January 2002

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State Budget 

Chris Micheli is an attorney and registered lobbyist for the Sacramento governmental relations firm of Carpenter Snodgrass & Associates (916/447-2251) or cmicheli@ carpentersnodgrass.com, where he specializes in legislative tax matters.

California Governor Gray Davis announced his proposed budget for the 2002-03 fiscal year (beginning July 1, 2002) on January 10, including a number of tax law changes.  The most critical aspect is his “proposal to move the state closer to federal tax law in several areas, beginning with the 2002 tax year for most provisions.”

In addition, the budget proposal includes several other changes to California tax laws.  On January 11, Governor Davis also announced his support for a production industry wage tax credit.

Conformity Proposals

The governor’s budget includes the following federal tax law conformity proposals:

• Critical retirement plan changes.  The budget proposes to conform to changes made in the federal Economic Growth and Tax Relief Reconciliation Act of 2001.  This includes increased Individual Retirement Account (IRA) contribution limits (from $2,000 to $3,000 in 2002 and up to $5,000 by 2008, and indexed thereafter), pension (401k, 457, 403b, SEPs) catch-up contributions for individuals age 50 or older (an additional $1,000 in 2002 rising to $5,000 by 2006, and indexed thereafter), changes in rules for defined benefit and SIMPLE plans, and increased limits on deferrals under state and local deferred compensation plans. In addition, this proposal would prevent the potential for retirement plans to be disqualified for state tax purposes if they follow federal law changes adopted in the future.

• Qualified tuition plans.  The budget proposes to conform to federal tax law to ensure that distributions from qualified tuition programs would be tax-free, rather than being included in the income of the student.

• Dependent care tax credit.  The budget proposes to conform to new federal law, which increased the maximum amount of expenses to which the federal credit percentage credit could be applied (from $2,400 for one child and $4,800 for two or more to $3,000 for one child and $6,000 for two or more), and also increased the maximum federal credit percentage for the lowest income taxpayers.  This proposal would base the state’s child-care credit on these new federal amounts and credit percentages.  Thus, the maximum state credit a taxpayer with two dependents could receive would increase by $416 – from $907 ($4,800*0.30*0.63) to $1,323 ($6,000*0.35*.063).

• Conform to federal estimated payment rules.  The budget proposes to conform to federal law that requires that, in order to avoid underpayment penalties, 90 percent of tax due for the year must be paid either through withholding or estimated tax payments.  California law only requires 80 percent of the tax due be paid.

• Alternative Minimum Tax (AMT) treatment of charitable contributions of appreciated property.  The budget proposes to conform to federal law, which does not require charitable contributions of certain appreciated property to be treated as a tax preference item for purposes of the alternative minimum tax.

•  Mandate any federal election apply for California tax purposes.  The budget proposes to require a taxpayer to make the same elections under state and federal tax laws.  Corporations are allowed to elect different tax positions for federal and state tax purposes.  Although there are as many as 15 elections, the largest effect is from Subchapter S versus Subchapter C elections, Section 338 (how a company acquisition is treated), and installment sales. A separate state election permits multi-state/national corporations to move gain to other states or tax jurisdictions, frequently resulting in the gain not being subject to tax by any state or tax jurisdiction.  This proposal would require corporations to use the federal election for California tax purposes.  In general, this proposal would prohibit a separate state election for all federal elections that apply for California purposes with two exceptions – the election to itemize deductions and the election to allow a taxpayer to deduct disaster losses in the immediately preceding taxable year.

Fiscal Impact of Conformity Proposals

The following chart lists the fiscal impact of the governor’s conformity proposals:

Governor’s Other Tax Proposals

In addition to the conformity proposals set forth above, Governor Davis’ budget proposal includes the following:

• Clarify sate sales tax exemption for diesel fuel used in farming and food processing.  To assist farmers, Chapter 156, Statutes of 2001 (AB 426), provided a sales tax exemption for diesel fuel, which included the transportation of farm products to the marketplace.  At the time the measure was signed, the governor indicated that technical clean up of this exemption was required.  His signing message stated, “The state sales tax exemption for diesel fuel used in farming should better define that it is intended only to apply to delivery to the first destination from the farm.  This will target the benefits to those intended – the farmers.”  The (State) Board of Equalization is currently considering regulations to implement this exemption and some parties would like to see the exemption include all diesel fuel used in getting commodities to the final consumer.  Thus, fuel used to get the products to the processing plant, then to the wholesaler, then to the retailer, and finally to the retailer’s outlets would all be exempt.  Board of Equalization staff indicates that this broader definition would result in revenue losses of $50 million more than anticipated when the legislation was enacted. This loss would adversely affect the Public Transportation Account.

• Reduce the interest rate paid on corporate and estate tax overpayments.  Currently, the interest rate paid on corporate and estate tax overpayments is the federal short-term rate plus three percentage points, which is now 7 percent.  This is far higher than market rates.  The governor’s proposal would reduce the rate to the lesser of the three-month Treasury bill rate or 5 percent, which is similar to what is done for sales tax overpayments.  This change will save the state $25.4 million in interest expense.

Production Industry Tax Credit

Although not part of his 2002-03 budget proposal, Governor Davis announced that he would support a targeted tax credit for California’s film industry.  It is intended “to halt the exodus of film industry jobs from California to Canada and other states.”  The proposal is for a 15 percent tax credit on the cost of wages for employees working on motion pictures filmed in California.  The 15 percent wage-based tax credit, modeled after a federal proposal that the governor supports, would apply to each employee substantially involved in the production of a California-based film. The credit would apply to the first $25,000 of an employee's salary. For production companies to receive the credit, employees would have to perform all or nearly all of their services in California. The credit would target California productions that have been the most negatively impacted by "runaway production" by applying only to low- or mid-size productions (Movies of the Week, mini series, cable productions, etc.). Legislation will be required to implement the tax credit that would take effect July 1, 2004.