Major 1997 Tax Relief Measures are Enacted

By Chris Micheli

Calling it a tax cut for "working Californians," Governor Pete Wilson has signed tax relief measures that feature the largest cut for personal income taxpayers in more than 50 years and conformity to federal tax laws that provide reduced taxes on capital gains. 

The governor, speaking to residents of Roseglen Street in the Los Angeles County community of Temple City, where he went to underscore the "middle-class" nature of the personal income tax (PIT) reduction, declared: "This year, we did something that will benefit every family on this block. We gave you want you wanted the most and that's reining in a government that does an all too effective job of picking your pocket every April 15." 

The October 1 bill-signing ceremony for SB 1233 (Stats. 1997, Ch. 612) was described by the governor as a tax cut approaching $1 billion over the next three years - "a tax cut for working Californians, not some nickel-and-dime gesture." Not since 1943, when Governor Earl Warren reduced the maximum tax rate from 15 percent to 6 percent, have Californians enjoyed such tax relief. 

Senate President Pro Tem Bill Lockyer, lead author of the measure along with Assembly Speaker Cruz Bustamante and Assembly Member Curt Pringle, said the final compromise "pushes the benefit to more middle-income taxpayers." 

Majority Democrats in the Legislature, led by Mr. Lockyer and Mr. Bustamante, torpedoed the governor's mid-July proposal to adjust PIT brackets for an across-the-board $1 billion tax cut. The governor made the proposal about two months after reporters questioned why tax cuts were not offered for personal income taxpayers, since they had produced nearly all of the unanticipated budget surplus. 

The governor eventually scaled back his proposal for a 10 percent reduction in the bank and corporation tax rate (atop the 5 percent reduction approved last year) to accommodate PIT relief. He still sought a 5 percent bank and corporation tax rate reduction, but the Legislature, at least in 1997, refused to go along. 

Chances for a major tax cut seemed dim last summer when the governor decided to spend $1.2 billion of the surplus to pay off a debt to the state employee pension fund. But the compromise was pulled together in the predawn hours of September 13, just before the Legislature quit for the year. Senator Lockyer had to convince a number of Assembly Democrats that the tax-cut package, coupled with prospects of a pay raise for state employees and his long-sought trial court funding plan, relieving counties of the costs, were worth voting against the wishes of the powerful California Teachers Association. 

The package, valued at $1.7 billion over the next three years, was passed by nearly unanimous votes in the Assembly and Senate. The action stunned many observers because so much of the 1997 session was marred by partisan bickering, a lengthy budget impasse and angry debate over welfare reform. Following last year's enactment of SB 38 (Lockyer/Pringle, Stats. 1996, Ch. 954), which provides over $280 million in targeted tax relief over three years, this year's legislative session was not expected to produce significant tax changes.

1997 Tax Relief Package Summary
Tax Reduction	1997-98	1998-99	1999-2000
Dependent credit increase by $50 1/1/98 and $100 1/1/99	$95 million	$325 million	$637 million
Capital gains for all homes sold after 5/7/97	$25 million	$110 million	$70 million
Subchapter S conformity	$18 million	$21 million	$22 million
Subtotal	$138 million	$456 million	$729 million
Tax Reduction (effective 1/1/98)
AMT relief	$8 million	$81 million	$85 million
IRA conformity	$4 million	$14 million	$31 million
R&D conformity	$10 million	$46 million	$48 million
Subtotal	$22 million	$141 million	$164 million
Tax Reduction
SB 455 (Omnibus Conformity)	$0	$0	$29 million
AB 366 (Bunker Fuel Exemption)	$5 million	$10 million	$10 million
AB 1217 (Enterprise Zone)	$1 million	$1 million	$1 million
Subtotal	$6 million	$11 million	$40 million
Grand Total	$166 million	$608 million	$933 million

The 1997 tax deal is embodied in six separate pieces of legislation. As the accompanying chart sets forth, the tax package contains the following major provisions: 

Dependent Exemption Credit Increase 

This provision (CRTC § 17054) increases the current amount of the exemption credit for dependents from $68 to $222 over three years. The current credit is $68 for taxable years beginning in 1996. 

SB 1233 increases that credit on January 1, 1998 to authorize a credit of $120, and then to $222 on January 1, 1999. The exemption credit will be adjusted for inflation thereafter. 

According to Senator Lockyer's Office, the median California tax filer (which is a family of four with adjusted gross income of $45,000) will receive a $300 tax cut in 1999 due to the increased credit. The increase in the dependent exemption credit will lower the tax bills of roughly 3 million of California's 12.6 million individual and joint tax returns filed each year. 

This is a new provision that had not been contained in any pending legislation, but was added to the final tax package. It is the most significant aspect of the tax deal and is valued at over $600 million annually when fully implemented. 

Capital Gains Tax Conformity 

These provisions (CRTC §§ 17152, 18037.6, 18510) (IRC §§ 121, 1034, 1038, 1250) allow taxpayers to avoid taxes on capital gains from the sale 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. 

The conformity from May 7, 1997 through June 30, 1998 is contained in SB 5 (Lockyer/Lewis, Stats. 1997, Ch. 610). The permanent conformity from July 1, 1998 forward is contained in SB 1233. 

Subchapter S Corporation Conformity 

These provisions (CRTC §§ 17275.6, 17731.5, 19365, 23732, 23800.5, 23801, 23802, 23802.5, 23804, 23804.5, 23806, 23813) (IRC §§ 170, 512, 641, 1361, 1362, 1363, 1366, 1367, 1368, 1371, 1377) conform California law to federal law on Subchapter S corporation changes made  in the Small Business Job Protection Act of 1996. 

