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® CTEC QE CALIFORNIA TAX Published by Martin Associates CTEC QE California Tax Contents Introduction ………………………………………………………………………………………………………………………………. 1 Course Objectives ……………………………………………………………………………………………………………………. 1 Chapter 1 California Tax System for Individuals ………………………………………………………………………… 2 A – Introduction ………………………………………………………………………………………………………………………. 2 B – Chapter Learning Objectives ……………………………………………………………………………………………….. 2 C – Taxes and Taxing Agencies …………………………………………………………………………………………………. 2 D – California Income Tax ……………………………………………………………………………………………………….. 3 Filing Requirement ………………………………………………………………………………………………………………. 3 Filing Status ………………………………………………………………………………………………………………………… 3 How Does My California Filing Status Relate to My Federal Filing Status? ……………………………….. 5 E – Special Filing Situations ……………………………………………………………………………………………………… 5 Estates and Trusts ………………………………………………………………………………………………………………… 5 Like-Kind Exchanges …………………………………………………………………………………………………………… 5 Innocent Spouse (Joint Filer) ………………………………………………………………………………………………… 6 F – Community Property Issues …………………………………………………………………………………………………. 6 Community Property Defined ……………………………………………………………………………………………….. 6 Commingled Property ………………………………………………………………………………………………………….. 7 Prenuptial Agreements …………………………………………………………………………………………………………. 7 Income from Community Property ………………………………………………………………………………………… 7 Community Property Rules Applied to Registered Domestic Partners ………………………………………… 8 Community Income Tax Debt Relief for Innocent Spouse ………………………………………………………… 8 G – Common Law Marriages …………………………………………………………………………………………………….. 8 H – Tax Rates for Individuals ……………………………………………………………………………………………………. 9 2019 Tax Year California Tax Rate Schedules ………………………………………………………………………… 9 I – Propositions 30 and 55 ……………………………………………………………………………………………………….. 10 J – Kiddie Tax and Form 3800 …………………………………………………………………………………………………. 11 Backup Withholding…………………………………………………………………………………………………………… 11 K – Summary ………………………………………………………………………………………………………………………… 12 Chapter 1 Review Questions ……………………………………………………………………………………………….. 13 Chapter 2 The Franchise Tax Board …………………………………………………………………………………………. 15 A – Introduction …………………………………………………………………………………………………………………….. 15 B – Chapter Learning Objectives ……………………………………………………………………………………………… 15 C – Franchise Tax Board (FTB) – The Basics ……………………………………………………………………………. 15 D – California Payroll Taxes ……………………………………………………………………………………………………. 15 Employment Development Department (EDD) ……………………………………………………………………… 16 Unemployment Insurance Tax …………………………………………………………………………………………….. 16 Employment Training Tax (ETT) ………………………………………………………………………………………… 17 State Disability Insurance Tax (SDIT) and Voluntary Plan for Disability Insurance (VPDI) ……….. 17 Mental Health Services Tax (the “Millionaire Tax”) ………………………………………………………………. 17 E – California Sales and Use Tax ……………………………………………………………………………………………… 17 Tax Rate …………………………………………………………………………………………………………………………… 18 Internet Transactions Taxable to California …………………………………………………………………………… 18 Doing Business in California and Business Licenses ………………………………………………………………. 19 Board of Equalization (BoE) ……………………………………………………………………………………………….. 21 F – Property Taxes …………………………………………………………………………………………………………………. 21 Property Value …………………………………………………………………………………………………………………… 21 ii Proposition 13 …………………………………………………………………………………………………………………… 22 County Assessors ………………………………………………………………………………………………………………. 22 G – California Personal Income Tax (PIT) ………………………………………………………………………………… 23 H – Summary ………………………………………………………………………………………………………………………… 23 Chapter 2 Review Questions ……………………………………………………………………………………………….. 24 Chapter 3 Franchise Tax Board Programs ……………………………………………………………………………….. 26 A – Introduction …………………………………………………………………………………………………………………….. 26 B – Chapter Learning Objectives ……………………………………………………………………………………………… 26 C – Franchise Tax Board (FTB) Mission …………………………………………………………………………………… 26 D – Other FTB Programs ………………………………………………………………………………………………………… 26 City Business Tax Program—Data Exchange ………………………………………………………………………… 26 Court-Ordered Debt (COD) …………………………………………………………………………………………………. 27 E – Cancellation of Debt Income (CODI) ………………………………………………………………………………….. 27 F – Interagency Intercept Collection (IIC) …………………………………………………………………………………. 27 G – Substandard Housing Program …………………………………………………………………………………………… 28 H – Vehicle Registration Collections ………………………………………………………………………………………… 28 I – Voluntary Disclosure Program ……………………………………………………………………………………………. 28 J – FTB Organization ……………………………………………………………………………………………………………… 29 K – Taxpayers’ Rights Advocate Office ……………………………………………………………………………………. 30 Discretionary Relief …………………………………………………………………………………………………………… 31 Community Outreach …………………………………………………………………………………………………………. 31 L – Summary …………………………………………………………………………………………………………………………. 31 Chapter 3 Review Questions ……………………………………………………………………………………………….. 32 Chapter 4 Residency and Domicile ……………………………………………………………………………………………. 34 A – Introduction …………………………………………………………………………………………………………………….. 34 B – Chapter Learning Objectives ……………………………………………………………………………………………… 34 C – Resident Categories ………………………………………………………………………………………………………….. 34 Resident ……………………………………………………………………………………………………………………………. 34 Nonresident ………………………………………………………………………………………………………………………. 35 Part-Year Resident …………………………………………………………………………………………………………….. 35 Nonresident Spouse with No California-Source Income …………………………………………………………. 35 Military Service Members …………………………………………………………………………………………………… 36 D – Reporting of Income …………………………………………………………………………………………………………. 36 E – Filing Requirements ………………………………………………………………………………………………………….. 36 Domicile …………………………………………………………………………………………………………………………… 36 California Gross Income and Adjusted Gross Income Thresholds ……………………………………………. 37 Residency Issues and Filing Requirements ……………………………………………………………………………. 39 State Income Tax Withholding …………………………………………………………………………………………….. 39 F – Guidelines for Determining Residency ………………………………………………………………………………… 39 Residency Safe Harbor: Being Out of State for an Employment Contract …………………………………. 39 Closest Connections …………………………………………………………………………………………………………… 41 Temporary or Transitory Purposes ……………………………………………………………………………………….. 41 G – Summary ………………………………………………………………………………………………………………………… 46 Chapter 4 Review Questions ……………………………………………………………………………………………….. 47 Chapter 5 Household Employers and Employees ………………………………………………………………………. 49 A – Introduction …………………………………………………………………………………………………………………….. 49 B – Chapter Learning Objectives ……………………………………………………………………………………………… 49 C – Household Employers ………………………………………………………………………………………………………. 49 Definition of Employer ………………………………………………………………………………………………………. 49 Definition of Wages …………………………………………………………………………………………………………… 50 iii Withholding from Wages ……………………………………………………………………………………………………. 50 D – Forms for Reporting …………………………………………………………………………………………………………. 51 Payroll Taxes …………………………………………………………………………………………………………………….. 51 Value of Meals and Lodging ……………………………………………………………………………………………….. 51 Calculating the Taxable Amounts ………………………………………………………………………………………… 52 Wage Variations ………………………………………………………………………………………………………………… 52 E – Summary …………………………………………………………………………………………………………………………. 53 Chapter 5 Review Questions ……………………………………………………………………………………………….. 54 Chapter 6 Gross Income, Adjusted Gross Income, and Profits …………………………………………………… 56 A – Introduction …………………………………………………………………………………………………………………….. 56 B – Chapter Learning Objectives ……………………………………………………………………………………………… 56 C – Income ……………………………………………………………………………………………………………………………. 56 Wages ………………………………………………………………………………………………………………………………. 56 Family Support Payments …………………………………………………………………………………………………… 57 Capital Gains and Losses ……………………………………………………………………………………………………. 57 Early Withdrawal from Retirement Plans ……………………………………………………………………………… 57 Social Security and Railroad Retirement ………………………………………………………………………………. 57 Interest Income ………………………………………………………………………………………………………………….. 57 Rental Income …………………………………………………………………………………………………………………… 58 Paid Family Leave and Unemployment Benefits ……………………………………………………………………. 58 Cancellation of Debt Income (CODI) …………………………………………………………………………………… 58 Mortgage Forgiveness Debt Relief ……………………………………………………………………………………….. 59 Gifts and Inheritances …………………………………………………………………………………………………………. 59 Proceeds from Real Estate Transactions ……………………………………………………………………………….. 59 Income from the Sale of Your Principle Residence ………………………………………………………………… 60 Foster Care Payments …………………………………………………………………………………………………………. 60 In-Home Support Services ………………………………………………………………………………………………….. 60 Unemployment Compensation …………………………………………………………………………………………….. 60 Gambling and Lottery Winnings ………………………………………………………………………………………….. 60 Prizes and Awards ……………………………………………………………………………………………………………… 60 Information Returns (1099) …………………………………………………………………………………………………. 61 Foreign Employment Income ………………………………………………………………………………………………. 61 Covenants Not to Compete ………………………………………………………………………………………………….. 61 D – Gross Income and Gross Profit ………………………………………………………………………………………….. 61 California Gross Income …………………………………………………………………………………………………….. 61 E – Cost of Goods Sold and Inventory Considerations ………………………………………………………………… 62 F – Summary …………………………………………………………………………………………………………………………. 63 Chapter 6 Review Questions ……………………………………………………………………………………………….. 64 Chapter 7 Deductions and Expenses …………………………………………………………………………………………. 66 A – Introduction …………………………………………………………………………………………………………………….. 66 B – Chapter Learning Objectives ……………………………………………………………………………………………… 66 C – Deductions and Thresholds: Standard Deduction or Itemized?……………………………………………….. 66 D – Standard and Itemized Deductions – 2019 Tax Year …………………………………………………………….. 67 The Standard Deduction ……………………………………………………………………………………………………… 67 Itemized Deductions …………………………………………………………………………………………………………… 67 E – Income from a Business …………………………………………………………………………………………………….. 70 F – Business Gross Receipts vs. Income ……………………………………………………………………………………. 70 Nonresident Business Income ……………………………………………………………………………………………… 71 G – Clean Fuel Vehicles First Year Deduction …………………………………………………………………………… 71 H – Types of Business Entities ………………………………………………………………………………………………… 71 iv Sole Proprietorship …………………………………………………………………………………………………………….. 71 Partnerships ………………………………………………………………………………………………………………………. 72 Corporations ……………………………………………………………………………………………………………………… 72 I – Marijuana Businesses and Income Tax …………………………………………………………………………………. 73 Cash Issues ……………………………………………………………………………………………………………………….. 74 Banking ……………………………………………………………………………………………………………………………. 74 J – Cost of Goods Sold ……………………………………………………………………………………………………………. 75 K – Expenses …………………………………………………………………………………………………………………………. 75 Club Dues …………………………………………………………………………………………………………………………. 75 Meal and Beverage Expenses ………………………………………………………………………………………………. 75 Travel and Transportation Expenses …………………………………………………………………………………….. 75 Gift Expenses ……………………………………………………………………………………………………………………. 76 Expense Disallowance for Substandard Housing ……………………………………………………………………. 76 Unreimbursed Business Expenses ………………………………………………………………………………………… 76 L – Business Expenses ……………………………………………………………………………………………………………. 78 M – Professional Fees and Start-Up Expenses ……………………………………………………………………………. 78 N – Expenses from a Business …………………………………………………………………………………………………. 78 Sole Proprietorship …………………………………………………………………………………………………………….. 78 Partnership ………………………………………………………………………………………………………………………… 79 S Corporation ……………………………………………………………………………………………………………………. 79 C Corporation ……………………………………………………………………………………………………………………. 79 O – Investment Expense ………………………………………………………………………………………………………….. 79 P – Summary …………………………………………………………………………………………………………………………. 79 Chapter 7 Review Questions ……………………………………………………………………………………………….. 80 Chapter 8 Credits …………………………………………………………………………………………………………………….. 82 A – Introduction …………………………………………………………………………………………………………………….. 82 B – Chapter Learning Objectives ……………………………………………………………………………………………… 82 C – Credits ……………………………………………………………………………………………………………………………. 82 D – Personal Exemption Credit ………………………………………………………………………………………………… 82 California Personal Exemption Credits …………………………………………………………………………………. 83 E – California Earned Income Tax Credit (CalEITC) ………………………………………………………………….. 83 Qualifications for the Credit ………………………………………………………………………………………………… 83 Adjusted Gross Income Limits …………………………………………………………………………………………….. 83 Minimum Wage Workers ……………………………………………………………………………………………………. 84 Credit Phaseout …………………………………………………………………………………………………………………. 85 Filing Status ………………………………………………………………………………………………………………………. 85 Residency and Age …………………………………………………………………………………………………………….. 85 Rules for Qualifying Children for the CalEITC ……………………………………………………………………… 85 Notices Taxpayers May Receive ………………………………………………………………………………………….. 86 EITC and CalEITC: Obligations for Tax Professionals …………………………………………………………… 87 F – Child Tax Credit and Young Child Tax Credit ……………………………………………………………………… 87 G – Disabled Access Credit for Eligible Small Businesses ………………………………………………………….. 87 H – Work Opportunity and Welfare-to-Work Credits …………………………………………………………………. 88 I – Joint Custody Head of Household ……………………………………………………………………………………….. 88 J – Child and Dependent Care Expenses Credit ………………………………………………………………………….. 89 K – Adoption Credit ……………………………………………………………………………………………………………….. 91 L – Credit for Taxes Paid to Other States ………………………………………………………………………………….. 91 M – California State Income Tax Refund ………………………………………………………………………………….. 91 N – Renter’s Credit ………………………………………………………………………………………………………………… 91 O – College Access Tax Credit ………………………………………………………………………………………………… 92 v P – Dependent Parent Credit ……………………………………………………………………………………………………. 92 Q – Joint Custody Head of Household Credit …………………………………………………………………………….. 92 R – Senior Head of Household Credit ……………………………………………………………………………………….. 92 S – Credit for Prior Year Alternative Minimum Tax …………………………………………………………………… 92 T – California Film and Television Tax Credit Program 2.0 ………………………………………………………… 92 25% Tax Credit …………………………………………………………………………………………………………………. 93 20% Tax Credit …………………………………………………………………………………………………………………. 93 5% Tax Credit …………………………………………………………………………………………………………………… 93 U – California Competes Tax Credit …………………………………………………………………………………………. 94 V – College Access Tax Credit ………………………………………………………………………………………………… 95 W – New Employment Credit ………………………………………………………………………………………………….. 96 Definition of Terms ……………………………………………………………………………………………………………. 96 Claiming the Credit ……………………………………………………………………………………………………………. 97 X – Claim of Right …………………………………………………………………………………………………………………. 98 Y – Mortgage Interest Tax Credit …………………………………………………………………………………………….. 98 Z – Summary …………………………………………………………………………………………………………………………. 98 Chapter 8 Review Questions ……………………………………………………………………………………………….. 99 Chapter 9 Casualty , Theft , and Disaster Losses……………………………………………………………………… 101 A – Introduction …………………………………………………………………………………………………………………… 101 B – Chapter Learning Objectives ……………………………………………………………………………………………. 101 C – California Rules on Losses ………………………………………………………………………………………………. 101 D – Defining Disaster Losses …………………………………………………………………………………………………. 102 Recent California Disasters ……………………………………………………………………………………………….. 102 E – Calculating and Claiming a Disaster Loss ………………………………………………………………………….. 103 Individual Taxpayers ………………………………………………………………………………………………………… 103 Business Taxpayers ………………………………………………………………………………………………………….. 104 Due Date Postponements …………………………………………………………………………………………………… 104 When to Claim the Loss ……………………………………………………………………………………………………. 105 Disaster Loss Examples…………………………………………………………………………………………………….. 105 F – Summary ……………………………………………………………………………………………………………………….. 107 Chapter 9 Review Questions ……………………………………………………………………………………………… 108 Chapter 10 Net Operating Losses ……………………………………………………………………………………………. 110 A – Introduction …………………………………………………………………………………………………………………… 110 B – Chapter Learning Objectives ……………………………………………………………………………………………. 110 C – Federal and California Net Operating Loss (NOL) Rules …………………………………………………….. 110 D – Business Losses ……………………………………………………………………………………………………………… 110 At-Risk Rules ………………………………………………………………………………………………………………….. 110 Passive Activity Limitations ……………………………………………………………………………………………… 111 Installment Sales ……………………………………………………………………………………………………………… 111 E – Capital Transactions Issues ………………………………………………………………………………………………. 111 F – Depreciation …………………………………………………………………………………………………………………… 111 Listed Property ………………………………………………………………………………………………………………… 111 Section 179 Deduction ……………………………………………………………………………………………………… 111 Modified Accelerated Cost Recovery System (MACRS) ………………………………………………………. 112 Accelerated Cost Recovery System (ACRS) ……………………………………………………………………….. 112 FTB Form FTB 3885A ……………………………………………………………………………………………………… 113 G – Capitalize or Expense ……………………………………………………………………………………………………… 113 H – Summary ………………………………………………………………………………………………………………………. 113 Chapter 10 Review Questions ……………………………………………………………………………………………. 114 Chapter 11 Health Care …………………………………………………………………………………………………………. 116 vi A – Introduction …………………………………………………………………………………………………………………… 116 B – Chapter Learning Objectives ……………………………………………………………………………………………. 116 C – The Affordable Care Act …………………………………………………………………………………………………. 116 D – Affordable Health Care in California ………………………………………………………………………………… 116 E – State Mandate for Health Insurance …………………………………………………………………………………… 118 F – Self-Employed Health Insurance Deduction ……………………………………………………………………….. 119 G – Small Employer Health Insurance Credit …………………………………………………………………………… 119 H – Health Savings Accounts (HSAs) …………………………………………………………………………………….. 119 How HSAs Work …………………………………………………………………………………………………………….. 119 Tax Advantages ……………………………………………………………………………………………………………….. 120 California Rules Regarding HSAs ……………………………………………………………………………………… 120 I – Medical Savings Accounts (MSAs) ……………………………………………………………………………………. 121 J – Long-Term Care Insurance ……………………………………………………………………………………………….. 121 K – Summary ………………………………………………………………………………………………………………………. 121 Chapter 11 Review Questions ……………………………………………………………………………………………. 122 Chapter 12 Alternative Minimum Tax ……………………………………………………………………………………. 124 A – Introduction …………………………………………………………………………………………………………………… 124 B – Chapter Learning Objectives ……………………………………………………………………………………………. 124 C – What Is the Alternative Minimum Tax? …………………………………………………………………………….. 124 Calculating the AMT ………………………………………………………………………………………………………… 124 Calculating the AMTI ………………………………………………………………………………………………………. 125 Personal Property Taxes and Real Property Taxes ………………………………………………………………… 125 California AMT Exemption Phase-Outs ……………………………………………………………………………… 125 Credit for Prior Year Minimum Tax …………………………………………………………………………………… 126 Exemption for Small Businesses ………………………………………………………………………………………… 126 Estimated Tax Payments and the AMT ……………………………………………………………………………….. 126 D – Summary ………………………………………………………………………………………………………………………. 126 Chapter 12 Review Questions ……………………………………………………………………………………………. 127 Chapter 13 Retirement …………………………………………………………………………………………………………… 129 A – Introduction …………………………………………………………………………………………………………………… 129 B – Chapter Learning Objectives ……………………………………………………………………………………………. 129 C – Individual Retirement Accounts (IRAs) …………………………………………………………………………….. 129 Lump-Sum Distributions …………………………………………………………………………………………………… 130 Lump-Sum Election …………………………………………………………………………………………………………. 130 California Residents Receiving Out-of-State Pensions ………………………………………………………….. 130 Nonresidents of California Receiving California Pensions …………………………………………………….. 130 Basis ………………………………………………………………………………………………………………………………. 130 Military Pension ………………………………………………………………………………………………………………. 130 Roth IRAs ……………………………………………………………………………………………………………………….. 131 D – Social Security ……………………………………………………………………………………………………………….. 131 E – Summary ……………………………………………………………………………………………………………………….. 131 Chapter 13 Review Questions ……………………………………………………………………………………………. 132 Chapter 14 Real Property ………………………………………………………………………………………………………. 134 A – Introduction …………………………………………………………………………………………………………………… 134 B – Chapter Learning Objectives ……………………………………………………………………………………………. 134 C – Capital Gains and Losses …………………………………………………………………………………………………. 134 Capital Gains Tax Rates ……………………………………………………………………………………………………. 134 Sale of an Assisted Housing Development to Low-Income Residents …………………………………….. 135 Property Inherited Before 1987 ………………………………………………………………………………………….. 135 Capital Loss Carryback …………………………………………………………………………………………………….. 135 vii Basis Differences of Business Property ………………………………………………………………………………. 135 Gain on the Sale of a Personal Residence ……………………………………………………………………………. 135 Installment Sales ……………………………………………………………………………………………………………… 136 Withholding on California Real Estate ……………………………………………………………………………….. 136 Passive Activity Losses and the Sale of Real Estate ……………………………………………………………… 138 Short Sales ………………………………………………………………………………………………………………………. 139 D – Summary ………………………………………………………………………………………………………………………. 140 Chapter 14 Review Questions ……………………………………………………………………………………………. 141 Chapter 15 Procedural Issues …………………………………………………………………………………………………. 143 A – Introduction …………………………………………………………………………………………………………………… 143 B – Chapter Learning Objectives ……………………………………………………………………………………………. 143 C – Filing California Tax Returns and Paying Tax ……………………………………………………………………. 143 Estimated Tax Payments …………………………………………………………………………………………………… 143 D – Penalties ……………………………………………………………………………………………………………………….. 144 E – Claims for Refund …………………………………………………………………………………………………………… 144 F – MyFTB Online Services ………………………………………………………………………………………………….. 144 Benefits Offered ………………………………………………………………………………………………………………. 144 Access to MyFTB …………………………………………………………………………………………………………….. 147 MyFTB for Tax Preparers …………………………………………………………………………………………………. 147 Power of Attorney ……………………………………………………………………………………………………………. 148 30-Day Deferral Option Now Available for MyFTB Users ……………………………………………………. 150 G – Dependent Social Security Number (SSN) ………………………………………………………………………… 151 H – Amended Return E-Filing for Individuals ………………………………………………………………………….. 151 I – New Office of Tax Appeals ………………………………………………………………………………………………. 151 J – Business Entity E-File Requirement …………………………………………………………………………………… 152 K – Summary ………………………………………………………………………………………………………………………. 152 Chapter 15 Review Questions ……………………………………………………………………………………………. 153 1 Introduction This course is designed to prepare California tax professionals for the 2020 filing season (tax year 2019). As of the writing of this course, some of the official 2019 tax information has not been released. Throughout the course, tax years are as indicated. The course covers the latest information available from the FTB on tax law and procedural changes that affect the 2019 tax year. The course is written according to the specific requirements set forth by the California Tax Education Council (CTEC) and has been CTEC-approved through a professional review process designed and required by CTEC. Information provided in this course comes from the Franchise Tax Board (at ftb.ca.gov), the California Revenue and Tax Code (leginfo.legislature.ca.gov), and the federal Internal Revenue Code (irs.gov). Course Objectives After successfully completing this course, you will be able to:  understand the basics of the California tax system for individuals  recognize the duties of the Franchise Tax Board  apply rules related to a myriad of California taxes  recognize Franchise Tax Board programs’ rules and requirements  given a taxpayer’s situation, determine his or her filing status, residency status, and filing requirements  recognize tax issues and requirements related to household employees  recognize what makes up gross income and adjusted gross income  understand deductions and expenses  apply rules for various tax credits  understand the rules related to casualty, theft, and disaster losses  apply rules related to net operating losses  be familiar with health insurance instruments and recent policy changes  understand the alternative minimum tax and be familiar with its basic components  recognize and apply rules related to various retirement instruments and situations  understand rules regarding real property transactions  be familiar with basic procedures for filing tax returns 2 Chapter 1 California Tax System for Individuals A – Introduction Like many other states in the union, the State of California has a multi-faceted system of taxation. Taxes are levied by various governmental agencies at the State and local levels on taxpayer income, payroll, and real property among other items. California tax practitioners are thus called upon to have a broad knowledge and understanding of the tax system in order to serve their clients effectively and ensure compliance. For tax years 2015 and later, California generally conforms to the Internal Revenue Code as it existed on January 1, 2015. However, many of the 2017 Tax Cuts and Jobs Act’s (TCJA’s) federal changes were adopted by California. In this chapter we will review in general terms the system of taxation that was in effect in California during the 2019 tax year. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  determine whether someone has to file a tax return in California  determine the filing status of a taxpayer  identify and apply community property rules  identify tax rates  identify and apply the rules related to California payroll taxes, sales and use tax, property tax, and income tax  determine a person’s California residency status for tax purposes C – Taxes and Taxing Agencies Depending on their individual personal circumstances, California taxpayers may be liable to pay some or all of the following types of taxes, each of which is administered by the agency listed in the following table. Tax Responsible Agency Federal Income Tax U.S. Internal Revenue Service California Income Tax CA Franchise Tax Board California Payroll Tax CA Employment Development Department California Sales and Use Tax CA Board of Equalization Property Taxes County Governments 3 We will now discuss each of these taxes in turn, with the exception of the federal income tax which is discussed in other courses. D – California Income Tax The State of California, through the agency of its Franchise Tax Board (FTB), taxes residents on their worldwide income regardless of source. Taxpayers who are deemed to be “nonresidents” for California tax purposes are taxed on any income they derive from California sources, regardless of whether they set foot in the state during the year. Over the years many seasonal visitors to California have found themselves presented with large and unexpected tax liabilities. Residency and filing status are key determinants of taxable income. Filing Requirement Whether or not a taxpayer owes and/or has to pay California taxes depends on a number of factors. Most generally, California filing is required if the taxpayer lives in or has California-source income, files a federal return, and has income over a certain threshold. The California taxing authority indicates that the taxpayer must file Form 540 if any one of the following applies:  The taxpayer owes income tax (i.e., he or she might not have to file if owed a refund or there is no income tax due).  The taxpayer owes tax on a lump-sum distribution.  You owe tax on a qualified retirement plan – including, but not limited to, an Individual Retirement Account (IRA) or an Archer Medical Savings Account (MSA).  The taxpayer is paying taxes for a child under age 19 or student under age 24 who has investment income of over $2,100.  The taxpayer owes alternative minimum tax (AMT).  The taxpayer owes recapture taxes.  The taxpayer owes tax on an accumulation distribution from a trust. Many of these requirements are described further or explained in other sections of this course. Filing Status In most cases, the taxpayer uses the same filing status for the California return and the federal return. Marital status for a specific tax year affects many tax rates, deductions, credits, and other matters. This filing status depends primarily on the taxpayer’s legal marital status as of December 31 of that tax year. Detailed information is available in FTB Publication 1031 (Guidelines for Determining Residency Status). Single (S) This status applies if the taxpayer was not married or in a registered domestic partnership, he or she divorced or became legally separated, or if he or she did not remarry or enter into another RDP during the tax year. Married Filing Jointly (MFJ) This status applies to a taxpayer married or in a Registered Domestic Partnership (RDP) regardless of whether the partners lived together, one whose spouse or RDP died during the tax year (and the taxpayer did not remarry), or if the taxpayer’s spouse died in the filing year before the filing of the tax year’s return. 4 California treats RDPs as spouses for tax purposes. The federal government does not recognize the registered domestic partnership and requires an actual marriage for a taxpayer to claim the self-employed health insurance deduction on his or her partner. Head of Household (HOH) Specific requirements for qualifying as HOH are set forth in FTB Publication 1540, California Head of Household Filing Status. Applicable income tax rates are lower for taxpayers with this status. For the most part, the status pertains to taxpayers – single, married but living apart, in an RDP but living apart – when that taxpayer paid more than one-half the cost of domestic upkeep for the tax year. In general, head of household filing status is for unmarried individuals and certain married individuals or RDPs living apart who provide a home for a specified relative. HOH status is also appropriate for the taxpayer who: 1. was not married or in an RDP on December 31 2. paid more than half the cost of home upkeep for the tax year 3. used the home for more than half the year as the main home for himself and a relative specified as qualifying 4. was not a resident alien during any of the tax year For tax year 2019, the taxpayer must include Form FTB 3532, Head of Household Filing Status Schedule, or the FTB will deny the HOH status. This form indicates how the taxpayer determined HOH status was appropriate, and the FTB will deny HOH status if the form is not included with the tax return. Qualifying Widow(er) Joint tax return tax rates may be used when:  The taxpayer’s spouse or RDP died and the taxpayer did not get married or enter into an RDP again.  The taxpayer has a child, stepchild, or adopted child whom the taxpayer could claim as a dependent.  The child had gross income of at least $4,150 (for 2018 tax year; 2019 tax year information is pending).  The child filed a joint return.  The taxpayer could be claimed as a dependent on someone else’s return. If you are not claiming the child as your dependent, indicate the child’s name under the “Qualifying Widow(er)” filing status selection on Form 540. Married or Registered Domestic Partnership Filing Jointly or Separately California requires RDPs to file as married/RDP filing jointly or married/RDP filing separately. In California, RDPs have the same responsibilities and legal benefits as married couples. If a taxpayer entered into an RDP in another state their partnership will be recognized by California as long as the legal union is substantially equivalent to such a union in California. For California tax purposes, references to a spouse, wife, or husband also include a California RDP (which can stand for “Registered Domestic Partnership” and “Registered Domestic Partner”). As explained in FTB Publication 737, Tax Information for Registered Domestic Partners, community property rules determine how income should be divided for tax purposes. 5 It should be noted that you may not claim a personal exemption credit for your spouse (in California; federal law did away with personal exemptions). You may, however, be able to file as HOH if your child lived with you (and apart from your spouse or RDP) during the entire last six months of the tax year. Federal versus California RDP Rules The IRS does not treat a registered domestic partnership as a married couple. California’s filing status choices for married couples, however, all treat RDPs as marriages. How Does My California Filing Status Relate to My Federal Filing Status? Filing Status for California is usually the same as the federal filing status. There are exceptions.  Exception: You are in an RDP. o If you file your federal taxes as “single,” you have to use Married/RDP Filing Jointly or Married/Filing Separately for California. o If you file as HOH on your federal tax return, you may use the HOH status in California only if you can legitimately claim you are unmarried or not in an RDP.  Exception: You or your spouse was a U.S. military member on active duty during the year.  Exception: You were a nonresident for the entire year and you had no California-source income for the year. However, if one of the spouses earns California-source income and is domiciled in a community property state, community income will be split between the two spouses. Both spouses are treated as though they have California-source income (and cannot qualify for the nonresident spouse exception discussed later in this course). Under community property rules, if the spouse earning the California-source income is domiciled in a community property state, community income will be split equally between the spouses. Both spouses will have California source income and they will not qualify for the nonresident spouse exception. If you had no federal filing requirement, use the same filing status for California that you would have used to file a federal income tax return. If you filed a joint tax return and either you or your spouse/RDP was a nonresident for the year, file the Long or Short Form 540NR, California Nonresident or Part-Year Resident Income Tax Return. If this status is used, community property rules apply to income division between the spouses/RDPs. Community property rules are discussed later in this chapter. E – Special Filing Situations There are certain taxpayer situations with specific rules. Estates and Trusts When a person dies, the property he or she owns at that time forms an estate. Estates have their own system of taxation. A trust is created when a person provides property (trustor) for the benefit of someone else (the beneficiary) and that property (the trust “corpus”) is to be managed by a third party (trustee or fiduciary). Trusts also have their own taxation rules. Like-Kind Exchanges When property is exchanged for other property that is the same kind (“like-kind”), there are certain situations in which a taxpayer must report the exchange in California. These situations are as follows:  the owner exchanges California property for like-kind property outside of California 6  the person subject to California tax defers any gain or loss from such an exchange under IRC Section 1031 Such exchanges require the taxpayer to file Franchise Tax Board (FTB) Form 3840 in the year of the exchange and each subsequent year until the replacement property is no longer in the hands of that taxpayer. The filings must happen until tax is paid, the owner dies, the property is part of a charitable donation, or the replacement property is sold in a taxable sale. California taxpayers do not have to file Form 3840 for personal property exchanges, but substantiation records must be available if the FTB requests them. The TCJA changed the federal rules to limit the application of Section 1031 to exchanges of real property. California did not change its rules. Innocent Spouse (Joint Filer) Both joint-filers of a tax return bear responsibility for taxes, penalties, and interest. There are some circumstances under which it would be unfair to hold one of the spouses liable. Unfairness situations include the non-innocent spouse’s being the party who created some or all of the tax debt. The FTB considers the following factors in determining whether equitable relief should be granted:  Some or all of the tax debt was caused by the other spouse/RDP.  The innocent spouse was the victim of abuse or financial control by the other spouse/RDP during the marriage or RDP.  Whether the innocent spouse knew at the time of signing the return that tax was due.  Whether the innocent spouse’s financial situation makes it feasible for that person to pay the tax debt.  Whether a divorce decree, termination of RDP, or some legally binding agreement identifies the innocent or the other spouse as legally responsible for paying the debt.  Whether the innocent spouse received a significant benefit from not paying or underpaying.  Whether the innocent spouse violated income tax laws in subsequent years.  Whether the innocent spouse received IRS relief for the same tax years. Court-ordered relief may be appropriate when a court has issued an order (divorce or termination of RDP) releasing the innocent spouse. F – Community Property Issues California is a community property state, as defined below. California rules related to dividing property affect homes, cars, furniture, bank accounts, cash, investments, business interests, life insurance policies with cash values, pension and retirement accounts, stock options, and other deferred compensation. Community Property Defined There are currently nine states with family code provisions declaring them community property states. These currently include Alaska (if the spouses choose community property), California, Nevada, Texas, Arizona, Idaho, Louisiana, New Mexico, and Washington. If the spouses file separate returns, community income and deductions must be split equally between the two people. Community property status applies to income of a married couple, anything purchased during the marriage by either partner, and (generally) income received during a separation if there is an intention to resume the marriage. 7 When spouses in a community property state do not have an agreement contradicting the marital property treatment rules, income is treated as community property. If those spouses separate without an intention to revive the marital relationship, the earnings of each person are that person’s separate property. Assets owned by one spouse before the marriage are considered that spouse’s separate property. Income from such assets is community property. California community property rules “begin” when two people enter into a marriage or RDP and end basically if and when all community assets have been divided. Laws of intestacy also apply to community property – when one spouse or partner dies, that person’s community property share is passed to his or her heirs according to that person’s will. Often, wills will specify that each spouse’s property is to pass to the other. However, if this situation does not apply, the deceased spouse’s property does not automatically go to the surviving spouse. Commingled Property In many marriages or RDPs, especially those of longer duration, it can become challenging to identify each spouse’s separate property. That is, it becomes easy for a couple to mix community and separate property. When such assets are mixed, it can be difficult to determine the proper disposition of property in a divorce. The property acquired by the couple during marriage will be treated upon divorce as either community property or separate property, depending on a number of factors. This characterization can be very complicated, but the general rule is that all of either spouse’s earnings and accumulations from the date of marriage to the date of legal separation are community property. Separate property includes property either spouse obtained prior to getting married, gifts and inheritances during the marriage, or property acquired after legal separation. In a divorce, the court will presume that property acquired during a marriage is community property. However, if one spouse can trace his or her separate property into an existing marital asset, the court can treat that marital asset as separate property. Direct tracing can be accomplished by providing bank statements from a separate property bank account to show that separate property funds were used to purchase an asset (like a car) during the marriage. Prenuptial Agreements Prenuptial agreements are contracts between the two spouses/RDPs. These agreements often cover what happens to separate property in a divorce. Whether a specific provision applies to a California or IRS tax situation depends basically on the legality of that provision. Beginning in the 2019 tax year, alimony tax rules changed. Before this change, the person paying the alimony could deduct the payments he or she made. This deduction would happen above-the-line. The recipient would have to pay the taxes on alimony (i.e., income). For divorces initiated after December 31, 2018, alimony passes from one spouse to the other tax-free. The spouse responsible for paying alimony must pay the alimony in after-tax dollars. That is, the responsibility for tax payments changed from the recipient to the payor. Income from Community Property For the most part, unless the spouses have agreed otherwise, the income from community property belongs to the “community” – to the spouses or RDPs. If they file separate returns, they must split this income equally. If there is a credit applicable to a dependent who is supported by money from the marriage, either spouse or RDP may claim the credit in the case of their filing separate returns. The California Family Code provides that if spouses or RDPs separate with no intention of resuming the marriage, earned income by each spouse belongs to that spouse as his or her separate property. 