Update on Federal Tax Law Conformity in California: A Review of 1997 Developments

By Gina Rodriquez and Chris Micheli

As readers may recall, last year the California Legislature enacted a number of provisions conforming California law to federal law. This year, the Legislature again adopted several significant measures that conformed California law to a majority of the federal provisions enacted from 1993 through 1996.

Since the enactment of the federal Omnibus Budget Reconciliation Act (OBRA) of 1993, the California Legislature has struggled to conform state tax law to those changes in the Internal Revenue Code (IRC), as well as other recent federal tax law changes.

Since Congress' IRC overhaul in 1986, California has generally followed with a conformity measure the next year, usually by urgency legislation, so that the changes are effective simultaneously with any new federal provisions. For example, in 1987, a state law was passed to conform California tax law to most changes made by Congress in 1986. That has been the normal course of events until 1993. In 1993, Congress enacted President Bill Clinton's budget plan, which passed both houses of Congress without a single Republican vote.

This fact, coupled with the large number of revenue-raising tax changes, caused Republicans in the California Legislature to reject most attempts to conform to the OBRA of 1993. That position finally changed in 1996 when the Legislature and Governor Pete Wilson approved SB 38 (Lockyer and Pringle, Stats. 1996, Ch. 954) containing a number of important conformity provisions.

For federal tax law conformity, 1997 proved to be another important year. For the first time in many years, an omnibus conformity measure was enacted, as well as other legislation that contained specific conformity provisions.

Overview of 1997 California Conformity Legislation

Capital gains provisions allow taxpayers to avoid taxes on capital gains from the sale or exchange of a primary residence on or after May 7, 1997, of a primary residence, up to $250,000 for singles and up to $500,000 for couples. Homeowners may claim these exemptions every two years. (SB 5, Lockyer and Lewis, Ch. 610, and SB 1233, Lockyer, Bustamante and Pringle, Ch. 612.)

Subchapter S corporations provisions of SB 5 generally conform California law to federal law changes made in the Small Business Job Protection Act of 1996, as of January 1, 1997, with these two exceptions:

Unintentionally invalid S corporation elections are allowed prospectively, but not retroactively. If the FTB determines that there was reasonable cause for the failure to make a timely S corporation election, then the FTB may treat that election as made on time for that income year.

Qualified S corporation subsidiaries are subject to the $800 minimum franchise tax. The parent must pay both the $800 minimum franchise tax and any tax on the net income of the subsidiary. Qualified S corporation subsidiaries are required to make the same taxpayer elections at the state level as they do at the federal level. No separate election is allowed.

Individual retirement accounts (IRAs) provisions (effective January 1, 1998) allow an individual taxpayer to put funds into an IRA for higher education expenses or for acquisition of a personal residence by a first-time homebuyer. The bill, based on a similar provision in the federal Taxpayer Relief Act of 1997, also raises the income limits for deducting IRA contributions (SB 1233).

Gina Rodriguez

Chris Micheli

Gina Rodriquez is an enrolled agent and serves as Sacramento editor for Spidell Publishing, Inc. (916/676-0662). Chris Micheli is an attorney and legislative advocate for Carpenter Snodgrass & Associates in Sacramento (916/447-2251).

Note: Click here to view Gina and Chris' detailed tables showing where California does and does not conform to federal tax changes enacted since 1993.

Research and development tax credit (R&D) provisions conform (effective January 1, 1998) California's R & D tax credit to federal changes made by the Small Business Job Protection Act of 1996 (AB 1042, Wayne, Ch. 613.) Unlike the federal credit, however, the state conformity is permanent and not dependent upon re-enactment of the federal credit.

Unintentionally, due to a chaptering problem with legislation, California fully conforms to the federal credit percentage provided for in the alternative three-tier credit regime for the 1997 tax year only. There will be a legislative attempt to correct this early next year.

AMT exemption amounts were increased for joint returns, $45,000 for 1997 and $57,260 for 1998 (SB 1233.) The 1997 federal amounts were inadvertently conformed to in SB 455.

