What California Pre-revenue Companies Need to Start Now to Preserve State Net Operating Loss Carryforwards

If you are a pre-revenue CA domiciled company with employees in other states, you need to sell something before December 31, 2016.

Not sure what to sell? Keep reading…

Last week, I went to battle with Big Accounting over the reporting of California net operating loss (NOL) carryforwards. My client has one office… in CA; has 98% of its employees in CA. They have no sales. Their only gross receipts are from interest income.

Why does this matter to you?

In November 2012, CA voters passed Proposition 39 mandating that businesses apportion taxable income/loss to CA based solely on gross receipts. Prop 39 would, in theory, be advantageous for CA businesses and unfavorable for non-CA companies doing business in CA.

For example, if a CA business had $10 total revenue of which $9 comes from CA sources, it would apportion 90% of its taxable income/loss to CA. But if it had no revenue at all, none of its NOL is available in CA. This is devastating to start-ups that plan on using 2016 NOLs to offset future profits.

But you say, wait! We have interest income from bank deposits. Isn’t this CA income?

The unfortunate answer is no.

Recent case law mandates that income related to the “Treasury Function” is excluded for apportionment consideration. CA regulations define treasury function to include actions in support of the cash flow needs of a trade or business.

While this definition may at first appear all inclusive, I believe it has limits.

If your business leases office space and you have a security deposit on which you are paid interest, I don’t believe this is related to a treasury function. Alternatively, if your landlord requires you to have a letter of credit for the benefit of the landlord *and* your bank requires an interest-bearing, compensating balance account as security for the letter of credit, that interest may not be connected with the treasury function.

Be ready for a fight!

Big Accounting may not agree. My client had interest income related to their office lease. While their audit firm agreed in concept that this interest was not related to the treasury function, they were unwilling to allow my client to report the CA NOL in its audited financial statements.

Their solution was to petition the state for an alternative apportionment method based on an assertion that the results were not reflective of the business realities.

Get Real

Guess who gets paid to prepare petitions. Big Accounting. I cannot, in good conscience recommend to clients that they spend money this way. Maybe there’s a simpler solution.

Sell something. Check your interest income. While California has detailed rules and regulations on this issue, it’s probably in your best interest to look for a way to generate some CA receipts, no matter how small.

You should start now to understand your options.

If you have a question about how this affects you email me or call me at 408-278-8375. I’ll be happy to let you know where you stand on this issue.