8 California and federal tax rules are different in how community property laws apply when one spouse is a nonresident alien. Federal law deems community property rules inapplicable in most instances. The California Board of Equalization provides generally that the resident spouse is liable for income tax one one-half of the nonresident spouse’s income. Such treatment has been applied when a California domicile is maintained by the nonresident, the nonresident earns income in California, or the resident is entitled to one-half of the nonresident spouse’s income. Community Property Rules Applied to Registered Domestic Partners In California, RDPs are treated the same as married persons for tax purposes. Community property rules would therefore apply to RDPs the same as they would for married couples. The IRS does not provide for this kind of treatment. Marriage can be between same-sex partners, so it would seem that the RDP status might not be as useful as it once was. Community Income Tax Debt Relief for Innocent Spouse An innocent spouse/RDP may be able to exclude community property income. All of the following requirements must be met:  The couple did not file a joint tax return.  The innocent spouse did not include an item of community income on a separate tax return for that tax year.  The innocent spouse did not know of that community income item.  The innocent spouse can prove that the unreported income was the responsibility of the other person. G – Common Law Marriages A common law marriage is one that is created by living together a certain amount of time and meeting other criteria that indicate a couple intends to be treated as married. There are only a few states that recognize common law marriages:  Alabama  Colorado  Iowa  Kansas  Montana  South Carolina  Texas  Utah  Washington Note that California is not one of these states. In states that do not recognize common law marriages, a taxpayer generally has to get a marriage license and enter into a legal marriage or RDP (where RDP is recognized). The federal government recognizes common law marriages for tax purposes if common law marriage is recognized in the state where the taxpayers live or in the state where they established their marriage. 9 H – Tax Rates for Individuals Taxpayers who are subject to California income tax are taxed on a progressive scale starting with their first dollar of income, at a rate of 1%. The rate rises through a series of income brackets depending on the taxpayer’s filing status, eventually culminating in a maximum marginal rate of 12.3%. This is the highest marginal tax rate in the country, with Maine in second place at 10.15% and Oregon in third place with 9.9%. However, California taxpayers earning over $1 million are subject to an additional Mental Health Services Tax of 1%, making the effective maximum tax rate 13.3% on income over $1 million. Rate of Inflation Personal income tax brackets in California are indexed from January 1 each year based on the rate of inflation during the preceding 12-month period from July 1 to June 30. As a result, the 2018 California personal income tax brackets were indexed by 2.6%. Income tax rates are shown in the following tables. 2019 Tax Year California Tax Rate Schedules Schedule X—Single or married/RDP filing separately Taxable income over But not over Tax is Of amount over $0 $8,544 $0.00 plus 1.00% $0 $8,544 $20,255 $85.44 plus 2.00% $8,544 $20,255 $31,969 $319.66 plus 4.00% $20,255 $31,969 $44,377 $782.22 plus 6.00% $31,969 $44,377 $56,085 $1,532.70 plus 8.00% $44,377 $56,085 $286,492 $2,469.34 plus 9.30% $56,085 $286,492 $343,788 $23,897.19 plus 10.30% $286,492 $343,788 $572,980 $29,798.68 plus 11.30% $343,788 $572,980 AND OVER $55,697.38 plus 12.30% $572,980 10 Schedule Y—Married/RDP filing jointly, or qualifying widow(er) with dependent child Taxable income But not over Tax is Of amount over $0 $17,088 $0.00 plus 1.00% $0 $17,088 $40,510 $170.88 plus 2.00% $17,088 $40,510 $63,938 $639.32 plus 4.00% $40,510 $63,938 $88,754 $1,576.44 plus 6.00% $63,938 $88,754 $112,170 $3,065.40 plus 8.00% $85,422 $112,170 $572,984 $4,938.68 plus 9.30% $112,170 $572,984 $687,576 $47,794.38 plus 10.30% $572,984 $687,576 $1,145,960 $59,597.36 plus 11.30% $687,576 $1,145,960 AND OVER $111,394.75 plus 12.30% $1,145,960 Schedule Z—Head of Household Taxable income over But not over Tax is Of amount over $0 $17,629 $0.00 plus 1.00% $0 $17,629 $41,768 $176.29 plus 2.00% $17,629 $41,768 $53,843 $659.07 plus 4.00% $41,768 $53,843 $66,636 $1,142.07 plus 6.00% $53,843 $66,636 $78,710 $1,909.65 plus 8.00% $66,636 $78,710 $401,705 $2,875.57 plus 9.30% $78,710 $401,705 $482,047 $32,914.11 plus 10.30% $401,705 $482,047 $803,410 $41,189.34 plus 11.30% $482,047 $803,410 AND OVER $77,503.36 plus 12.30% $803,410 I – Propositions 30 and 55 California tax rates also include a temporary increase in taxes that was authorized by voters in 2012 when they passed Proposition 30. This initiative was aimed at increasing the funds available for education within the state and is active from January 1, 2012 through to December 31, 2018. The marginal tax rate on high income earners increased by this law, and Proposition 30 also provided for an increase in the state sales tax by 0.25% over four years (from January 1, 2013 through December 31, 2016). Proposition 55 continued these income tax rates through 2030. 11 J – Kiddie Tax and Form 3800 The tax on children is sometimes called the “Kiddie Tax.” It applies to unearned income (i.e., not wages from a job). The rules apply in order to prevent parents from shifting certain income to their children in order to take advantage of a child’s lower marginal tax rate. California and federal law are the same in some respects on income tax rules regarding a child’s interest and dividend income. In 2019, for any child (under 19) or student (under age 24), the taxpayer can choose to include that income on the parents’ income tax return, as long as there was not more than $2,200 in such income. When there is more than $2,200 in investment income, California Forms 540 and 3800 should be completed to calculate the tax due on a separate Form 540 for the taxpayer’s child. The federal government simplified this tax under the TCJA. The TCJA applies the trusts and estates rates for a child’s net unearned income. If the child reports investment income on his or her federal return, only California-taxable income will be entered on Form 3800. Usually, the federal and California amounts are the same. The relevant forms are as follows:  a Form FTB 3800 (Tax Computation for Certain Children with Investment Income) to calculate the child’s tax  a separate Form 540 for the child In some situations, Form FTB 3803 (Parents’ Election to Report Child’s Interest and Dividends) can be used to make an election to include the income on the parents’ return. California conforms to the Small Business and Work Opportunity Act of 2007 provision which increased the age of children to 18 (and to 23 for a student). That is, for the Kiddie Tax rules to apply, the child must be under age 18 at the end of the tax year, 18 and not providing half of his or her own support with earned income, or 19–23 (i.e., under age 24) and a student who does not provide half of his or her own support with earned income. Children who meet any of the following criteria are not subject to the Kiddie Tax:  They did not have to file a return because their income was not enough to report.  They earned more than half of their required support.  They file MFJ. When a parent taxpayer qualifies, in part because the child’s income comes only from interest and/or dividends, the child’s income of $1,100 to $11,000 can be reported using FTB 3803. If the taxpayer qualifies, he or she may elect to report the child’s income of $10,000 or less (but not less than $1,000) on the parent’s or parents’ tax return by completing Form FTB 3803 (Parents’ Election to Report Child’s Interest and Dividends) which is comparable to federal Form 8814. To make this election, the child’s income must be only from interest and/or dividends. The election is not available if estimated tax payments were made during the tax year in the child’s name or if the child is subject to backup withholding. Backup Withholding The IRS has backup withholding rules to ensure that tax due is paid. If tax is underpaid in one period, the payor may be required to withhold 24% from future payments. Such backup withholding is required when a taxpayer did not provide a correct taxpayer identification number to that payor or when a taxpayer did not report all required interest and dividend income to the IRS. 12 A taxpayer can prevent or stop backup withholding by correcting the mistake he or she became subject to in the first place. Corrections may include correcting the taxpayer identification number previously provided to a payor, the amount owed is paid, and/or any missing returns are filed. Certain payments excluded from backup withholding include canceled debts, distributions from retirement accounts, long term care benefits, and unemployment, to name a few. K – Summary This chapter provided an overview of California’s taxation system. It explained filing status, residency determination, community property rules, and a few special filing situations. The chapter provided information on income tax rates for individuals. Finally, the Kiddie Tax was explained. 13 Chapter 1 Review Questions 1. Which of the following is a false statement regarding California and federal filing status? A. California filing status is never the same as federal. B. Registered Domestic Partner filing status is not the same for California and federal. C. If a Registered Domestic Partner files federal taxes as “single,” he or she has to file as “Married/Filing Separately” for California. D. If a Registered Domestic Partner files as “Head of Household” on his or her federal tax return, then California “Head of Household” filing status is appropriate if that person is not married or in an RDP. 14 Answers to Chapter 1 Review Questions 1. A. That’s correct! The question asks for the statement that is false. It is false that the California and federal filing statuses are never the same. They are usually the same. B. This answer is incorrect. The question asks for the statement that is false. It is true that Registered Domestic Partner filing status is not the same for California and federal. Only California recognizes a Registered Domestic Partnership as a legal union to be treated the same as a marriage. The federal government recognizes legal marriages, but not RDPs. C. This answer is incorrect. The question asks for the statement that is false. It is true that if a Registered Domestic Partner files federal taxes as “single,” he or she has to file as “Married/Filing Separately” for California. California treats RDPs the same as marriages. D. This answer is incorrect. The question asks for the statement that is false. It is true that if a Registered Domestic Partner files as “Head of Household” on his or her federal tax return, then “Head of Household” filing status is not available appropriate for California only if that person is not married or in an RDP. A married person or an RDP is treated as married, and a Registered Domestic Partnership is treated the same as a marriage in California. 15 Chapter 2 The Franchise Tax Board A – Introduction California’s complex tax system requires a great deal of attention for its appropriate administration. The Franchise Tax Board (FTB) is the entity charged with such administration. The FTB is in charge of payroll taxes, sales and use taxes, property taxes, and the California personal income tax. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify the statewide and local agencies that are responsible for collecting the taxes typically paid by California employees on a regular basis  identify the three payroll taxes besides personal income tax that are withheld from employees’ salaries by the Employment Development Department  identify the current standard rate for California Sales and Use Tax, taking into account the effect of Proposition 30 C – Franchise Tax Board (FTB) – The Basics California’s Franchise Tax Board (FTB) is headquartered in Sacramento with field offices in major locations throughout the state and in Chicago, Houston, and New York. The FTB’s primary mission is to administer corporate and personal income taxation in California. The FTB also collects overdue vehicle registration payments and court-ordered debt. The office of the FTB’s Taxpayers’ Rights Advocate reports each year to the State Legislature as required by the Taxpayers’ Bill of Rights, addressing both taxpayers’ concerns and systemic issues within the FTB. Each year’s report not only identifies taxpayers’ errors that were detected during the previous year’s initial tax return processing but also includes details of FTB strategies to improve taxpayer compliance. Methods to achieve this goal often include law changes, increased enforcement capabilities, improved staff training, and enhanced communications with taxpayers and tax practitioners. D – California Payroll Taxes Each year, California collects over $50 billion in payroll taxes and the Employment Development Department processes tens of millions of tax documents and employer remittances. 16 Employment Development Department (EDD) The EDD administers such benefit programs as unemployment insurance and disability insurance. The Employment Development Department (EDD) administers four different payroll taxes:  Unemployment Insurance Tax (UIT)  Employment Training Tax (ETT)  State Disability Insurance (SDI)  Personal Income Tax (PIT) Unemployment Insurance Tax This tax is designed to help in cooperation with the U.S. Department of Labor to provide payment to individuals who are eligible for unemployment assistance payments. The federal government’s tax rate on the first $7,000 of wages is 6.0%. California’s tax rate on the first $7,000 in wages is 1.5% to 6.2%. The tax is paid by the employer. An employer must pay a percentage of the first $7,000 in each employee’s wages in a calendar year. The percentage rate and amount of taxable wages varies each year, with employers being notified by the EDD in December each year of their obligations for the coming year. During recent years, 2015-2019, the tax payment requirement for unrated employers was 3.4% and 6.2% for rated employers. As noted, this percentage must be paid annually on each employee’s first $7,000 of wages. Employers generally pay the 3.4% for their first two to three years. However, this rate can range from 1.5% to 6.2% (resulting in a $105 to $434 expense per employee per year) depending on the employer’s rating and the balance in the state’s unemployment insurance fund. An employer’s experience rating, which determines the UIT rate, is based on the employer’s stability of employment (how many employees have been fired or laid off?) and potential for future unemployment (are there indications of trouble ahead?). The same basic factors are used by all states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands in determining an experience rating. For California, before these factors are even considered, there must be some work in California. The four experience-rating factors are as follows:  localization—If there is one state in which all or most of the employee’s services are provided, then unemployment insurance must be paid to that state; if there is no such state, then look at  base of operations—The most permanent place from which the employee starts work and returns to receive the employer’s instructions; if there is no such state, then look at  place of direction and control—The state from which the employer gives general direction and exercises control over the employee’s work (as long as the employee actually performs some work in that state); if there is no such state, then look at  residence of employee—If the employee merely resides (see residency rules discussed previously in this course) and performs some work in California, unemployment insurance is owed by the employer. When an employee does not satisfy any of the tests but has some connection between work and California, the tax preparer or taxpayer can contact the EDD directly at www.edd.ca.gov. 17 Employment Training Tax (ETT) The employment training tax is designed to provide funds to train employees in selected industries to improve California businesses’ competitiveness. Similar to the UIT, the ETT is paid by the employer based on a percentage of each employee’s wages. The current rate is 0.1% of the first $7,000 (i.e., the same wage base as with UIT) of the wages paid to each employee in a calendar year. The current maximum per employee therefore is $7 per year. State Disability Insurance Tax (SDIT) and Voluntary Plan for Disability Insurance (VPDI) This tax supports the program to provide temporary benefit payments to workers with disabilities not related to or caused by their job (or due to pregnancy or childbirth). The SDIT also provides paid family leave (PFL) benefits, which is used by individuals who are unable to work because of their need to care for a seriously ill family member or new child. In 2019, the SDIT rate is 1.0% on a taxpayer’s first $118,371 of taxable wages. In most instances, California does not allow a deduction for the tax but the federal government does. However, if a California taxpayer worked for two or more employers during the tax year and received more than $114,967 in wages (2018 tax year figure). There is also a Voluntary Plan for Disability Insurance (VDPI) which is not deductible on the federal return. If a taxpayer ends up paying more SDI/VDPI than is owed, claiming the excess requires filing Form 540 or 540NR. The short-form tax return cannot be used to claim this credit. In some cases, a taxpayer may have worked for more than one employer during the year and had excess SDI payments that exceed the tax that would have been due on the maximum wage limit, which was $118,371. With a rate of 1.0%, the maximum withholding would be $1,184. Mental Health Services Tax (the “Millionaire Tax”) For taxpayers with California taxable income over $1,000,000 during the tax year must pay 1% of the amount over $1,000,000 as the Mental Health Services Tax. This tax resulted from the 2004 Proposition 63 as a way to “provide better coordinated and more comprehensive care to those with serious mental illness, particularly in underserved populations.” Example: Bob has $2,000,000 in California taxable income for the year. His tax would be 1% of the amount over $1,000,000. The tax would be $10,000 (or the excess $1,000,000 × 1%). E – California Sales and Use Tax California’s Sales Tax generally applies to the sale of tangible personal property, including vehicles, in the state. California’s Use Tax applies to the use, storage, or other consumption in the state of those same kinds of items that were purchased from a retailer outside the state. Out-of-state retailers who are engaged in business in California are required to collect the Use Tax, whenever applicable, from the consumer at the time of making the sale. The tax rate for Use Tax is the same as for Sales Tax. Some items are exempt from Sales and Use Tax, of which the more commonly seen are:  sales of certain food products for human consumption  sales to the U.S. government  sales of prescription medicine 18 More information can be found in Board of Equalization Publication 61, Sales and Use Taxes: Exemptions and Exclusions. The purpose for these types of taxes is essentially the same thing: to tax consumption. California’s use tax provides for state collection of taxes on “tangible personal property” either purchased in or consumed in California by the purchaser (i.e., not re-sold). The use tax applies when a sales tax does not capture such consumption. Sales tax would normally apply at the point of sale. That is, the difference between sales and use tax is in where the tax is collected – at the point of sale by the seller (sales tax) or by the user in the jurisdiction in which the property is used or consumed (use tax). Tax Rate The general statewide rate for Sales and Use Tax is currently 7.25% (having been reduced by the expiration of the 2013–2016 provisions of Proposition 30 from its previous level of 7.50%). However, many cities and municipalities across the state have approved additional “district” taxes which further increase the rate. According to the Board of Equalization (BoE) which administers the Sales and Use Tax, more than 75% of businesses in California are either located in special tax districts or do business there. Example: Assume that in Orange County the tax rate is 7.75%. This rate reflects the 7.25% statewide base rate plus 0.50% for the Orange County Local Transportation Authority. The rate applies countywide, with the exception of some cities that levy an additional tax of their own. Example: Assume that in the Town of Mammoth Lakes, located in Mono County, the tax rate is 7.75%. This rate reflects the 7.25% statewide base plus 0.50% for a Town Parks, Recreation, and Trails Transactions and Use Tax. The 7.75% rate applies only within the town limits of Mammoth Lakes. The tax rate in areas of Mono County outside the Town of Mammoth Lakes is 7.25%. A jurisdiction assessing the use tax generally collects it monthly or annually. Many specific goods and services are not taxable in various jurisdictions. Example: Janie is a resident of Jurisdiction A, which has a 7.5% sales and use tax. She purchases nonexempt goods (or services) while visiting in State C and takes them back home to use them. If Janie paid under 7.5% sales tax to State C, the difference (shortfall) is owed to A. Example: Chris is a resident of B, which is assumed to have a 5% sales tax. He pays 4.0% sales tax goods he purchases while visiting D. That is, D collects 4.0%. Chris will owe 1% to B (5% – 4% = 1%). Whatever sales tax was paid at the time of purchase will be a credit against the amount owed for later consumption (etc.) in the home state. If the state in which goods or services were purchased has no sales tax but the home state has a 10% use tax, the use tax owed to the home state will be 10%. Internet Transactions Taxable to California Out-of-state sellers are increasingly subject to sales tax at the point of sale. The specific rules have been making their way through the courts, especially in 2019. Even as the laws evolve, the consumer is actually responsible for remitting to his or her home state any unpaid sales tax on online purchases. Enforcement of such a requirement has proven challenging. When an online retailer has a physical presence in a state (office, warehouse, etc.), that retailer has to collect sales tax from customers in that state. The states have had variations of a “nexus” requirement determining whether a specific retailer had to collect sales tax from customers outside the state. Beginning on April 1, 2019, a law went into in effect in California requiring sellers with over $100,000 in sales or 200 transactions in California to collect sales tax, regardless of any other connection to or “nexus” with California. 19 There is generally a rule always to collect sales tax on Internet sales to customers who are in states where the business (seller) has a physical presence. Under California laws AB 28 and AB 155, an Internet retailer who meets all of the following conditions has to collect sales tax even though that retailer has no California physical presence:  The retailer pays someone in California to direct would-be buyers to that retailer.  The retailer has a contract with someone in California to direct would-be buyers to the website or link.  The retailer’s total sales price from sales directed to California customers must exceed $10,000 (within the preceding 12 months).  The retailer’s total sales from California customers (whether directed to them or otherwise) within the preceding 12 months. For the California purchaser who buys from out-of-state or Internet sellers (or by phone, mail, or in person), use tax should be reported on the individuals’ income tax return for items purchased with no sales tax collected if such items are given away, stored, or used within California. There are tax worksheets and formulas to use to determine the amount of use tax owed. Board of Equalization (BoE) publications provide guidance as to which items need to be reported directly to the BoE and which should instead be reported on the individual income tax return. When tax is owed (and unpaid) for prior years, the BoE has a voluntary disclosure program for certain purchasers to acknowledge their liability and thereby limit penalties and interest. For the taxpayer purchasing goods from a foreign country and bringing them to California, the use tax is the purchase price listed on the U.S. Customs Declarations form (less the applicable per-person exemption). If the taxpayer’s filing status is “Married/RDP Filing Separately,” the spouses may split up the reporting of the use tax due on their income tax returns. Doing Business in California and Business Licenses Beginning with taxable year 2011, a taxpayer is considered to be “doing business in California” if it actively engages in any transaction for the purpose of financial or pecuniary gain or if any of the following conditions are satisfied:  The taxpayer is organized or commercially domiciled in California.  the taxpayer’s California sales (including sales made through agents and independent contractors) exceed the lesser of $500,000 or 25% of the taxpayer’s total sales.  The taxpayer’s real and tangible personal property in California exceed the lesser of $50,000 or 25% of the taxpayer’s total real and tangible personal property.  The taxpayer pays the lesser of $50,000 or 25% of its total compensation in California. Note: Even if these thresholds are not met, a business taxpayer may still be considered “doing business in” California if the taxpayer actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California. Doing business in California also requires various permits, licenses, and/or accounts. The BoE regulates companies doing business in California, and as indicated above, it runs the sales and use tax programs. Businesses include sole proprietorships, partnerships, corporations, LLPs, LLCs, and others. 20 The BoE also supervises several tax and fee programs, including the registering of sellers and granting of permits when all of the following conditions apply:  The seller engages in business in California.  The seller will sell or lease tangible personal property that would be subject to sales tax if sold at retail.  The seller will make sales for a temporary period (under 91 days) at one or more locations. Some businesses must set up a use tax account. Such an account must be arranged if all of the following conditions are met:  The business receives at least $100,000 in gross sales (all receipts from in-state and out-of-state business operations) from business operations per calendar year.  The business does not hold a use tax direct payment permit.  The business is not otherwise registered with the BoE to report use tax. California has more than 100 categories of business license taxes and fees for permits and accounts. These can be imposed on businesses, occupations, and professions. Examples include the following:  California seller’s permit—If you are doing business in California and intend to sell or lease tangible personal property subject to sales tax sold at retail, you are required to have a seller’s permit and prominently display it at your place of business. Many businesses are required to obtain permits in addition to the seller’s permit. o cannabis tax permit—If you are a distributor of cannabis and cannabis products, you must obtain a cannabis tax permit. o cigarette and tobacco products license—If you sell cigarettes and tobacco products at retail, you must have a California Cigarette and Tobacco Products Retailer’s License before purchasing or selling cigarettes or tobacco products. o covered electronic waste recycling fee (eWaste)—You must have an eWaste account if you sell or lease covered electronic devices (CEDs) such as computer monitors, laptop computers, or portable DVD players with LCD screens. o tire fee—If you sell new tires or lease/rent motor vehicles, construction equipment, farm equipment, and motorized equipment with new tires you must have a tire fee account.  International Fuel Tax Agreement (IFTA)—You must have an IFTA license if you are an interstate motor carrier reporting fuel taxes. An IFTA license allows a taxpayer to file one tax report that covers all member jurisdictions.  lead-acid battery fees—You must register as a battery dealer and pay the California battery fee if you sell replacement lead-acid batteries at retail in California. Dealers may also be liable for the manufacturer battery fee. You must separately register as a manufacturer and pay the manufacturer battery fee if you are a manufacturer of lead-acid batteries and sell, offer for sale, or distribute the lead-acid batteries in California. If the manufacturer is not subject to the jurisdiction of this state, a dealer or other person who imports the lead-acid battery into California for sale or distribution is responsible to register and pay the manufacturer battery fee.  lumber products assessment—Beginning January 1, 2013, a new law requires a one percent (1%) assessment on purchases of lumber products and engineered wood products for use in California, based on the selling price of the products. 21  underground storage tank—If you own an underground storage tank, you must register with the California Department of Tax and Fee Administration. You will be required to file underground storage tank fee returns and pay any fee amounts due for the reporting period. More information can be found on the website for the California Department for Tax and Fee Administration (https://www.cdtfa.ca.gov/services/permits-licenses.htm). Board of Equalization (BoE) Apart from collecting Sales and Use Tax, the BoE and its 4,000 employees are responsible for collecting a number of other special taxes and fees including those on alcoholic beverages and cigarette and tobacco products. The BoE also has an oversight role with regard to Property Taxes. F – Property Taxes California has one of the highest average property tax rates in the country and each of the 58 counties in the state is responsible for collecting property taxes within its borders. Because property taxes are calculated based on the value of homes as determined by County Assessors, the highest average amount of tax for 2018 was levied by Marin County in the San Francisco area while the lowest average amount was levied by Modoc County in the north-east corner of the state, bordering Oregon and Nevada. Example: Oliver owned a home in Sausalito in Marin County which was valued by the county at $2.7 million. In 2017 he paid property taxes of $17,010, based on the county assessment rate of 0.63%. In 2018 he moved to Alturas in Modoc County where he was pleasantly surprised to learn that the property tax on his new $200,000 home was only $1,200, based on the county assessment rate of 0.6 %. Property Value As we have seen, each county in California sets and applies an assessment rate to property based on the value of that property according to the County Assessor in each case. This leads us quite logically to the next question which is also often asked annually by homeowners: How does the County Assessor calculate the value of each property? Although some disgruntled homeowners may think that their local County Assessor makes up his or her own rules, the Board of Equalization sets out clear policies and guidelines on a statewide basis. These Property Tax Rules are included in Title 18 of the California Code of Regulations, and in the simplest sense they define the value of a given property in a very similar way to the definition of “fair market value” for goods and property of any kind. In other words, the price that a buyer with full information about the property in question would be willing to pay for that property under the prevailing market conditions – and that the seller would be willing to accept. Applying that principle to real property, we are referring to the price in cash (or equivalent) at which the unencumbered or unrestricted fee simple interest (subject to any easements or other legally enforceable restrictions) in the property would transfer from the seller to the buyer. 22 While the above definition offers a convenient method of valuing a property, for accuracy it relies heavily on the actual transfer or ownership having taken place. Since homes are not sold every year, the BoE has set out in the Property Tax Rules several alternative methods for County Assessors to use in arriving at property valuations. In these rules County Assessors are called upon to consider one or more of the following methods as may be appropriate when estimating the value of a property being appraised:  comparative sales approach—the price or prices at which the property in question and other similar properties have recently been sold  stock and debt approach—the prices at which part-ownership interests in the property in question and other similar properties have recently been sold, also taking into account the extent to which these prices would have been increased if there had been no prior claims on the assets  replacement or reproduction cost approach—the cost of replacing the property in question with new property of similar characteristics and features, or of reproducing the property at current price levels at its current location minus the extent to which the property’s value has been reduced by depreciation, obsolescence, and physical deterioration  income approach—the amount that investors, taking into account the associated risks involved, would be prepared to pay for the right to receive the income that the property would reasonably be expected to produce Proposition 13 In 1978 California voters approved Proposition 13 which substantially changed the taxation of real property in California. As a result of this amendment to the Constitution of California:  The maximum amount of property tax cannot exceed 1% of the property’s assessed value, in addition to any bonds or fees approved by the voters.  Real property can only be reappraised in case of a change of ownership or new construction.  With the exception of the two cases listed above, the assessed value of any real property may not increase by more than 2% annually, regardless of the rate of inflation. The only exception to this rule is when the County Assessor has previously granted a temporary reduction due to market value decline. County Assessors While the Assessor in each county is responsible for determining the value of each property and the corresponding tax owed, it is the role of the County Treasurer or Tax Collector to collect property taxes. At the state level, the Board of Equalization acts in an oversight capacity to ensure compliance by county assessors with property tax laws, regulations, and assessment issues. As part of its oversight duty, the BoE conducts periodic compliance audits of the programs conducted by all 58 County Assessors. The BoE also develops property tax assessment policies and informational materials to guide the assessors and local assessment appeals boards. 23 G – California Personal Income Tax (PIT) While we saw earlier that the Franchise Tax Board is responsible for receiving and processing tax returns, it is the Employment Development Department that administers the reporting, collection, and enforcement of withholding personal income tax from the wages of employees. California PIT is owed by the taxpayer on the income of California residents and on income that California nonresidents derive within California. The FTB and EDD administer the California PIT program to provide resources needed for California public services such as schools, public parks, roads, health, and human services. As with federal tax withholding amounts, the California withholding amounts are determined according to the information provided by the employee on his or her W-4 (or DE 4 – the state withholding form). H – Summary We saw in this chapter that a tax practitioner preparing the annual tax returns of a Californian taxpayer is likely to encounter a myriad of taxes that the client has paid throughout the year. If the client is a wage earner, the practitioner will see evidence of federal and California income tax withholding, federal and California payroll tax withholding, sales tax, and property tax if the client owns a home. These taxes are administered by agencies at the federal, California, and sometimes local levels. In the next chapter we will look at the Franchise Tax Board in more detail. 24 Chapter 2 Review Questions 1. Which of the following statements is true regarding the conformity of federal and California unemployment benefits? A. Both taxing authorities require the employer to withhold the unemployment benefits tax amount from the employee. B. If there is unemployment insurance tax levied in California, there is none for federal. C. There is no unemployment insurance tax at the federal level. D. Both taxing authorities tax on the first $7,000 of wages. 2. Which of the following statements is true regarding Internet transactions’ sales and use tax? A. There is no federal sales and use tax. There is California sales and use tax. B. The federal and California taxing authorities both have a sales and use tax. C. In 2019, a state law went into effect requiring sellers with over $200,000 in sales in California to collect sales tax, regardless of their connection to California. D. In 2019, a state law went into effect exempting California residents from property tax if they were subject to over $100,000 in sales tax. 25 Answers to Chapter 2 Review Questions 1. A. This answer is incorrect. The state and federal unemployment insurance tax is paid by the employer, not by the employee – there is no withholding from the employee’s wages for this tax. B. This answer is incorrect. Unemployment insurance tax applies for federal and state tax returns. C. This answer is incorrect. Unemployment insurance tax applies for federal and state tax returns. D. That’s correct! Currently, only the first $7,000 of wages is taxed. 2. A. That’s correct! There is no federal sales and use tax. B. This answer is incorrect. There is no federal sales and use tax. C. This answer is incorrect. In 2019, a state law went into effect requiring sellers with over $100,000 in sales in California to collect sales tax, regardless of their connection to California. D. This answer is incorrect. Whether property tax is due has nothing to do with whether they were responsible at all for California sales and use tax. 26 Chapter 3 Franchise Tax Board Programs A – Introduction As explained earlier in this course, the Franchise Tax Board (FTB) administers California income taxes for individuals and businesses. However, the FTB interfaces with a number of other statewide and local agencies as part of its daily operations. This chapter briefly reviews these programs and the FTB’s overall organization. The chapter concludes with a discussion on the role of the Taxpayers’ Rights Advocate Office in particular. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify the main purpose of each of the five programs that the FTB operates in conjunction with other statewide and local agencies  identify the main characteristics of the FTB’s Voluntary Disclosure program  identify the main function of the FTB Taxpayers’ Rights Advocate Office  given examples of individuals who pay others to work in or around their home, determine whether an employer-employee relationship exists and identify any reporting requirements C – Franchise Tax Board (FTB) Mission According to the Franchise Tax Board’s 2017-2020 Strategic Plan, the mission is: “. . . to help taxpayers file timely and accurate tax returns and pay the correct amount to fund services important to Californians.”1 D – Other FTB Programs Not only does the FTB collect income taxes from individuals and businesses, it also performs a number of other functions such as the following. City Business Tax Program—Data Exchange The FTB exchanges data with participating cities to help identify self-employed individuals who are not meeting their individual and business filing requirements. Data provided by FTB to the cities helps cities identify businesses that may not be meeting their local business tax filing obligations. 27 Court-Ordered Debt (COD) The FTB is authorized by the Legislature to collect court-ordered debt on behalf of participating courts and agencies in all 58 counties. This debt includes debts imposed upon a person by California courts such as fines, state or local penalties, bail, forfeitures, restitution fines and orders, vehicle code violations, or any other amounts related to criminal offenses. The FTB’s administrative costs to operate this program are funded by the participating courts and agencies and may not exceed 15% of the amount collected by the FTB. E – Cancellation of Debt Income (CODI) When debt is written off in part or in full by a lender, an individual borrower may have to report Cancellation of Debt Income (CODI) indicated on a 1099-C. Such forgiven debt is treated as regular income for tax purposes. If a taxpayer does not pay a lender in full when a loan is due (and in the case of real property, for instance, if the property is sold and the lender cannot be repaid in full), the lender reports the loss to the IRS and to the FTB and sends the taxpayer a 1099-C, indicating the amount of debt cancelled. That is, this amount is taxable unless it corresponds to one of five exceptions provided by the IRC exceptions and incorporated into the California Revenue and Taxation Code:  The discharge occurred as part of bankruptcy.  