The omnibus conformity measure, SB 455 (Alpert, Ch. 611), contains more than 75 provisions that conform California law to selected federal changes made by the Revenue Reconciliation Act of 1993, the General Agreement on Tariffs and Trade Act of 1994, the Health Insurance Portability and Accountability Act of 1996, and the Small Business Job Protection Act of 1996.

Among the major provisions of this new law are:

An increase in the small business equipment expensing deduction under IRC § 179 to $13,000 in 1997, and $16,000 in 1998 (California does not conform on the bank and corporation tax law provisions) (CRTC § 17255) (IRC § 179).

An increase in the deduction for self-employed health insurance from 25 percent to 40 percent for 1997 only (CRTC § 17273) and (IRC § 162 (l)). This is another inadvertent conformity provision.

Repeal of the five-year income averaging for lump-sum distributions (CRTC §§ 17062, 17072 and 24601) (IRC §§ 55 and 62).

New pension rules, including the creation of SIMPLEs, or Savings Incentive Match Plans for Employees (CRTC §§ 17081, 17201, 24272.2, and 24601) (IRC §§ 72 and 219).

Repeal of the $5,000 exclusion from income of employee death benefits (CRTC § 17132.5) (IRC §§ 101 and 406).

A safe-harbor for payment of 100 percent of the prior year's tax for personal income taxpayers' estimated tax payments (CRTC § 19136.2) (IRC § 6654).

Rollover of gain from the sale of publicly traded securities in specialized small business investment companies (CRTC §§ 18044, 24916, and 24956) (IRC § 1044).

Treatment of abandonment of lessor improvements at termination of a lease (CRTC §§ 17201 and 24349) (IRC § 168).

Application of involuntary conversion rules for Presidentially-declared disasters (CRTC §§ 18031, 24947 and 24949.5) (IRC § 1033).

Basis adjustment to property held by a corporation in which the stock in the corporation is replacement property under the involuntary conversion rules (CRTC §§ 18031 and 24947) (IRC § 1033).

Substantiation requirements for the deduction of certain charitable contributions, except that California's requirements are deemed satisfied when a taxpayer meets the federal requirements (CRTC §§ 17275.5 and 24357) (IRC § 170).

Disclosure of quid pro quo contributions, except the state requirements are deemed satisfied when an organization meets the federal requirements (CRTC §§ 18648.5 and 19182.5) (IRC §§ 6115 and 6714).

Treatment of storage of product samples (CRTC § 17201) (IRC § 280A).

Denial of a deduction for indirect contributions to political parties (CRTC §§ 17283 [repealed] and 24429) (IRC § 276).

Amortization of reforestation expenses from five to seven years under the bank and corporation tax law (personal income tax law already conforms to the seven years) (CRTC §§ 17278.5 and 24372.5) (IRC § 194).

Class life for gas station convenience stores and similar structures (CRTC §§ 17250 and 24349) (IRC § 168).

Depreciation under the income forecast method (CRTC §§ 17250.5 and 24349) (IRC § 167).

Unintentionally, due to a chaptering problem with legislation, California fully conforms to the federal R&D credit for 1997.

Recharacterization of capital gains income from a conversion transaction to ordinary income (CRTC §§ 17201, 17250, 17321, 17851, 17856, 18151, 24344, 24349, 24451 and 24990) (IRC §§ 163, 167, 305, 751, 1258, and 1267-1278).

Partnership distributions of marketable securities to partners (CRTC §§ 17851 and 17868) (IRC §§ 731 and 737).

Housing provided to employees by academic health centers (CRTC § 17131) (IRC § 119).

Income exclusion for payments received by a self-employed individual through an arrangement similar to an accident or health insurance policy (CRTC § 17131) (IRC § 104).

A new 1 percent tax on the gross income of publicly traded partnerships that elect to be treated as partnerships for California tax purposes (CRTC §§ 17008.5 and 23038.5) (IRC § 7704).

