California’s recently enacted Senate Bills 167 and 175 introduce significant tax changes for California startups, restricting the ability to deduct losses and fully utilize tax credits over the next three years. While these measures aim to address the state’s budget concerns, they will likely increase tax burdens and add new financial challenges for founders.
What Do These Tax Changes Mean for Your Startup?
1. Net Operating Loss (NOL) Deductions Are Suspended
Starting in tax year 2024, if your startup earns $1M or more in annual taxable income, you’ll no longer be able to use Net Operating Loss (NOL) deductions to reduce your tax liability for the next three years. This change can be a setback for companies that are growing fast but are not yet profitable. Usually, NOL deductions let you apply past losses to future gains, easing your tax burden when you start generating profit.
However, during this suspension, the existing 20-year carryforward period for unused losses is being extended: by three years for losses before 2024, by two years for 2024 losses, and by one year for 2025 losses. Startups with less than $1M in taxable income are exempt from the NOL suspension.
2. Limits on Business Tax Credits
If your company relies on tax credits to offset expenses—like R&D credits for payroll expenses—you’ll only be able to use them to offset up to $5 million of your tax liability each year. This cap will impact many startups that invest heavily in research and development, as they won’t be able to fully take advantage of their credits. The carryover period will be extended by the same number of years that the credit is disallowed due to this limitation.
3. Refundable Credit Election
On a brighter note, under the new California tax law, you can choose to receive a refundable credit of up to 20% on eligible credits during the three-year limitation period. Once you make this election, you can apply the refundable amount as a credit against your taxes for five years, starting from the third year after the election. For example, if your business earned $6 million in qualified credits for 2024 but could only use $5 million due to the cap, you could opt for a refundable credit. Starting in 2027, $200,000 of this refundable credit could be applied annually for five years. While it doesn’t entirely make up for the limits, it’s a way to still benefit from the credits you’ve earned.
These new tax changes will likely create cash flow challenges for many early-stage startups in California. If you’re used to using past losses to reduce your tax bill, you won’t have that option for the next few years. If you’re spending a lot on R&D, you might not be able to use all your credits, which can lead to a higher tax bill than you anticipated. Combined with federal tax laws from the Tax Cuts and Jobs Act (TCJA)—which requires startups to amortize R&D expenses over several years instead of expensing them all at once—this could make 2024 a challenging year for tax planning.
What You Can Do Next
Planning ahead and working with experienced tax professionals matters now more than ever. Startups need to get strategic about how they manage their finances under these new laws. There are options to mitigate the impact, such as adjusting the timing of income recognition and being more deliberate with how and when you use credits and deductions.
While these tax changes could be frustrating for many founders, they’re not insurmountable. Burkland’s tax team is here to help you navigate these new rules and create a plan to manage your tax burden. Contact us to discuss your next steps and ensure your startup is prepared.
By keeping up with the changes and taking a proactive approach, you can avoid being caught off guard and continue to position your startup for growth.