The discharge occurred when the taxpayer was insolvent.  The discharge was associated with qualified farm indebtedness.  The discharge was associated with qualified real property business indebtedness (other than for a C corporation taxpayer).  The discharge occurred before January 1, 2013 and was qualified principal residence indebtedness. Between 2014 and 2019, if the taxpayer recognized CODI for federal tax purposes, the amount was deducted for California tax purposes. Whether or not there is relief from California tax on cancellation of debt income depends on the broader facts and circumstances surrounding an individual situation, including the type of debt (recourse or non-recourse) that has been discharged, the forum or situation leading to the discharge (bankruptcy court, insolvency), and possibly the occupation of the debtor (e.g., teachers). Note: If a debt is cancelled in a Title 11 case (i.e., Chapter 11 Bankruptcy), the taxpayer should include IRS Form 982 with both the federal and state tax returns to indicate that the debt has been discharged in bankruptcy. F – Interagency Intercept Collection (IIC) On behalf of the State Controller’s Office, the FTB operates the IIC program to intercept funds that would otherwise be paid to a taxpayer who has delinquent debts owed to government agencies and California colleges. In this program, the FTB reduces the amount paid to the taxpayer by the amount owed to the agency or college. The types of payments that are intercepted in this way include:  personal income tax refunds  lottery winnings  unclaimed property disbursements 28 Interceptions are made on behalf of:  participating California state, city, or county agencies  participating California state colleges, community college districts, or other post-secondary educational institutions G – Substandard Housing Program The Substandard Housing Program is designed to aid state and local agencies that are responsible for discouraging unsafe living conditions that violate the California Health and Safety Codes. The FTB carries out this task by disallowing income tax deductions claimed for interest, taxes, amortization, and depreciation on housing that city or county regulatory agencies have determined to be substandard according to the state or local health and safety codes. It is only these regulatory agencies that are authorized to issue determinations whether or not a given property is noncompliant or compliant with the codes. H – Vehicle Registration Collections The FTB has been collecting overdue vehicle registration fees since 1993 when the Legislature passed Revenue and Taxation Code Section 10878 which transferred this responsibility to the agency. This allows the California Department of Motor Vehicles (DMV) to focus on its primary services to its customers: motor vehicle licensing, driver’s license certification or renewal, and annual vehicle registration renewals. Each year a significant number of the approximately 26 million vehicle registration accounts to which the DMV has mailed renewal notices become delinquent. Because the DMV lacks the administrative authority to take involuntary collection actions, such as bank or wage levies, it must instead file actions against debtors in small claims court. I – Voluntary Disclosure Program The Voluntary Disclosure Program is designed to help obtain voluntary compliance with California tax laws. The program offers qualified entities, qualified shareholders, or beneficiaries the opportunity to voluntarily disclose their liability for any unmet filing requirement or other California tax liability they may have incurred. Under the conditions of the program:  Any of the above qualified entities or individuals who elect to participate in the program must disclose their California tax liability that pertains only to their last six taxable years.  The FTB will not levy penalties associated with the taxpayer’s return filings for the six-year period covered by the voluntary disclosure agreement.  The FTB will waive its authority to assess taxes, additions to taxes, fees, or penalties for the taxable years before the six taxable years that are the subject of the voluntary disclosure agreement. Although the general outline of the program might sound appealing at first glance, taxpayers and their representatives who are considering applying to participate are well-advised to consult the FTB website for more information as the definitions of qualified entities, qualified shareholders, and qualified beneficiaries are rather restrictive. 29 J – FTB Organization The FTB was created in 1929 with the office of the Franchise Tax Commissioner. Since 1929, the FTB has grown to over 6,000 people spread across 12 offices. The FTB is comprised of seven divisions and two other offices, each of which is responsible for a number of different functions. Each of the nine organizational units reports to the FTB Executive Officer. Division Subdivisions Legal Division  General Tax Administration and Procedure Bureau  Multistate and Business Entity Tax Bureau  Settlement and Litigation Bureau  Technical Resources Bureau Filing Division  Filing Compliance Bureau  Filing Methods and Budget Bureau  Filing Services Bureau  Processing Services Bureau Technology Services Division  Information Security Officer  Application Services  Operations and Infrastructure Services  Tax Systems Modernization Bureau Administrative Services Division  Business and Human Resources Bureau  Communications Services Bureau  Internal Audit Bureau  Privacy, Security and Disclosure Bureau 30 Division Subdivisions Accounts Receivable Management Division  ARM Advisory, Analysis and Services Bureau  Business Entity Collection Bureau  Field and Complex Account Collection Bureau  PIT Billing and Collection Services Bureau  Special Programs Bureau  Statewide Collection Bureau Audit Division  Audit Services, Administration, and Protest Bureau  Criminal Investigation Bureau  Individual and Pass Through Entity Audit Bureau  National Business Audit Bureau  Technical Resource and Services Bureau Finance and Executive Services Division  Economic and Statistical Research Bureau  Financial Management Bureau  Legislative Services Bureau  Planning and Project Oversight Bureau  Procurement Bureau Taxpayers’ Rights Advocate Office Below K – Taxpayers’ Rights Advocate Office The main purpose of this office within the Franchise Tax Board is to provide another avenue of communication for those taxpayers who have been unable to resolve their tax problems through the normal channels at the FTB. The goal of the Taxpayers’ Rights Advocate Office is to protect taxpayers’ rights and ensure that their tax problems are handled promptly and fairly, thus coinciding with the California Taxpayers’ Bill of Rights which requires the FTB to adequately protect the rights, privacy, and property of all California taxpayers when it assesses or collects tax. In order to ensure impartiality in its operations, the Taxpayers’ Rights Advocate and Executive and Advocate Services staff are independent of the Audit and Collections areas within the FTB. When a taxpayer contacts the Taxpayers’ Rights Advocate with an ongoing state income tax problem that he or she has been unable to resolve through the normal FTB channels, it is the representatives in the Executive and Advocate Services (EAS) division of the Taxpayers’ Rights Advocate Office who coordinate the resolution of the taxpayer’s complaints and problems. 31 Discretionary Relief Under certain conditions when a taxpayer who has been unable to find relief through the normal FTB channels is able to demonstrate that he or she did not contribute significantly to the tax matter in question, the Taxpayers’ Rights Advocate may use its discretionary authority to grant relief up to the amount of $10,000 for any taxable year. This authority allows the Taxpayers’ Rights Advocate to use its discretion to provide relief by abating penalties, fees, additions to tax, or interest under certain circumstances that are related to an FTB error or delay. Community Outreach The Taxpayers’ Advocate Office also is responsible for improving communication with the public, and as such it coordinates education and outreach efforts to provide tax information to a variety of its constituent groups. Speakers from the office present a variety of tax-related topics to taxpayers, tax practitioners, small business owners, and industry groups throughout California depending on the interest of each particular audience. The topics of interest presented most commonly include California tax updates, forms of ownership, and areas of noncompliance. L – Summary In this chapter we saw that the FTB has responsibilities within California that reach far beyond the administration of the tax code. A number of other organizations make use of the FTB’s database and collection tools to aid in the payment of debts that range from traffic fines to college fees to vehicle registrations. We also reviewed the organization structure of the FTB with an emphasis on the office whose job it is to safeguard the rights of taxpayers in their dealings with the FTB. In the next chapter we will review the rules that govern whether or not an individual is subject to the California taxes administered by the FTB. 32 Chapter 3 Review Questions 1. Which of the following statements is true regarding substandard housing? A. California provides a tax credit to improve such housing. B. When depreciation expense associated with substandard housing is reported on the federal return, California will provide a tax deduction for that expense. C. California disallows income tax deductions for substandard housing. D. California allows income tax deductions for substandard housing, including a deduction for property tax paid on that housing. 2. Which of the following statements is true regarding cancellation of debt income (CODI)? A. If a lender forgives a borrower’s debt, CODI is taxable regardless of the borrower’s financial circumstances. B. If a lender forgives a borrower’s debt, CODI is taxable as regular income. C. California requires the lender to report its loss to the Franchise Tax Board but not to the IRS. D. If a lender forgives a borrower’s debt, CODI is taxable as capital gains. 33 Answers to Chapter 3 Review Questions 1. A. This answer is incorrect. California disallows income tax credits for substandard housing. B. This answer is incorrect. California disallows income tax deductions for substandard housing, regardless of any depreciation expense. C. That’s correct! California disallows income tax deductions for substandard housing. D. This answer is incorrect. California disallows income tax deductions for substandard housing, regardless of any property tax owed or paid. 2. A. This answer is incorrect. If a lender forgives a borrower’s debt, CODI might not be taxable if the borrower was insolvent. B. That’s correct! Forgiven debt is considered “Cancelation of Debt Income” as is taxable. C. This answer is incorrect. California requires the lender to report its loss to the FTB and IRS. D. This answer is incorrect. If a lender forgives a borrower’s debt, CODI is taxable as ordinary income. 34 Chapter 4 Residency and Domicile A – Introduction The preparation of an accurate California tax return relies heavily on the accurate determination of the client’s residency status. Residency is significant because it determines how income is taxed by California. Determining residency involves collecting key facts to examine all the circumstances of the client’s particular situation. In this chapter we will review the rules and requirements that are used to determine whether individual taxpayers are California residents or nonresidents for tax purposes. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify the three residency categories into which taxpayers can be grouped for California tax purposes  identify the difference between the terms “domicile” and “resident” as they apply to California tax liability  identify the main characteristics of the Residency Safe Harbor and the six- and nine-month rules for determining a taxpayer’s California residency status  given examples of taxpayers who enter or leave the state, correctly determine their California residency status for tax purposes C – Resident Categories With respect to California, every taxpayer can be classified into one of the following categories:  resident  nonresident  part-year resident Each category is generally defined as follows. Resident A California resident is an individual who:  is present in California for reasons other than a temporary stay or because he or she is in transit to another destination  has his or her “domicile” in California, but is physically outside California for a temporary stay or because he or she is in transit to another destination Example: Jenny relocated permanently to Long Beach with her family in 2018. She is a California resident for tax purposes in 2019. 35 California Revenue and Taxation Code (R&TC) Section 17014(b) provides a special rule for certain U.S. government officials and their spouses. If those individuals have a California domicile, their absences from the state are considered to be temporary or transitory. Thus, they remain California residents for taxation purposes. This rule applies to the following persons:  any elected U.S. official  anyone on the staff of a member of the U.S. Congress  any presidential appointee, subject to Senate confirmation, other than military and foreign service career appointees According to R&TC Section 17014(c), any California resident individual who is temporarily absent from the state remains a resident of California throughout the period of his or her absence. Nonresident A nonresident is an individual who does not qualify as a California resident according to the rules described above. An individual is generally considered to be in California for a temporary or transitory purpose if he or she is:  simply passing through the state  in California for a brief rest  in California for a vacation  in California for a short period to complete a particular transaction, perform a particular contract, or perform a particular engagement Example: Grant resided in San Diego until 2018 when he was transferred by his company to take up a new job in New York. He is a California nonresident for tax purposes in 2019. Part-Year Resident A part-year resident is an individual who qualifies as a California resident for part of the year and as a nonresident for the remainder of the year. Example: Phil lived in San Francisco but was laid off from his job in 2018. After six months of searching, he found a new job in Texas and relocated there in February 2019. He is a California part-year resident for tax purposes in 2019. Nonresident Spouse with No California-Source Income A nonresident pays tax only on California-source income as long as his or her income is below the threshold amounts provided by the FTB on its website. This residency issue can become more complicated than it seems. California taxpayers who file jointly for federal purposes must file a joint return for California except when one of the spouses was:  an active service member during the taxable year  a nonresident of California for the entire taxable year and had no California-source income during that year One challenge occurs when one spouse is domiciled in California and the other is a resident of and domiciled in a different state. One-half of the California-source income would, under community property rules, be attributable to the nonresident spouse. The couple would have to file a return indicating all of the California-source income. 36 However, if both spouses are domiciled in a separate property state and only one of them has Californiasource income, the spouse with the California-source income may file a separate California return. Military Service Members California has special rules for determining a military service person’s residency status:  A member who leaves California under permanent military orders is treated as a nonresident.  An out-of-state member stationed in California is treated as a nonresident (unless they adopt California as their domicile).  For a member who leaves California under permanent military orders but retains a California domicile and has a spouse who remains a California resident, the resident spouse is taxed on half of the community income. Under the Military Spouses Residency Relief Act (MSRRA), a taxpayer may be exempt from California taxation. The taxpayer:  must not have been in the military  must have been legally married to the military member  must have lived with the military spouse/RDP  must have had a military spouse with a permanent change of station (PCS) orders moving him or her to California  must have been domiciled in a state other than California This topic is covered in greater detail in FTB Publication 1032, Tax Information for Military Personnel. D – Reporting of Income Provided that their income exceeds certain thresholds that we shall see later in this chapter, the three categories of taxpayer must file a tax return to report on the following sources of income: Taxpayer Category Reported on California Tax Return Resident  Income from all sources Nonresident  Income from California sources Part-year resident  Income from all sources while a California resident and  Income from California sources while a nonresident E – Filing Requirements Domicile The above definition of a California resident included taxpayers who had their domicile in California but spent part or all of the year outside the state on a temporary stay. In order to understand the impact of this part of the definition, it is important to understand the meaning of the term “domicile.” In the State of California, the term “domicile” has a special legal definition that sets it apart from the term “residence.” This is contrary to the case in many other states where “domicile” and “residence” are regarded as interchangeable terms. 37 For tax purposes, a domicile is defined as the place where someone voluntarily establishes him or herself and family, not simply for a special or limited purpose, but with a current intention of making it her or his true, fixed, permanent home and main place of residence. It is the place where he or she intends to return to after being absent. A taxpayer can have only one domicile at a time. Once he or she acquires a domicile, it is retained until he or she acquires another. This means that a change of domicile requires the taxpayer to do all of the following:  Abandon his or her prior domicile.  Physically move to the new locality and reside there.  Demonstrate by his or her actions the intent to remain in the new locality permanently or indefinitely. A residence is a dwelling abode that has some permanency beyond a merely temporary lodging place. In most cases an individual’s domicile and residence will be the same physical location. An individual can have only one domicile at a time, as noted above, but he or she can have several residences. The main difference between a domicile and a residence is the intent of the individual regarding the location that he or she intends to make a home either permanently or indefinitely. The following examples may help to clarify the distinction between the two terms according to California’s interpretation. Example: Wade is domiciled in Texas and comes to Los Angeles on business. His intention is to return to Texas as soon as his project in California has been completed. While in California he maintains a home in Los Angeles and stays in California for ten months. Residency Determination: Wade retains his Texas domicile because his stay in California was for a limited purpose. Example: Sherry moved from Oregon to California in September of 2018 to begin a permanent job. She sold her home in Oregon and bought a home in California. She moved all her personal belongings to California, opened a California bank account, and got a California driver’s license. She has no intention of returning to Oregon. Residency Determination: Sherry became a California domiciliary in September of 2018 when she moved to California. She came to California with the intention to remain there indefinitely with no fixed intention of returning to Oregon. Example: Mark and his wife Cindy were both born and raised in California. Mark obtained employment in San Jose right after his graduation from a California college in 2006. In 2016, Mark was sent to Australia for a one-year assignment. While Mark was away Cindy remained at their California home with their two children. While living and working in Australia, Mark rented an apartment and joined a local social club. He returned to California in 2017. Residency Determination: Mark remained domiciled in California throughout his absence. He maintained his ties with California and the ties he established with Australia did not demonstrate that he intended to remain there permanently. California Gross Income and Adjusted Gross Income Thresholds Taxpayers whose incomes exceed the thresholds in the table below and are deemed to be 2019 residents of California will file their tax returns on either California Resident Income Tax Return Form 540 or Form 540 2EZ. A return must be filed if either the California Gross Income or the California Adjusted 38 Gross Income exceeds the threshold amount shown below for filing status, age, and number of dependents. If California state income tax was withheld or California estimated tax payments were made, a return should be filed in order for the taxpayer to get a refund. Filing Status Age as of December 31, 2019* California Gross Income California Adjusted Gross Income Dependents Dependents 0 1 2 or more 0 1 2 or more Single or head of household Under 65 $17,693 $29,926 $39,101 $35,388 $47,621 $56,796 65 or older $23,593 $32,768 $40,108 $41,288 $50,463 $57,803 Married/RDP filing jointly or separately Under 65 (both spouses /RDPs) $47,188 $56,363 $63,703 $14,154 $26,387 $35,562 65 or older (one spouse) N/A $29,926 $39,101 $20,054 $29,229 $36,569 65 or older (both spouses /RDPs) N/A $32,768 $40,108 $28,312 $40,545 $49,720 Qualifying widow(er) Under 65 N/A $29,926 $39,101 $34,212 $43,387 $50,727 65 or older N/A $32,768 $40,108 $40,112 $49,287 $56,627 Dependent of another person (Any filing status) Under 65 More than his or her standard deduction 65 or older More than his or her standard deduction * If a person turns 65 on January 1, 2020, she or he is considered to be age 65 at the end of 2019. California Gross Income consists of all non-exempt income received from all sources in the form of money, goods, property, or services. California Adjusted Gross Income consists of a taxpayer’s federal adjusted gross income from all sources, reduced or increased by California adjustments. 39 Residency Issues and Filing Requirements Taxpayers who do not meet the definition of California residents are regarded as nonresidents for tax purposes. These individuals are only of interest to the State of California if they have income from sources in California. California nonresidents are only required to file a California tax return if the following two conditions are met:  Their income from all sources exceeds the threshold amount in the table above appropriate to their filing status and number of dependents.  Part of their income is from California sources. Taxpayers who meet these conditions must file their tax return using either the Long Form 540NR or the Short Form 540NR, California Nonresident or Part-Year Resident Income Tax Return. Individuals who qualify as part-year residents may also be required to file a California tax return to report their income for tax purposes. California part-year residents must file a California tax return if their total taxable California income exceeded the amounts shown in the table above appropriate to their filing status and number of dependents. For the purpose of part-year residents, “total taxable California income” includes both:  the taxpayer’s income from all sources while a California resident  income from California sources while a California nonresident Taxpayers who meet these conditions must file their tax return using either the Long Form 540NR or the Short Form 540NR, California Nonresident or Part-Year Resident Income Tax Return. State Income Tax Withholding Businesses with employees working in California must withhold and pay California income tax on those employees’ salaries in addition to withholding and paying federal income tax. A taxpayer who did not owe any federal income tax for the previous year and does not expect to owe may be exempt from California withholding. For the nonresident who earns income over $1,500 in a calendar year, the payor must withhold 7%. F – Guidelines for Determining Residency Now that we have reviewed the general nature of the three categories of residency status, let us go further and discuss the rules that govern those cases where a taxpayer’s living situation does not fit neatly into a given category. Residency Safe Harbor: Being Out of State for an Employment Contract From what we have seen so far, it would appear at first glance that a taxpayer who leaves California temporarily without selling his or her home runs the risk of being taxed on all worldwide income by California, whether or not the taxpayer sets foot in the state. Fortunately, a safe harbor rule was created to address this situation for certain individuals who are domiciled in California but leave California under employment-related contracts and are absent of at least 546 consecutive days. The FTB established this rule for tax years beginning on or after January 1, 1994. This safe harbor does not apply to a person who has intangible income of over $200,000 for an employment-related contract year or the main purpose of being absent from California is personal income tax avoidance. 40 Spouses or RDPs of persons covered by this safe harbor can also benefit from the rule, unless any return visit to the state does not exceed a total of 45 days during the taxable year. The safe harbor allows for a taxpayer who is domiciled in California but who is outside California under an employment-related contract for an uninterrupted period of at least 546 consecutive days to be considered a nonresident unless one or both of the following two conditions is met:  The taxpayer’s intangible income exceeds $200,000 in any taxable year during which the employment-related contract is in effect.  The taxpayer’s main purpose for being absent from California is to avoid personal income tax. The spouse (or Registered Domestic Partner) of an individual covered by this safe harbor rule will also be considered a nonresident while he or she accompanies the individual outside California for at least 546 consecutive days. Temporary return visits to California that do not exceed a total of 45 days during any taxable year covered by the employment contract will not prevent the taxpayer from being able to claim the benefits of the safe harbor rule. The residency status of individuals who do not meet the requirements of the safe harbor is determined based on the facts and circumstances of each case. Taken on its own, an individual taxpayer’s occupation, business, or vocation is insufficient for the determination of his or her residency status. Instead, all relevant information available is taken into account when determining residency status. For example, students (who are residents of California) who leave the state to attend a school in another state do not automatically become nonresidents, nor do students (who are nonresidents of California) who come to California to attend school automatically become residents. In situations such as these, taxpayers must determine their residency status based on their individual facts and circumstances (as will be discussed later in the chapter). Safe Harbor Examples The following questions and answers will provide some insight into the workings of the safe harbor rule. Question 1: Olivia is a California resident who agreed to work in China for one year. She returned to California after her employment contract expired. After staying in California for three months she signed another contract with the same employer to return to China and work there for another year. Does Olivia file a resident or nonresident return? Answer: Unfortunately for Olivia, she cannot be considered a nonresident under the safe harbor rule because she did not meet the condition that required her to be absent from California for an uninterrupted period of at least 546 consecutive days for employment reasons. Even though she was absent for a total greater than 546 days, she cannot combine the days from the two separate contracts. Olivia thus remains a California resident and will file a resident return. Question 2: Frank is a California resident who transferred for a two-year work assignment to his employer’s head office in Sweden. While still based in Sweden, Frank returned to California for a threeweek vacation. Does Frank file a resident or nonresident return? Answer: Under the provisions of the safe harbor rule, Frank was a nonresident of California for the two years that he was working in Sweden. His three-week visit to California did not disqualify him because it was less than 45 days and is thus considered temporary. Therefore, Frank files a nonresident return. Question 3: Krystal and Bob are married and are California residents. Krystal agreed to work in Qatar for 22 months under an employment contract. Her family remained in Pleasanton, CA. At the midpoint of her contract she returned to visit her family in Pleasanton for a month. How do Krystal and Bob file their California tax return? 41 Answer: Thanks to the safe harbor rule, Krystal can be considered a nonresident during her absence. Her month-long visit to California is considered temporary since it did not exceed the 45-day threshold. Bob is still considered a resident of California because he remained there during the period that Martha worked in Qatar. As is the case for all married couples, Krystal and Bob have two options for filing their California tax return:  For a joint return, they would use Form 540 NR, the nonresident return.  For a separate return, Martha would use Form 540NR and Bob would use Form 540. Closest Connections In general, a person is a resident of California if California is the place where that person has his or her “closest connections.” A number of the factors that can be used to help determine taxpayer residency status are shown in the list below. Tax practitioners will need to compare their clients’ ties to California with their ties to other places. When making use of these factors, practitioners should bear in mind that a client’s residency is determined by the strength of his or her ties, not simply the number of ties. Some of the main factors to consider when determining residency for a client are as follows:  the amount of time the client spends in California versus amount of time he or she spends outside California  the location of the client’s spouse (or Registered Domestic Partner) and children  the location of the client’s principal residence  the state that issued the client’s driver’s license  the state where the client’s vehicles are registered  the state in which the client maintains his or her professional licenses  the state in which the client is registered to vote  the location of the banks where the client maintains accounts  the origination point of the client’s financial transactions  the location of the client’s medical professionals and other health care providers (doctors, dentists, etc.), accountants, and attorneys  the location of the client’s social ties, such as the client’s place of worship, professional associations, or social and country clubs of which he or she is a member  the location of the client’s real property and investments  the permanence of the client’s work assignments in California The above is by no means an exhaustive list of the factors that should be considered. Practitioners should take all of the facts of a client’s particular situation into account to determine his or her residency status. Temporary or Transitory Purposes As stated above, a taxpayer’s state of residence is generally that in which the taxpayer has his or her closest connections. When a taxpayer departs from his or her state of residence, it is important to determine if the client’s presence in a different state or country is for a temporary or transitory purpose. The purpose and length of the taxpayer’s stay must also be considered when determining residency. 42 Taxpayers Entering California By definition, anyone who is present in California for temporary or transitory purposes is considered a nonresident of California. For example, a taxpayer who comes to California for a vacation at the beach, to complete the purchase of a car, or is simply passing through LAX on the way to a vacation in Hawaii, can be said to have a temporary or transitory purpose for his or her presence in California. As a nonresident, that taxpayer is taxed only on his or her income from California sources. On the other hand, a taxpayer who is present in California for other than a temporary or transitory purpose is considered a resident of California. For example, a taxpayer who is assigned by his employer to an office in California for a long or indefinite period, or who retires and comes to California with no specific plans to leave, or who is ill and is in California for an indefinite recuperation period can be said to be in California for a purpose that is other than temporary or transitory. As a resident, that taxpayer is taxed on income from all sources. Even though a taxpayer may have connections with another state, he or she is regarded as a California resident if his or her stay in California is for other than a temporary or transitory purpose. As resident, the taxpayer will have all income from all sources within reach of the California taxing authority. Incoming Taxpayer Examples The following questions and answers will provide some insight into the classification of individuals who enter California. Question 1: David is a sales engineer who lives in Connecticut with his family. Every three months he travels to other states to visit his clients. His average stay in each location is one or two weeks and the total time spent in California for any taxable year does not exceed six weeks. His family usually remains in Connecticut while he is away on business. How is David treated for California tax purposes? Answer: Because his stays in California are temporary or transitory in nature, David is not considered to be a California resident. As a nonresident, he is taxed only on his income from California sources, which also includes his income for services performed in California. Question 2: In November 2016, Barbara moved to Los Angeles from Ohio on an indefinite job assignment. She rented an apartment in LA and continued to live there. She kept her house and bank account in Ohio until March 2017, at which time she sold her house and transferred her bank account to California. How is Clara treated for California tax purposes? Answer: Barbara’s assignment in California was for an indefinite period, which means that her stay in California was not of a temporary or transitory nature. As a result, Barbara became a California resident upon entering the state in November 2016, even though she maintained her ties in Ohio until March 2017. For the 2016 tax year Barbara is a California part-year resident (i.e., a nonresident until November and then a resident for the remainder of the year). For the 2017 tax year Barbara is a California resident. And as a resident she is taxed on her income from all sources. Taxpayers Leaving California Any individual who leaves the state for a temporary or transitory purpose continues to be a resident of California for tax purposes. But as covered in the discussion about the safe harbor rules, a taxpayer who is absent from California under an employment-related contract for a period of at least 546 consecutive days may be considered to be an exception to the previous statement. 43 Departing Taxpayer Examples The following questions and answers will provide some insight into the classification of individuals who leave California. Question 1: Lonnie was a resident of California until October 2016. At that time, he declared himself to be a resident of Idaho, where he has a vacation home. He has kept his home in California and continues to spend about six or seven months there each year. He spends only about three months each year in Idaho in between traveling to other states and countries. Although he has transferred his bank accounts to Idaho, he continues to maintain his golf club and business connections in California. How is Lonnie treated for California tax purposes? Answer: Lonnie’s action of declaring residency in Idaho does not by itself establish residency for him in that state. His closest connections are to California, he spends more time there than anywhere else and his absences from California are for temporary or transitory purposes. As a result, Lonnie is a resident of California and is taxed on his income from all sources. Question 2: Ginny and her husband Paul are California residents. Ginny accepts a contract to work in Chile for 14 months and leases an apartment near her office there. Meanwhile Paul and the children will remain in California, living in the family home. Before accepting the job, Ginny made sure that her contract states that her employer will arrange her return back to California at the conclusion of her assignment. How are Ginny and Paul treated for California tax purposes? Answer: Ginny maintains strong ties with California because Paul and the children will remain in their California home during her absence. As guaranteed by her contract, Ginny’s clear intent is to return to California, and her absence is temporary and transitory. Ginny remains a California resident during her absence outside the state. She and Paul are taxed on income from all sources, including income earned in Chile. Question 3: Mauro receives and accepts a permanent job relocation to Brazil. He and his wife Fran sell their home in California, pack up their three children and all of their possessions and move to Brazil on June 2, 2017. Mauro and Fran lease an apartment in Sao Paulo and then enroll their children in school. Mauro and Fran both obtain driver’s licenses from Brazil and make a number of sporting and social connections in their new home. They have no intention of returning to California. How are Mauro and Fran treated for California tax purposes in 2017? Answer: Mauro and Fran are part-year residents. Up until June 1, 2017, they were California residents, but on June 2, 2017, they became nonresidents. All of their income while they were residents is taxable by California. From the point in time that they become nonresidents, only income from California sources is taxable by California. They will file as part-year residents for the 2017 tax year. Question 4: Trevor is a resident of California who accepts a 15-month job assignment in Afghanistan. Trevor puts his personal belongings in storage in California, including his car and motorcycle. He is registered to vote in California and has a California driver’s license. Trevor maintains his bank accounts in California while he is out of the country and plans to return to California after completing his assignment. In Afghanistan he stays in a compound provided for him by his employer, and the only ties he establishes there are connected to his employment. How is Trevor treated for California tax purposes? Answer: Trevor has kept more connections with California than he has established in Afghanistan, and because he is on a fixed-term assignment his absence is for a temporary or transitory purpose. As a result, Trevor remains a California resident while he is in Afghanistan. As a California resident, Trevor’s income from all sources is taxable by California, including the income that he earns from his assignment in Afghanistan. 