In addition to the last-minute mega-deal, three other tax bills were enacted that conform or partially conform California law to federal laws. Those are:

AB 530 (Lempert, Ch. 851) establishes the Golden State Scholarship Trust Act, a structured open savings program with tax benefits to help individuals plan for the future costs of higher education at public and private colleges, as well as vocational institutions.

Beginning on January 1, 1998, the trust will be maintained as a qualified state tuition program under IRC § 529 and administered by the Student Aid Commission. It will operate like a deferred compensation plan for higher education savings, with options to terminate and change contribution amounts.

AB 713 (Caldera, Ch. 600) conforms California law to the federal Taxpayer Bill of Rights 2 (Public Law 104-168). Among the provisions of AB 713 that will partially conform California law to the TBR 2 are:

The FTB must process mail received from private delivery services designated by the IRS as though it were mailed with the postal service. They must treat the date an item is recorded with the designated delivery service as the postmark date (CRTC § 21027) (IRC § 6103).

For California purposes, taxpayers may amend separate returns to a joint return even if the separate liabilities are not paid, if they amended the federal returns to change the filing status (CRTC § 18525) (IRC § 6013).

The FTB must notify a taxpayer of the reason for termination of an installment agreement, and the notice must be mailed 30 days before the termination occurs. In addition, the Taxpayers' Rights Advocate is required to establish procedures for an independent departmental review for terminated agreements in the event that the taxpayer requests such review. The request for review does not stay collection actions (CRTC § 19008) (IRC § 6159).

Taxpayers will have 15 calendar days to pay an amount due after notice and demand without accruing additional interest (under previous law, the time period was 10 days) (CRTC §§ 19049 and 19111) (IRC §§ 6601 and 6651).

FTB retroactive regulations are limited to 24 months after passage of a law or within 24 months of the date of publication of a federal temporary or final regulation when California conforms to the underlying law (CRTC §§ 19503 and 23004) (IRC § 7805).

SB 1234 (Alpert, Ch. 608) conforms California tax laws to the federal "check-the-box" regulations.

Major Items of Nonconformity

It is important to note that California has not conformed to a number of federal tax law provisions. The following is a sampling of federal provisions without corresponding state tax law provisions:

Denial of the deduction of lobbying expenses (IRC §§ 162, 170 and 6033).

Denial of the deduction for compensation of certain employees in excess of $1 million (IRC § 162).

Denial of the deduction for the contribution of appreciated stock to certain private foundations (sunset date was extended to June 30, 1998) (IRC § 170).

Denial of the dependent exemption for failing to provide a proper taxpayer identification number (IRC §§ 151, 6109 and 6213).

Denial of the reserve method for bad debts for thrift savings associations (IRC §§ 50, 52, 291, and 585).

Deduction for self-employed health insurance which was increased to 100 percent and accelerated in its phase-in (California's deduction is 40 percent for 1997 tax year only) (IRC § 162).

Real estate professional rules for passive activities (IRC § 469).

Unrecognized gain portion of a charitable contribution not included as a preference item for alternative minimum tax purposes (IRC §§ 56 and 57).

Denial of the deduction for club dues (California does deny a deduction if the club discriminates) (IRC § 274).

Accelerated depreciation for property used in a trade or business conducted within an Indian reservation (IRC § 168).

Survey of Federal and California Laws

In charts available on the Cal-Tax Internet site (http://www.caltax.org), we summarize the major federal tax law changes enacted in 1993, 1996 and 1997 to which California has conformed. The federal acts that are covered include the Revenue Reconciliation Act of 1993, General Agreement on Tariffs and Trade Act of 1994, Health Insurance Portability and Accountability Act of 1996 and the Small Business Job Protection Act of 1996.

Conclusion

Despite the important tax relief measures from the mega-deal this year, California is out of conformity with several hundred federal provisions, many of which are effective in 1997. This is due to the recent enactment of the Taxpayer Relief Act of 1997 (P.L. 105-34).

It remains to be seen whether California will conform to these provisions of federal law next year. The tax package from this year is premised upon the state's general fund receiving a significant increase in tax revenues over the next three to five years. There may not be enough funding to make other tax law changes.