Legal ruling 1996-5

Subject: Net Operating Losses - "Eligible Small Business" and "New Business"

Issues

This legal ruling sets forth the Franchise Tax Board's position as to the scope of the terms "eligible small business" and "new business" as used in Revenue and Taxation Code §§ 17276 and 24416, relating to net operating losses.

1. What is the proper method to be used in defining the extent of a business activity for purposes of the "eligible small business" determination?
2. What gross receipts of a business activity are to be considered in making the "eligible small business" determination?
3. What prior trade or business activities are to be taken into account for purposes of applying the "prior trade or business activities" test?
4. What is the proper method to be used in defining the extent of a business activity for purposes of applying the "asset test" and what gross receipts of such activity are to be taken into account?

Law and Analysis

Prior to 1994, California generally provided a net operating loss (NOL) deduction equal to 50 percent of the federal carryover amount, although for two years (1991-1992) NOLs were suspended completely. (Revenue and Taxation Code §§ 17276.3 & 24416.3.) These NOL rules applied equally to all taxpayers.

During the 1993 California legislative session, these NOL rules were substantially revised (AB 34, Stats. 1993, Ch. 880, applicable to taxable and income years beginning on or after January 1, 1994). Two important special rules were added to provide more favorable NOL treatment for losses incurred in operating either an "eligible small business" or a "new business." In general, "small businesses" were permitted to carry forward 100 percent of any net operating loss attributable to the eligible small business for a period of five years, while "new businesses" were permitted to carry forward 100 percent of any net operating loss for a period of up to eight years. However, the 1993 legislation did not clearly define either of these terms.

The following year, in response to a perceived need for clearer definitions of these two critical terms, the California Legislature substantially amended the NOL provisions (AB 2407, Stats. 1994, Ch. 949, applicable to taxable or income years beginning on or after January 1, 1994). While these 1994 amendments added more specific definitions of the terms "eligible small business" and "new business," further guidance has been requested. This ruling sets forth the Franchise Tax Board's position with respect to the scope of these two terms.

The 1994 legislation defined the term "eligible small business" as follows:

"Eligible small business" means any trade or business that has gross receipts, less returns and allowances, of less than one million dollars ($1,000,000) during the taxable [income] year. (Revenue and Taxation Code §§ 17276(e)(1) & 24416(f)(1).)

The 1994 legislation defined the term "new business" as follows:

Except as provided in subdivision (f)[g], "new business" means any trade or business activity that is first commenced in this state on or after January 1, 1994. (Revenue and Taxation Code §§ 17276(e)(2) & 24416(f)(2).)

Revenue and Taxation Code §§ 17276(f) & 24416(g) provide the following rules for determining whether a trade or business activity will qualify as a "new business":

(f)[g] For purposes of this section, in determining whether a trade or business activity qualifies as a new business under paragraph (2) of subdivision (e), the following rules shall apply:

(1) In any case where a taxpayer or partnership purchases or otherwise acquires all or any portion of the assets of an existing trade or business (irrespective of the form of entity) that is doing business in this state (within the meaning of Section 23101), the trade or business thereafter conducted by the taxpayer or partnership (or any related person) shall not be treated as a new business if the aggregate fair market value of the acquired assets (including real, personal, tangible, and intangible property) used by the taxpayer or partnership (or any related person) in the conduct of its trade or business exceeds 20 percent of the aggregate fair market value of the total assets of the trade or business being conducted by the taxpayer or partnership (or any related person). For purposes of this paragraph only, the following rules shall apply:

(A) The determination of the relative fair market values of the acquired assets and the total assets shall be made as of the last day of the first taxable [income] year in which the taxpayer or partnership (or any related person) first uses any of the acquired trade or business assets in its business activity.

(B) Any acquired assets that constituted property described in Section 1221(1) of the Internal Revenue Code in the hands of the transferor shall not be treated as assets acquired from an existing trade or business, unless those assets also constitute property described in Section 1221(1) of the Internal Revenue Code in the hands of the acquiring taxpayer or partnership (or related person).

(2) In any case where a taxpayer or partnership (or any related person) is engaged in one or more trade or business activities in this state, or has been engaged in one or more trade or business activities in this state within the preceding 36 months ("prior trade or business activity"), and thereafter commenced an additional trade or business activity in this state, the additional trade or business activity shall only be treated as a new business if the additional trade or business activity is classified under a different division of the Standard Industrial Classification (SIC) Manual published by the United States Office of Management and Budget, 1987 edition, than are any of the taxpayer's or partnership's (or related person's) current or prior trade or business activities.