44 Question 5: Miriam is a single taxpayer and a resident of California. She accepts a two-year assignment in Fiji, covering the period from January 1, 2016, to December 31, 2017. Miriam rented out her condo and put her car and other belongings in storage in California. She has kept her California bank accounts, voter registration, and driver’s license. Miriam has less than $200,000 of intangible income during each of the two years of her contract. Her intention was always to return to California after completing her assignment. Miriam returned to California on vacation for the months of July 2016 and June 2017. How is Miriam treated for California tax purposes? Answer: Miriam meets the safe harbor rule because she was outside California on an employer-related contract for more than 546 uninterrupted days, and did not return to California for more than 45 days in 2016 or 2017. She is therefore considered to be a nonresident during her absence from the state and will file a nonresident return. Nine-Month and Six-Month Rules There are some guidelines as to where to draw the line for resident/temporarily absent versus nonresident who spends some time in California. Revenue and Tax Code Section 17016 aims to help remove the ambiguity that may arise from a taxpayer’s presence in California for what he or she may consider a temporary purpose. Under this rule an individual is presumed to be a California resident for any taxable year in which he or she spends more than nine months in the state. This distinction has a dramatic difference on income tax owed to California. For the person staying in California for an aggregated period of under six months in a tax year, the temporary or transitory purpose applies. For the person staying more than nine months, the presumption of residency applies. The nine-month presumption can be rebutted with sufficient evidence. The sixmonth safe harbor can also be taken away for the individual engaging in certain activities (i.e., anything for profit). The nine-month rule is intended as more of a guideline than a hard and fast rule. If an individual can provide satisfactory evidence that he or she is in the state for a temporary or transitory purpose, the presumption of residency that would otherwise take effect after nine months can be nullified. It should be noted that this rule was only intended to be applied in the case of a taxpayer who has entered the state from another jurisdiction. It should not be assumed that a given taxpayer is automatically classified as a nonresident simply because he or she was present in California for less than nine months. As we have already seen, under certain conditions a taxpayer may be classified as a California resident even though he or she did not set foot in the state during the year. Common reasons for a person to be present or even domiciled in California for a temporary or transitory purpose is to vacation, to complete a transaction, or to pass through on the way to somewhere else. The key determinant of residency is the “temporary or transitory” character of the person’s purpose. However, some actions that might seem to speak toward a more permanent status, such as opening certain bank accounts (e.g., for personal expenses), owning a home, joining country clubs, etc. – these by themselves do not destroy someone’s purpose as being temporary or transitory. Retiring to California or staying in California to recover from an illness (for an indefinite period) would be more likely to constitute stays that are not temporary or transitory. A detailed discussion of the meaning of the term “temporary or transitory purpose” is provided in California Code of Regulations (CCR) Section 17014(b). According to that regulation, the facts and circumstances of each particular case have a large bearing on the determination of whether or not an individual is in California for a temporary or transitory purpose. Individuals who are in California under any of the above circumstances would be considered to be nonresidents of California. 45 On the other hand, an individual would be considered to be present for other than temporary or transitory purposes if he or she is in California:  for retirement with no set intention to leave within a short period of time  to recover from an illness or injury for an indefinite or relatively long period of time  for a business purpose that will take an indefinite or relatively long period of time to accomplish  for work in a position that may last for an indefinite period of time or permanently Example: Kevin and Sue are domiciled in Nebraska where they have maintained their family home for five years. Kevin works for a large university, but in September 2016 he took a six-month leave of absence to become a temporary consultant for a California university. He and Sue moved to San Diego in September 2016, rented an apartment and opened a checking account. Meanwhile their home in Nebraska was left vacant and they retained their Nebraska bank accounts. They stayed in California from September 2016 until February 2017, when they returned to Nebraska. Residency Determination: Kevin and Sue were in California for a short period for the purpose of Kevin completing a particular engagement as a temporary consultant. Kevin and Sue were in California for a temporary or transitory purpose and thus they are nonresidents of California for tax purposes. Example: Bill is domiciled in Kansas and has lived there for 40 years. Two years ago he developed a serious medical condition related to his respiratory system. His doctor told him to live in a warm climate near the ocean until he recovers, which may take several years. Bob took his doctor’s advice and moved to southern California. Residency Determination: Bill is present in California for an indefinite period while he recovers from his illness. His stay in California is therefore not for a temporary or transitory purpose and thus he is a California resident for tax purposes. The individual:  must be domiciled outside California and maintain a permanent place of residence at the domicile location  must not take part in any activities or engage in any other conduct within California beyond what is normally expected of a seasonal visitor, tourist, or guest Regular visitors to the state can normally be expected to establish some ties to California, but the following connections will not, in and of themselves, cause an individual to lose his status as a seasonal visitor, tourist, or guest:  owning or maintaining a home  opening a bank account for the purpose of paying personal expenses  holding membership in local social clubs Example: Paul and Kathy lived and worked in Minnesota for 20 years until they retired in the summer of 2013. Starting from winter that year, the couple spends four months each year in California. They return to Minnesota in the spring and spend the next eight months at their family home that they have owned since 1993. They both have valid Minnesota driver’s licenses, are registered to vote in Minnesota, and maintain Minnesota bank accounts. Paul and Kathy also own a small California home which they use during their annual stay in the state. For the sake of convenience, they also opened a California checking account that they use for their personal expenses. The couple are members of a California country club. Their time in California is purely leisure for the two retirees and they do not engage in any California business activities. 46 Residency Determination: Under the conditions laid out in CCR Section 17014(b) Paul and Kathy are considered to be seasonal visitors who are present in California for temporary or transitory purposes. As a result, they are nonresidents of California. G – Summary While we saw in this chapter that the residency status of an individual taxpayer has a direct impact on how he or she is treated for California tax purposes, we also saw that the matter of determining residency status can be quite involved. Depending on a given taxpayer’s situation, he or she may be considered a resident, nonresident, or part-year resident. The tax treatment differs for each of these categories, and although the safe harbor rule and nine-month rule help to provide clarification, the facts and circumstances of each case must always be taken into consideration when determining California residency status. 47 Chapter 4 Review Questions 1. Bill is domiciled in Kansas and has lived there for 40 years. Two years ago he developed a serious medical condition related to his respiratory system. His doctor told him he should live in a warm climate near the ocean until he recovers. The doctor advised Bill that that recovery could take years. Bill took his doctor’s advice and moved to southern California. Is Bill considered a California resident for California income taxation purposes? A. Bill is present in California for an indefinite period. His stay in California is therefore not for a temporary or transitory purpose; he is a California resident for tax purposes. B. Bill is present in California for over nine months, but he will be allowed to claim that he is a resident of Kansas for California tax purposes. He will therefore owe no California state income tax. C. As indicated, Bill maintains his Kansas home. He will therefore be treated for California income tax purposes as a visitor under the six-month rule. D. Because Bill moved to California and remained there for medical purposes, the six-month rule applies to the situation; he is not a California resident. 48 Answers to Chapter 4 Review Questions 1. A. That’s correct! He stayed in California for more than nine months. The nine-month rule would apply, and he would be treated as a California resident for California income tax purposes. B. This answer is incorrect. The nine-month rule operates as a guideline for the threshold at which a person will be treated as a California resident for California income tax purposes. C. This answer is incorrect. Keeping an out-of-state home will not exempt a person from being treated as a California resident for California income tax purposes. D. This answer is incorrect. The purpose for Bill’s staying in California does not counteract the ninemonth rule, which speaks to Bill’s being in California other than for a transitory purposes. He will be treated as a California resident for California income tax purposes. 49 Chapter 5 Household Employers and Employees A – Introduction Consistent with nationwide efforts to close the tax gap and ensure all individuals pay the correct amount of tax, the Internal Revenue Service and a number of state agencies have begun to devote more attention in recent years to the area of household employees. In this chapter we will review the rules that govern household employers and the tax liabilities they and their employees face in California. We will begin by defining which individuals qualify as employers and employees and then discuss the details of employee compensation. We will conclude by discussing the employer’s reporting and withholding obligations. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  given examples of individuals who pay others to work in or around their home, determine whether an employer-employee relationship exists  given details of an employer’s salary payments, identify the nature and timing of the employer’s reporting obligations C – Household Employers Definition of Employer An individual who pays wages to one or more people to work as employees in or around his or her home on a full-time, part-time, or even temporary basis may be considered to be a household employer. However, not every person who performs work for the benefit of a taxpayer in this situation can be considered an employee. The following table offers some examples of the type of workers that are typically considered household employees compared with those that are not employees of the homeowner. Household Employees Not Household Employees Cooks Self-employed carpenters Gardeners Workers employed by a lawn service company Housekeepers Plumbers employed by an independent company Home health aides Nurses leased from a temporary employment agency Pool maintenance workers Workers employed by a pool maintenance company 50 Definition of Wages Wages paid to an employee can take many forms such as cash, check, or non-cash compensation such as the fair value of meals and lodging. The main point is that all compensation an employee receives for his or her personal services are considered to be wages, and as such they are potentially subject to taxation. This principle applies regardless of whether a worker is engaged on a casual or temporary basis, as a day laborer, or as part-time or full-time. Other payments related to the employee’s job such as performance bonuses, commissions, overtime pay, and vacation pay are also regarded as wages. Withholding from Wages A household employer who employs one or more people to perform work on his or behalf may be subject to the requirement to withhold payroll taxes from the wages of the employee(s). The threshold for this requirement is when the employer pays a total of $750 or more in cash wages to an employee within a calendar quarter. The employer must register with the Employment Development Department (EDD) within 15 days of reaching or passing the $750 mark. Registration can be performed by telephone, online, or by filing the Form DE 1HW, Registration Form for Employers of Household Workers. When completing this registration, the employer has the option to elect to pay his or her payroll tax obligations on an annual basis rather than quarterly, which is the default option. However, if the employer pays a combined total of $20,000 or more in wages during the year, then the associated payroll taxes must be remitted to the EDD on a quarterly basis. There are thus two types of household employers in terms of their reporting requirements:  quarterly employers  annual employers Their obligations can be summarized as follows: Type of Employer Reporting of Wages Payment of Taxes Quarterly Quarterly Quarterly Annual Quarterly Annually Regardless of whether an employer pays taxes annually or quarterly, employee wages and withholding are reported each quarter according to the schedule below. When the due date falls on a Saturday, Sunday, or legal holiday, the next business day is considered to be the last timely date. Report Covering Filing Due Dates January, February, March April 1 April, May, June July 1 July, August, September October 1 October, November, December January 1 51 D – Forms for Reporting As mentioned above, the main difference between annual and quarterly employers is the frequency of their payments of taxes related to their employees’ wages. The table below summarizes the related forms and reporting intervals. Employer Type Every Quarter Every Year Quarterly Employer  Quarterly Contribution Return and Report of Wages (DE 9)  Quarterly Contribution Return and Report of Wages (Continuation) (DE 9C)  Payroll Tax Deposit (DE 88) with payment N/A Annual Employer  Employer of Household Worker(s) Quarterly Report of Wages and Withholdings (DE 3BHW) Employer of Household Worker(s) Annual Payroll Tax Return (DE 3HW) with payment Payroll Taxes The type(s) of payroll taxes that the employer must withhold from the employee’s wages depends on the total amount of wages paid to the employee during the calendar quarter. Please see the following table. Total Wages per Quarter Withholding Requirement Below $750 None From $750 to $999.99 State Disability Insurance (SDI) only $1,000 or above State Disability Insurance (SDI), Unemployment Insurance (UI), and Employment Training Tax (ETT) While household employers are not required to withhold California income tax from the employee’s wages, they are still required to report to the EDD the taxable wages paid to each employee. Value of Meals and Lodging Employers need to be aware that any meals and lodging provided to their employees are considered wages, and as such need to be assigned a monetary value. For employees who are covered under a contract of employment or union agreement, the taxable value of meals and lodging should not be less than the estimated value stated in that document. If the cash value is not stated in an employment contract or union agreement, the tables and information below supplied by the EDD can be used to determine the value of the meals and/or lodging an employer provides to his or her employees. Value of Meals Tax Year 3 Meals per Day Breakfast Lunch Dinner Meal Not Identified 2019 $11.80 $2.40 $3.65 $5.75 $4.25 52 To calculate the value of lodging for a client, multiply the amount that he or she could rent the property for (ordinary rental value) by two-thirds (0.6667). Ordinary rental value may be calculated on a monthly or weekly basis. The table below shows the minimum and maximum amounts to report for lodging. Value of Lodging Year Minimum per Week Maximum per Month 2019 $49.55 $1,528 Calculating the Taxable Amounts As we have just seen, employees may also receive noncash compensation such as meals and lodging in addition to wages by cash or check. This noncash compensation is ignored when calculating whether the employer has reached the $750 and $1,000 thresholds for registration and withholding, but such compensation is taken into account when calculating the basis on which the applicable payroll taxes should be calculated. Example 1: George paid his gardener a total of $720 in cash during the last quarter and provided meals for him to the value of $100. George can ignore the $100 value of the meals provided to the gardener because he has not yet reached the cash wage limit of $750. He is thus not required to register with the EDD. Example 2: Martha paid her home health aide a total of $790 in cash during the last quarter and provided meals for her to the value of $50. Martha must now register with the EDD because she has passed the $750 threshold. She must also withhold SDI, and she must do so on the entire $840 in compensation that the employee received. Example 3: Nancy paid her housekeeper a total of $850 in cash during the last quarter and provided meals for her to the value of $200. Nancy must now register with the EDD because she has passed the $750 threshold. She must also withhold SDI based on the entire $1,050 in compensation that the employee received. She is not required to pay UI and ETT because her total cash wages paid have not yet passed the $1,000 mark. Example 4: Keith decided to outsource the maintenance of his swimming pool and paid a part-time employee a total of $1,180 in cash during the last quarter and provided meals for him to the value of $100. Keith must now register with the EDD because he has passed not only the $750 threshold but also the $1,000 mark. He must withhold SDI and pay UI and ETT on the entire $1,280 in compensation that the employee received. Wage Variations Although an employer may have registered with the EDD and started to report and pay taxes related to his or her employees, there is always the possibility that the number of employees and amount of wages paid may vary over time. Increases in employees and wages paid are easily accounted for in the quarterly reporting process, but reductions in subsequent quarters below the $750 and $1,000 wage threshold amounts call for different treatment. For Employers Liable for SDI Only If the wages paid by an employer fall below $750 in a given quarter, the employer must continue to withhold SDI from his or her employee’s wages for the remainder of the current year and for the entire calendar year that follows. 53 For Employers Liable for SDI, UI, and ETT If the wages paid by an employer fall below $1,000 in a given quarter, the employer must continue to withhold SDI from his or her employee’s wages for the remainder of the current year and for the entire calendar year that follows. The employer must also continue to pay UI and ETT for the same period (until the end of the following calendar year). E – Summary In this chapter we defined the nature of household employers and employees and saw that an employee’s taxable income can take the form of meals and lodging in addition to the cash payments that we normally think of as salary. We also saw that California employers have various registration, reporting, and withholding obligations that are based on the amount of taxable income they provide to their employees. 54 Chapter 5 Review Questions 1. Vida paid her home health aide a total of $790 in cash during the last quarter and provided meals for her to the value of $50. Which of the following is not required of Vida? A. Vida must register with the EDD because she passed the $750 threshold. B. Vida must withhold SDI on the $840 in total compensation. C. Vida must register with the IRS because she passed the $750 threshold. D. Vida must register with the FTB because she passed the $750 threshold. 2. Under which circumstances will Ricki be considered a household employer and have to withhold money from payments she makes in return for household services? A. Ricki has an unemployed friend. Ricki takes on that friend as a part-time, paid-in-cash housekeeper. B. Ricki searches on the Internet for lawn services and finds one near her house called “Plano Lawn Services, Inc.” She chooses this landscaper to provide occasional lawn services and pays Plano Lawn Services, Inc. in cash. C. Ricki searches on the Internet for lawn services and finds one near her house called “Plano Lawn Services, Inc.” She chooses this landscaper to provide occasional lawn services and pays Plano Lawn Services, Inc. with a personal check. D. Ricki is so happy with the services she purchases every week from Plano Lawn Services, Inc. that she decides to provide expense reimbursement for her landscaper’s commuting expenses. 55 Answers to Chapter 5 Review Questions 1. A. This answer is incorrect. The question asks what is not required of Vida. Vida must register with the EDD because she passed the $750 threshold. B. This answer is incorrect. The question asks what is not required of Vida. Vida must withhold SDI on the $840 in total compensation. C. That’s correct! It is not required for Vida to register with the IRS because she passed the $750 threshold. D. This answer is incorrect. The question asks what is not required of Vida. Vida must register with the FTB because she passed the $750 threshold. 2. A. That’s correct! The friendship is irrelevant in determining whether payments in cash for services are income. They are taxable as income. B. This answer is incorrect. The landscaper is employed by Plano Lawn Services, and it is that company’s responsibility to withhold any taxes. Form of payment makes no difference. C. This answer is incorrect. The landscaper is employed by Plano Lawn Services, and it is that company’s responsibility to withhold any taxes. Form of payment makes no difference. D. This answer is incorrect. The landscaper is employed by Plano Lawn Services, not Ricki. 56 Chapter 6 Gross Income, Adjusted Gross Income, and Profits A – Introduction In preparing a California tax return, the preparer uses the federal adjusted gross income as a starting point and makes adjustments based on differences between federal and state tax law. California tax law is based primarily on the January 1, 2015 federal Internal Revenue Code (IRC). California tax law conforms in some areas to rules established or changed by the 2017 Tax Cuts and Jobs Act (TCJA), but there are important areas in which they differ. This chapter focuses on the items California requires the taxpayer to treat as income. The course later covers how various adjustments are required on the California return to arrive at California adjusted gross income. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify the components of gross income  understand the difference between gross income and adjusted gross income  understand the difference between gross profit and gross receipts C – Income Federal tax requires the taxpayer to report income from any source. California gross income is a little different on this issue, especially with respect to income earned from non-California sources and outside of California by a California resident or a non-resident with some income in California. California’s definition of adjusted gross income is the same as the federal, but California does not recognize deductions for certain expenses that are above-the-line on the federal return. These nonCalifornia deductions include such things as the qualified expenses incurred by elementary and secondary school teachers and attorney’s fees and court costs paid related to whistleblower awards related to tax code violation reporting/whistleblowing. Wages Wages paid to an employee can take many forms such as cash, check, or non-cash compensation such as the fair value of meals and lodging. The main point is that all compensation an employee receives for his or her personal services are considered to be wages, and as such they are potentially subject to taxation. This principle applies regardless of whether a worker is engaged on a casual or temporary basis, as a day laborer, or as part-time or full-time. Other payments related to the employee’s job such as performance bonuses, commissions, overtime pay, and vacation pay are also regarded as wages. All compensation from an employer is considered income: earnings, bonuses, commissions, severance pay, tips, and anything else received in return for the performance of services for that employer. 57 Family Support Payments Alimony is spousal maintenance. Child support is what is paid by a parent to provide health insurance and otherwise provide financial support for that parent’s children. In California, child support is sometimes called “family support.” Alimony Alimony is treated differently by the federal government and the California government for tax purposes. When a couple legally separates or divorces, the decree or order may indicate that one spouse/former spouse pay monthly support to the other. In California, alimony payments are taxed to the recipient and deducted by the payor. That is, alimony payments are treated as income by California. Beginning in the 2019 tax year, federal alimony tax rules changed. Before this change, the person paying the alimony could deduct the payments he or she made. This deduction would happen above-the-line. The recipient would have to pay the taxes on alimony (i.e., as part of income). For marriage settlement agreements on or before December 31, 2018, alimony received or paid is reported on the taxpayer’s federal return. These amounts will also be reported to California. For marriage settlement agreements signed after December 31, 2018, alimony received or paid is not reported on the taxpayer’s federal return. The California return will require an adjustment for alimony received or paid. Federally, alimony goes from one spouse to the other tax-free. Any payments one spouse makes to the other for things like property settlement, retirement benefits from community property, and voluntary payments do not count as alimony. Capital Gains and Losses Under federal law, capital gains have lower tax rates. Under California law, there is no such distinction – gains are taxed as ordinary income. All gains and losses from the sale or exchange of capital assets must be reported. When a taxpayer sells something for more than he spent to purchase it, taking adjusted basis into account, there is a capital gain. When a taxpayer sells something for less than he spent to purchase it, taking adjusted basis into account, there is a capital loss. Early Withdrawal from Retirement Plans Treatment of pensions and retirement plan distributions are covered in greater detail later in this course. The general rule is that early distributions are treated as income. Any early federal distribution will show up in federal AGI. Such a distribution will transfer to the California return. Social Security and Railroad Retirement The IRS and the FTB treat taxation of Social Security payments differently. The federal government will tax Social Security benefits according to a formula set forth in its explanatory publications. Any such income included to arrive at federal AGI should be excluded from California income – there should be a subtraction of this amount from income. Railroad Retirement income (both Tiers I and II) are exempt from California tax. These benefit payments are taxable at the federal level. Interest Income Several types of interest income are exempt from state tax in California. Interest on most U.S. bonds and other securities is exempt, as is interest California bonds. Interest on bonds of states other than California is not exempt. 58 Federal law exempts interest from fewer types of U.S. obligations than California does but allows exemptions on obligations of any state (or political subdivision of a state). Interest from municipal bonds is tax-free at the federal and California levels. Rental Income From the federal government, you should receive a 1099-MISC if you earned at least $600 for rents, services, prizes, and awards. These amounts should be recording as income on the federal return. California uses the federal AGI as a starting point for completing the state tax return; there is no adjustment to be made. Rental income is received for occupancy of real estate, and the income includes monthly rent and cancellation penalties. The owner must pay federal and California taxes on profits received from renting out property. All “ordinary and necessary expenses” paid to maintain the property are allowed as a deduction. For California tax purposes, California residents are taxed on all rental income. Nonresidents are taxed only on rental income from California property. Paid Family Leave and Unemployment Benefits California does not tax unemployment or paid family leave benefits. The federal government does tax unemployment and paid family leave compensation. When there is unemployment compensation reported to the taxpayer on IRS Form 1099-G, the amount of compensation included in the federal AGI should be entered on the California return. As noted previously, the California Employment Development Department is the entity that administers benefits under the Paid Family Leave rules. Again, this income is taxable at the federal level, and the value should be included on the California return so that it can be adjusted out of California taxable income. California’s FPL rights extend for up to six weeks for individuals who:  have a new baby, adopt a child, or foster a child  need to care for a seriously ill spouse, domestic partner, child, parent, sibling, grandparent, grandchild, or parent-in-law Cancellation of Debt Income (CODI) When debt is written off in part or in full by a lender, an individual borrower may have to report Cancellation of Debt Income (CODI) indicated on an IRS Form 1099-C. Such forgiven debt is treated as regular income for tax purposes. If a taxpayer does not pay a lender in full when a loan is due (and in the case of real property, for instance, if the property is sold and the lender cannot be repaid in full), the lender reports the loss to the IRS and to the FTB and sends the taxpayer a 1099-C, indicating the amount of debt cancelled. 59 That is, this amount is taxable unless it corresponds to one of five exceptions provided by the IRC exceptions and incorporated into the California Revenue and Taxation Code:  The discharge occurred as part of bankruptcy.  The discharge occurred when the taxpayer was insolvent.  The discharge was associated with qualified farm indebtedness.  The discharge was associated with qualified real property business indebtedness (other than for a C corporation taxpayer).  The discharge occurred before January 1, 2013 and was qualified principal residence indebtedness. Between 2014 and 2019, if the taxpayer recognized CODI for federal tax purposes, the amount was deducted for California tax purposes. Whether or not there is relief from California tax on cancellation of debt income depends on the broader facts and circumstances surrounding an individual situation, including the type of debt (recourse or non-recourse) that has been discharged, the forum or situation leading to the discharge (bankruptcy court, insolvency), and possibly the occupation of the debtor (e.g., teachers). Note: If a debt is cancelled in a Title 11 case (i.e., Chapter 11 Bankruptcy), the taxpayer should include IRS Form 982 with both the federal and state tax returns to indicate that the debt has been discharged in bankruptcy. Mortgage Forgiveness Debt Relief California does not conform to federal on tax treatment of this type of discharge of indebtedness (DOI) income. Gifts and Inheritances Gifts and inheritances are not included in income unless they later produce income. The income on the gifts and inheritances is taxable. Income from gifts and inheritances tend to include some or all of these items:  interest income—earned on various types of accounts (including mortgage escrow), refunds, offsets, credits, and out-of-state municipal bonds: o federal—The interest amount is treated as income. o California—The interest income is included in federal AGI, which is used as a starting point for completing a California return and reported to California.  dividends—income paid by a company to owners of its stock: o federal—Report as ordinary income. o California—This ordinary income will be included on the federal return, as noted, and will thereby be reported to California. o There is no lower rate for dividend income. Proceeds from Real Estate Transactions Only net proceeds from real estate transactions are taxable. 60 Income from the Sale of Your Principle Residence California and IRS rules match and allow a taxpayer to exclude gain on sale of a principal residence. A taxpayer may exclude this gain from income if he owned and used the home for at least two out of five years. The two years do not have to be consecutive. The taxpayer can have only one principal residence at a time. Qualifying residences are not limited to houses – they include such things as houseboats, cooperative apartments, etc. No gain has to be reported if it was less than $250,000, the taxpayer has met the ownership and occupancy requirements, and the exclusion has not been used in the previous two years. Any gain over $250,000 is taxable. For joint filers, the excludable amount is $500,000. The simple rule is that a taxpayer’s gain is the difference between purchase price and sale price. There might also be adjustments in basis that need to be taken into consideration. Foster Care Payments A taxpayer can exclude these payment from gross income if they are paid by a state or local government or a licensed child placement agency. In-Home Support Services If the taxpayer provides in-home support services, lives with the recipient of such services, and is paid by Medicare waiver payments, the income from providing these services will be exempt. The wages are reported on the federal return and are included in federal AGI, and this figure is reported to California. Unemployment Compensation Unemployment compensation is taxed by the federal government. It is not taxed by California. When completing the California tax return, the taxpayer subtracts the amount from income to arrive at the properly adjusted figure. Gambling and Lottery Winnings Gambling includes such things as lotteries, raffles, racetracks, and casinos. To the extent of gambling winnings, the IRS allows a deduction for expenses and losses incurred. California does not conform. California and Mega Millions lottery winnings are excluded from California taxable income, but lottery winnings from other states are included in taxable income. If the taxpayer had gambling losses and offset them with California lottery income, he may need to reduce the losses included in federal itemized deductions. The income will be reflected in the taxpayer’s federal AGI. Federal AGI is reported to California. Prizes and Awards California generally matches federal law here. California specifically lists prizes and awards as being includable in taxable income. There are exceptions – employee achievement awards and awards received in recognition of charitable, scientific, or artistic achievement. Eligibility requires that the winner not have to provide future services or take any action in recipient selection. The award must be transferred by the payer to a charity designated by the recipient. 61 Information Returns (1099) A taxpayer might receive any number of 1099s from the IRS. Both individual and business taxpayers receive 1099s. These forms, used only for reporting, cover such compensation types as non-employee compensation, retirement and pension income, interest income, dividends, and proceeds from the sale of stock. Foreign Employment Income A United States employer can be: o an individual resident of the United States o a partnership (if 2/3 or more of the partners are U.S. residents) o a trust, if all the trustees are residents of the United States o a corporation organized under the laws of the United States or of any state o a limited liability company organized under the law of the United States or of any state o any Indian tribe covered by the U.S. Code Title 26 Section 3306 A citizen who works for a U.S. employer and performs services for that employer outside the United States and Canada, that citizen is liable for California UI, ETT, and SDI if: o the employer’s principal place of business in the United States is in California or o the employer has no place of business in the United States but o is an individual resident of California or o is a corporation or LLC organized under California laws or o is a partnership or trust and the number of partners or trustees who are California residents is greater than the number of partners or trustees who are residents of any other state Nonresident aliens are subject to California income tax law for most services such aliens perform in California. Covenants Not to Compete In California, for the taxpayer receiving income from a covenant not to compete, such income is taxable as being California-source if that income is separately identifiable from the sale of other intangible assets. This situation occurs, for example, when a taxpayer sells his portion of a business and receives a separate payment for agreeing not to compete with the buyer of the business. D – Gross Income and Gross Profit California Gross Income As noted previously, California residents are taxed on all income from all sources. Nonresidents are taxed only on income from California sources. For taxable years beginning on or after January 1, 2002, a nonresident or part-year resident determines his or her California tax by multiplying California taxable income by an effective tax rate. The effective tax rate is prorated according to the following formula: Prorated tax = CA taxable income × Tax on total taxable income Total taxable income 62 Whatever a taxpayer receives as income, without any deductions, is gross income. In contrast, gross profit is gross receipts less the costs used to produce the associated income. For a company, gross profit is equal to gross income less the cost of goods sold (COGS). E – Cost of Goods Sold and Inventory Considerations COGS represents a company’s inventory value – both the sold and remaining inventory. It includes all costs for making the inventory and getting it to customers. Cost of goods sold might also be referred to as cost of sales. COGS = Beginning Inventory + Purchases – Ending Inventory That is, the taxpayer entity takes the value of beginning inventory, adds the value of purchases (expenses incurred due to purchases of goods and services to make additional inventory) during the tax year, and then subtracts the value of the inventory left over at the end of the year (ending inventory). Only the value of the inventory that is sold is captured by cost of goods sold. You have what you start with, add in anything you buy, then take out what you are left with at the end of the year. The chosen inventory costing method affects income tax. Placing an appropriate value on the inventory can be accomplished by a number of methods: o last-in-first-out (LIFO) o first-in-first-out (FIFO) o specific identification (SI) o weighted average (WA) The LIFO method in most cases results in a greater tax deduction than FIFO does, assuming inflationary conditions. It assumes that the most recent inventory made is the most expensive. Therefore, assigning a larger value to the portion going out results in a bigger expense. FIFO usually results in a lower tax deduction than LIFO, assuming inflationary conditions. The oldest inventory is assumed to be sold first, in some instances to take inventory obsolescence into consideration. The Specific Identification Method involves assigning the actual costs to each specific item of inventory. This method is more often chosen by producers of a few, expensive inventory items: airplanes, submarines, medical equipment, and similar types of goods. With higher sales volume of less expensive individual items (TVs, hamburgers) the method would be costly to apply due in part to record-keeping requirements and labor hours to work the software or manually track costs for each item. In the weighted average cost method, the cost of goods available for sale is divided by the number of units available for sale and may be used when inventory items are so intertwined or identical to each other that it is not feasible or cost-effective to assign specific costs to single units. To calculate the weighted average cost, you determine the cost of goods available for sale (AFS). This value is the sum of the beginning inventory value and the value of purchases. The AFS value is divided by the number of units available for sale. You are looking at what was available for sale during the year (what you started with plus what you bought) and dividing its cost by the number of units. You get a weighted-average cost per unit. This figure is used to assign a cost to ending inventory and COGS. AFS = Value of Beginning Inventory + Purchases WA = AFS ÷ Units of Inventory Available COGS = (WA × Beginning Inventory Units) + (WA × Units Purchased) – (WA × Ending Inventory Units) 63 The WA method is the easiest way to track inventory expense. It is easier to store actual inventory without designating which was obtained or made first and which was last. The records for purchases do not need to be as detailed as with other methods. You only need to keep records of the totals. Labor costs to maintain records is lower. There are, of course, advantages and disadvantages to each of the costing methods. More detailed coverage of these and related issues are beyond the scope of this course. F – Summary In preparing a California tax return, the preparer uses the federal adjusted gross income as a starting point and makes adjustments based on differences between federal and state tax law. California tax law is based primarily on the January 1, 2015 federal Internal Revenue Code (IRC). California tax law conforms in some areas to rules established or changed by the 2017 Tax Cuts and Jobs Act (TCJA), but there are important areas in which they differ. This chapter focused on the items California requires the taxpayer to treat as income. The course later covered how various adjustments are required on the California return to arrive at California adjusted gross income. The chapter also delved into how to look at the various types of profit (gross, net), how to assign a costing method to inventory, and how to calculate the value of inventory using each of those methods. 