Legislative Analyst Office, January 2001

California's Tax System A Primer Chapter 4

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Bank and Corporation Tax

Overview of the Bank and Corporation Tax

California is one of 48 states to tax corporate profits, and its bank and corporation tax (BCT) is the state's third largest source of General Fund revenues. In 1999-00, it raised an estimated $6.1 billion, or 9 percent of the total. The BCT applies to all corporations which earn income derived from, or that is attributable to, sources in California. Nonprofit corporations (such as churches and charitable organizations) are exempt, as are insurance companies (which instead pay a gross premiums tax).

Of the nearly half million corporations filing BCT returns in California, only about 60 percent actually report profits and thus, pay BCT taxes. The remainder report losses, and thus, are subject only to the state's minimum tax. Those firms making profits are distributed among different industry sectors. Manufacturing firms account for almost one-third of all BCT tax liabilities.

The BCT actually encompasses three different individual taxes--the corporate franchise tax, corporate income tax, and bank tax. The corporate franchise tax is paid by most businesses in the state for the privilege of doing business in California, while the corporate income tax is paid by businesses which do not have sufficient presence or activity in the state for franchise tax purposes. The bank tax is paid by banks and financial institutions. All three components of the BCT are assessed based on income, with the franchise tax overwhelmingly dominating--accounting for over 98 percent of BCT revenues.

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Key BCT Features

The BCT's key features include:

• A basic tax rate on profits of 8.84 percent and an $800 minimum tax except during a firm's first two years of operation. Banks and financial institutions pay at a higher rate of 10.84 percent to compensate for being exempt from certain local levies.
• Corporations are also subject to an Alternative Minimum Tax (AMT) similar in principle to the personal income tax (PIT) AMT, but at a slightly lower rate of 6.64 percent.
• A reduced tax rate of 1.5 percent for Subchapter S corporations, whose income "flows through" and is taxed on shareholders' PIT returns (see shaded box).
• The right to "carry forward" a certain percentage of the net operating losses (NOLs) incurred in one year so as to reduce taxable profits in subsequent years.
• The apportionment to California of a share of the domestic or worldwide business income for multistate and multinational corporations.
• A broad range of income exemptions, exclusions, and deductions, as well as tax credits. The value of these tax expenditure programs (TEPs) to taxpayers exceeds $3.7 billion (see the accompanying figure for a description of the largest TEPs).

Relationship to Federal Law

California conforms in a great many BCT areas to federal corporate tax law regarding its basic structure and TEPs. However, some notable exceptions exist. For example, federal law offers more generous depreciation allowances, does not levy an entity-level tax on Subchapter S corporations, and allows 100 percent of NOLs to be "carried forward" as well as to be "carried back" to prior tax years.

Taxation of S Corporations "S corporations" are business entities that receive the limited liability benefits of a corporation, but are taxed like a partnership. That is, their income is "passed through" to shareholders on a pro-rata basis and taxed at each individual's personal income tax rate rather than at the regular corporate rate. In 1998, there were more than 143,000 S corporation returns filed in California, generating $388 million in bank and corporation tax revenues. About one-in-three California corporations are S corporations. Regarding their tax treatment, S corporations: Pay a reduced corporate income tax rate of 1.5 percent (3.5 percent for financial S corporations). Are not subject to the alternative minimum tax, but are subject to the same minimum tax requirements as other corporations. Most California S corporations are small businesses which also have elected federal Subchapter S corporation status, in that they have no more than 75 shareholders and only one class of stock. However, there also are many very large S corporations in terms of assets, sales, and net income.

Taxing National and International Corporations

The taxation of corporations doing business only in California is relatively straightforward in terms of computing their taxable profits, in that California profits equal the difference between receipts and allowable deductions (such as expenses for employee salaries). Most businesses filing under the BCT are California-only corporations; however, most corporate income--almost 75 percent--accrues to multistate and multinational corporations.

For these firms, California profits are determined by apportioning a share of their total domestic or worldwide business income to California, based on California's weighted share of their total property, payroll, and sales (in most cases, the sales factor is double-weighted in doing this calculation). International corporations are given the option of using a domestic or worldwide base in doing their apportioning. In contrast to business income's treatment, nonbusiness corporate income, such as interest, is "sourced" to different states and nations using a set of prescribed rules.

The BCT's Distribution

In 1998, over 97 percent of BCT filers had taxable income of less than $500,000. The tax revenues generated by these firms accounted for about 15 percent of the total BCT taxes paid. Corporations earning a taxable income of $500,000 or more, in contrast, represented only 3 percent of returns, but had 85 percent of the tax liability.

Comparisons to Other States

California's basic BCT rate of 8.84 percent is relatively high compared to other states (see accompanying figure). However, in making interstate tax-burden comparisons, one also must take account of more than just the tax rate--such as the various TEPs taxpayers benefit from. One way to adjust for this is by looking at corporate income taxes relative to personal income. In this regard, California's BCT burden is a bit above average for the U.S. as a whole (0.7 percent versus 0.5 percent).

Comparison of Key BCT Provisions
1999 Tax Year
State	Tax Rate (%)	General Minimum Tax ($)	S Corporation Taxability
Pennsylvania	9.99%	--	Exempt
Massachusetts	9.50	$456	Exempt
New Jersey	9.00	250	Taxable
California	8.84	800	Taxable
New York	8.50	100 - 1,500	Taxable
Arizona	8.00	50	Exempt
Wisconsin	7.90	--	Exempt
North Carolina	7.50	--	Exempt
Oregon	6.60	10	Exempt
Ohio	5.10 - 8.50	50	Exempt
Utah	5.00	100	Exempt
Illinois	4.80	--	Taxable
Michigan	2.20	--	Taxable

The BCT's Future

The BCT's relatively subdued growth performance in California throughout much of the 1990s also occurred nationally and raises questions regarding the BCT's future role as a major revenue source. While BCT growth occurred in the most recent two years, its flatness in prior years during which the economy performed well remains a concern. For example, between 1994-95 and 1998-99 BCT revenues were basically stagnant even though overall economic growth was strong. This pattern is not fully understood, but some tax experts have pointed to increased use of creative corporate accounting and tax shelters--activities that could continue to constrain growth in the future.

Future BCT growth also could be affected by the substantial overhang of previously generated, but as yet unclaimed NOLs. Although the magnitude of NOLs has declined recently, they still total almost $70 billion, and are worth a potential tax savings of approximately $6 billion to California corporations (and thus, revenue losses to the state), if and when used.

BCT Policy Issues

Key BCT issues involve:

• Income Apportionment. Does California's use of a double-weighted sales factor in its income apportionment formula best achieve the state's tax policy goals?
• Dividend Taxation. California (like the federal government) "double-taxes" dividend income, since it is taxed under both the PIT and BCT. Should this be changed?
• Integration. More generally, since both the PIT and BCT tax income, some have proposed integrating the two taxes in some fashion. Should this be considered?
• Federal Conformity. California conforms to federal BCT law in many areas. Is California's policy of generally conforming still appropriate, and should additional conformity occur where it does not currently exist (such as with depreciation)?
• Tax Expenditure Programs. Are certain BCT-related TEPs ineffective or inefficient and, therefore, deserving of elimination or modification?
• Revenue Performance. Given the BCT's relatively subdued growth performance in the recent past, what will its growth be and are there associated problems with how the tax is being administered and enforced?

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