.B. 167

California has the option to pause the NOL suspension and $5 million credit limitation provisions of S.B. 167. S.B. 175 provides that the suspension and limitation will not apply to tax years in which (1) the Director of Finance determines by a specified date that general fund money over the multiyear forecast is sufficient without the revenue impact of the NOL suspension and credit limitation and (2) there is legislation in the annual budget specifying that those provisions will not be applied. For tax years beginning on or after January 1, 2025, and before January 1, 2026, the specified date by which the Director of Finance must make this determination is May 14, 2025. For tax years beginning on or after January 1, 2026, and before January 1, 2027, the specified date is May 14, 2026.

Enactment of Refundable Credits Under S.B. 175

Regarding the S.B. 167 provisions governing the $5 million limitation on the use of California tax credits, S.B. 175 enacts a new provision to allow businesses and individuals subject to the temporary credit limitation to use their credits after the limitation period ends. Taxpayers would do so by electing to receive a refund of the credits that they would have otherwise used to reduce California tax liability during the limitation time period.

Specifically, for tax years beginning on or after January 1, 2024, and before January 1, 2027, a taxpayer may make an irrevocable election to receive an annual refundable credit amount equal to 20 percent of the qualified credits that would have otherwise been available to reduce tax in the tax year of the election but for the $5 million limitation. The election must be made on an original, timely filed return for the tax year for which the election is made in the form and manner prescribed by the California Franchise Tax Board (FTB).  

Further, the period during which the credit may be refunded is the first five consecutive tax years beginning the third tax year after the tax year that the taxpayer makes the election. For example, if a taxpayer made the election in 2024, the first year in which it may be able to obtain a refund of the credit is 2027 (e.g., after the credit limitation period ends). During the refundable period, the annual refundable credit amount is applied first against tax due for the tax year and then against other amounts due. Any remaining balance is then refunded to the taxpayer.  

Because California’s research credit and California Competes credit are among the tax credits subject to the $5 million limitation under S.B. 167, they are eligible for this refundable credit provision. Given the required timing of the election and the time frame under which the refundable credit can be received, upfront planning is critical.  

Exclusion of Income in the Sales Factor Under S.B. 167

S.B. 167 enacts a provision intended as a clarification of existing California law that states that income not included in apportionable business income “by any reason, including, but not limited to, exclusion, deduction, exemption, elimination, or nonrecognition” is excluded from the sales factor of California’s apportionment formula. Consistent with legislative intent, the provision applies to tax years beginning “before, on, or after the effective date of the act adding this section.”  

Notably, S.B. 167 authorizes the FTB to promulgate regulations to implement the new section but states that California’s Administrative Procedures Act (APA) does not apply to any regulation or guidance established or issued by the FTB. This is problematic because APA oversight is critical to ensuring that regulations are clear, necessary, and legally valid and to provide the public with a meaningful opportunity to participate in their adoption. 

Over the years, taxpayers have filed refund claims or taken the position on original California tax returns that gross receipts are included in the sales factor even though a portion of the income was deducted and therefore not included in apportionable business income. Although the exclusion of deductible gross receipts from the sales factor provision of S.B. 167 was intended to retroactively overturn the California Office of Tax Appeal’s decision in the Appeal of Microsoft, which concluded that gross (not net) receipts are includible in the sales factor, the provision goes beyond the Microsoft decision and applies more broadly to include any income not included in apportionable business income “by any reason.” Because the new provision applies both retroactively and prospectively, it could adversely affect taxpayer positions on this issue.

To learn how BDO can help you navigate these new California tax rules, please visit our State & Local Tax Services page.