64 Chapter 6 Review Questions 1. Is federal adjusted gross income (AGI) the same as California adjusted gross income? A. Yes, because AGI is AGI. B. Yes, because in preparing a California return, the preparer looks first to the AGI on the federal return. C. No, because of mandatory inventory costing methods. D. No, because there are adjustments to California AGI needed to calculate state taxable income. 2. Generally speaking, California nonresidents are taxed by California on: A. their worldwide income B. their California-source income only C. their U.S.-source income only D. their investment income, regardless of the source 65 Answers to Chapter 6 Review Questions 1. A. This answer is incorrect. California and federal adjusted gross income can be different for a very wide variety of reasons: different deductions, different credits, and different state gross income (from which AGI is derived). B. This answer is incorrect. California and federal adjusted gross income can be different for a very wide variety of reasons: different deductions, different credits, and different state gross income (from which AGI is derived). This fact does not change merely because federal and California AGI are looked at this way. C. This answer is incorrect. Inventory costing methods are generally chosen by the business or owner and the specific method chosen is not dictated by tax law. D. That’s correct! California AGI has to be adjusted in order to calculate state taxable income. 2. A. This answer is incorrect. California residents are taxed on their worldwide income, but this does not apply to nonresidents. B. That’s correct! The State of California taxes nonresidents only on the income that these taxpayers receive from California sources. C. This answer is incorrect. California is not able to tax nonresidents on income earned from any state except California. D. This answer is incorrect. The investment income of nonresidents is taxed by California, but only if that income is from a California source. 66 Chapter 7 Deductions and Expenses A – Introduction Deductions and credits are very different. A deduction lowers the amount of income subject to tax. A credit (discussed elsewhere in this course) reduces the amount of tax owed. If a taxpayer owes $1,000 in tax, for example, a $1,000 credit would reduce that liability to zero. A deduction would merely lower the taxable income. A credit is worth more than a deduction of the same amount. A deduction is said to occur “above-the-line” and is used in determining adjustable gross income. A credit is said to occur “below-the-line” and is used to reduce actual tax dollar for dollar. California’s dependent deduction of $326 may be claimed for each of the children or others who live with and are supported by the taxpayer. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  apply rules related to the standard deduction  understand how to itemize and what can be itemized  recognize implications related to expenses for key business organization forms C – Deductions and Thresholds: Standard Deduction or Itemized? When a taxpayer is calculating tax liability, there are certain items that can be deducted to arrive at adjusted gross income (AGI). Either the taxpayer may itemize his deductions (i.e., claim specific deductions on Form 1040 Schedule A for federal taxes) or pay the standard deduction which varies by filing status. The taxpayer may not claim both itemized and standard deductions. The IRS and FTB both allow all filing statuses to claim the standard deduction, but California has a lower standard deduction than the federal government does. The Tax Cuts and Jobs Act (TCJA) significantly raised the federal standard deduction. More taxpayers therefore claim the standard deduction rather than itemizing. Some of the itemized deductions were capped (previously not capped) or eliminated completely. Most taxpayers have historically claimed the standard deduction, and this trend is expected to continue because the amounts have increased so significantly under the terms of the TCJA. And the number will most likely increase even more because the TCJA also made tweaks to some itemized deductions, capping them at a certain amount where they were unlimited before. Other itemized deductions were eliminated entirely. As long as you are not claimed as someone else’s dependent on that person’s tax return, you qualify for the standard deduction. 67 D – Standard and Itemized Deductions – 2019 Tax Year This course has covered various issues with respect to the standard deduction. The Standard Deduction With the passage of the TCJA, the federal standard deduction was increased so significantly that many taxpayers have chosen the standard deduction over itemizing. California and federal standard deduction amounts are as follows: Filing Status California Standard Deduction Federal Standard Deduction Single $4,537 $12,200 M/RDP Filing Separately $4,537 $12,200 Married/RDP Filing Jointly, or Qualifying Widow(er) $9,074 $24,400 Head of Household $9,074 $18,350 Itemized Deductions There are situations in which a taxpayer must itemize rather than taking the standard deduction. Married couples who file separately must use the same method. Thus, if one spouse itemizes, the other spouse must itemize (and cannot take the standard deduction). Nonresident aliens must also itemize. However, it is not necessary for the state choice to be the same as the federal; itemizing on federal does not require itemizing on the California return. What Expenses Can Be Itemized? A taxpayer should itemize if total itemized deductions exceed the standard deduction, or if the taxpayer does not qualify to claim the standard deduction. 68 Common Itemized Deductions A taxpayer’s deductions cannot be more than 50% of California (CA) adjusted gross income (AGI). The following table summarizes common itemized deductions. Itemized Deductions: 2019 Deduction California Allowable Federal Allowable Medical and Dental Expenses Excess over 7.5% of federal AGI Excess over 10% of federal AGI Home Mortgage Interest Home purchases up to $1,000,000 Home purchases up to $750,000 Real Estate Tax Limited if it exceeds 50% of AGI $10,000 Vehicle/Vessel License Fee Limited if it exceeds 50% of AGI $10,000 Unreimbursed Employee Business Expenses Limited to 2% of AGI None Gambling Losses Up to amount of winnings Up to amount of winnings Disaster Losses Excess over $100 and 10% of federal AGI Excess over $100 and 10% of federal AGI Alimony See discussion of alimony None Although deductible (to a limited extent), there is no California credit for interest paid or accrued on mortgages used to purchase a principal or secondary residence. Prior Year State Balance Due When a taxpayer has underpaid for a prior year, it is in that taxpayer’s best interest to compute, file, and pay any such underpayment. When the taxpayer owes money to the IRS and pays it later in an installment or lump sum, such taxes are not deductible. Disaster Loss When the President or Governor declares a loss by a disaster the taxpayer suffered from in California, the loss can be deducted. California law matches federal law in its treatment of casualty and disaster losses. Miscellaneous Itemized Deductions Subject to the 2% Threshold The TCJA did away with the deduction for miscellaneous itemized deductions subject to the 2% floor at the federal taxation level. This suspension of deductions is set to last until January 1, 2026. California, for the most part, follows the IRC as it existed on January 1, 2015. California does not conform to the federal suspension of miscellaneous itemized deductions. These deductions are limited – California deductions cannot be greater than 50% of a taxpayer’s California adjusted gross income. Employee Business Expenses Rather than adjustments to gross income, California and federal unreimbursed employee business expenses are treated as miscellaneous itemized deductions. Only the total amount of miscellaneous itemized deductions in excess of 2% of the taxpayer’s federal AGI is deductible. California and federal rules limit deductions for business meals and entertainment expenses to 50%, which is calculated before the 2% floor applies. 69 Reimbursed expenses that are included in gross income are deducted from gross income. Medical (and Dental) Expenses The federal deduction for 2019 is the portion of medical and dental expenses in excess of 10% of federal AGI. Such expenses include insurance premium costs that are not paid by an employer. Qualifying medical and dental care costs also fall within this itemization category. The California threshold is 7.5% of AGI. State and Local Tax Deduction The TCJA limits the state, local, and property tax deduction for federal purposes to $10,000 beginning in 2018, or $5,000 if for the MFS taxpayer. In California, there is no limit if the taxes are imposed on business assets. Mortgage Interest Deduction The TCJA limits the mortgage interest deduction to $750,000 (down from $1 million in 2017). Only interest on acquisition debt may be deducted – debt incurred to buy, build, or substantially improve a home. Interest on home equity loans taken out for other purposes cannot be deducted. Gifts to Charities/Contributions to Voluntary Funds Effective in 2018, the TCJA raised the maximum value of deductible charitable gifts of money or property to 60% of a taxpayer’s federal AGI. For some types of gifts, the limits are 20%, 30%, and 50%. California’s allowable deduction rules generally follow federal law. The state deduction cannot include the amount already deducted for federal purposes in arriving at federal AGI. Additional rules are summarized below:  There is a five-year carryover of excess contributions.  The deduction is limited to charitable contributions to qualified organization(s) rather than those to a specific person.  The deduction can include automobile expenses, with 14 cents per mile in California for tax year 2018.  The contributions must be verifiable. One change to prior law is that now donations made to colleges in exchange for the right to purchase sporting events tickets are not deductible. Voluntary contribution funds recognized by California include the following:  Alzheimer’s Disease and Related Dementia Voluntary Tax Contribution Fund  California Breast Cancer Research Voluntary Tax Contribution Fund  California Cancer Research Voluntary Tax Contribution Fund  California Domestic Violence Victims Fund  California Firefighters’ Memorial Fund  California Peace Officer Memorial Foundation Fund  California Sea Otter Fund  California Senior Citizen Advocacy Voluntary Tax Contribution Fund  California Seniors Special Fund 70  California YMCA Youth and Government Voluntary Tax Contribution Fund  Emergency Food for Families Voluntary Tax Contribution Fund  Habitat for Humanity Voluntary Tax Contribution Fund  Keep Arts in Schools Voluntary Tax Contribution Fund A voluntary contribution election is made on the tax return and the payment can be made from actual payments to the fund, credits, and your refund. As noted, individual taxpayers may take the standard deduction or itemize for California regardless of their federal choice. However, RDPs and MFS taxpayers must make the same selection as each other – if one itemizes, the other must itemize. There are some significant differences between California and federal itemized deductions. Some of the allowable deductions for federal but not California are as follows:  state, local, and foreign income taxes  state disability insurance tax  qualified sales and use taxes  miscellaneous itemized deductions for expenses related to producing federally taxable (but not California taxable) income E – Income from a Business When looking at income, you should remember to include income from a business – which includes things like plumbing services (trades) and CPA services (professions). If there is a clear separation of the part of the business conducted in California from that not conducted in California, you would just include the California-source income for your California taxes. If you cannot split up the California-sourced from the non-California sourced income, there is a formula to use to determine how much of the income should be included in your California tax calculations. F – Business Gross Receipts vs. Income When a taxpayer engages in transactions and activity in the regular course of business, the income that arises is “business income.” Gross receipts are the amounts realized in the sale or exchange of property, performance of services, or use of property or capital (rents, royalties, interest, dividends) in a transaction that produces business income. There is no reduction for the cost of goods sold or the basis of the property sold. Gross receipts include money and the fair market value of other property or services received. Under the IRC, gross receipts do not include the following amounts:  proceeds of the principal of a loan, bond, mutual fund, certificate of deposit, or similar marketable instrument  principal amount received under a repurchase agreement or other transaction properly characterized as a loan  proceeds from issuance of the taxpayer’s own stock or from sale of treasure stock  damages and other amounts received in litigation  property acquired as an agent on behalf of someone else  tax refunds (and other tax benefit recoveries) 71  pension reversions  contributions to capital  cancellation of debt income  certain amounts realized from exchanges of inventory Nonresident Business Income Residency is important here. A business has a “commercial domicile,” which is the principal business location. A nonresident’s California income includes income from a business, trade, or profession carried on in California. If this business happens inside and outside of California and these parts are separate and distinct from each other, only the income from business actually conducted in the state is taxable as California-source income. G – Clean Fuel Vehicles First Year Deduction Under federal law, a taxpayer may claim a first-year deduction for purchasing a vehicle that uses clean fuels. This deduction is not available for California tax purposes and the federal deduction must be added back as an adjustment to arrive at California income. In California, state vehicles admissions standards exceed those in other states, and there is no perceived need for tax incentives to encourage taxpayer behavior in this area. H – Types of Business Entities Although there are many considerations in selecting a business entity type other than tax issues, entity type plays a large role in business tax. Sole Proprietorship With a sole proprietorship, the business and the owner are one and the same. It is an unincorporated business and a “flow-through” entity. Unincorporated, it has no legal recognition as its own entity or even as something that exists apart from the individual taxpayer. It is a business form that is easy to form and keep up, but the owner is liable for business debts and can be required to pay these debts from personal assets. Because a sole proprietorship is a flow-through entity, the individual taxpayer includes income and expenses on his or her personal tax return. For federal purposes, a married couple can have a sole proprietorship together, but an RDP cannot. When filing an individual California return, the federal Schedule C (indicating profit or loss from business) must be included with the California Form 540. Note: If the business is a farming business, the taxpayer uses Schedule F instead of Schedule C. A sole proprietor must withhold California state income and franchise (sales/use) tax if that person is considered a “withholding agent.” A withholding agent is someone who can control, receive, have custody of, dispose of, or pay California-source income. Without an FTB waiver for a reduced withholding amount, such an agent must withhold disbursements of California-source income to a nonresident payee. For the first $1,500 in payments made during a calendar year, the sole proprietor has the choice of whether or not to withhold. However, if a sole-proprietor agent is required to withhold and remit backup withholding to the IRS, that person must do the same in California with the FTB. 72 Partnerships When two or more persons act together to carry on a trade or business for profit, their arrangement is likely to be treated as a partnership. The requirement “for profit” is key: each person/partner must be contributing assets, labor, or skill and must expect to share in the business’s profits and losses. Partnerships are pass-through entities, meaning that the partnership is not taxable at an entity level – its income or loss passes through to the individual partners’ tax returns. General and Limited Partnerships There are several types of partnerships. In a general partnership, the partners are all personally liable (jointly and severally) for the partnership’s debts. In a limited partnership, one or more partners is basically only a financial partner – one who limits his liability to his contributed funds. General partnerships that do business in California and in other states have to apportion their income using Schedule R, which goes with FTB Form 565 (Partnership Return of Income). For federal purposes, there are small partnership provisions allowing those with ten or fewer partners (domestic, individual persons) to avoid being treated as a partnership for tax purposes. They would therefore not be required to file entity-level returns. California does not conform to these federal provisions. In California, such partnerships are treated the same as all others. Limited Partnerships A limited partnership must have at least one limited and one general partner. As noted previously, a limited partner’s liability is capped at his or her (or its – a partner can be a business entity) investment in the partnership. The annual California tax for a limited partnership is $800. Corporations Another common form of business entity is the corporation. Prospective owners of a corporation transfer money and/or property in return for shares of the corporation’s stock. That is, the shareholders are the owners. Corporations have their own deductions. A corporation’s profit is often said to be taxed twice – once at the corporate level, and then again when the corporation’s profits are distributed as dividends to the shareholders. C Corporations Corporations come in many shapes and sizes. Each is a separate entity from its owners, managers, and operators. As a legal “person,” it can enter into contracts, pay taxes, borrow money, make investments, etc. Its owners are its stockholders, and such persons or entities who contribute assets or money can receive shares of stock in return. Corporate shareholders, as owners, are entitled to any dividends the corporation pays. When a corporation shows a profit, it ultimately returns that profit to the business for investment or pays it out to stockholders in dividends. When a corporation liquidates, any residual assets (after creditors are paid) must be paid to the stockholders. Stockholder-lenders are treated first as lenders (and therefore have priority in payment over non-lender stockholders) in the event of liquidation. 73 S Corporations An S corporation is separate from its owners so that these owners have protection against liability. It pays California income tax at the entity level (but not at the federal level) and is a pass-through entity, meaning that profits and losses flow through to the individual owners. A corporation with 1-100 shareholders may elect to be treated as an S corporation. There can only be one class of stock. Shareholders must be individuals (or estates or certain types of trusts). They show on their personal returns their share of the company’s income, deductions, losses, and credits. An S corporation is allowed tax credits and net operating loss and has its own rules for taxing built-in gains and excess passive income. The annual California income tax for an S corporation is the greater of 1.5% of the corporation’s net income or $800. Newly incorporated or qualified corporations are exempt from the annual minimum franchise tax for their first year of business. Like other businesses, S corporations that do business in California and other states must apportion their income on Schedule R. Foreign Corporations Some corporations from other states or countries transact business in California. To do so legally, they must complete Form S&DC-N (Statement and Designation by Foreign Corporation). There are various other forms to be completed and fees to be paid. I – Marijuana Businesses and Income Tax In 1996, California became the first state in the country to legalize medical marijuana use, but when Proposition 64 was passed by the voters at the 2016 federal election by a margin of 57% to 43%, it made California the fifth state to legalize recreational use of marijuana after Colorado, Washington, Oregon, and Alaska. Later that same election day, results showed that voters in Massachusetts and Nevada had added their states to the list. This set off a series of actions in California aimed at making recreational marijuana (also known as cannabis) available for commercial sale in the state as of January 1, 2018. Much work has needed to be done to establish the framework for the establishment and regulation of marijuana-related businesses, and the whole matter is further complicated by the fact that the use, possession, sale, cultivation, and transportation of marijuana is illegal under federal law in the United States. However, the federal government has ruled that if a state passes a law to allow the recreational or medical use of marijuana, it is free to enact that law under the condition that a regulation system for cannabis is in place. On June 27, 2017, the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA) was passed by the state legislature. This bill established a comprehensive system to control and regulate the cultivation, distribution, transport, storage, manufacturing, processing, and sale of medicinal and adultuse cannabis and related products. The MAUCRSA defines the power and duties of the various state agencies responsible for controlling and regulating the commercial medicinal and adult-use cannabis industry. Under the current California law, the California Department of Justice has ruled that medical cannabis businesses are required to operate as a nonprofit cooperative or collective. These entities may be incorporated or unincorporated, and they are required to report their income by filing an annual tax return. For federal tax purposes, marijuana businesses cannot take deductions other than for cost of goods sold (COGS). Under IRC Section 280E, a business that engages in the trafficking of a Schedule I or II controlled substance cannot take tax deductions or credits at the federal level. The key exception is for COGS, although this term is defined more narrowly by the IRS than by the California Revenue and Tax Code. 74 Cash Issues Even though the cultivation and sale of cannabis has become legal in California and other states, cannabis remains classified as a Schedule 1 drug on the federal Controlled Substances Act. This means that any individual or business that operates in the cultivation and sale of cannabis is acting in violation of federal law in the same way as those individuals who produce or distribute illegal drugs such as heroin and LSD. A further consequence of the above for would-be cannabis entrepreneurs is that any private U.S. bank that is insured by the federal government is forbidden by law from knowingly handling money from cannabis businesses. And, since most banks won’t do business with pot growers, manufacturers, or retailers, the result is that many marijuana companies typically operate only in cash. Given the size of the state and its population, it is expected that California’s cannabis industry will grow to some $7 billion annually and become the country’s largest legal pot economy. Although there is currently no specific California tax on the medical marijuana industry, the beginning of 2018 will also see the launch of a new state levy of 15% on all cannabis purchases by both recreational and medical consumers. These taxes will need to be remitted to the state by businesses along with the usual payroll and income taxes that are withheld on behalf of employees. This raises a dilemma for cannabis businesses since without access to banks, they are unable to deposit their daily business proceeds and electronically transfer funds to their suppliers and the various governmental agencies with whom they must by necessity do business. Some states have found a workaround that allows them to establish accounts with a handful of local credit unions, but this is at best a short-term solution since taxing authorities are by nature wary of cash-only businesses and their potential use for tax evasion and money laundering activities. Several bills have been introduced to the U.S. Congress in an attempt to create a fair and transparent structure for meeting the financial services needs of the cannabis industry, but none have yet passed. Banking The federal Department of Justice (DOJ) and the Financial Crimes Enforcement Network (FinCEN) issued guidance in 2014 based on the 2013 “Cole Memo.” The intent of the guidance was to allow banks to provide services to the legal cannabis industry, with the condition that those banks would report any activities by their clients that would conflict with the following enforcement priorities of the DOJ:  Prevent distribution of marijuana to minors.  Prevent marijuana revenue from funding criminal enterprises, gangs, or cartels.  Prevent marijuana from moving out of states where it is legal.  Prevent use of state-legal marijuana sales as a cover for illegal activity.  Prevent violence and use of firearms in growing or distributing marijuana.  Prevent drugged driving or exacerbation of other adverse public health consequences associated with marijuana use.  Prevent growing marijuana on public lands.  Prevent marijuana possession or use on federal property. Despite the issuance of such guidance, many banks were reluctant to expose themselves to liabilities that they may incur by failing to observe or report suspicious activities by their clients. Most banks don’t see the rules laid down by the guidance as a legal protection against charges that could include aiding drug trafficking. And, they say the rules are hard to follow, in effect placing the burden on banks to determine if a pot business is operating legally. The matter of business banking thus remains unresolved, awaiting further legislation or clearer guidance from the federal level. 75 In 2016, California State Treasurer John Chiang formed a task force known as the Cannabis Banking Working Group to try to address the cannabis cash issue in recognition of that fact that the state expects to collect hundreds of millions of dollars annually from legal sales of marijuana. “It is unfair and a public safety risk to require a legal industry to haul duffel bags of cash to pay taxes, employees, and utility bills,” Chiang said in a statement, before proposing that the state use armored cars to transport the cash between businesses and the relevant taxing authorities. The armored car tax collection solution came about amid fears that operators carrying large bags of cash could be targets for theft and create problems for the state workers collecting and counting the money. The armored car system would be an interim solution to the problem, but in its final report, the Cannabis Banking Working Group noted that changes are needed in Washington to either legalize cannabis on the federal level or shield financial institutions that serve the cannabis industry from possible prosecution. J – Cost of Goods Sold As noted previously, COGS for marijuana businesses is an area of non-conformity between California and federal tax law. On the federal return, a marijuana business cannot take deductions or credits because marijuana is not yet legal at the federal level. Some states have legalized marijuana and their tax codes treat marijuana businesses the same as other legal businesses. California is one such state. COGS represents a company’s inventory value – both the sold and remaining inventory. It includes all costs for making the inventory and getting it to customers. This topic will be covered in greater detail in the “Credits” chapter. K – Expenses In calculating AGI, there are several relevant expenses, some of which are covered below. Club Dues California does not allow a deduction for club dues paid for membership in any business, pleasure, social, athletic, lunch, sport, airline, or hotel club. California does not allow a deduction for business expensed incurred at a club that discriminates based on age, sex, race, religion, color, ancestry, or national origin. Sexual orientation is not included in this prohibited discrimination list. Meal and Beverage Expenses Federal law does not allow deductions for entertainment expenses. There is a 50% limit on business meals – it was expanded to include meals provided by an on-premises cafeteria. The taxpayer should keep records to substantiate the relationship between the meal expenses and the active conduct of trade or business. The limit does not apply to expenses incurred by taxpayers while they are away on business, although such expenses cannot be “lavish or extravagant” under the circumstances. Travel and Transportation Expenses California and federal law allow an employer to provide tax-favored transportation benefits. That is, there may be commuting expense reimbursements for such items as transit passes and tokens for mass transit, vanpooling, or employer-provided parking. The value of the benefit must not exceed its fair market value. Under federal law, the maximum monthly tax-free benefit for 2019 was $265. The employer may take a deduction for excess over $265, but the employee cannot exclude that excess. 76 If a taxpayer travels for merely educational purposes, the cost of that travel cannot be deducted. Charitable travel expenses are deductible if there are no significant elements of recreation or vacation in that travel. If a taxpayer attends a convention or other meeting in connection with investment activities, the taxpayer cannot deduct the associated travel expenses. To be deductible, the meeting has to offer significant business-related activities, meetings, lectures, etc. Gift Expenses A taxpayer may deduct up to $25 per recipient for business gifts given. A gift to a company that is intended to be for someone’s personal use or benefit will be treated as an indirect gift to that person (and is subject to the $25 per recipient limit). Expense Disallowance for Substandard Housing The Substandard Housing Program assists state and local agencies responsible for abating unsafe living conditions that violate California Health and Safety Codes. Substandard housing is property in violation of California state or local health and safety codes as determined by city or county regulatory agencies. Only these regulatory agencies have authorization to issue determinations that property is noncompliant (substandard) or compliant. When a regulatory agency notifies the Franchise Tax Board (FTB) of a noncompliant substandard property, the FTB disallows any income tax deductions claimed for interest, taxes, amortization, or depreciation on that property during the period of noncompliance. These expenses are not deductible even if paid during the period of noncompliance. This applies to both individuals as well as sole proprietors. When the property is noncompliant for part of a year, the FTB disallows the deductions at a rate of 1/12 for each month the property is noncompliant. If the taxpayer and/or sole proprietor no longer own(s) the property, the FTB disallows the deductions from the date of noncompliance to the date the property was sold. If the taxpayer and/or sole proprietor own more than one property, the FTB only disallows deductions on the noncompliant property. Property is substandard from the date of noncompliance to the date of compliance. The Franchise Tax Board will continue to disallow the income tax deductions during the substandard period. Even if the property is repaired, the property is considered substandard until the regulatory agency re-inspects the property and issues a Notice of Compliance. Unreimbursed Business Expenses In general, unreimbursed business expenses incurred by an employee are deductible, but only as an itemized deduction and only to the extent the expenses exceed 2% of adjusted gross income. Previous law and IRS guidance provide examples of items that may be deducted under this provision. This nonexhaustive list includes:  business bad debt of an employee  business liability insurance premiums  damages paid to a former employer for breach of an employment contract  depreciation on a computer a taxpayer’s employer requires him to use in his work  dues to a chamber of commerce if membership helps the taxpayer perform his job  dues to professional societies  educator expenses 77  home office or part of a taxpayer’s home used regularly and exclusively in the taxpayer’s work  job search expenses in the taxpayer’s present occupation  laboratory breakage fees  legal fees related to the taxpayer’s job  licenses and regulatory fees  malpractice insurance premiums  medical examinations required by an employer  occupational taxes  passport fees for a business trip  repayment of an income aid payment received under an employer’s plan  research expenses of a college professor  rural mail carriers’ vehicle expenses  subscriptions to professional journals and trade magazines related to the taxpayer’s work  tools and supplies used in the taxpayer’s work  purchase of travel, transportation, meals, entertainment, gifts, and local lodging related to the taxpayer’s work  union dues and expenses  work clothes and uniforms if required and not suitable for everyday use  work-related education The provision suspends all miscellaneous itemized deductions that are subject to the 2% floor under present law. Thus, under the provision, taxpayers may not claim the above-listed items as itemized deductions for the taxable years to which the suspension applies. California conforms, under the PITL, to the federal rules relating to miscellaneous itemized deductions under IRC Section 67, as of the specified date of January 1, 2015, with modifications, but does not conform to the federal suspension of all miscellaneous itemized deductions. Therefore, valid employee business expenses are defined as:  paid or incurred during the taxpayer’s tax year  required to carry on a trade or business  ordinary and necessary  not reimbursed by the taxpayer’s employer  not eligible to obtain reimbursement from the taxpayer’s employer  rural mail carriers’ vehicle expenses 78  subscriptions to professional journals and trade magazines related to the taxpayer’s work  tools and supplies used in the taxpayer’s work  purchase of travel, transportation, meals, entertainment, gifts, and local lodging related to the taxpayer’s work  union dues and expenses  work clothes and uniforms if required and not suitable for everyday use  work-related education L – Business Expenses All “ordinary and necessary” business or trade expenses are deductible, with the California rules generally matching the federal rules. Areas of nonconformity include the following:  no state deduction for criminal activity expenses (no federal deduction either, but the rules differ a little)  no federal deduction for adding new jobs that would qualify for the California new jobs credit  no deduction for country club dues if the country club or similar organization engages in discriminatory practices M – Professional Fees and Start-Up Expenses A business’s start-up costs for organizational costs is deductible for federal and California purposes. Organizational costs include things like marketing, legal services, incorporation and similar fees, and salaries. A taxpayer can generally deduct up to $5,000 in start-up expenses and $5,000 in organizational costs (legal services, incorporation fees, etc.). California does not conform to a federal increase in start-up expenses that went into effect for the 2010 tax year. Tax preparation fees are no longer deductible on the California return. The TCJA also removed the miscellaneous itemized deduction for legal fees except those fees incurred in employment-related disputes. A taxpayer may deduct legal expenses related to doing or keeping a job (including those paid to defend against criminal charges arising out of the taxpayer’s trade or business). A taxpayer may also be able to deduct legal fees related to claims of unlawful discrimination, claims against the U.S. government, and claims made under the Social Security Act. Such fees are treated as an adjustment to income, and they are not limited to 2% of AGI or subject to the AMT phase-out. N – Expenses from a Business As noted previously, expenses from a business can be considered in identifying and calculating an NOL in certain circumstances. Only some types of business entities have specific implications for individual taxpayers. Primarily, tax law treats corporations differently from pass-through entities (sole proprietorships, partnerships, etc.). With pass-through entities, business profits and losses are “passed through” to their owners’ tax returns. Sole Proprietorship The business and its owner are treated as being “one and the same.” As an unincorporated business, it does not legally exist separately from the individual taxpayer-owner. The individual taxpayer includes income and expenses on his or her personal tax return. For federal purposes, a married couple can have a sole proprietorship together, but an RDP cannot. 79 Partnership A partnership exists (whether formalized or not) when two or more persons act together to carry on a trade or business for profit. Each partner must be contributing assets, labor, or skill and must have an expectation of sharing in the entity’s profits and losses. Partnerships are pass-through entities, meaning that the partnership is not taxable at an entity level – its income or loss passes through to the individual partners’ tax returns. S Corporation An S corporation is separate from its owners but for federal tax purposes does not pay income tax at the entity level. California taxes S corporation income at the entity level – the greater of 1.5% of net income or $800. C Corporation With a C corporation, net operating income is recognized and dealt with at the federal taxation level. It is not passed through to the owners’ (i.e., shareholders) personal returns. O – Investment Expense California does not conform to the federal TCJA changes with respect to certain investment expenses. Investment advisory fees (and previously acceptable California itemized deductions) are still allowable for California tax purposes. They are not allowable at the federal level. That is, California allows a deduction for investment expense up to the amount of net investment income. Net capital gain from the disposition of investment property is generally excluded from investment income. For federal purposes, taxpayers may elect to include part or all of their net capital gain investment income to calculate the investment interest limitation if they also reduce the amount of net capital gain eligible for special federal capital gains tax rates. A similar election may also be made for California taxation purposes. However, California treats capital gain as ordinary income. P – Summary Deductions and credits are very different. A deduction lowers the amount of income subject to tax. A credit (discussed elsewhere in this course) reduces the amount of tax owed. If a taxpayer owes $1,000 in tax, for example, a $1,000 credit would reduce that liability to zero. A deduction would merely lower the taxable income. A credit is worth more than a deduction of the same amount. A deduction is said to occur “above-the-line” and is used in determining adjustable gross income. A credit is said to occur “below-the-line” and is used to reduce actual tax dollar for dollar. 80 Chapter 7 Review Questions 1. Which statement is true with respect to the standard deduction and itemized deductions? A. Jordan has California gross income of $45,000, California adjusted gross income of $6,000, and federal gross income of $125,000. He has itemized deductions of $3,000. He is single. He should take the standard deduction because it is greater than his itemized deductions. B. Jordan has California gross income of $45,000, California adjusted gross income of $6,000, and federal gross income of $125,000. He has itemized deductions of $3,000. He is married to a nonresident whose residence is in Washington State. He should take the standard deduction because it is higher than his itemized deductions. C. Jordan has California gross income of $45,000, California adjusted gross income of $6,000, and federal gross income of $125,000. His wife’s California adjusted gross income is $20,000. He has itemized deductions of $3,000. She has itemized deductions of $8,000. Jordan and his wife are both California residents. They file as “Married Filing Separately.” Each person should take his or her standard deduction. D. Jordan is single. He has California gross income of $45,000, California adjusted gross income of $6,000, and federal gross income of $125,000. He has itemized deductions of $18,000. He should itemize his deductions because the $18,000 he would take as a deduction of $18,000, an amount that is greater than the standard deduction. 