As the Franchise Tax Board explains, California tax law generally conforms to the federal Internal Revenue Code (IRC). However, there are numerous differences between California and federal tax laws.
The fundamental problem for taxpayers with these state and federal differences is that they are required to make adjustments to the financial figures from their federal tax returns. The FTB provides a thorough discussion of specific areas of nonconformity in their Publication 1001.
The last successful federal tax conformity bill in this state was enacted on September 30, 2015. That measure was AB 154, whose primary purpose was to update the IRC reference in California law from January 1, 2009 to January 1, 2015. Because of this IRC reference, there are continuing differences between California and federal tax laws.
In addition, California does not automatically conform to federal changes. In other words, it requires a bill to be enacted in this state for California to conform to federal tax law changes, such as those enacted by the TCJA in December 2017. Some states use a similar approach to California (adopting the federal IRC by reference), while others use the IRC as a starting point.
Why does federal tax conformity matter to taxpayers and the State? While California and other states have their individual approaches to state taxation, such as rates, exemptions, etc., they all rely in part upon the federal IRC. The main purpose of conformity is to reduce the compliance burden of having an entirely separate state tax system. Conformity allows taxpayers, practitioners and state tax administrators to rely on federal statutes, regulations, IRS rulings, etc. States also rely upon consistent definitions, the work done by federal audits and tax enforcement.
Governor Gavin Newsom has proposed several specific items of federal tax conformity, essentially to pay for a substantial expansion of California’s earned income tax credit for low-income individuals. His plan is to conform to items that will generate at least a $1 billion of projected revenue. Two items, including conformity to federal opportunity zones, will decrease revenues to the State.
California’s Legislative Analyst said this approach is “problematic” and recommends the Legislature to consider the EITC and conformity packages separately. The following are some of the conformity proposals from Governor Newsom:
Limitation on business losses from active participation in the business. Federal law caps the amount of the deduction for active business losses; prior federal law did not limit these losses and neither does current state law.
Like-kind exchanges would be limited to real estate assets; prior federal law and current state law allow the deferral of taxes on all types of assets. This limitation would raise considerable revenue.
Limiting the deduction on fringe benefits paid by businesses for their employees. Federal law now precludes businesses from deducting specified fringe benefits, including those related to entertainment, parking, and transportation. State law currently allows the deduction for all of these benefits provided to employees.
The following are the items that have been proposed for California to conform to specific provisions of the TCJA:
- Section 11012 Limitation on Losses for Taxpayers Other than Corporations
- Section 11024 Increased Contributions to ABLE accounts
- Section 11025 Allow 529 plans to rollover to ABLE accounts
- Section 13102 Small Business Accounting Method Reform and Simplification
- Section 13302 Eliminate NOL Carrybacks
- Section 13303 Limit Like-Kind Exchanges to Real Property
- Section 13304 Limitation on Fringe Benefits
- Section 13504 Repeal of Technical Termination of Partnerships
- Section 13531 Limitation on Deduction for FDIC Premiums
- Section 13601 Modification of Limitation on Excessive Employee Remuneration
- Section 13823 Opportunity Zones
Taxpayers and practitioners should also be aware that there is a proposal circulating to eliminate separate IRC Section 338(h)(10) elections. When this was last proposed more than a decade ago, it was very controversial.