(3) In any case where a taxpayer or partnership, including all related persons, is engaged in trade or business activities wholly outside of this state and the taxpayer or partnership first commences doing business in this state (within the meaning of Section 23101) after December 31, 1993 (other than by purchase or other acquisition described in paragraph (1)), the trade or business activity shall be treated as a new business under paragraph (2) of subdivision (e).

(4) In any case where the legal form under which a trade or business activity is being conducted is changed, the change in form shall be disregarded and the determination of whether the trade or business activity is a new business shall be made by treating the taxpayer or partnership as having purchased or otherwise acquired all or any portion of the assets of an existing trade or business under the rules of paragraph (1) of this subdivision.

(5) The term "related person" shall mean any person that is related to the taxpayer or partnership under either Section 267 or 318 of the Internal Revenue Code.

(6) The term "acquire" shall include any gift, inheritance, transfer incident to divorce, or any other transfer, whether or not for consideration.

One of the key changes in the 1994 legislative amendments was to focus the "eligible small business" or "new business" inquiry upon the trade or business activity actually conducted, rather than upon the particular form of entity within which the activity or activities are being conducted. This had the effect of permitting a taxpayer that was operating an otherwise substantial business to have, in limited circumstances, an additional business activity or activities that might qualify as either "small" or "new."

Another key change in the 1994 amendments was to provide, in the case of a "new business," that a putative "new" business activity would only be treated as a "new business" for purposes of the NOL rules where the "new" business activity was classified under a different division of the Standard Industrial Classification Manual, 1987 edition ("SIC Manual"). Thus, for example, if a taxpayer (or a related party) was already engaged in manufacturing activities in California (Division D of the SIC Manual), then a new business activity of the taxpayer (or any related party) that would also be properly classified under Division D of the SIC Manual could not qualify as a "new business" under the NOL rules. The Franchise Tax Board's position is that, consistent with the general legislative intent of the 1993 and 1994 amendments to encourage new business formation and expansion in California, the "prior trade or business activities" test of Revenue and Taxation Code §§ 17276(f)(2) & 24416(g)(2) needs to be interpreted to apply the "different division" requirement only to those activities being conducted or that had previously been conducted by the taxpayer (or any related party) either within California or within and without California.

In the case of the "asset test" of Revenue and Taxation Code §§ 17276(f)(1) & 24416(g)(1), the Franchise Tax Board's position is that, consistent with the general legislative intent of the 1993 and 1994 amendments to encourage new business formation and expansion in California, the denominator of the fraction should be calculated by using a "divisional" approach in defining the extent of the trade or business activity. This rule will result in the inclusion of the total assets of the post-acquisition trade or business activity conducted by the acquiror and any related party that are classified under the "same division" in the SIC Manual. Finally, the denominator shall be computed by taking into account all assets within such business on a worldwide basis, unless a valid water's-edge election is in effect, in which case the denominator shall only include the assets used in the same division within the water's-edge.

In addition, in applying the "asset test" of Revenue and Taxation Code §§ 17276(f)(1) & 24416(g)(1) to the acquisition of existing trade or business assets, the Franchise Tax Board's position is that, consistent with both the general legislative intent of the 1993 and 1994 amendments to encourage new business formation and expansion in California, and the Franchise Tax Board's position with respect to application of the "different division" requirement, assets need only be included in the numerator of the fraction where those assets are used by the acquiror (or a related party) in a business activity that is classified under the same division of the SIC Manual in which such assets were used prior to their acquisition.

In the case of an "eligible small business," no specific rule to define the scope of the trade or business activity was set forth in the 1994 amendments. The Franchise Tax Board's position is that in determining what constitutes a taxpayer's "trade or business activity" for purposes of the "eligible small business" test, the same "different division" standard applicable to the "new business" determination should be used. This position is based upon Revenue and Taxation Code §§ 17276(b)(4) & 24416(b)(4), which require that in any case where the business activity being tested qualifies as both an "eligible small business" and a "new business," then the business activity will be treated as a "new business" for the first three years of its existence. Since this priority rule contemplates that there will occasionally be an overlap between the two sets of provisions, it is reasonable to infer that the Legislature intended the same basic criteria to apply in defining the scope of the business activity under the "eligible small business" and "new business" rules.

Facts

In each of the following factual situations, assume that the business activities of each taxpayer are properly assigned to the stated Standard Industrial Classification (SIC) Codes, as published in the SIC Manual.