2. Which of the following statements is false regarding business start-up and organizational costs? The business is in California. A. Start-up costs are deductible for federal and California purposes. B. Start-up costs are deductible for California purposes but not for federal. C. A taxpayer can deduct $5,000 in start-up expenses. D. A taxpayer can deduct $5,000 for organizational costs. 81 Answers to Chapter 7 Review Questions 1. A. That’s correct! The California standard deduction is $4,537 for a person filing as “single.” This amount is greater than the $3,000 in itemized deductions Jordan has. B. This answer is incorrect. Because Jordan’s spouse is a nonresident alien, they have to itemize. C. This answer is incorrect. When spouses file as “Married Filing Separately,” if one spouse itemizes, the other spouse must itemize. D. This answer is incorrect. Jordan would be unable to itemize because his itemized deduction total of $18,000 is more than half of his California adjusted gross income of $6,000. If he were to itemize, he’d be limited to a deduction of half of his California AGI, which would equal $3,000. 2. A. This answer is incorrect. The question asks which statement is false. The statement that “start-up costs are deductible for federal and California purposes” is true. B. That’s correct! Start-up costs are deductible only for California tax – not for federal. C. This answer is incorrect. The question asks which statement is false. The statement that a “taxpayer can deduct $5,000 in start-up expenses” is true. D. This answer is incorrect. The question asks which statement is false. The statement that a “taxpayer can deduct $5,000 in organizational costs” is true. 82 Chapter 8 Credits A – Introduction As noted in the previous chapter, credits are worth more than deductions. A credit reduces tax liability itself dollar for dollar. This chapter covers California credits and some federal credits. It highlights differences between California and federal rules when applicable. Perhaps the most significant credit is the Earned Income Tax Credit (EITC). The federal and California versions differ, and areas of nonconformity will be highlighted as applicable. There are many tax preparer due diligence requirements with respect to this credit in particular. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify and know when to apply rules for different tax credits  be familiar with many specific tax credits  identify the main features of the California Earned Income Tax Credit and identify the criteria for taxpayer eligibility  identify tax preparer due diligence obligations relating to the California Earned Income Tax Credit and identify the FTB checklist form that is part of those obligations C – Credits Credits and deductions are very different. A deduction (discussed elsewhere in this course) lowers the amount of income subject to tax. A credit reduces the amount of tax owed. If a taxpayer owes $1,000 in tax, for example, a $1,000 credit would reduce that liability to zero. A deduction would merely lower the taxable income. A credit is worth more than a deduction of the same amount. A deduction is said to occur “above-the-line” and is used in determining adjustable gross income. A credit is said to occur “below-the-line” and is used to reduce actual tax dollar for dollar. D – Personal Exemption Credit The Tax Cuts and Jobs Act (TCJA) did away with personal exemptions at the federal level. California personal exemption credits are as follows: 83 California Personal Exemption Credits Filing Status/Qualification 2019 Tax Year Exemption Amount Married/Registered Domestic Partner (RDP) filing jointly or qualifying widow(er) $244 Single, married/RDP filing separately, or head of household $122 Dependent $378 Blind $122 Age 65 or older $122 E – California Earned Income Tax Credit (CalEITC) If a taxpayer works and has low income, he or she may be eligible for a credit that reduces tax owed or gives him or her a refund. The California Earned Income Tax Credit (CalEITC) was adopted several years ago. Similar in many ways to the federal credit of the same name, this credit also carries with it the same risk of possible fraud by taxpayers as we have seen in the federal arena. The characteristics and eligibility requirements of the credit are discussed in this chapter to highlight the importance of the related due diligence required by tax professionals. The terms of several other tax credits were changed slightly, and these will all be discussed in turn during this chapter. This tax credit is refundable, and thus may allow taxpayers who owe no income tax to receive a tax refund provided they meet the conditions for the CalEITC. Qualifications for the Credit A taxpayer qualifies for CalEITC if all of the following apply:  He or she has wages and adjusted gross income within certain limits.  The taxpayer, spouse, and any qualifying children each have a Social Security number issued by the Social Security Administration that is valid for employment.  He or she does not use the “married/RDP filing separately” filing status.  He or she lived in California for more than half the tax year. The following definitions and rules apply for the purposes of the CalEITC. Adjusted Gross Income Limits AGI and earned income play a role in determining eligibility for the CalEITC. Earned income includes income received by the taxpayer from:  W-2 wages  net earnings from self-employment  salaries, tips  other employee compensation subject to California withholding The taxpayer’s California income must be no greater than the amounts shown in the following table. 84 2019 California Earned Income Tax Credit (CalEITC) Number of Qualifying Children California Maximum Income CalEITC (up to) IRS EITC(up to) None $30,000 $240 $529 1 $30,000 $1,605 $3,526 2 $30,000 $2,651 $5,828 3 or more $30,000 $2,982 $6,557 Minimum Wage Workers The higher CalEITC income limits will allow more minimum wage workers to benefit from the credit. Prior to the expansion, many minimum wage workers earned too much to qualify for the credit, even though they earned too little to make ends meet given California’s high cost of living. First, let’s look at the California minimum wage. California Minimum Wage Tax Year Minimum Wage 2017 $10.50 2018 $11.00 2019 $12.00 In 2017 the CalEITC maximum for a family with two qualifying children was $22,302. This meant a taxpayer could be paid for 41 hours a week at minimum wage without disqualifying himself from the CalEITC – there was no disincentive to work a full-time job. That is: $22,302 ÷ $10.50 ÷ 52 weeks = 41 In 2018 the CalEITC maximum for a family with two qualifying children was $24,950. This meant a taxpayer could be paid for 44 hours a week at minimum wage without disqualifying himself from the CalEITC. That is: $24,950 ÷ $11.00 ÷ 52 weeks = 44 For example, a family with one child is not eligible for the CalEITC unless they earned less than about $10,000 a year, a salary that translates into working just 19 hours per week at the state minimum wage of $10.00 per hour. This pay set-up left little encouragement for workers to find full-time employment. The following table sets out the difference between 2017 and 2018 in terms of the maximum number of hours a minimum wage earner could work without being disqualified from claiming the CalEITC. Tax Year Maximum Hours of Work per Week Zero Children 1 Child 2 Children 3 or More Children 2017 27 41 41 41 2018 29 44 44 44 85 Raising the income limits to qualify for the CalEITC not only allows more minimum wage workers to benefit from the credit, but the increase also makes the credit available to more workers living in or near poverty. Prior to the expansion, the CalEITC’s income limits fell well below the official federal poverty line. As a result, many workers living in poverty were not eligible for the credit. Raising the income limits closer to or above the poverty line is important because many families with incomes this low struggle to afford basic expenses, particularly in high-cost areas of the state. As shown above, the California minimum wage was raised from $10.50 to $11.00 for the 2019 tax year. Credit Phaseout The size of the CalEITC for a particular family or individual depends on how much they earn and how many children they support. Specifically, the credit “phases in” (increases) for higher levels of earnings up to a certain maximum point, after which the credit “phases out” (decreases) for higher levels of earnings until it reaches $0. In tax years 2017 and 2018, the phase-out for workers with one or more children started at $24,950. Filing Status Taxpayers must use one of the following filing statuses when they apply for the credit:  single  married/Registered Domestic Partner (RDP) filing jointly  head of household (HOH) Married/RDP Filing Separately status may not be used. Residency and Age The taxpayer’s principal residence must be in California for more than half the tax year. There is no age restriction for taxpayers with a qualifying child. Taxpayers who do not have a qualifying child (or whose spouse does not have a child if they file a joint return) must be between 25 and 65 years old at the end of the tax year. Rules for Qualifying Children for the CalEITC A qualifying child in relation to the CalEITC must meet the following three criteria:  relationship—The child must be the taxpayer’s child, stepchild (whether by blood or adoption), foster child, sibling or stepsibling, or a descendant of any of them.  residence—The child must have had the same principal residence as the taxpayer in California for more than half the tax year. Certain exceptions apply.  age—The child must be younger than the taxpayer and either: o under the age of 19 at the end of the tax year o under the age of 24 if a full-time student for at least five months of the year o a permanently and totally disabled child may be included at any age 86 The child only qualifies for one return. If the child can be claimed by more than one taxpayer, the following tiebreaker rules apply, listed in order. The child’s qualification goes to: 1. the parent 2. If more than one taxpayer is the child’s parent, the qualification goes to the parent with whom the child lived for the longest time during the year, or if the time was equal, the parent with the highest adjusted gross income. 3. If no eligible parent claims the child, the qualification goes to the individual claiming the child, as long as that person’s AGI exceeds the AGI of any parent eligible to claim the child. 4. If no taxpayer is the child’s parent, the qualification goes to the taxpayer with the highest AGI. Notices Taxpayers May Receive Since this is a new and refundable credit, the FTB is aiming to make sure that taxpayers are kept well informed of the status of their applications for EITC. In addition, the FTB aims to prevent the type of fraudulent and incomplete claims that have caused the IRS to pay out billions of dollars in erroneous claims each year for the federal EITC. For those reasons the FTB has created five new taxpayer notices to help administer the new CalEITC. Each of these notices is specific to a given tax year. Each of the five notices is described below. FTB 4502, Additional Documentation Required—Refund Pending This notice is sent when the FTB determines it does not have enough information to approve the claimed CalEITC prior to processing the tax return and issuing a refund. This notice provides specific instructions on the type(s) of supporting documentation a taxpayer must submit to validate the claimed CalEITC. If the FTB does not receive the required supporting documentation within 30 days of the notice date, instead of issuing a refund in the amount of the claimed CalEITC, it will send FTB 5818, Notice of Tax Return Change to the taxpayer advising them of the adjustment. FTB 4513, Earned Income Tax Credit—Acceptance Letter This notice is sent when the FTB accepts the required supporting documentation that a taxpayer has submitted to substantiate their claimed CalEITC. This notice provides confirmation that the FTB accepted the claimed CalEITC for the tax year on the notice. FTB 4514, Additional Documentation Required—Refund Issued This notice is sent when the FTB determines that it does not have enough information to approve the claimed CalEITC and the FTB already processed the tax return and issued a refund. This notice provides specific instructions on the type(s) of supporting documentation the taxpayer must submit to validate the claimed CalEITC. If the FTB does not receive the required supporting documentation within 30 days of the notice date, or the provided documentation does not substantiate the claimed CalEITC, the FTB will send FTB 4515, Earned Income Tax Credit – Adjustment Made, to the taxpayer advising them of the adjustment. FTB 4515, Earned Income Tax Credit—Adjustment Made This notice is sent when the FTB does not receive the requested supporting documentation or that the documentation it has received is insufficient to support the claimed CalEITC. This notice indicates that the FTB has adjusted the claimed CalEITC amount and provides the specific reason(s) for the adjustment. 87 In addition, the notice provides the taxpayer(s) with options should they disagree with the decision to adjust their CalEITC. FTB 4516, Earned Income Tax Credit Denial This notice is sent when:  A taxpayer files a Formal Claim for Refund that the FTB has denied. The notice includes information on how to file an appeal with the Board of Equalization.  The FTB denies the CalEITC with a balance due. The notice includes instructions on how to pay and how to file a Formal Claim for Refund. EITC and CalEITC: Obligations for Tax Professionals Just as is the case when completing claims for federal EITC, paid preparers must meet due diligence requirements when they determine a taxpayer’s eligibility for, and the amount of, the California Earned Income Tax Credit (CalEITC). FTB 3596, Paid Preparer’s California Earned Income Tax Credit Checklist While at the federal level preparers must complete Form 8867 to demonstrate that they have applied due diligence, when a preparer prepares CalEITC claims he or she must ask all the questions required on FTB 3596, Paid Preparer’s California Earned Income Tax Credit Checklist. In addition, the preparer must ask additional questions when the information the client gives seems incorrect, inconsistent, or incomplete. Form FTB 3596 must be completed and submitted for all paper and electronic tax returns and all other CalEITC claims. This requirement applies to all CalEITC claims, regardless of the presence or absence of a qualifying child. Preparers must also retain a copy of the completed FTB 3596 and the worksheet showing the CalEITC computation contained in the instructions of the Form FTB 3514, California Earned Income Tax Credit. The Franchise Tax Board may assess a $500 penalty for each failure by paid preparers to comply with these due diligence requirements. While Parts I, II, and III of Form FTB 3596 provide a checklist of the taxpayer’s eligibility to claim the CalEITC, Part IV is used as a checklist to ensure that the preparer has exercised due diligence in making the claim for the credit. Part V is used to record the types of documents the taxpayer provided to the preparer of the claim form. F – Child Tax Credit and Young Child Tax Credit At the federal level, the Child Tax Credit doubled under the Tax Cuts and Jobs Act (TCJA). More of the credit is now refundable and the income limitations are much looser. Under the TCJA, the federal child tax credit is $2,000 per qualifying child under age 17. Up to $1,400 is refundable. The income phase-out starts at $240,000 for a taxpayer with a filing status of single, HOH, or MFS. The phase-out starts at $440,000 for taxpayers filing MFJ. For tax year 2019, the Young Child Tax Credit was introduced. It applies to taxpayers with a child or children under age six as of the end of the tax year. The credit can be up to an additional $1,000. G – Disabled Access Credit for Eligible Small Businesses A small business is one with annual gross receipts of $25 million or under for the three years before the tax year. The business cannot be a tax shelter. If the business has not existed for three years, the taxpayer should use the average for the actual duration of existence. If there is a partial tax year involved, the business should annualize the gross receipts. 88 Both the federal and state laws provide a credit for expenses associated with providing physical access for the disabled. First, a taxpayer would calculate eligible expenses. For federal purposes, the credit is for 50% of these expenses that are between $250 and $10,250. California’s maximum credit is $125. The taxpayer must reduce any deduction taken for the same expenses. H – Work Opportunity and Welfare-to-Work Credits The federal government allows two credits for employers that hire people from long-term family assistance recipients and other targeted groups. For the federal return, any wage expenses used to claim either credit must be used to reduce any such wage expense deduction. California does not conform to federal rules on this issue. Taxpayers must add the federal credits back to California income. I – Joint Custody Head of Household There is also a credit for Joint Custody/Head of Household. If a taxpayer does not use the Married/RDP Filing Jointly status, he or she may qualify for this credit if:  The taxpayer was unmarried at the end of the tax year.  The taxpayer covered over half the home expenses and that home was the main home of the child (or step-child or grandchild) for 146 to 219 days of the tax year.  The child’s custody terms are set forth in a legal separation document, a final decree of divorce, or in a document used to start divorce proceedings (but there has been no final order issued).  The child is married (or in an RDP). If the taxpayer can claim an exemption credit for the child, the taxpayer can claim a credit for joint custody/head of household. This credit equals the lesser of 30% of the net tax or $484. That is, $484 is the maximum that can be claimed in 2019. 89 J – Child and Dependent Care Expenses Credit For a taxpayer with some earned income and federal adjusted gross income of $100,000 or less in the 2019 tax year, there is a child and dependent care credit that may be available to reduce income tax liability at the federal and state levels. The credit applies when the taxpayer paid for someone else to take care of the taxpayer’s child, spouse, or dependent. This is a nonrefundable tax credit applied against taxes owed. Any excess over the actual tax liability will not be refunded. That is, it is nonrefundable. The purpose of this credit is to assist a taxpayer with various household and dependent care expenses paid during the tax year in order for that taxpayer to seek or maintain gainful employment. The expenses must have been incurred in the care for a qualifying child under age 13, another dependent, or spouse/RDP physically or mentally unable to care for himself. 2019 Child and Dependent Care Expenses Credit Federal AGI 2019 California Deduction Percentage $40,000 or less 50% Over $40,000 but under $70,000 43% Over $70,000 but under $100,000 34% $100,000 or more No Credit The following requirements must all be met in order for a taxpayer to claim the credit:  If the taxpayer is married or an RDP, there must generally be a joint tax return filed.  Care was provided in California.  The care was provided to a qualifying person.  Care expenses were incurred so that the taxpayer or spouse/RDP could engage in job-seeking activities.  The taxpayer or spouse/RDP earned wages or self-employment income (“earned income”) during the year.  The taxpayer and qualifying person lived together for over half the year.  The care provider was not the taxpayer’s spouse/RDP or the qualifying person’s parent or person for whom the taxpayer is claiming a dependent exemption. (The care can be provided by the taxpayer’s child if that child was over 18 by the end of the tax year.)  The taxpayer reports the required information about the care provider and qualifying person(s).  Federal AGI is $100,000 or less. 90 A qualifying person can be:  a child under 13 who meets the requirements to be a dependent (but only for that part of the year during which the child was under 13)  the taxpayer’s spouse or RDP who was physically or mentally unable to care for himself or herself  another person who was physically or mentally unable to provide self-care and either: o was the taxpayer’s dependent o would have been the taxpayer’s dependent except that:  the person received gross income of $4,150 or more  the person filed a joint tax return  the taxpayer or, if filing a joint return, the taxpayer’s spouse or RDP could be claimed as a dependent on someone else’s tax return That is, although the person for whom the care was provided could not be claimed as a dependent for any of the above reasons, the person could be a qualifying person as long as additional requirements are met. If the qualifying person is a child, these requirements are as follows:  relationship—A child must be the taxpayer’s child, stepchild, adopted child (even if the adoption is not finalized), eligible foster child (placed with the taxpayer by a court or authorized placement agency), sibling, step-sibling, or a descendent of one of these relatives.  age—The child must be under 13.  residency—The child must live with the taxpayer for more than half the year.  support—The child must not have provided more than half of his or her own support.  joint return—The child must not have filed a joint federal or state income tax return.  citizenship—The child must be a citizen or national of the United States or a resident of the United States, Canada, or Mexico. Since tax year 2012, California has had records/proof of expenses requirements for a taxpayer to claim this personal income tax credit. Until 2012, the Employer Child and Daycare Expenses Credit was allowed. There might still be carryover expenses allowed for claiming the repealed credit. When an individual taxpayer supports a qualifying child or relative who is a dependent, there may be a dependent exemption available to the taxpayer. In order to treat a child as a “qualifying child” for these purposes, the child must meet four tests:  relationship—A child must be the taxpayer’s child (birth or adopted), stepchild, eligible foster child, sibling, half-sibling, step-sibling, niece, nephew, or grandchild (or a descendant of one of these relatives).  age—The child must be 18 or younger (or under 24 if a full-time student (sometimes stated as “23 or under”)) or any qualifying relative who becomes permanently or totally disabled during any time in the calendar year.  residency—The child must live with the taxpayer for more than half of the tax year.  support—The child must not provide more than half of what the taxpayer provides toward support. 91 K – Adoption Credit When a taxpayer finalizes an adoption, there is a 50% credit for adoption costs. The credit can be claimed in the year in which the adoption was finalized, but adoption costs incurred up to that point (including expenses associated with a prior unsuccessful adoption of a different child) can be claimed as part of that credit. The child has to have been a citizen or legal resident of the United States and in the custody of a California public agency prior to adoption. The types of expenses that can be claimed are as follows:  agency fees (a California public agency)  adopting family travel expenses  unreimbursed medical expenses For 2018, the credit may not exceed $2,500 per child. If adoption costs were higher than $2,500, the excess can be carried over to future years. Any deduction taken for the expenses included in the credit calculation must be used as the adjustment to reduce the adoption credit. L – Credit for Taxes Paid to Other States A California taxpayer who pays income taxes in a state other than California may be eligible for a credit for those taxes. California’s Form 540 Schedule S provides a list of states to which this rules applies. This schedule must be completed and submitted for each state in which the eligible taxes were paid. If the income taxed in the other state was also taxed by California, even if not in the same year, the amount may be eligible for the credit if the taxes paid related to the same transaction or transactions. Additional rules apply:  California residents are eligible for this credit only if the income was non-California source.  The other state does not allow a credit for the California tax. The credit will offset taxes paid to the other state(s) in order to avoid double taxation. The California taxpayer does not qualify for the credit if the other state(s) give him a credit. M – California State Income Tax Refund California state income tax refunds are taxed at the federal level but not state level. If this refund is included as taxable income for federal purposes, the taxpayer makes an adjustment on the state return to exclude the refund. However, interest received on refunds of federal taxes is not deductible at the federal or California level. N – Renter’s Credit A taxpayer who pays rent for at least half of the tax year may qualify for the Renter’s Credit. The property cannot have been tax exempt. The taxpayer’s California income has to have been $42,932 or under (filing statues single or M/RDP filing separately) or $85,864 or under (filing statuses M/RDP filing jointly, HOH, or qualified widow(er)). The taxpayer cannot have lived with someone who could claim him as a dependent, and he or his spouse cannot have been given a property tax exemption during the 2019 tax year. The amount of the credit is $60 or $120 depending on filing status. 92 O – College Access Tax Credit If a taxpayer contributes to the College Access Tax Credit (CATC) Fund (which provides financial aid to low-income college students), that taxpayer will receive a tax credit of 50% of the contribution. P – Dependent Parent Credit For the taxpayer who provides care for an elderly parent (whether or not he or she lives with that parent), there may be a credit available. The most the taxpayer can claim is $469. When a taxpayer claims this credit, he cannot claim the Joint Custody Head of Household Credit. Q – Joint Custody Head of Household Credit If a taxpayer has joint custody of a child, stepchild, or grandchild and pays for more than half of that person’s expenses, the taxpayer may qualify for the Joint Custody Head of Household Credit. In addition to incurring half the cost of care, the taxpayer’s home has to have been the child’s main home for 146 to 219 days for the tax year. The taxpayer is disqualified if filing status is M/RDP filing jointly, HOH, or qualifying widow(er). There must be a legal custody agreement in place – the taxpayer must have been unmarried at the end of the tax year, or lived apart from his or her spouse for the whole tax year. R – Senior Head of Household Credit If the taxpayer is 65 or older, has qualified for HOH in at least one of the two years before the tax year, and has income under $76,082, the taxpayer may qualify for the Senior Head of Household Credit if the qualifying person has died in the two years before the tax year. The maximum credit is $1,380. S – Credit for Prior Year Alternative Minimum Tax The taxpayer may qualify for this credit if he had an Alternative Minimum Tax (AMT) carryover from the previous year and paid AMT for that year (and had adjustments and tax preferences other than exclusions). T – California Film and Television Tax Credit Program 2.0 The film and television industry has long been a mainstay of the California economy, and as such has been the beneficiary of governmental support in one form or another for a number of years. In 2014 bill AB 1839 was passed to revise and expand the tax credit program that had previously been in place. This new tax credit, which is allocated and certified by the California Film Commission (CFC), applies for taxable years beginning on or after January 1, 2016 and will continue until fiscal year 2019–2020. The credit is claimed on Form FTB 3541. The new five-year program introduces a number of changes compared to the previous tax credit program:  Starting with the 2015–2016 fiscal year, program funding was increased from the previous $100 million under the old scheme to $330 million per fiscal year until 2019–2020. (The California fiscal year runs from July 1 to June 30.)  Eligibility for funding is expanded to include big-budget feature films, one-hour TV series (for any distribution outlet), and TV pilots. 93  The budget cap for studio and independent films is eliminated. Although there is no cap for the overall production budget of applicants for the credit, eligibility for the tax credit will apply only to each project’s first $100 million in qualified spending (for studio films) or the first $10 million (for independent films).  The CFC will use a “jobs ratio” formula and other ranking criteria to select the projects that will receive tax credits under the program. Penalties may be applied for projects that overstate job creation.  Additional credits of up to 5% of qualified expenditures for visual effects and music scoring/recording performed in-state may be allowed. To qualify for the credit, a production must either:  film either 75% of its principal photography days entirely in California  spend 75% of its total budget in California The amount of the credit available for a given production is based on a percentage of its budget. 25% Tax Credit Available to:  TV series with a minimum budget of $1 million that filmed their prior season outside California before relocating to the state (After the first season is filmed in California, the credit is reduced to 20%.)  independent films with a minimum budget of $1 million (The credit only applies to the first $10 million of qualified expenditures. To qualify as an independent film, a project must be produced by a non-publicly traded company in which the proportion of ownership by a publicly traded companies is not more than 25%.) 20% Tax Credit Available to the following:  new television series intended for any distribution outlet with a minimum budget per episode of $1 million (Each episode must be at least 40 minutes in length, excluding commercials.)  TV pilot episodes with a minimum budget of $1 million  features with $1 million minimum budget (The credit applies only to the first $100 million in qualified expenditures.) 5% Tax Credit Available for qualified motion pictures produced in California for:  music scoring and music track recording by musicians  visual effects, provided a minimum of $10 million in qualified visual effects expenditures were incurred in California, or the work performed in California represents at least 75% of the film’s visual effects budget More information can be found on the California Film Commission website. 94 U – California Competes Tax Credit This credit became effective in 2014 and was designed to incentivize the operation of businesses in California. It would do so by encouraging businesses to relocate to the state from elsewhere, and also by encouraging existing California firms to remain in the state and expand their operations. The credit is available for all taxable years up until the end of the 2030 calendar year. The credit is administered through the Governor’s Office of Business and Economic Development (also known as GO-Biz), and businesses intending to apply for the credit must submit their application online. After review of the applications, tax credit agreements are negotiated by GO-Biz and approved by a statutorily created “California Competes Tax Credit Committee,” which consists of:  the State Treasurer  the Director of the Department of Finance  the Director of GO-Biz  an appointee by the Speaker of the Assembly  an appointee by the Senate Committee on Rules As part of the credit agreement, businesses who apply for the credit must commit themselves to meet certain employment or project investment requirements, referred to as “milestones.” According to the legislation that created the credit, the FTB is required use techniques such as reviewing certain businesses books and records to make sure that all businesses who have been approved for the credit are in compliance with the agreed-upon milestones. Yearly milestones that are set within the credit agreement and reviewed by the FTB for each business typically include:  California full-time employment numbers  salary levels  project investment Normally the credit agreements are each set for a duration of five years, with an additional three years to maintain employment increases and salary levels. The FTB may conduct several reviews during this eight-year period or it may conduct only one, depending on the circumstances. 95 V – College Access Tax Credit In September 2014 the Senate passed legislation (SB798) to encourage contributions to the funding of higher education by creating a College Access Tax Credit Fund. Under this program which became effective retroactively for the 2014 tax year, a College Access Tax Credit (CATC) is available to individuals and business entities that contribute to the CATC Fund. The fund is administered by the California Educational Facilities Authority (CEFA). The CATC was available for taxable years 2014 through 2017, but California House Bill AB 490, which was passed in 2017, extended the credit for another five years to December 31, 2022. Meanwhile the CATC fund has roughly $500 million on hand for allocation to California taxpayers in 2017. The credit is a percentage of the amount contributed by the taxpayer each taxable year: Taxable Year Credit Percentage 2014 60% 2015 55% 2016–2019 50% The credit can be used by the taxpayer to offset California tax, including reducing the tax below tentative minimum tax. A pre-condition to being able to claim the credit on their state income tax return is that taxpayers must have received a certificate from CEFA acknowledging their donation. Contributions to the fund may also be deductible as a charitable contribution on the taxpayer’s federal tax return. However, a charitable deduction and tax credit cannot both be claimed on the taxpayer’s California tax return for the same contribution. If a taxpayer has claimed the federal deduction, it will be necessary to add back the amount of the charitable deduction taken on his or her federal return as a state adjustment on his or her California tax return. Contributions to the fund are claimable as a tax credit on a California tax return in the tax year in which the initial application was made. However, at the federal level, the corresponding charitable contribution can only be claimed for the tax year in which the payment was actually made. As a result it is possible that an application made in late December 2016, but not approved until January 2017, would be claimed by the taxpayer on his or her 2016 California return and on his or her 2017 federal return. Further information on the credit and the available methods for making a contribution can be found on the CEFA website. In summary, a taxpayer is eligible to claim the credit for the taxable year in which he or she submitted the application if all of the following conditions are met:  CEFA received a completed application by mail, in person, facsimile, or online on or before the CEFA deadline.  CEFA issued a Notice of Allocation Reservation to the taxpayer.  The taxpayer provided CEFA a Contribution Submittal Form and contribution on or before the due date listed on the Notice of Allocation Reservation.  CEFA provided the taxpayer with a signed College Access Tax Credit Certification. 96 Example: Bob wants to contribute to the CATC fund, so he applies for a CATC reservation on August 1, 2017. He proposes to contribute $20,000 to the fund. On August 11, CEFA grants Bob a $10,000 credit reservation (50% × $20,000). Several days later on August 15, 2017, Bob makes his $20,000 contribution to the fund. After receiving the funds, CEFA mails a credit certification for $10,000 to Bob on August 20, 2017. Bob can claim a $10,000 College Access Tax credit on his 2017 California tax return. He can also claim a $20,000 charitable contribution on his federal return. However, Bob cannot claim a charitable contribution on his California return in relation to his $20,000 donation. W – New Employment Credit The New Employment Credit (NEC) replaced the Enterprise Zone Hiring Tax Credit and became effective as of January 1, 2014. The credit is available for each taxable year beginning on or after that date, and before January 1, 2026. Definition of Terms Before discussing further the details of the credit, it is important to understand the terms used in describing the related conditions for eligibility: Applicable percentage = Net increase in current year full-time equivalent employees over base year full-time equivalent employees Current year qualified employees  base year—the year before the first qualified employee is hired  designated geographic area (DGA)—may be: o one of the designated census tracts that have the highest unemployment and highest poverty in the state o a former Enterprise Zone (in existence on December 31, 2011, designated in 2012) and any revision to an EZ prior to June 30, 2013, except census tracts within those EZs with lowest unemployment and lowest poverty levels o a former Local Agency Military Base Recovery Area (LAMBRA) (in existence on July 11, 2013)  full-time equivalent employees—California full-time employees prorated based on hours or weeks worked by full-time employees (35+ hours per week)  Hiring credit = Applicable percentage × Tentative credit amount  qualified employee—a person who met any of the following conditions at the date of hire: o unemployed six months prior to the date of hire (Higher education students must have graduated at least 12 months prior to hire.) o veteran unemployed since separation from service during the last 12 months o Earned Income Tax Credit recipient in the previous year o ex-offender previously convicted of a felony o recipient of CalWORKS or Welfare 97  qualified taxpayer—an employer engaged in a trade or business within a DGA. Unless its annual receipts are less than $2 million, the following types of operations are ineligible for the credit: o temporary help services or retail trades o businesses primarily engaged in:  food services  alcoholic beverage places  theater companies and dinner theater  casinos and casino hotels  qualified wage—amount in excess of 150% of minimum wage up to 350% of minimum wage, unless located in special Designated Pilot Areas in which case the floor is $10 per hour instead of 150% of the minimum wage  Tentative credit = 35% of Qualified wage Claiming the Credit The credit can be claimed by qualified employers that hire qualified full-time employees and pay or incur qualified wages for work performed in a designated geographic area (DGA). The maximum credit per employee is $56,000 over five years. The credit is based on 35% of qualified wages, but to be eligible for the credit, a qualified taxpayer must have a net increase in its total number of full-time employees working in California in comparison to its base year. This calculation is based on the number of annual full-time equivalent employees for each of those years. More information is available on the FTB website, but the general procedure for claiming the credit is as follows:  When a new eligible employee is hired, the employer must complete the related new hire reporting requirements with the Employment Development Department (EDD) within 20 days of the employee’s first day of work.  Within the next 30 days, request a Tentative Credit Reservation (TCR) from the FTB. This application must be completed online and its purpose is to ensure the new employee is qualified for the purposes of the credit.  File an annual certification of employment online with the FTB on or before the 15th day of the third month of the qualified taxpayer’s current taxable year. This certification serves to update the number of qualified employees on record for the qualified employer.  