The much-touted business tax overhaul passed by the L.A. City Council could prove somewhat less than meets the eye as certain businesses expecting 15 percent tax cuts may have to wait years longer than originally anticipated.
What’s more, many small businesses that were promised tax exemptions won’t actually see them kick in fully until the 2007 tax year.
These and other details largely escaped notice during the congratulations that were showered in council chambers on Nov. 17 as a landmark business tax reform package 11 years in the making finally won approval.
Even so, the package put forward by councilmembers Wendy Greuel and Eric Garcetti, now awaiting Mayor James Hahn’s signature, eliminates taxes by July 1, 2006 for 130,000 businesses that take in less than $100,000 in annual gross receipts. It also exempts many film production houses and writers starting next year and phases in tax cuts for the remaining 60,000 to 70,000 businesses in the city.
The total tax savings for business has been put at $92 million, though it will take several years to reach that level of savings.
Originally, the tax cuts were to be 3 percent a year for five years. But councilmembers balked at this firm commitment for fear it could worsen the city’s structural budget deficit. Instead, in a last-minute compromise, the council set up annual thresholds for total business tax revenues. The thresholds start at the current $384 million and increase 4 percent per year; if those targets aren’t met in a particular year, then the tax cuts are put on hold for that year.
“I do see it likely that in some years, there won’t be tax cuts,” said Jack Walker, a retired tax attorney who served as vice president of the city’s Business Tax Advisory Committee. “My guess is that by the end of five years, we’ll probably see tax cuts of between 5 percent and 10 percent instead of the 15 percent originally envisioned.”
Both Greuel and Garcetti dispute this, saying that business taxes have risen consistently over the last 15 years, through two recessions. They also said that the increased ability to go after scofflaws should bring in $10 million more each year. And they said that in a pinch, money could be taken from a $20 million business tax reform fund to help ensure the cuts take place.
“We’re committed to making these cuts happen,” Greuel said.
Walker and other business advocates who spent up to 10 years pushing for business tax reform were pleased with the package overall. “Given the city’s budget picture, an entrenched city bureaucracy and a progressive city council, this is a pretty remarkable deal,” he said.
Simplifying the code
As the tax reform package begins to take effect over the next two years, L.A. businesses will notice several changes.
Starting Jan. 1, companies that now use billings to report their gross receipts such as architectural or public relations firms will be able to shift to cash-basis accounting. This allows them to report as gross receipts only actual payments received instead of work billed for but not yet paid for.
Also on Jan. 1, an especially onerous burden on many businesses will be eliminated: having to pay taxes on bad debts that they never expect to collect.
“When I found out about this, I was simply astounded that businesses could be paying taxes on money they have no reasonable hope of ever seeing,” Councilman Tony Cardenas said during the council debate. Cardenas inserted the clause to eliminate this practice.
Of perhaps greater significance, though, are the small business exemptions.
To be phased in over two years, businesses with less than $50,000 in annual gross receipts will no longer have to pay taxes on receipts coming in after next July 1, while businesses taking in between $50,000 and $100,000 will be exempted on July 1, 2006. (This latter group will still be paying taxes on receipts coming in during the first half of 2006, so the full effect of this exemption won’t be felt until the 2007 tax year.)
These exemptions alone are expected to cost the city treasury $12 million. But tax reform proponents say that by eliminating three-fifths of businesses from the tax rolls, they will be able to focus limited city resources on ensuring that the remaining 40 percent of businesses pay up.
For those that still must pay, it will be easier to figure out how much they owe. That’s because the package takes the present system of 75 tax categories and condenses it down to seven.
The current tax law starts out with six basic rate levels ranging from $1.18 per $1,000 in gross receipts to $5.91 per $1,000. But over the years, industry-specific amendments have been written into the code specifying different tax rates for the first $10,000 in receipts, the first $20,000 or some other threshold.
For example, a law firm with $1 million in gross receipts has been paying $106.43 for the first $18,000 and then $5.91 for every $1,000 on top of that for a total of $5,910. A retailer with $2 million in receipts has been paying $110.86 for the first $75,000 and then $1.48 for each $1,000 above that, for a total of $2,959.
“Companies were telling me they were spending more on accountants and tax lawyers just to figure out what they owe than on the tax liability itself,” said Brendan Huffman, chief lobbyist for the Los Angeles Area Chamber of Commerce.
In a previous reform attempt undertaken by then-Mayor Richard Riordan, an effort was made to reassign tax brackets to specific industries. But that proposal faltered when it became clear that in order to be revenue-neutral, some businesses would actually see increases in their tax rates.
Under the Greuel-Garcetti reform package, almost all these industry-specific exemptions have been wiped out of the tax code, leaving just the six tax rate levels. “You no longer have to spend so much time figuring out which category you’re in,” Greuel said last week. “We’ve taken an archaic and cumbersome system and simplified it.”
Besides these broad changes, the Greuel-Garcetti package contains several tax breaks for entertainment-related entities.
Most publicized has been the raising of the tax exemption threshold for writers and other “creative artists,” to $300,000 per year from $50,000. Writers claim that the city has been unfairly classifying them as business owners, even those who have full-time jobs in other industries and sell an occasional script on the side.
“We do have a very small community of high-end professionals that bring in more than $300,000 per year from their writing, but many of our members are not businesses,” said Writers Guild of America spokeswoman Cheryl Rhoden. She said she hopes the change will lead more writers to move to Los Angeles.
Another change involves tax reductions for film and commercial production companies. Under the existing system, production companies are taxed differently than most other firms: they are assessed based on the cost of their productions.
“These thresholds were set years ago and never kept up with the pace of inflation in the production business,” said Steve Kaplan, senior vice president of the Association of Independent Commercial Producers. “These days, it’s nearly impossible to do a production for under $1 million and most exceed $4 million. So even small mom-and-pop operations are being taxed at the same amount as Paramount Studios and that’s just not fair.”
Starting next July 1, the package raises the minimum threshold to $2.5 million and the maximum threshold to $12 million. (The minimum and maximum taxes stay the same, at $145 and $12,711 respectively.)
There is still one major piece of unfinished business: dealing with payments that companies receive but pass through to subcontractors, agents or other parties.
Under the current tax code, these “pass-through” payments are taxed twice: once when received by the prime contractor and again by the subcontractors when they receive them. Business groups have long complained it’s unfair for prime contractors to have to pay taxes on receipts that never go to their own bottom lines.
Greuel and Garcetti said the issue was too complicated to deal with by the end of this year the deadline demanded by a coalition of business groups for any reforms to be in place.
Greuel and Garcetti have pledged to revisit this issue as early as January. The problem is how to monitor these pass-through payments to make sure they’re legitimate exclusions.
Both Greuel and Garcetti said they want to periodically revisit the across-the-board tax cuts, with an eye towards even more cuts if revenues permit. “I’d like to come back and make that 15 percent a 25 percent cut or even 30 percent cut if we can,” Greuel said.
