On January 10, California Gov. Gavin Newsom released his 2025-2026 budget proposal to the California Legislature. The proposal indicates that the budget is fully balanced with no deficit and that as a result of stronger than anticipated economic performance and increased cash receipts, the state is projecting $16.5 billion in revenue in the three-year budget window.
The proposed budget includes several tax proposals, which the state estimates will increase general fund revenues by $186 million in fiscal 2025-2026. The tax proposals include:
- Use of a mandatory single sales factor apportionment formula for financial institutions beginning in tax year 2025;
- An extension of the elective pass-through entity tax (PTET), which is scheduled to sunset after 2025;
- An increase from $330 million to $750 million in the cap on the California film and television tax credit for fiscal years 2025-2026 through 2029-2030;
- An exclusion from income of wildfire settlements paid in tax years 2025 through 2029, regardless of when the fire occurred, beginning in tax year 2025; and
- An exclusion from income of some military retirement and survivor benefits beginning in tax year 2025.
Mandatory Single Sales Factor for Financial Institutions
Currently, financial institutions and businesses in agricultural and extraction industries that are subject to the California corporation tax must apportion business income using a three-factor formula consisting of property, payroll, and single-weighted sales. However, other corporations must use a single sales factor to apportion business income.
To align “financial institutions with nearly all other corporations, and [reward] businesses for locating in the state,” Newsom proposes requiring financial institutions to apportion their business income using a single sales factor. According to the proposed budget, “single sales factor apportionment is generally more beneficial than three-factor apportionment to firms with a larger physical presence in the state as they can exclude their property and payroll factors from the calculation.” That proposal is expected to increase revenues by $330 million in fiscal year 2025-2026 and by more than $250 million annually thereafter.
Elective PTET Extension
The Tax Cuts and Jobs Act of 2017 limited to $10,000 the deduction for state and local tax (SALT) that individual taxpayers can take on their federal tax returns. The PTET, which was enacted by the California Budget Act of 2021, allows taxpayers with income from pass-through entities to electively pay California tax at the entity level and receive a California personal income tax credit for that amount. However, the PTET is scheduled to sunset after 2025 along with the $10,000 federal SALT cap. The proposed budget states that “to provide certainty that the PTET will continue to be available to California taxpayers if a SALT cap remains in effect, the Budget proposes to extend the PTET, subject to the federal SALT cap being extended.”
BDO Insights
- Although Newsom’s proposal indicates that it is a balanced budget with no budget deficit, it is uncertain whether the recent wildfires in Los Angeles County will affect the budget estimates, given that the total cost of the wildfires to California is still unknown. Further, because California has extended the tax payment and filing deadlines for taxpayers in the disaster areas, state revenue collections could be delayed.
However, as part of California’s budget process, in May, the governor typically releases a revised version of the budget that accounts for updated revenue and expenditure estimates. The May revision could include changes to account for any wildfire-related expenditures. Newsom is expected to release the May revision by May 14, and the Legislature will have until June 15 to pass the budget for fiscal year 2025-2026. - A move to a mandatory single sales factor for financial institutions could harm out-of-state institutions, which would no longer be able to account for their out-of-state property and payroll when computing the amount of business income apportioned to, and therefore taxable in, California. On the other hand, the proposal could benefit some financial institutions with significant California operations by no longer requiring them to account for their in-state property and payroll in apportioning their business income.
Although the proposal’s exact terms are unknown, financial institutions should consider how this change could affect their California tax liabilities beginning in tax year 2025. - While California’s willingness to extend the PTET beyond 2025 certainly provides some flexibility for taxpayers, the proposal appears to be contingent upon Congress extending the federal SALT cap. The post-election changes in the federal administrative and legislative branches could affect whether the federal SALT cap is extended beyond 2025.
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