These conformity provisions are contained in SB 5. While SB 5 contains a minor increase in the tax rate applicable to Subchapter S corporations (the current rate is 1.5 percent) to make the conformity "revenue neutral," SB 1233 eliminates that rate increase. The estimate for this conformity is about $22 million on an annual basis. 

Alternative Minimum Tax (AMT) Relief 

This provision (CRTC § 17062) (IRC § 55) reduces the number of taxpayers required to pay the AMT by increasing the exemption amounts and the exemption phase-out income levels. The tax, which is intended to target upper-income taxpayers who qualify for many tax deductions and credits, has begun to capture middle- and lower-income Californians because it has not been adjusted for inflation in a decade. 

This provision ensures that fewer individuals will be required to make the burdensome AMT calculation by indexing these amounts for taxable years beginning in 1998, similar to the provisions of the federal Revenue Reconciliation Act of 1993. This item is contained in SB 1233. 

According to Senator Lockyer's office, the number of persons in an AMT position will drop from an estimated 240,000 to only about 14,000 taxpayers due to this provision. It is estimated to cost the state's general fund about $85 million when fully implemented. It takes effect on January 1, 1998. 

Individual Retirement Account Conformity 

These provisions (CRTC §§ 17085.8, 17210.6, 17507.4, 17507.6, 19184, 23712) (IRC §§ 72, 219, 408, 7701) 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 also raises the income limits for deducting IRA contributions, and lets individuals withdraw money penalty-free from existing IRAs for certain purposes. This item also conforms on "Roth IRAs." 

It is based upon the new IRA rules enacted by Congress in the Taxpayer Relief Act of 1997 (P.L. 105-34). This conformity is valued at about $31 million in annual benefits to personal income taxpayers. It is effective for payments and distributions in taxable years beginning on or after January 1, 1998. 

Research and Development Tax Credit Conformity 

AB 1042 (Wayne, Stats. 1997, Ch. 613) (CRTC §§ 17052.12 and 23609) (IRC § 41) conforms California's R&D tax credit to the changes made to the federal credit by the Small Business Job Protection Act of 1996 (P.L. 104-188). The state conformity is effective for tax years beginning on or after January 1, 1998. 

Unlike the federal credit, however, the state conformity is permanent and not dependent upon reenactment of the federal credit by Congress. The conformity provisions are: 

(1) the three-tier alternative incremental method for computing the research credit, but with credit percentages reduced in proportion to the 11percent state credit as compared with the 20 percent federal credit; 

(2) modification of the "start-up" provision to accommodate companies with little sales and large research expenses in the base period; and 

(3) a 75 percent limitation (rather than 65 percent) for contract research conducted by a research consortium. 

These provisions had been contained in several different bills during the course of the Legislative Session, including AB 1499 (Caldera/Lempert/Alquist/Cunneen), AB 1044 (Revenue & Taxation Committee), and AB 1356 (Figueroa/Cunneen). The conformity amounts to about $48 million on an annual basis in tax credits. 

Omnibus Conformity Measure 

SB 455 (Alpert) is this year's overall federal conformity measure. It contains more than 75 provisions that conform California law to selected provisions of the Internal Revenue Code 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 bill are: 

• An increase in the small business equipment expensing deduction under IRC § 179 to $13,000 in 1997 and $16,000 in 1998. 
• Repeal of the five-year income averaging for lump-sum distributions. 
• New pension rules, including the creation of Savings Incentive Match Plans for Employees (SIMPLE). 
• Repeal of the $5,000 exclusion from income of employee death benefits. 
• A safe-harbor for payment of 100 percent of the prior year's tax for personal  income taxpayers' estimated tax payments. 
• A new 1 percent tax on the gross income of publicly traded partnerships that elect to be treated as partnerships for California tax purposes. 

This bill "costs" about $30 million annually and its provisions were agreed upon by interested parties because they are considered "non-controversial" items.

Future Conformity? Despite these important tax relief measures, California is out of conformity with several hundred provisions of federal law after the recent enactment of the federal Taxpayer Relief Act of 1997 (P.L. 105-34). Among the provisions of the new federal act to which California does not conform: Rules for capital gains, including different rates and holding periods. $500 per child tax credit. The exclusion from income for interest paid on certain college loans, as well as a deduction for contributions to a prepaid college plan. It remains to be seen whether California will conform to these and several hundred other 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 next year.  - Chris Micheli

Bunker Fuels Tax Exemption Extension 

AB 366 (Havice, Stats. 1997, Ch. 615) (CRTC § 6385) extends for five years until January 1, 2003 the exemption from sales/use taxation for "bunker fuels." This exemption is for the sale of fuel and petroleum products to a water common carrier for immediate shipment outside of California for consumption in the conduct of the carrier's business. 

The exemption had been scheduled to expire on January 1, 1998. The bill also requires a study be completed regarding the fiscal and policy impacts of the exemption. It amounts to $10 million annually in foregone revenue for the state. 

Enterprise Zone Created 

AB 1217 (Bustamante, Stats. 1997, Ch. 602) was the final piece of the tax package. The bill (CGC § 7097; CRTC §§ 17053.33, 17053.34, 17267.6, 23633, 23634, 24356.6), which costs the state's general fund $1 million on an annual basis, requires the Trade & Commerce Agency to designate a targeted tax area meeting specified criteria after January 1, 1998. The bill is intended to benefit the Sequoia area in Fresno County.