When applying for the credit, the employer must: a. calculate the tentative credit amount (total qualified wages × applicable credit percentage of 35%) b. calculate the applicable percentage (net increase in current year full-time equivalent employees over base year full-time equivalent employees divided by current year qualified employees) c. calculate the allowable credit (tentative credit amount from Step A × the applicable percentage from Step B) (The result is the amount that is available to use as a credit in the current tax year.) 98 The credit is claimed on Form 3554. More information on the form and the conditions for claiming the credit can be found on the FTB website. X – Claim of Right A taxpayer may have a “claim of right” adjustment in certain situations. If an item of income was included in gross income for an earlier tax year and it is repaid, if that repayment obligation is over $3,000, an adjustment is allowable in the year in which the repayment occurs. Instructions for computing the adjustment are provided by Section 17049 of the California Revenue and Tax Code. Y – Mortgage Interest Tax Credit The California tax credit program provides for a first-time buyer tax credit equal to 20% of the mortgage interest paid during the year. As a credit, it reduces tax dollar-for-dollar (rather than being a deduction, which reduces income in order to arrive at taxable income). This 20% can be rolled forward for up to three years. If a taxpayer itemizes deductions, he or she can still deduct the remaining 80% of the interest. There is no double-counting. If a taxpayer receives a credit for 20%, that same 20% cannot be used as a deduction. To qualify, the taxpayer (and spouse, if married) must be a U.S. citizen, permanent resident, or qualified alien. The property must be the taxpayer’s principal residence. With a few exceptions, the credit is only for first-time homebuyers. The taxpayer has to move into the residence within 60 days of closing and remain living there during the loan duration. The credit applies only to new mortgages (not re-financing). Z – Summary In this chapter we reviewed a number of different tax credits, with particular emphasis on the CalEITC which was introduced for the 2015 tax year. We saw that this credit is similar in many ways to the federal EITC, although the amounts offered to taxpayers by the California EITC are lower than those at the federal level. Also similar to the federal EITC, we saw that California has implemented a number of due diligence obligations – most notably the requirement to file Form FTB 3596, Paid Preparer’s California Earned Income Tax Credit Checklist. We also reviewed some other credits that are designed to stimulate employment in different locations and sectors of the economy and the College Access Tax Credit that is designed to increase funding for education. 99 Chapter 8 Review Questions 1. Which statement is true with respect to the Earned Income Tax Credit? A. There is a federal EITC and a California EITC. B. There is no longer a phase-out for the California EITC. C. Taxpayers whose filing status is “Married Filing Separately” can qualify for the EITC. D. A taxpayer eligible for an Earned Income Tax Credit must select either the California credit or the federal credit. 2. Which statement is true with respect to the Renter’s Credit? A. A taxpayer who pays rent for only half of the tax year cannot qualify for the Renter’s Credit. B. A taxpayer with the filing status “Married Filing Separately” cannot qualify for the Renter’s Credit. C. A single taxpayer has to have California income below $20,000 to qualify for the $60 Renter’s Credit. D. A taxpayer who rents tax-exempt property cannot qualify for the Renter’s Credit. 3. Which statement is false with respect to the Adoption Credit? A. If adoption costs are higher than the amount of the credit for one child, the excess can be carried forward. B. The credit can be claimed in the year in which the adoption was finalized. C. The credit is $2,500 for each child. D. Any adoption expenses incurred before the year in which the adoption was finalized cannot be counted for purposes of the Adoption Credit. 100 Answers to Chapter 8 Review Questions 1. A. That’s correct! Both the FTB and the IRS provide for an EITC. B. This answer is incorrect. There is a phase-out for the California EITC. C. This answer is incorrect. Taxpayers whose filing status is “Married Filing Separately” do not qualify for the EITC. D. This answer is incorrect. A taxpayer eligible for an Earned Income Tax Credit can take both the California credit and the federal credit. 2. A. This answer is incorrect. A taxpayer who pays rent for at least half of the tax year may qualify for the Renter’s Credit. B. This answer is incorrect. A taxpayer with the filing status “Married Filing Separately” can qualify to claim the Renter’s Credit. C. This answer is incorrect. A single taxpayer earning $41,641 or less can qualify to claim the Renter’s Credit. D. That’s correct! A taxpayer who rents tax-exempt property cannot qualify for the Renter’s Credit. 3. A. This answer is incorrect. The question asks which answer is false. It is actually true that if adoption costs are higher than the amount of the credit for one child, the excess can be carried forward. B. This answer is incorrect. The question asks which answer is false. It is actually true the credit is claimed in the year in which the adoption was finalized. C. This answer is incorrect. The question asks which answer is false. It is actually true that the credit is $2,500 for each child. D. That’s correct! It is false that any adoption expenses incurred before the year in which the adoption was finalized cannot be counted for purposes of the Adoption Credit. 101 Chapter 9 Casualty , Theft , and Disaster Losses A – Introduction California suffers from many types of natural disasters: earthquakes, floods, and wildfires are a frequent occurrence in California. Every year, there have been emergency declarations by the California Governor and by the U.S. President. Tax professionals in California therefore need to be familiar with the rules related to tax relief for casualty losses caused by disasters. In this chapter we will review the options available for taxpayers to aid in their financial recovery by claiming their losses as a deduction on their California tax returns. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify the conditions that must currently be met for taxpayers to claim a casualty, theft, or disaster loss on their California tax return  identify the timing options available for taxpayers who wish to claim such a loss  identify the formulas used by individual and business taxpayers to calculate these losses C – California Rules on Losses In general, the law in California with regard to the treatment of losses resulting from a casualty or disaster follows the federal law. However, taxpayers may deduct a disaster loss on their California tax return for any loss they may suffer in a city or county that the California Governor has declared to be in a state of emergency. Prior to 2014, this state of emergency required further legislation by the state before the provisions of the disaster loss system could be activated. On its own, a declaration by the Governor of a state of emergency or disaster is insufficient to make losses by taxpayers deductible for federal purposes. What is required in addition or instead is a declaration of a major disaster or disaster area by the President of the United States, by which taxpayers become eligible for federal assistance under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. According to federal law, a casualty event takes place when a taxpayer experiences the damage or loss of property due to an event such as a fire, flood, earthquake, or other similar event that is:  sudden  unexpected  unusual A casualty loss for tax purposes occurs when a taxpayer’s insurance or other reimbursements are insufficient to repay all of his or her losses from the casualty event. 102 According to California law, a taxpayer’s casualty loss is classified as a disaster loss for California purposes when both of the following conditions are met:  The taxpayer’s loss has occurred in an area that the President of the United States or the Governor of California declares a state of emergency.  The taxpayer’s loss occurred because of the declared disaster. Examples of casualty losses include property damaged due to an earthquake, flood, or some other occurrence that is sudden, unexpected, or unusual. Normal wear and tear are not included. A theft is the criminal taking of money, property, or services of someone else without consent and with intent to deprive the owner of it. A state tax deduction is permissible to the extent the damage was not paid for fully by insurance (or otherwise). Damage does not have to be complete for these rules to apply. For personal use property that is not completely destroyed, the taxpayer can deduct any unreimbursed value in the amount of either:  the property’s adjusted basis  the decrease in the property’s fair market value as a result of the casualty Fair market value is the amount at which property would change hands between a willing buyer and seller. Adjusted basis generally means what the taxpayer paid for the property plus the cost of any improvements, less deductions such as depreciation. In determining the appropriate deduction, adjusted basis would be used because the fair market value of property after theft is zero. For business or income-producing property, the loss is the adjusted basis less any salvage value or insurance reimbursements. The taxpayer must subtract $100 and 10% of his federal AGI. When the loss deduction exceeds income, the taxpayer has a net operating loss (NOL). The taxpayer reports the loss to California using the IRS’s Form 4684. Federal law currently allows only a deduction for presidentially declared disasters as personal casualty losses. D – Defining Disaster Losses California law conforms to federal law other than the federal requirement for a presidentially declared disaster for a personal casualty loss. California lists specific events as disasters. Excess losses get carryforward treatment (100% of excess may be carried over for 15 taxable years). A casualty loss can become a disaster loss when the taxpayer sustains the loss in the designated disaster area and the taxpayer actually sustained the loss because of that disaster. Recent California Disasters A number of disaster declarations have been made related to California over the past few years:  Holy Fire – August of 2018  Carr Fire – July of 2018  Tubbs, Atlas, and multiple other fires – October of 2017 The President declared Napa, Solano, Sonoma, and Yuba counties a federal disaster area.  San Bernardino County Rainstorm – July of 2017 While not declared at the federal level, legislation was passed for California purposes declaring a disaster in San Diego County.  Pawnee Fire – June of 2018 103  March Winter Storms – March of 2018  Southern California Mudslides – January of 2018  Lilac Fire and various other fires – December of 2017 A more thorough list, going back many years, is available on the Franchise Tax Board website. The website also provides event codes that should go on the state tax return. E – Calculating and Claiming a Disaster Loss In general, taxpayers claiming the disaster loss should write the name of the particular disaster in red ink at the top of their tax return to alert FTB to expedite the refund. Individual Taxpayers Individual taxpayers must determine the amount of their personal loss by taking the lesser of:  his or her adjusted basis of the property  the reduction of the fair market value of the property caused by the disaster From this figure:  the taxpayer subtracts any insurance or other reimbursement received (or that could have been received if the taxpayer filed a claim)  and then subtracts $100 per disaster event  and then subtracts 10% of his or her federal AGI In other words: Personal disaster loss = The lesser of:  Adjusted basis, or  Reduction in FMV – Insurance or other reimbursement received, or receivable – $100 per disaster event – 10% of federal AGI Individual taxpayers must use federal Form 4684, Casualties and Thefts, to make their claim, completing Section A, Personal Use Property. This form must be submitted along with the taxpayer’s California tax return, a copy of the taxpayer’s federal return (original or as amended), and a statement that outlines the date and location of the disaster that is the subject of the claim. 104 Business Taxpayers Business taxpayers must determine the amount of their business loss by taking the lesser of:  their adjusted basis of the property or  the reduction of the fair market value of the property caused by the disaster  then subtracting any insurance or other reimbursement received or expected Unlike the calculation performed by individual taxpayers, business taxpayers do not subtract $100 per disaster event or 10 percent of their federal AGI. The calculation is thus much simpler: Business disaster loss = The lesser of:  Adjusted basis, or  Reduction in FMV – Insurance or other reimbursement received or expected Individual taxpayers must use federal Form 4684, Casualties and Thefts, to make their claim, completing Section B, Business and Income-Producing Property. This form must be submitted along with the taxpayer’s California tax return, a copy of the business taxpayer’s federal return (original or as amended), and a statement that outlines the date and location of the disaster that is the subject of the claim. Due Date Postponements In recognition of the difficulties faced by taxpayers affected by disasters, the Internal Revenue Service often postpones due date deadlines by up to 12 months for taxpayers who live or operate a business in a disaster area declared by the President. The California Franchise Tax Board automatically follows the same postponement deadlines as declared by the IRS and in some cases both agencies may cancel for the duration of the postponement any interest or penalties on underpaid taxes that would normally apply. From its records, the IRS identifies taxpayers who are affected in any given disaster area and then automatically applies filing and payment relief. This normally includes:  individuals whose principal residence is located in the disaster area  businesses that have their principal place of business in the disaster area However, other categories of taxpayer may also be affected by the disaster but will not be identified by the IRS record search. These taxpayers are also eligible for postponement relief, for example:  relief workers who belong to a recognized organization and are working in the disaster area  individuals or businesses for whom their deadline-related records are located in the disaster area  individuals who were visiting the disaster area and were killed or injured as a result of the disaster Taxpayers in these latter categories must contact the IRS to apply for relief. 105 When to Claim the Loss Taxpayers who qualify to claim a disaster loss have two choices when claiming the deduction. They can either:  claim the disaster loss on the tax return for the year in which the disaster took place  claim the disaster loss on their prior year’s return, amending that return if it has already been filed Selecting the second option of claiming on the prior year’s return has the advantage of reducing the taxpayer’s tax liability for that year, thus creating a refund that can be quickly issued by the Franchise Tax Board to help the taxpayer’s financial recovery. Examples of Amending Previous Year’s Return Taxpayers who have already filed the prior year’s return and wish to amend it by filing Form 540X, Amended Individual Income Tax Return, should bear in mind that the due date for filing Form 540X is normally April 15 of the following year (unless special legislation is passed to extend that deadline). Example 1: The machinery shed on Tom’s farm was destroyed by fire during a declared wildfire disaster in August 2016. He has already filed his 2015 tax return and now has up until April 15, 2017 to file Form 540X to amend that return. Example 2: Same details as above, except Tom is in no hurry to recoup his losses. He can simply wait until the early part of 2017 to file his 2016 return, claiming the disaster loss on that return. Disaster Loss Carryover While losses from disasters can generally be carried forward, not all California disasters are treated equally. In some cases 100 percent of the excess losses can be carried forward for 20 years, while in other cases the limit is 15 years. For disaster losses that taxpayers sustained between 2004 and 2011, 100 percent of the excess loss can be carried over for up to 15 years and back one year (so that the FTB can issue a refund). To claim a disaster loss, the taxpayer must file an amended return for the preceding year or claim it on the tax return filed for the year of the loss. Disaster Loss Examples Example 1. 2014 Napa Earthquake. For this disaster that took place on August 24, 2014, the IRS extended all deadlines that were scheduled between the day of the disaster and January 15, 2015. These deadlines were all postponed until January 15, 2015. This included individuals and businesses that had previously obtained an extension until October 15, 2014, to file their 2013 returns and corporations and businesses that had received a similar extension until September 15. It also included the estimated tax payment for the third quarter of 2014, which would normally have been due on September 15. Taxpayers affected by this disaster were also advised that interest and penalties for late filing or late payment would be abated in relation to any deadlines that normally would have fallen within the postponement period. Taxpayers who believed they may fall outside the IRS’ automatic identification process were advised to call the toll-free IRS Disaster Hotline to request postponement relief. In addition, California Senate Bill 35 (SB 35) was enacted almost a year later to provide relief at the state level for taxpayers affected by the earthquake. The bill was intended to provide individuals who were unable to quantify the extent of their earthquake-related losses until after the 2014 tax filing deadline the ability to apply their losses to their prior year tax returns, which in turn would allow them to obtain a refund more quickly in the current year. 106 The bill not only extended the deadline for filing an amended return to claim losses caused during the past year by an earthquake, but also allows individuals affected by future natural disasters in California to apply disaster losses to their prior year tax returns through to January 1, 2024. The bill was also aimed at avoiding unnecessary confusion by ensuring that the deadlines are the same for California and the federal income tax. Although the 6.0 earthquake only lasted 10–20 seconds, it was the largest earthquake in the Bay Area since 1989 and caused millions of dollars in damage. Immediately after the event, Solano County officials declared a state of emergency and reported that the earthquake caused $20 million to county public buildings, and businesses and homes in the city of Vallejo. The county’s emergency declaration was lifted once the Federal Emergency Management Agency (FEMA) had been mobilized to help in recovery efforts. Example 2. October 2017 Wildfires. Following the widespread wildfires that occurred in different parts of the state beginning on October 8, 2017, the President declared that a major disaster existed in the State of California. The IRS then announced that affected taxpayers in California would receive tax relief. This relief would potentially apply to individuals with a residence or business in Butte, Lake, Mendocino, Napa, Nevada, Orange, Solano, Sonoma, and Yuba counties. As part of the tax relief, the IRS (and by extension the FTB) granted additional time to file (up to January 31, 2018) for certain deadlines falling on or after October 8, 2017, and before January 31, 2018. This included taxpayers who had a valid extension that was due to run out on October 16, 2017, for the filing of their 2016 tax return. It also included the quarterly estimated income tax payments that were originally due on January 16, 2018, and the quarterly payroll and excise tax returns that were normally due on October 31, 2017. It also included calendar-year tax-exempt organizations that had an automatic filing extension due to run out on November 15, 2017. In addition, penalties on payroll and excise tax deposits that were due on or after October 8, 2017, and before October 23, 2017, would be abated provided that the deposits were made by October 23, 2017. Given that California law generally follows federal law regarding the treatment of losses incurred as a result of a casualty or a disaster, the FTB will also follow these extended dates and will cancel interest and any late filing or late payment penalties that would otherwise apply. Any taxpayers who are eligible for the above tax relief and who receive a late filing or late payment penalty notice from the FTB or IRS that has an original or extended filing, payment, or deposit due date that falls within the postponement period are advised to call the telephone number on the notice to have the penalties abated. In addition to the above, at the federal level the Tax Cuts and Jobs Act of 2017 provided similar benefits that had been provided by the Disaster Tax Relief Act to taxpayers that had been affected by Hurricanes Harvey, Irma, and Maria earlier in the year. These federal provisions include:  Ten percent early withdrawal penalty from retirement plans does not apply to qualified disaster distributions from 2016 or later.  Rollover period for qualified disaster distributions from 2016 or later is extended from 60 days to three years. 107 F – Summary In this chapter we not only reviewed the definition of a disaster loss but also saw that catastrophic events that lead to disaster declarations seem to occur quite frequently in California. We reviewed the formulas that individuals and businesses use to calculate their disaster losses and noted that the state and federal governments can postpone tax filing deadlines to give affected taxpayers time to recover from their physical losses before addressing the matter of their financial reporting obligations. The 2014 Napa earthquake serves as a graphic example of the cooperative efforts made by many agencies to mitigate the effects of this disaster. 108 Chapter 9 Review Questions 1. Which of the following losses would be classified as a loss for California tax purposes? A. A California resident’s Montana vacation home is destroyed by a tsunami from the Great Salt Lake. B. California Taxpayer Trent was isolating at his Alameda, California home when he turned the music up too loud in his home office to drown out the sounds of a parade going by outside. The windows blew out, and then a wind storm swept through the neighborhood and blew other houses’ windows out, causing the governor to declare a disaster area. Trent claims the loss of his windows as a disaster loss. C. A taxpayer’s home gets so much rain in June that he has to replace his roof. He treats the roof as a casualty loss. D. The governor declares a state of emergency in Napa when severe drought dries up all the vineyards. Although the area had experienced dry conditions from time to time over the years, no one had seen anything like the severity of this drought. The vineyard owner treats the loss of his vineyard as a casualty loss. 2. Which of the following is not a general characteristic of a casualty event? The event is: A. unusual B. due to a cause that should have been foreseen and prevented C. unexpected D. sudden 3. Which of the following statements is true regarding disaster losses? A. The California FTB follows the same postponement of deadlines as the IRS does. B. When there is a postponement due to a disaster, the taxpayer can wait until the following year’s due date to file and pay taxes for the year in which the disaster occurred. There will be no penalties assessed. C. The IRS will only allow a postponement to people it identifies from its records as living or working in the disaster area. D. A disaster loss is the same as a theft loss. 109 Answers to Chapter 9 Review Questions 1. A. This answer is incorrect. A tsunami in Montana from the Great Salt Lake would not be a California disaster. B. This answer is incorrect. The loss was not caused by the wind storm declared a disaster. C. This answer is incorrect. The rain is considered wear and tear. D. That’s correct! The governor declared a disaster for the event (unusual in its severity) that caused the loss. 2. A. This answer is incorrect. Being unusual is one of the characteristics of a casualty event (e.g., the loss of valuable timber trees due to an invasive insect that had never been seen before in the state). B. That’s correct! If a farmer who ignored repeated warnings from his neighbors to spray his fruit trees to prevent a disease known to be carried by insects in his local area subsequently lost a number of his trees to the disease, it would be difficult to argue that this event was unusual, sudden, or unexpected. C. This answer is incorrect. This is a characteristic of a casualty event (e.g., an undersea earthquake that causes flooding in coastal areas). D. This answer is incorrect. Suddenness is a characteristic of a casualty event (e.g., a wall of water that rushed down a creek bed in a flash flood event). 3. A. That’s correct! In the case of a disaster loss, California follows federal deadline postponement. B. This answer is incorrect. Tax payment due dates cannot be postponed in this manner without the taxpayer owing penalties. C. This answer is incorrect. Some taxpayers not revealed by a records search can still qualify if they contact the IRS to apply for relief. D. This answer is incorrect. These are two different types of losses. 110 Chapter 10 Net Operating Losses A – Introduction One area in which California and federal rules do not conform is in treatment of net operating losses (NOLs). A taxpayer has an NOL if he or she has more deductions than income – that is, when there is negative income. To qualify for a deduction, the loss must have been generated from deduction due to expenses from a business, work as an employee, casualties, theft, moving, or rental property. If the loss or a portion of it is deductible, it can be used to offset income in profitable years. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  understand how to calculate losses  know when to apply key business loss rules C – Federal and California Net Operating Loss (NOL) Rules As of tax year 2019, California does not allow NOL carrybacks. Just prior to this rule change, there was a two-year carryback period for California. D – Business Losses Tax refund rules for business NOLs is tied to the type of business entity and whether the taxpayer’s investment in the business was at all “at risk.” After the Tax Cuts and Jobs Act, a business loss can still be carried forward but it cannot be carried back. The carryforward amount is limited to 80% of taxable income. The carryforward period is unlimited. Taxpayers can usually use business NOLs to reduce personal taxable income. There are limits to the amounts that can be carried forward – these limits are called “excess loss limits.” The IRS indicates that an excess loss is the amount by which the total deductions from all trades or businesses exceed a taxpayer’s total gross income and gains from those trades or businesses, plus $250,000 (or $500,000 for a joint return.?). That is, a taxpayer may not take more than $250,000 (or $500,000) as a loss for a single year. Excess loss limits apply to pass-through entities, because their income is passed through to a taxpayer’s personal tax return. The excess loss calculation is tricky, as there are many factors that can affect it. Two common sources of complication are the at-risk rules and passive activity loss rules. At-Risk Rules The personal tax return reflects total income and losses from all business and personal sources. The IRS provides specific rules for how to calculate the NOL. There are at-risk limitations: deductions are limited to the amounts the taxpayer had at risk (could be lost) at the end of the year in activities that taxpayer did not materially participate in. These rules prevent investors from writing off (through a flow-through entity) more than the amount they invested if they were not material participants in the business. 111 If a person invests $20,000 in a business, and that business fails, the person’s investment can be recognized as a loss. To that amount, reductions of the federal and state income tax bracket percentages would apply. If the individual is in the 32% marginal tax rate bracket for federal and 5% for state, the reduction would be 37% × $20,000. The taxpayer could reduce his or her tax liability by $7,400 ((32% + 5%) × $20,000 = $7,400). Excess losses can be carried forward. Passive Activity Limitations Similarly, business loss deductions from passive activity (the owner does not participate on a “regular, continuous, or substantial” basis) are limited to the amount of income from that business. Installment Sales If property has been sold at a gain and the taxpayer will receive a payment in tax years after the one for which the taxpayer is filing, the sale can be reporting on the installment method. E – Capital Transactions Issues When there has been a capital asset sold or exchanged, the cost or other basis is first subtracted from the sales price. Sales commissions are not included in the sales price. Basis is the property cost plus improvements and then minus depreciation, amortization, and depletion. In California, if a basis other than cost was used, there are additional calculations that must be performed because federal rules differ on this issue from California rules. F – Depreciation In order to recognize the “using up” of a capital asset, its value is decreased every year by a statutorily determined percentage. There are differences between California and federal rules related to such cost recovery. That is, depreciation provides an income tax deduction to allow recovery of the cost basis of certain types of property. Most tangible and certain intangible (intellectual property) assets are depreciable. Listed Property California and federal law are the same with respect to listed property, other than for cell phones. California still treats cell phones as listed property, whereas the federal government does not (beginning in 2010). California conforms to federal law on the Federal Class Life Asset Depreciation Range (ADR) System. This system indicates the useful life for different types of property. Although federal law allows a corporation to choose a depreciation period that does not match the ADR, California does not. Section 179 Deduction In order to use the (federal) Section 179 deduction on listed property, that property has to have been used more than 50% in a qualified business. Otherwise, the property should be depreciated using the straightline method (the taxpayer looks on a statutory list and finds out the number of years the property is considered useful; the purchase price is divided by the number of years and an equal depreciation expense amount applies every year of that property’s useful life. Note that the recovery period for cell phones and other telecommunications devices have a recovery period of five years. California conforms, with some modification, to IRC Section 179 covering the additional first-year depreciation or the election to expense the property if below a certain value. 112 California does not conform on the following topics:  expanded Section 179 definition of property for certain depreciable tangible personal property or for qualified real property improvements  enhanced IRC Section 179 expensing election  first-year depreciation deduction allowed for certain automobiles acquired and placed in service 2010 through 2018  federal modifications to depreciation limitations on luxury automobiles  depreciation under Modified Accelerated Cost Recovery System (MACRS) for corporations (California allows MACRS when the depreciation expense is passed through to partnerships) Modified Accelerated Cost Recovery System (MACRS) MACRS is a depreciation method used for tax purposes. There are different depreciation schedules for tax purposes when MACRS is used. The capitalized cost of an asset is still recovered over a specified period through annual depreciation deductions. MACRS, which applies to most assets, allows for faster depreciation over a longer cost recovery period. A recovery period, which generally but not always matches between federal and California law, is the useful life that has been assigned to assets in a certain class. Accelerated Cost Recovery System (ACRS) California allows “any consistent and reasonable method of depreciating assets as long as the methods do not result in more depreciation during the first 2/3 of the property’s useful than would result through use of the declining balance method. If the declining balance method is used, the rate of depreciation must not exceed twice the annual rate had the straight-line method been used for the same property.” ACRS was replaced by MACRS in 1986. California accepts the following depreciation methods:  straight line—cost less salvage value, in equal amounts over useful life  double declining balance—a form of accelerated depreciation  sum-of-the-years-digits—another form of accelerated depreciation  other—as noted above (which usually includes ACRS and MACRS) For some classes of assets, specific depreciation methods are assigned:  3-, 5-, 7-, and 10-year classes—double declining balance method (switching to straight-line when straight-line provides a larger deduction)  15- and 20-year property—150% declining balance method (switching to straight-line when straight-line provides a larger deduction)  residential rental property and nonresidential real property—straight-line method A California taxpayer may make an irrevocable election to use the straight-line method of depreciation for all property in a single class. 113 FTB Form FTB 3885A Form FTB 3885A is used when the amount of depreciation allowed in California is different than that for federal purposes. There have been changes in both schemes over the years that often result in there being a different basis for the same asset:  different depreciation methods  different recovery periods  different credits  different accelerated expensing rules G – Capitalize or Expense A capital expenditure includes payments made to improve buildings, buy new equipment, or make other long-term outlays. The cost must be depreciated rather than expensed. A repair, on the other hand, can be deductible currently. Treatment is based on the facts and circumstances of individual situations. H – Summary This chapter explained one area in which California and federal rules do not conform – treatment of net operating losses (NOLs). A taxpayer has an NOL if he or she has more deductions than income – that is, when there is negative income. To qualify for a deduction, the loss must have been generated from deduction due to expenses from a business, work as an employee, casualties, theft, moving, or rental property. If the loss or a portion of it is deductible, it can be used to offset income in profitable years. Various important rules apply to business losses, most importantly perhaps the at-risk rules and the passive activity limitations. 114 Chapter 10 Review Questions 1. Which of the following is true with respect to at-risk and passive activity rules? A. An excess in NOLs can only be carried back. B. The at-risk limitations apply to limit deductions to the amounts the taxpayer could have lost at the end of the year. C. If a taxpayer is in the 32% marginal tax rate bracket for federal and 5% for California, the taxpayer should select the federal deduction because it is higher. D. Business loss deductions from passive activity (the owner does not participate on a “regular, continuous, or substantial” basis) are limited to the fair market value of any tangible property that taxpayer had contributed to the business. 115 Answers to Chapter 10 Review Questions 1. A. This answer is incorrect. An excess in NOLs can be carried forward. B. That’s correct! For deductions the taxpayer could have lost at the end of the tax year, the at-risk limitations apply. C. This answer is incorrect. If a taxpayer is in the 32% marginal tax rate bracket for federal and 5% for California, the taxpayer adds these rates together. D. This answer is incorrect. Business loss deductions from passive activity (the owner does not participate on a “regular, continuous, or substantial” basis) are limited to the income from that business. 116 Chapter 11 Health Care A – Introduction In this chapter, the student will learn about the Affordable Care Act, health care rules in California, and various vehicles for individuals to plan for their own health care and long-term care expenses. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify areas of nonconformity between California and federal law with respect to health care taxation rules  understand various financial vehicles for planning for health expenses  understand what circumstances exist for a child to be covered by a parent’s health insurance policy C – The Affordable Care Act The federal law known as the Affordable Care Act (ACA) was passed with the goal of expanding health care coverage and lowering costs. California and the federal government expanded the term “medical care” to include qualified long-term care premiums and services. The ACA created marketplaces (also known as “exchanges”) for consumers to shop for their own health insurance with the ability to compare plans easily. California runs such an exchange, called “Covered California.” California tax law conforms to federal law by excluding from California gross income the value of health care coverage the taxpayer purchases for himself or provides to adult children (who are not dependents of the taxpayer). There is also a deduction that self-employed taxpayers can take for health insurance premiums for such adult children (under age 27). D – Affordable Health Care in California California provides a health exchange to provide various types of health insurance plans for eligible enrollees. This exchange, Covered California, offers four tiers of plans. Eligibility for plans depends on income. As with the federal ACA, the major goal is to provide access to high-quality, affordable health care coverage. The exchange also has information on California Medicaid (Medi-Cal). 117 The Covered California and similar plans provide choices for consumers that allow them to determine what best fits their financial resources (and can pay for premiums and co-pays) and health care requirements. The four Covered California plans are the:  bronze plan—customer pays 40%  silver plan—customer pays 30%  gold plan—customer pays 20%  platinum plan—customer pays 10% of the health care cost There are also enhanced silver plans for people with lower income who qualify for lower out-of-pocket costs. With an enhanced silver plan, a customer gets the benefits of gold and platinum but pays only for silver. Another option is a minimum coverage plan. A person qualifies if any one of the following statements is true:  The customer is under 30.  The customer cannot afford health coverage.  The customer qualifies for a hardship exemption. The Affordable Care Act requires that all the health plans sold on the California exchange (in the “Covered California” marketplace) have the following minimum coverage elements:  hospitalization  ambulatory  urgent and emergency  prescriptions  maternity and breastfeeding  lab  preventative and wellness  mental health and drug abuse  pediatric (including dental and vision) As noted above, eligibility for the different plan tiers is largely a function of income. Plans offer lower premiums and various cost-sharing reductions. To qualify, the individual must:  be a U.S. citizen or legally present in the U.S.  enroll for health coverage through Covered California  not be receiving Medicare, Medi-Cal, or military health benefits  not have employer-sponsored health care coverage  have a household income of 100% to 400% of the federal poverty level 118 The California ACA protects patient access and services in several ways:  There are no annual dollar limits (for certain benefits).  There are no lifetime dollar limits (for certain benefits).  A child can be covered by a parent’s health plan while that child is under age 27.  New conditions are not a valid reason for an insurance company to terminate a person’s coverage.  Pre-existing conditions are not excluded from coverage and cannot be used to deny issuance of a policy.  An employer cannot fire an employee because that person selects an ACA plan instead of the employer’s plan.  An insured person may choose his or her own primary care doctor and specialists (including outof-network). The California ACA resembles the federal ACA in several ways. Parents can cover their children who are younger than 19 (or 24, for the child who is a student). For a taxpayer younger than 30, there are, in some instances, additional plans that can be purchased on top of the above plans. These “minimum coverage plans” are offered through Covered California. They cover such services as preventative care, doctor, urgent care visits (three), and some outpatient mental health services. Services that are not in the basic coverage require that the taxpayer spend $7,150 (in 2018) before in-network services are covered. After this threshold is met, in-network services are covered 100%. E – State Mandate for Health Insurance Beginning January 1, 2020, California taxpayers are required to have health insurance throughout the year. On the tax year 2020 return, a taxpayer who does not have qualifying coverage throughout the year may be subject to a penalty of $695 (or more) for an individual taxpayer, $345 for a dependent child, $1,390 for a married couple, and $2,085 for a family of four with two dependent children. Qualifying plans can be found through coveredca.com, as can information about financial help that might be available. Family of: AGI Ranges for Financial Aid 1 $0 to $74,940 2 $0 to $101,460 3 $0 to $127,980 4 $0 to $154,500 5 $0 to $181,020 6 $0 to $207,540 119 F – Self-Employed Health Insurance Deduction As noted elsewhere in this course, California treats RDPs as spouses for tax purposes. The federal government does not recognize the registered domestic partnership and requires an actual marriage for a taxpayer to claim the self-employed health insurance deduction on his or her partner. If there is an insurance plan entered into by the taxpayer’s business, the California taxpayer can claim a deduction for insurance coverage for himself, his spouse, and their dependents. The total state deduction cannot exceed federal limitations. The deduction is only applicable to expenses incurred while the taxpayer was not eligible to participate in an employer-subsidized plan. For federal tax purposes, there is an allowable deduction for health insurance coverage of a taxpayer’s adult children under 27. For California state tax purposes, adult children who provide more than half of their own support during the tax year do not qualify. G – Small Employer Health Insurance Credit The federal government allows a credit for a small business employer who provides health insurance for its employees. Any insurance deduction taken on the taxpayer’s return must be reduced by the amount of the credit. In California, the full amount of health insurance is deductible. There is no need for a similar credit. However, a taxpayer must adjust the state return to account for the amount taken as a federal credit. H – Health Savings Accounts (HSAs) Health Savings Accounts (HSAs) provide another means for people to meet their health care needs and to cover their health care costs. A HSA is a tax-exempt account an individual establishes and owns to accumulate funds to pay for qualified medical expenses. HSAs were introduced by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, which amended the Internal Revenue Code to allow individuals a tax deduction for amounts contributed to special accounts, established in their names, to save for future medical expenses. These accounts align with the goal of giving consumers more control over the costs of their health care and providing access to coverage that is affordable, flexible, and portable. HSAs are used in conjunction with high-deductible health plans (HDHPs) offered by many insurance companies. How HSAs Work An individual establishes a health savings account, which is a trust or custodial account, and makes contributions to it for current and future medical expenses. As noted, it is intended to be used with a highdeductible health plan, or HDHP – either an individual HDHP or a family HDHP. Contributions to an individual’s HSA can be made by the individual or by another (such as an employer or family member) on behalf of the individual. 