Situation 1: Taxpayer A is an individual engaged in the following two business activities -- (a) the wholesale distribution of fresh fruits and vegetables (SIC Code 5148, Division F, Wholesale Trade) in California and Oregon, and (b) the operation of coin-operated pinball machines in bowling alleys (SIC Code 7993, Division I, Service) in California. During the taxable year, A's gross receipts from the wholesale distribution activity are $5,000,000, and A's gross receipts from the coin-operated pinball machine activity are $500,000. A originally commenced each of these business activities during 1990.

Analysis 1: A is engaged in two business activities, the wholesale distribution of fruits and vegetables, and the operation of coin-operated amusement devices, that are each properly classified in two different divisions of the SIC Manual. Since each of these two activities was originally commenced prior to January 1, 1994, neither would be considered a "new business" under Revenue and Taxation Code § 17276(e)(2). However, since each of A's business activities are properly treated under a different division of the SIC Manual, they must be tested separately to determine whether either may qualify as an "eligible small business." While A's wholesale distribution activity had gross receipts of $5,000,000 and thus would not qualify as an "eligible small business" under Revenue and Taxation Code § 17276(e)(1), A's coin-operated pinball machine activity had gross receipts for the taxable year of $500,000 and thus would qualify as an "eligible small business" for the taxable year. Assuming A had both an overall operating loss for the taxable year and an operating loss for the taxable year in the coin-operated pinball machine activity, then 100 percent of the loss attributable to the coin-operated pinball machine business activity could be carried forward for five (5) taxable years.

Holding 1: For purposes of determining whether a taxpayer who is engaged in more than one business activity may treat a portion of any net operating loss as a loss from an "eligible small business," each activity that is properly classified in a separate division of the SIC Manual from any of the taxpayer's other business activities shall be treated as a separate activity for "eligible small business" testing purposes.

Situation 2: Taxpayer B is a partnership with three equal unrelated individual partners, J, K, and L, engaged in the following three business activities -- (a) the manufacturing of motion picture apparatus and equipment (SIC Code 3861, Division D, Manufacturing) in California, (b) the operation of drive-in movie theaters (SIC Code 7833, Division I, Services) in New Mexico, and (c) commercial market research for the entertainment industry (SIC Code 8732, Division I, Services) in California. During the taxable year, B's gross receipts from the motion picture manufacturing activity are $10,000,000, B's gross receipts from the drive-in theater activity are $2,800,000, and B's gross receipts from the commercial market research activity are $700,000. B originally commenced the motion picture manufacturing activity during 1991, the drive-in theater activity during 1993, and the commercial market research activity during May of 1994. Assume B did not acquire the assets of an ongoing commercial market research business when B commenced this activity in May of 1994, and that neither B nor any related party operated a drive-in movie theater activity in California during the preceding 36-month period.

Analysis 2: The determination of whether B's losses which pass-through to its partners will be treated as from an "eligible small business" or from a "new business" will be made at the entity level under Revenue and Taxation Code § 17276(e)(4). B is engaged in three business activities that are properly classified in two different divisions of the SIC Manual, with the motion picture manufacturing activity properly classified in Division D (Manufacturing) of the SIC Manual, and both the drive-in movie theater activity and the commercial market research activity properly classified in Division I (Services) of the SIC Manual. B's motion picture manufacturing activity had gross receipts in excess of $1,000,000 and thus would not be classified as an "eligible small business" under Revenue and Taxation Code § 17276(e)(1). Moreover, since both B's drive-in movie theater activity and commercial market research activity are each properly classified in Division I of the SIC Manual, these two activities must be aggregated for purposes of determining whether either one is properly treated as an "eligible small business." When so aggregated, the gross receipts from the two activities exceed $1,000,000 and neither would be treated as an "eligible small business" under Revenue and Taxation Code § 17276(e)(1). This conclusion is not changed by the fact that B's drive-in movie theater activity is conducted wholly outside of California, since all activities within the same division of the SIC Manual are aggregated based upon worldwide gross receipts (water's-edge gross receipts in the case of an electing taxpayer under Revenue and Taxation Code § 25110, et. seq.).

However, B's commercial market research activity would be properly treated as a "new business" under Revenue and Taxation Code § 17276(e)(2). First, B's commercial market research activity was originally commenced after January 1, 1994, and B did not acquire the assets of an existing trade or business to commence this activity, so that the rules of Revenue and Taxation Code § 17276(f)(1) (the "asset test") do not apply. Second, in applying the "prior trade or business activities" test of Revenue and Taxation Code § 17276(f)(2), the "different division" requirement is satisfied since prior to B's commencement of the commercial market research activity in May of 1994, B's only prior trade or business activity within California was the manufacturing activity, which is classified in Division D of the SIC Manual. Since B's drive-in movie theater activity was conducted wholly outside of California during the preceding 36-month period, that activity, although classified within the same division of the SIC Manual as the commercial market research activity (Division I), may be properly disregarded for purposes of applying the "prior trade or business activities" test of Revenue and Taxation Code § 17276(f)(2).

