Got Losses? Why Pre-Revenue Start-Ups and Companies with No Gross Receipts Should Seek Relief from California’s Standard Apportionment Formula

• Start-ups often lack revenue during their first years of operation.
• Companies with uneven revenue streams may experience years of no revenue.
• California’s apportionment method for determining California taxable income is based solely on a sales factor for most businesses.
• Companies with no revenue within a tax year may have a 0% sales factor, effectively causing the company to apportion no losses to California that can be used against the company’s income in future years and reduce California tax.
• To seek relief, a taxpayer should consider petitioning California’s tax agency for permission to use an alternative apportionment formula.

Companies other than financial institutions, farms and extractive industries that conduct multistate activity are subject to California income tax based on a single-sales factor apportionment formula, which is the ratio of gross receipts within California to total gross receipts during the taxable year. For financial institutions, farms and extractive industries, California uses a three-factor apportionment formula that also takes into account a taxpayer’s property and payroll, a method that was available to all businesses for years beginning prior to January 1, 2013.

Apportioning Net Operating Losses

The single-sales factor apportionment formula may create an unfortunate tax consequence for pre-revenue start-ups and other companies with no revenue. During years of no revenue, a company would generate a net operating loss (NOL). An NOL must be apportioned to California based upon the apportionment formula and carried forward to apply against income in future taxable years. When an apportioning business has no sales, the numerator and denominator of the sales factor is zero, mathematically relegating the apportionment percentage to an error—no number results when divided by zero. Although there is no answer to this conundrum, the absence of any sales in California may relegate the sales factor to 0%. The result is the business may be unable to report any California NOL that may be used to offset future taxable income. This may be the result even if the company has only a single office in California, and when most or all property and payroll are in California.

Companies facing this issue may seek relief from this result by petitioning the California Franchise Tax Board (FTB) for an alternative apportionment formula that better represents the company’s activities in the state. The petition should suggest a reasonable alternative to single-sales factor apportionment that will result in the sourcing of its losses in a manner that more fairly reflects the extent of the company’s business activity in California. Specifically, the taxpayer may petition the FTB for a formula that provides an alternative to the single-sales factor formula. For example, a taxpayer may seek an apportionment formula based on its property and/or payroll located in California.

FTB Ruling 2019-01 (June 7, 2019) provides insight into this approach. The ruling provides examples of whether and when a taxpayer may petition for alternative apportionment. Included in the ruling is Situation 4, in which a taxpayer in an extractive business with zero gross receipts is provided as a circumstance when alternative apportionment may be appropriate. While the ruling does not provide a blanket approach for all taxpayers, it indicates that an alternative based upon an average of the property and payroll factors may be an acceptable method to properly reflect the activity of the taxpayer in the state, and in turn the taxable income or loss. The ruling does not apply this approach to businesses that by law use a single-sales factor formula, but it does indicate that the FTB would consider a departure from the standard formula when a business has no sales during a taxable year.

Petitioning for an Alternative Apportionment Formula

It is important to follow applicable procedures for seeking to use an alternative apportionment formula provided by the FTB. A taxpayer’s petition for an alternative apportionment formula must be granted by the FTB before that method can be used on an originally filed return, the FTB announced in FTB Notice 2004-5 (August 6, 2004). Absent the FTB’s prior approval, the tax agency may consider a taxpayer’s use of an alternative apportionment formula on an originally filed return an erroneous tax position subject to an accuracy-related penalty equal to 20% of the underpayment of tax, which may be triggered if the FTB disallows a NOL against taxable income in a subsequent year. Additionally, the relief sought in the petition must be limited to requesting an alternative apportionment formula. While an alternative apportionment petition may be submitted to cure the distortion that results from the application of the California allocation and apportionment provisions, the FTB stated in Ruling 2019-01 that it is not appropriate for a taxpayer to include other forms of possible relief in the petition such as requests relating to combined reporting or the treatment of business and nonbusiness income.

The Takeaway

Start-ups often have no income to report during their first few years of operation. Companies with varying income may experience years with zero revenue. To protect the tax attribute that arises from a year of losses, such companies should consider petitioning the FTB for an alternative apportionment method that would modify California’s single-sales factor formula and appropriately reflect the activity of the business in California. Obtaining the FTB’s permission to use an alternative apportionment formula that allows the company use of other factors such as a property and/or payroll is the only prescribed way to alleviate the uncertainty surrounding the appropriate California NOL. When the company does begin earning income, such alternative apportionment would safeguard the position to use NOLs and offset California taxable income in future years.