Did a California water's-edge election change the related-person asset or gross-receipts calculations for the net operating loss rules addressed in Legal Ruling 96-5?

Plain-English summary

Legal Ruling 1999-2 removed the special water's-edge treatment that Legal Ruling 96-5 had used when applying the net operating loss rules for an "eligible small business" or "new business."

FTB concluded that a water's-edge election did not change which related persons and amounts entered the ruling's asset and gross-receipts tests. The statutes defined "related person" by reference to Internal Revenue Code sections 267 and 318, not by membership in a California combined report.

The ruling therefore deleted every reference in Legal Ruling 96-5 to water's-edge taxpayers and the special rules previously applied to them, including references in the examples, analysis, and holdings.

What changed

Asset test

Legal Ruling 96-5 had said the denominator of the asset test would be computed differently when a valid water's-edge election was in effect.

Legal Ruling 1999-2 withdrew that position. Related persons were determined under Internal Revenue Code sections 267 or 318 and were not limited to the entities included in a combined report. The water's-edge election therefore did not alter the assets taken into account for the test.

Gross-receipts test

Legal Ruling 96-5 also had prescribed a different gross-receipts computation for an eligible small business with a water's-edge election.

Legal Ruling 1999-2 withdrew that treatment for the same reason. The statutory related-person definition extended beyond combined-report membership, so the election did not alter the gross receipts taken into account when determining whether a taxpayer could be treated as an eligible small business.

Effect on Legal Ruling 96-5

The ruling did not replace Legal Ruling 96-5 in full. It modified that ruling by deleting all water's-edge references and special rules, including the affected hypothetical examples and their analysis and holdings.

FTB said the withdrawn positions conflicted with the statutes and were inconsistent with the general principles of California's taxation of water's-edge taxpayers.

What this means for you

Businesses with a historical water's-edge election

For the NOL tests addressed in these rulings, the election did not confine related-person assets or receipts to the entities inside the combined report.

Accountants and tax professionals

Do not read the original water's-edge examples in Legal Ruling 96-5 without this modification. Legal Ruling 1999-2 expressly deleted those examples' special treatment.

Researchers using older FTB guidance

Read related rulings together and check whether a later ruling modifies, supersedes, or withdraws part of an earlier one. Here, relying on Legal Ruling 96-5 alone would produce the position FTB expressly removed.

Common questions

Q: Did a water's-edge election change the asset-test denominator?

A: No. Legal Ruling 1999-2 deleted the earlier special computation.

Q: Did the election change eligible-small-business gross receipts?

A: No. The ruling deleted that special computation as well.

Q: Why were entities outside the combined report still relevant?

A: The cited statutes defined related persons by reference to Internal Revenue Code sections 267 and 318 rather than limiting them to combined-report members.

Q: Was Legal Ruling 96-5 completely withdrawn?

A: No. It was modified by deleting its water's-edge references, examples, analysis, holdings, and special rules.

Q: Is this a current statement of California NOL law?

A: The page summarizes the 1999 ruling and the statutes it addressed. Current NOL rules and later guidance must be checked separately.

Citations and references

• Cal. Rev. & Tax. Code §§ 17276(e)(1), 17276(f)(1), 17276(f)(5), 24416(f)(1), 24416(g)(1), and 24416(g)(5)
• I.R.C. §§ 267 and 318
• FTB Legal Ruling 96-5, modified by this ruling

Source

• Landing page: California FTB Legal Rulings
• Official HTML: Legal Ruling 1999-2

Original ruling text

Home

Legal ruling 1999-2

STATE OF CALIFORNIA
Franchise Tax Board - Legal Division
PO Box 1720
Rancho Cordova CA 95741-1720

916 845 3309

FAX: 916 845 3648

Kathleen Connell, Chair
Johan Klehs, Member
B. Timothy Gage, Member

March 2, 1999

Net Operating Losses - "Elegible Small Business" and "New Business"

Purpose

Legal Ruling 96-5 sets forth the department’s position as to the scope of the terms "eligible small business" and "new business" as used in Revenue and Taxation Code §§ 17276 and 24416, relating to net operating losses. The Franchise Tax Board has determined that the positions articulated in that ruling, relating to the application of the net operating loss rules to taxpayers who have made a water’s-edge election, are in conflict with statutory provisions and inconsistent with the general principles underlying California’s taxation of water’s-edge taxpayers. Therefore, those positions should properly be deleted from that ruling. This ruling is specifically intended to remove any inference that different net operating loss rules apply in a case where a water’s-edge election is in effect.

Description of Specific Modifications

In describing the computation of the denominator for purposes of applying the "asset test" set forth in Revenue and Taxation Code §§ 17276(f)(1) and 24416(g)(1), Legal Ruling 96-5 states that the computation shall be different if a taxpayer has a valid water's-edge election in effect. However, since Revenue and Taxation Code §§ 17276(f)(5) and 24416(g)(5) define the term "related person" by reference to Sections 267 or 318 of the Internal Revenue Code, related persons are not limited to members of a combined report. Therefore, a water's-edge election will have no effect on the assets that must be taken into account for purposes of applying the "asset test."

In describing the computation of the "gross receipts" of an "eligible small business" under Revenue and Taxation Code §§ 17276(e)(1) and 24416(f)(1), Legal Ruling 96-5 states that the computation shall be different if a taxpayer has a valid water's-edge election in effect. However, since Revenue and Taxation Code §§ 17276(f)(5) and 24416(g)(5) define the term "related person" by reference to Sections 267 or 318 of the Internal Revenue Code, related persons are not limited to members of a combined report. Therefore, a water's-edge election will have no effect on the computation of the gross receipts that must be taken into account for purposes of determining whether a taxpayer may be treated as an "eligible small business."

All references to water's-edge taxpayers and the special rules applicable thereto in Legal Ruling 96-5, including the references in the specific hypothetical examples and the analysis and holdings accompanying those examples, are hereby deleted.

Effect on Other Rulings

Legal Ruling 96-5 is modified as described herein.

Drafting Information

The principal author of this ruling is Douglas K. Powers of the Franchise Tax Board, Legal Branch. For further information regarding this ruling, contact Mr. Powers at the Franchise Tax Board, Legal Branch, P.O. Box 1720, Rancho Cordova, CA 95741-1720.

Last updated: 09/24/2025