Holding 2: For purposes of determining if an activity qualifies as an eligible small business, in applying the gross receipts test under Revenue and Taxation Code §§ 17276(e)(1) & 24416(f)(1), all activities conducted by the taxpayer and related persons within the same division of the SIC Manual are aggregated based upon worldwide gross receipts (water's-edge gross receipts in the case of an electing taxpayer under Revenue and Taxation Code § 25110, et. seq.).

Situation 3: Taxpayer C is a corporation engaged in the following two business activities which it conducts within two separate divisions -- (a) the mining of copper ore (SIC Code 1021, Division B, Mining) in Idaho, and (b) the manufacturing of copper chloride and copper sulfate (SIC Code 2819, Division D, Manufacturing) in Utah. C's gross receipts from the mining activity are $20,000,000, and C's gross receipts from the manufacturing activity are $100,000,000, and C's total assets used in the copper ore mining activity as of the close of the income year are $10,000,000. C originally commenced its mining activity in California during 1975, but abandoned its California mining activity in 1977 and has thereafter exclusively conducted its mining activities in Idaho. In May of 1994, C decided to expand its mining activities into California and created a wholly-owned new subsidiary, S, to conduct these California mining activities. Assume C contributed cash in exchange for all of S's stock. S's gross receipts from its mining activities are $5,000,000. Assume that neither C nor S nor any other related party had previously conducted any trade or business activities in California during the preceding 36-month period.

Analysis 3: C's gross receipts from both its mining activity, Division B, Mining, of the SIC Manual, and its manufacturing activity, Division D, Manufacturing, of the SIC Manual, are in excess of $1,000,000, and thus neither activity would be classified as an "eligible small business" under Revenue and Taxation Code § 24416(f)(1). In addition, both of C's business activities were commenced prior to January 1, 1994, and thus neither activity would be treated as a "new business" under Revenue and Taxation Code § 24416(f)(2). In the case of S, since S's gross receipts from its mining activity are in excess of $1,000,000, S would not be classified as an "eligible small business" under Revenue and Taxation Code § 24416(f)(1). However, S would be treated as a "new business" under Revenue and Taxation Code § 24416(f)(2) since S was incorporated and first commenced its business activity in California after January 1, 1994, and would satisfy the "new to California" rules of Revenue and Taxation Code § 24416(g)(3). These latter rules would be satisfied even though C was previously engaged in mining activities classified under Division B of the SIC Manual since C, while a related party to S, was engaged in those mining activities wholly outside of California during the relevant preceding 36-month period.

Holding 3: For purposes of applying the "prior trade or business activities" test of Revenue and Taxation Code §§ 17276(f)(2) & 24416(g)(2), the "different division" requirement shall apply only to those activities being conducted or that had previously been conducted during the preceding 36-month period by the taxpayer (or any related party) within California, or within and without California, but not to those activities wholly outside California.

Situation 4: Same facts as Situation 3, except that C, in addition to its wholly-owned subsidiary S, also owns all of the stock of X, Y, and Z corporations. X has been engaged in the business of manufacturing hydraulic cement (SIC Code 3241, Division D, Manufacturing) in Texas since 1965, Y has been engaged in the business of selling paint and glass to the general public (SIC Code 5231, Division G, Retail Trade) in New York and New Jersey since 1971, and Z has been engaged in the business of mining iron ore (SIC Code 1011. Division B, Mining) in Australia since 1973. Assume that C and its affiliates have not made a water's-edge election under Revenue and Taxation Code § 25110, et. seq., for the income year. Assume also that instead of C capitalizing S with cash in May of 1994 to commence the California mining activity, C acquired substantially all of the operating assets of W, an unrelated corporation engaged in copper mining within California, for $10,000,000 (which acquisition price included no inventory-type assets), and C thereafter transferred all of W's acquired assets to S in a tax-free transaction. Further assume that in March of 1995, Y, which is 40 percent general partner in a partnership that has been engaged in the business of selling building materials to the general public (SIC Code 5211, Division G, Retail Trade) in California since 1985, has its partnership interest converted into an identical percentage interest in L, a California limited liability company, in a tax-free transaction in which no additional cash or other assets are contributed to L. In addition, assume that Z's total assets used in the iron ore mining activity as of the close of the income year are $80,000,000. Finally, assume that X's gross receipts from the hydraulic cement manufacturing activity are $150,000,000, Y's gross receipts from the paint and glass sales activity are $40,000,000, Z's gross receipts from the iron ore mining activity are $300,000,000, and L's gross receipts from the business materials sales activity are $8,000,000.

Analysis 4: None of the business activities of C, X, Y, Z, S or L would qualify as an "eligible small business" under Revenue and Taxation Code §§ 17276(e)(1) & 24416(f)(1) since the gross receipts from each activity are in excess of $1,000,000. Moreover, in the case of C, X, Y, and Z, none of their business activities would qualify as a "new business" under Revenue and Taxation Code § 24416(f)(2) since each of their respective business activities was originally commenced prior to January 1, 1994.

In the case of S, since S was incorporated and first commenced its business activity in California after January 1, 1994, S would be treated as a "new business" under Revenue and Taxation Code § 24416(f)(2) provided that S satisfies the "asset test" of Revenue and Taxation Code § 24416(g)(1). The "asset test" generally requires that in any case where any existing California business activity is acquired, either substantial additional assets must be contributed to the post-acquisition business activity or the acquired assets must represent a relatively small percentage of the acquiror's overall same SIC Manual division trade or business activity in order for the post-acquisition business activity to qualify as a "new business." For this purpose, Revenue and Taxation Code § 24416(g)(1) provides that the "asset test" will be satisfied where, as of the last day of the income or taxable year in which the acquisition occurs, the aggregate fair market value of the pre-acquisition assets (generally exclusive of inventory-type assets) used in the post-acquisition business activity does not exceed 20 percent of the aggregate fair market value of the total post-acquisition assets (computed on a worldwide basis, unless a valid waters'-edge election is effect) being used to conduct the acquiror's (including any related party's) trade or business activity. Under these facts, the assets of both C and Z must be included in the denominator for purposes of applying the "asset test" since C and Z are both related to S, C and Z are each engaged in a business activity classified in the same division of the SIC Manual (Division B, Mining), and no water's-edge election is in effect for the income year. Thus, since the pre-acquisition assets comprise 10 percent ($10,000,000/$100,000,000) of the total assets of the post-acquisition business activity being conducted by S and its related parties (C and Z), S would satisfy the "asset test" of Revenue and Taxation Code § 24416(g)(1) and S would qualify as a "new business". In contrast, if C and its affiliates did have a water's-edge election in effect for the income year, then the assets of Z would be excluded from the denominator and S would fail the "asset test" since the pre-acquisition assets would comprise 50 percent ($10,000,000/$20,000,000) of the total assets of the post-acquisition business activity being conducted by S and its related party (C). Finally, in applying the "prior trade or business activities" test of Revenue and Taxation Code § 24416(g)(2), the "different division" requirement is also satisfied since prior to S's commencement of the California mining activity in May of 1994, neither S nor any related party was engaged in any prior trade or business activities within California that were classified in Division B (Mining) of the SIC Manual.

In the case of L, since the "legal form" under which L was conducting its business activity was changed from a partnership to a limited liability company after January 1, 1994, Revenue and Taxation Code § 24416(g)(4) requires that the change in form be disregarded and the determination of whether L will be treated as a "new business" shall be made by applying the "asset test" of Revenue and Taxation Code § 24416(g)(1) to L's post-change business activity. Under these facts, since L's pre-change assets comprise 100 percent of L's post-change assets, L does not satisfy the "asset test" of Revenue and Taxation Code § 24416(g)(1) and will not be treated as a "new business."

Holding 4: For purposes of applying the "asset test" of Revenue and Taxation Code §§ 17276(f)(1) & 24416(g)(1), relating to the purchase or acquisition of an existing trade or business, the denominator of the fraction shall use a "divisional" approach in defining the extent of the trade or business activity to be included within the total assets of the post-acquisition trade or business activity conducted by the acquiror and any related party that are classified under the "same division" in the SIC Manual, and shall be computed by taking into account all assets within such business on a worldwide basis, unless a valid water's-edge election is in effect, in which case the denominator would only include the assets used in the same division within the water's-edge.

Drafting Information

The principal author of this ruling is Douglas K. Powers of the Franchise Tax Board Legal Branch. For further information regarding this notice, contact Mr. Powers at the Franchise Tax Board Legal Branch, P.O. Box 1720, Rancho Cordova, CA 95741-1720.