120 The maximum amount that may be contributed to an HSA in any year is set by law (subject to change annually), and is based on the kind of HDHP with which the HSA is linked. Following are the annual contribution limits for 2019 and 2020 for individual (self-only) HDHP coverage and family HDHP coverage. 2019 HSA Contribution Limit 2020 HSA Contribution Limit Individual HDHP Coverage $3,500 $3,550 Family HDHP Coverage $7,000 $7,100 All contributions to an HSA, regardless of source, count toward the annual maximum. A catch-up provision applies for plan participants who are age 55 or over, which allows for an increase in the annual contribution limit up to a specified amount. (Currently, this additional annual catch-up amount is $1,000.) Funds contributed to an HSA are used – tax-free – to pay for qualified medical expenses that are not covered by the HDHP plan to which the account is linked. These expenses can include the HDHP’s annual deductible (which can be quite high), along with the plan’s co-payments and coinsurance. Tax Advantages Federally, HSAs are triple tax advantaged. In this context, “tax advantaged” means:  Funds contributed to the account are not subject to federal income tax – they are either contributed on a pre-tax basis or deducted “above the line.”  Interest or earnings that accumulate in the account are not subject to federal income tax.  Funds taken from the account to pay for qualified medical expenses – at any time – are not subject to federal income tax. Furthermore, in the event of disability or at the age of 65, funds can be withdrawn for any purpose, without penalty (though ordinary income tax is payable on the amount withdrawn if it is not used for medical expenses). While an HSA account is technically a savings account, it is set up like a checking account. Sometimes checks are issued by the account custodian, but more often the account holder is given a debit card to pay pharmacies, doctors, and other health care providers. The account can be used to reimburse the account holder in the event he or she must pay for services personally (e.g., if the debit card is temporarily misplaced or authorization lines are down at the time of service). Because an HSA is owned solely by the participant, it is entirely portable. If an employer has made contributions to the account and the participating employee leaves the workplace for any reason, the account remains with the participant. California Rules Regarding HSAs Although California incorporates federal law concerning medical savings accounts (MSAs), it does not follow federal law for tax treatment of health savings accounts (HSAs). For California tax purposes, a taxpayer may not exclude employer HSA contributions from gross income, and there is no California deduction for taxpayer contributions to an HSA. Interest and dividends earned on HSAs are subject to California income tax. When a taxpayer rolls over amounts from an MSA to an HSA, the rollover is taxed as income by California. 121 I – Medical Savings Accounts (MSAs) Another option for some consumers to manage their health care costs is the Medical Savings Account (MSA). These accounts work in tandem with a high deductible health plan (HDHP). They work similarly to HSAs and were actually phased out in 2003 when HSAs were established. MSAs were restricted to small businesses and self-employed persons. MSA contributions could be made by only an employer or individual in one year – not both. Yearly contributions were not required. There are still some active MSAs. The remaining MSAs are limited to people who were active participants before January 1, 2008 or who take jobs at employers with existing HDHP/MSAs. Withdrawals are tax-free if used to pay for qualified medical expenses. California law largely follows federal law. Employer contributions, interest earned, and dividends earned are excluded from income. If an individual has a (federally) taxable MSA distribution, there is an additional form to file with a California return. Distributions from an MSA for unqualified purposes are treated as taxable income. The federal penalty is 15%, and the California penalty is 10%. Medicare Advantage MSAs have their own penalties – basically, any distribution subject to the federal 50% penalty is also subject to a California penalty. California does not allow a tax-free rollover from an MSA to an HSA. Amounts moved from an MSA to an HSA must be included in the taxpayer’s California AGI. J – Long-Term Care Insurance Qualified medical expenses include long-term care insurance premiums, but the amount deductible on the federal return is determined by the taxpayer’s age. Maximum deductible premium amounts are summarized below. IRS Publication 502 has additional information on qualified long-term care insurance contracts. K – Summary This chapter covered tax implications of several widely applicable health care insurance rules. There was specific attention paid to health insurance for the small business and the self-employed. It also covered several vehicles taxpayers can use to plan for their own health care expenses. 122 Chapter 11 Review Questions 1. Which statement is true with respect to affordable health care issues in California? A. California does not participate in a health exchange. B. Health plans sold in a health exchange have to cover hospitalization. C. The ACA requires coverage of pre-existing conditions only after the taxpayer has held the policy for a year. D. A child can remain on a parent’s health plan until that child is 29. 2. Which statement is true with respect to the California Affordable Care Act? A. There are annual dollar limits for all benefits. B. There are lifetime dollar limits for all benefits. C. An employer can require an employee to participate in the employer’s plan (instead of an ACA plan) in order for that employee to keep his job. D. An insured person may choose his or her own primary care doctor (including out-ofnetwork). 123 Answers to Chapter 11 Review Questions 1. A. This answer is incorrect. California’s health exchange is called “Covered California.” B. That’s correct! Hospitals sold on the Covered California Exchange must cover hospitalization expenses. C. This answer is incorrect. The ACA specifically requires coverage of pre-existing conditions without a waiting period. D. This answer is incorrect. A child can remain on a parent’s health plan until that child is 24. 2. A. This answer is incorrect. There are no annual dollar limits for some benefits. B. This answer is incorrect. There are no lifetime dollar limits for some benefits. C. This answer is incorrect. An employer cannot fire an employee for choosing an ACA plan instead of the employer’s plan. D. That’s correct! An insured person may choose his or her own primary care doctor (including outof-network) under the California Affordable Care Act. 124 Chapter 12 Alternative Minimum Tax A – Introduction There are many perceived (and actual) loopholes in the tax code(s) that might in some instances allow some taxpayers to pay less than their share of taxes. In order to avoid such a situation, there is an Alternative Minimum Tax, which a taxpayer must calculate and compare to tax liability derived under regular tax rules. The AMT is calculated by beginning with taxable income from regular taxes and applying adjustments to raise or lower the Alternative Minimum Taxable Income. This chapter covers AMT rules. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  understand the purpose of the alternative minimum tax  define the different components used to arrive at alternative minimum tax C – What Is the Alternative Minimum Tax? When calculating California or federal income tax, it is important to remember the AMT. A taxpayer sometimes owes this “alternative” tax so that he does not game the system to pay too little tax. In California, the rate is 7% of what is called an “alternative minimum tax base.” The taxpayer or preparer starts with taxable income and adds to or subtracts from that amount for an AMT exemption allowance and certain adjustments and preferences. Certain deductions only apply after a certain income threshold. One of the adjustments is based on medical expenses. For California AMT purposes, the unreimbursed medical expense threshold is 10%. The alternative minimum tax is added to regular tax. It is equal to any excess of tentative minimum tax (TMT) over the regular tax for that tax year. In California, “regular tax” for AMT purposes is income tax before any credits are applied. The IRS’s AMT rate is 26% of the first $191,000 of a single taxpayer’s alternative minimum taxable income (AMTI) that exceeds the applicable exemption amount and 28% of any additional AMTI over the exemption amount. The California rate is lower. Calculating the AMT For a California nonresident or part-year resident, a preparer would multiply the AMTI by a ratio to isolate the appropriate California income to consider. The AMT includes all parts of AMTI during California residency and/or California-source income. Carryovers, deferred income, suspended losses, and suspended deductions are allowed to the degree they came from California-source income. 125 For regular tax, there are certain deductions that carryover: NOLs, capital losses, investment interest expense, and others. Consideration of these items gets complicated. For the AMT, these same items are treated differently. Calculations may be determined by filling out draft forms for the applicable tax twice. The draft forms should just be used to calculate – not to send with the return. California is different from the IRS in counting personal exemptions for AMT purposes. Only the standard deduction is disallowed. California also allows certain credits to reduce a taxpayer’s regular tax amount below the TMT (after an allowance for the minimum tax credit). Some of these credits are as follows:  Nonrefundable Renter’s Credit  Credit for Excess Unemployment Compensation Contributions  credits for taxes paid to other states  credit for withheld tax  personal, dependent, blind, and senior exemption credits  Adoption Costs Credit  California Earned Income Tax Credit (EITC)  credits for qualified joint custody head of household and a qualified taxpayer with a dependent parent; and the senior head of household credit Calculating the AMTI To get to the alternative minimum tax, a preparer must first calculate the AMTI. The AMTI represents regular taxable income, with reductions for certain things and increased by certain things. Qualified taxpayers exclude their trade or business’s income, adjustments, and tax preference items. Personal Property Taxes and Real Property Taxes A taxpayer’s AMTI should include certain items from federal Schedule A:  state and local personal property taxes  state, local, or foreign real property taxes  home mortgage interest for non-purchase-money mortgage loans (home equity loans) California AMT Exemption Phase-Outs The California AMT exemption amounts are phased out above certain thresholds. For each dollar that AMTI exceeds the phase-out threshold, the exemption amount is reduced by 25 cents. The 2019 exemption amounts are:  $98,330 for M/RDP filing jointly or qualifying widower, with a phase-out threshold of $368,737  $73,748 for single and HOH, with a phase-out threshold of $276,552  $49,163 for M/RDP filing separately (and estates and trusts), with a phase-out threshold of $184,365 126 Credit for Prior Year Minimum Tax When a taxpayer has had California AMT in earlier years but not in the tax year, there is a carryover credit. The California credit is calculated the same way as the federal credit – just with California figures instead of federal figures. Both taxing authorities base AMT credits on the amount of AMT paid on items that defer tax (deferral preferences) but not items that permanently reduce tax (exclusion items). Unused credits may be carried forward indefinitely. Exemption for Small Businesses Federal law disallows the standard deduction and the deduction for personal exemptions for AMT calculation. California disallows only the standard deduction. California also departs from federal law and excludes from AMTI the income, adjustments, or items of tax preference attributable to a trade or business of a taxpayer who has an ownership interest in a trade or business or has gross receipts (less returns and allowance) of under $1 million. This $1 million is the limit for the aggregation of all trades or businesses in which the taxpayer has an ownership interest. Understandably, the California computation only includes the proportion attributable to nonresidents with California business or California-source income and to residents. The gross receipts figure includes both business and nonbusiness income. This $1 million limit applies to all filing statuses. Estimated Tax Payments and the AMT AMT must be included in the computation of estimated tax payments to avoid underpayment. D – Summary In this chapter, students learned the purpose of the AMT system – to prevent taxpayers from paying too little tax. The AMT provides a different set of rules, rates, and adjustments. If AMT exceeds income tax calculated under non-AMT rules, then additional tax above the regular return tax calculation will be due. 127 Chapter 12 Review Questions 1. Which statement is true with respect to the California alternative minimum tax (AMT)? A. Federal law disallows the standard deduction and the deduction for personal exemptions for AMT calculation. California disallows only the standard deduction. B. The California AMT cannot be carried over. C. The IRS’s AMT rate is 26% of the first $287,000 in federal adjusted gross income. D. AMT is not considered in the computation of estimated tax payments to avoid underpayment. 128 Answers to Chapter 12 Review Questions 1. A. That’s correct! California and federal rules regarding the deduction for personal exemptions for the AMT are different. California allows the personal exemptions for AMT calculation. The federal rules allow for neither. B. This answer is incorrect. The California AMT can be carried over. C. This answer is incorrect. The federal AMT is 26% of the first $191,000 of a single taxpayer’s alternative minimum taxable income above the applicable exemption amount. D. This answer is incorrect. A taxpayer must make estimated tax payments on AMT to avoid underpayment. 129 Chapter 13 Retirement A – Introduction Especially as the population ages, there is greater demand for retirement income plans that will cover people for their post-retirement lives. This chapter provides information about the tax implications of using different retirement vehicles, as well as the timing of distributions from those accounts. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  recognize and apply rules related to various retirement instruments and situations  understand the tax implications for different retirement planning approaches C – Individual Retirement Accounts (IRAs) Contributions to IRAs are deductible for federal and California tax purposes. For a traditional IRA, the most that can be contributed is the smaller of the age-based contribution limit or 100% of compensation. The limit on annual contributions to an Individual Retirement Arrangement (IRA) remains unchanged at $5,500. The additional catch-up contribution limit for individuals aged 50 and over is not subject to an annual cost-of-living adjustment and remains $1,000. If the taxpayer is covered by an employer’s retirement plan or if he or she files a joint tax return with his or her spouse who is covered by such a plan, the taxpayer may be entitled to only a partial deduction or no deduction at all, depending on his or her income. The taxpayer should see the federal instructions for more information. The taxpayer can elect to designate otherwise deductible contributions as nondeductible. However, he or she does not have to elect the same treatment for California purposes as for federal purposes. The deduction for taxpayers making contributions to a traditional IRA is phased out for singles and heads of household who are covered by a workplace retirement plan and have modified adjusted gross incomes (AGI) between $64,000 and $74,000 in 2019. For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $101,000 to $121,000. For a married individual filing a separate return, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $193,000 and $203,000. For singles, heads of household, qualifying widow(er), or married filing jointly or separately with a spouse who is not covered by a plan at work, his or her modified AGI can be any amount and he or she can take a full deduction up to the amount of his or her contribution limit. 130 For a married individual filing a separate return with a spouse who is covered by a workplace retirement plan, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000. For 2019, the AGI phase-out range for taxpayers making contributions to a Roth IRA is $193,000 to $203,000 for married couples filing jointly. For singles and heads of household, the income phase-out range is $120,000 to $135,000. For a married individual filing a separate return, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000. Lump-Sum Distributions If an employee’s benefits are paid to him in one taxable year, because of his death or termination of his employment, the taxable amount is subject to special treatment as a lump-sum distribution. The taxable amount is the total distribution less employee contributions, and any unrealized appreciation on employer securities included in the distribution. Under California and federal law, the $5,000 employer-provided death benefit exclusion was repealed. Payments received in 2019 on behalf of decedents dying on or after August 21, 1996, do not qualify for the exclusion. Lump-Sum Election You must include the taxable part of a lump-sum (retroactive) payment of benefits received in 2019 in your 2019 income, even if the payment includes benefits for an earlier year. California Residents Receiving Out-of-State Pensions If a taxpayer is a resident of California, he or she is subject to state income tax on all income. For example, if the taxpayer receives pension payments from a job performed outside of California but not received until after the taxpayer is a California resident, the distributions are fully taxable by California. Nonresidents of California Receiving California Pensions By contrast, California does not tax most types of retirement payments received by a nonresident after December 31, 1995. There are exceptions to this general rule, and California taxes certain types of pensions, profit sharing plans, and stock bonus plan payments. Basis When a California resident takes an IRA distribution, whether California taxes that distribution depends on whether the contributions were partially or fully nondeductible when they were made. If contributions were deductible when made, distributions are taxable. Nondeductible contributions make up the tax basis of the IRA. Portions of a distribution that are simply a recovery of basis are not taxable. By definition, the taxpayer is getting a return of the money initially invested. There is a difference between federal and California taxation if part of the basis is based on pre-1987 contributions. There was a difference in contribution limits, and this difference can provide the taxpayer an opportunity to adjust federal AGI to a lower amount for California. The adjustment is the lesser of the pre-1987 California basis and the IRA distribution included in the federal adjusted gross income. Military Pension If the taxpayer is a California resident, his or her military pension is taxable by California, regardless of where the service was performed. 131 Roth IRAs Federal law and California law are the same regarding contributions, conversions, and distributions. However, the taxable amount of a distribution may not be the same because of basis differences. Roth IRA contributions are not deductible. D – Social Security The IRS and the FTB treat taxation of Social Security payments differently. The federal government will tax Social Security benefits according to a formula set forth in its explanatory publications. Any such income included to arrive at federal AGI should be excluded from California income – there should be a subtraction of this amount from income. E – Summary This chapter covered tax strategies for minimizing taxation in retirement. Several different retirement accounts were described and explained. There was a reminder to consider Social Security income when estimating retirement income and planning for retirement. 132 Chapter 13 Review Questions 1. Which statement is true with respect to Social Security income? A. The IRS and FTB treat taxation of Social Security payments the same way. B. Any Social Security income included to arrive at California adjusted gross income should be excluded from federal income. C. There should be a subtraction from federal income equal to the Social Security income used to arrive at California AGI. D. Any Social Security income counted in arriving at federal AGI should be excluded from California income. 133 Answers to Chapter 13 Review Questions 1. A. This answer is incorrect. The IRS and FTB treat Social Security payments differently. B. This answer is incorrect. Federal gross income and adjusted gross income are calculated before the California return is started. C. This answer is incorrect. Federal income is calculated first. D. That’s correct! When Calculating California AGI, any Social Security income included as part of federal AGI should be adjusted out. 134 Chapter 14 Real Property A – Introduction A gain or loss on the sale of almost any asset is considered a capital gain or loss. In fact, most property owned by a taxpayer, whether used for personal purposes or held as an investment is a capital asset. A taxpayer’s house, furnishings, automobiles, stocks, and bonds are all capital assets. Gains and losses on the sale of assets not related to the sale of business property are initially reported on federal Form 8949 (as long-term or short-term) and the subtotals are then carried over to federal Schedule D. One key difference between California and federal tax is that while both California and federal tax shortterm capital gains as ordinary income, California also taxes long-term gains at ordinary income tax rates while federal taxes on long-term gains are based on a different scale that taxes long-term gains at a lower tax rate than ordinary income. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  understand rules regarding real property transactions  identify tax treatment of capital gains and losses in different types of real property transactions  be familiar with withholding rules  understand passive activity loss rules C – Capital Gains and Losses Generally, the taxpayer will not need to make any adjustments on the actual gain or loss. However, if the California basis of his assets differs from that of the federal, adjustments will be required. The following list indicates some of the occurrences that would cause differences in capital gain or loss amounts between the federal and California returns:  gain on sale or disposition of a qualified assisted housing development to low-income residents  disposition of property inherited before 1987  capital loss carryback  basis differences of business property  gain on the sale of a personal residence Capital Gains Tax Rates Although California generally treats capital gains and losses the same way, California taxes capital gains as ordinary income, and the amount of loss does not depend on the holding period. California does not permit capital loss carry-backs. 135 Sale of an Assisted Housing Development to Low-Income Residents Federal law does not allow special treatment on gains related to the sale of certain assisted housing. California law permits the deferral of such gain, under certain conditions, if the proceeds are reinvested in residential real property (other than a personal residence) within two years of the sale. If a difference exists between the taxpayer’s federal and California capital gain or loss amount, he or she must complete an FTB Schedule D. Unlike federal law, California law provides no special long-term capital gain rates for California taxpayers. The amount of capital loss limitation for California taxpayers is the same as the federal limitation, $3,000 ($1,500 if married/RDP filing separately). However, capital loss carryovers and capital loss limitations are based only on California-source income and loss items when calculating the California taxable income. Property Inherited Before 1987 Federal gain or loss may differ from the California gain or loss due to differences in the basis of property. For property inherited on or after January 1, 1987, the California basis and the federal basis are generally the same. The California basis of property inherited from a decedent is generally the fair market value at the time of death. Capital Loss Carryback Federal law allows a deduction for carrybacks of certain capital losses. California has no similar provision. Basis Differences of Business Property The California basis of assets may be different than the federal basis due to differences between California and federal law, which may affect the gain or loss on disposition. Gain on the Sale of a Personal Residence Both California and federal law allow an individual taxpayer to exclude from his or her gross income up to $250,000 ($500,000 for married/RDP taxpayers filing jointly) of gain realized on the sale or exchange of a personal residence if the taxpayer owned and occupied the residence as a principal residence for an aggregate period of at least two of the five years prior to the sale or exchange. California has an exception for taxpayers serving in the Peace Corps during the five-year period before the date of sale. The mandatory two-year period of ownership (ownership test) and occupancy (use test) may be reduced by the period of service, up to 18 months. For MFJ/RDP couples, either spouse can satisfy the ownership test, but both spouses must satisfy the use test. This is the only difference on the capital gains exclusion allowed for the sale of a residence. The dollar exclusion amounts, up to $250,000 ($500,000 for MFJ) are the same for both federal and California. Under both California and federal laws, if a taxpayer does not meet the two-year ownership and use requirement due to a change in place of employment, health, or unforeseen circumstances, the exclusion may be prorated. The exclusion amount is based on federal filing status and not on California filing status. The California rules are generally the same as the federal. If there is a difference between the amounts excluded (or depreciated, if recapture applies) between federal and California, complete California Schedule D. 136 Installment Sales If property was sold at a gain (other than publicly traded stocks or securities) and the taxpayer receives a payment in a tax year after the year of the actual sale, then the sale is reported using the installment method unless the taxpayer elects not to do so. The installment sales method is used to recognize revenue after the sale has occurred and when sales are stipulated under very extended cash collection terms. Payments will be made over time instead of all at once. Withholding on California Real Estate For taxable years beginning on or after January 1, 2009, when California real estate is sold on an installment basis, the buyer is required to withhold on the principal portion of each installment payment an amount based on either 3 ?% of the total sales price or the Optional Gain on Sale withholding amount (12.3% of the gain) from Form 593. Form 593 must be certified by the seller. If the taxpayer is the buyer he must withhold on the principal portion of each installment payment. Withholding payments must be submitted within 20 days following the end of the month in which the real estate transaction occurred. Sellers may be eligible for a release from withholding on installment payments following the close of escrow. To elect out of withholding on installment payments from the sale of California real property, the seller must fulfill the several requirements. He must file a California income tax return and report the entire gain on Schedule D-1 in the year of the sale. Other situations that do not require withholding include transactions where the total sales price (regardless of the number of parcels included in the single transaction) is $100,000 or less and certain foreclosed upon property. There are withholding requirements for sales of California real property closing on or after January 1, 2008. Real estate withholding is a prepayment of California state income tax for sellers of California real property. Real estate withholding is not an additional tax on the sale of real estate. It is a prepayment of the income (or franchise) tax due on the gain from the sale of California real property. California law requires real estate withholding whenever there is a transfer of title on California real property. Examples include:  sales or transfers of real property (including exchanges)  leaseholds/options  short sales  easements  personal property sold with real property (if not stated separately)  deferred exchanges  vacant land 137 The requirement to withhold is the responsibility of the buyer but may be performed by the real estate escrow person (REEP) on the buyer’s behalf. Unless an exemption applies, all of the following are subject to real estate withholding:  individuals  corporations  partnerships  limited liability companies  estates  trusts  real estate investment trusts (REITs)  relocation companies  bankruptcy trusts and estates  conservatorships Real estate withholding is not required when any of the following apply:  The total sales price is $100,000 or less: o When there are multiple sellers the withholding is determined by the total sales price, not each seller’s portion. o Sales of multiple parcels and/or family units (duplex, triplex, etc.) within the same escrow agreement constitute one transaction for purposes of determining the withholding requirements. Withholding is required where the combined sale price of all parcels exceeds $100,000, even though the sales price of each separate parcel in the same escrow transaction is under $100,000. Withholding is required on sales or transfers of California real property when the total sale price exceeds $100,000 and meets one of the following conditions:  The seller is a corporation with no permanent place of business in California immediately after the sale.  The seller is an individual or any other type of entity except for a partnership. Sellers who meet the above criteria may still qualify for a full or partial exemption. However, the law does not provide for early refunds of taxes withheld on sales of real estate. The taxpayer must file his or her California tax return to claim the amount withheld. Sellers are exempt from withholding if the:  property qualifies as his or her principal residence (IRC Section 121)  property was last used as his or her principal residence (IRC Section 121)  sale will result in a loss or zero gain for California tax purposes  transaction will qualify as a like-kind exchange, with some exceptions (IRC Section 1031)  transaction will qualify as an involuntary conversion (IRC Section 1033) 138  transaction will qualify for non-recognition treatment under IRC Section 351 (transfer to a corporation controlled by the transferor) or IRC Section 721 (contribution to a partnership in exchange for a partnership interest)  seller is a corporation with a permanent place of business in California  seller is a partnership  seller is an LLC classified as a partnership for federal and California income tax purposes, which is not a single member LLC that is disregarded for federal and California income tax purposes  seller is a tax-exempt entity  seller is an insurance company, individual retirement account (IRA), qualified pension plan, or charitable remainder trust Sellers who meet one of the above exemptions must sign a written certification under penalty of perjury to be exempt from withholding. As the seller, the taxpayer may choose between the two withholding calculation methods available:  Total Sales Price Method  Alternative Withholding Calculation Method Real estate escrow persons and Qualified Intermediaries (QIs) are not authorized to provide legal or accounting advice for purposes of determining withholding amounts. The Franchise Tax Board encourages sellers to consult with a tax professional for this purpose. To calculate the withholding using the Total Sales Price Method, the taxpayer multiplies the total sales price or boot by 3?% (.0333). Boot is defined as the money, debt relief, or the fair market value of “other property” received by the seller in an exchange in addition to replacement property. To calculate the withholding using the Alternative Withholding Calculation Method, also known as the Optional Gain on Sale Election Method, the taxpayer multiplies the estimated gain calculated on FTB Form 593-E, Real Estate Withholding – Computation of Estimated Gain or Loss, by the seller’s or transferor’s maximum tax rate. If the taxpayer elects to compute withholding using the Alternative Withholding Calculation Method, he or she is required to:  complete and sign FTB Form 593-E (the form he or she used to calculate the amount of his or her loss or gain for withholding purposes)  sign FTB Form 593 – Real Estate Withholding Tax Statement By signing these forms, the taxpayer certifies under penalty of perjury the gain shall not be less than the gain required to be recognized. California law requires the taxpayer to keep Form 593-E for his or her records for five years. The FTB may review relevant escrow information to ensure withholding compliance. Passive Activity Losses and the Sale of Real Estate Ordinarily, business and investment losses are deductible from other income. However, this is not always the case for losses from real estate rentals. Special passive activity loss rules prevent many landlords from deducting their rental losses from other non-rental income such as salaries or investment income. This is particularly common for higher income property owners. The result is that many rental property owners can only deduct their rental losses from passive income – that is, rental income or income from other businesses in which they are not actively involved. 139 For both federal and California tax returns, a passive activity includes any trade or business in which the taxpayer does not materially participate, and any rental activity regardless of participation. Beginning in 1994, and for federal purposes only, rental real estate activities performed by qualified real estate professionals are not automatically treated as passive activities. California does not conform to this provision. Therefore, for California purposes all rental activities are considered passive activities. Without passive income, rental losses become suspended losses that the taxpayer cannot deduct until he has sufficient passive income in a future year or sells the property to an unrelated party. The taxpayer may not be able to deduct such losses for several years. Suspended losses can be carried forward indefinitely and used in subsequent years against passive activity income. They are allowed in full upon a taxable disposition. Tax treatment of a capital gain or loss also depends on the length of time that the taxpayer held the capital asset. Examples of capital assets can be but are not limited to real estate, securities such as individual stocks or mutual funds, and collectibles like art, gold, or coins. The length of time a taxpayer has held a capital asset is called the holding period. If the taxpayer held the asset for more than one year, it is classified as a long-term asset. Any capital asset held for less than one year is classified as a short-term asset. This is important for determining federal treatment of capital gain or loss. Unlike federal law, California treats capital gains as ordinary income which means there are no holding period implications in the determination of a capital gain or loss. California passed Proposition 30 in 2012, and the ordinary income tax rates in the measure apply retroactively to January 1, 2012. Those earning $250,000 to $300,000 a year now pay 10.3% (up from 9.3%). For taxpayers earning $1 million or more, California’s new rate is 13.3% (up from 10.3%). Short Sales Section 580e of the Code of Civil Procedure also addresses mortgages. This section was added in 2010 and it prohibits a deficiency judgment on specific agreed to “short sales” (allowing the defaulter to sell the house at below cost, and the lender accepting the proceeds as payment in full). In 2011, Section 580e was amended to expand its provisions in order to mitigate the impact of the ongoing foreclosure crisis and to encourage the approval of short sales as an alternative to foreclosure. According to an IRS Information Letter dated September 19, 2013, the IRS has determined under the 2011 changes to the California Code of Civil Procedure Section 580e that California taxpayers who sell their principal residences in a short sale for less than what is owed on the home are relieved of incurring cancellation of indebtedness income, if the lender agrees to the short sale as full consideration of the mortgage debt, and there will be no cancellation of indebtedness income. The IRS’s letter answered the question regarding whether a homeowner would have taxable cancellation of indebtedness (COD) income when the lender approved a short sale considering California’s Code of Civil Procedure (CCP) Section 580e. The letter finds California’s anti-deficiency provision under Section 580e of the CCP which generally prohibits a lender who holds a deed of trust from either claiming a deficiency or obtaining a deficiency judgment from the homeowner after agreeing to a short sale, treats the homeowner’s obligation as a nonrecourse obligation for tax purposes. This means in California, upon a lender’s acceptance of the short sale any CCP 580e qualifying cancellation of indebtedness income is nontaxable nonrecourse debt. CCP 580e does not apply to all short sales. In addition to other restrictions this law states it does not apply if the trustor or mortgagor is a corporation, limited liability company, limited partnership, or political subdivision of the state. 140 California conforms to the relevant portions of the federal tax law governing the forgiveness of nonrecourse and recourse debt, so if the lender agrees to the short sale as full consideration of the mortgage debt, for tax purposes, the loan will be nonrecourse; thus, there is no cancellation of indebtedness income for California tax purposes. The IRS issued an April 29, 2014 IRS Information Letter which clarifies guidance in their original letter dated September 19, 2013. The new letter states, in part: Section 580b(a)(3) of the California’s Code of Civil Procedure (CCP) provides that:  A deficiency judgment will not apply in any event after a sale of real property under a mortgage that secures a purchase-money loan.  A purchase money loan is a loan that was used to pay all or part of the purchase price of an owner-occupied dwelling for not more than four families and that is secured by the property. Therefore, the IRS states their understanding is for loans that qualify under Section 580b(a)(3). A lender has no recourse against a mortgagor for a deficiency under any circumstance. The cancellation of a nonrecourse loan upon disposition of property does not result in cancellation of debt (COD) income. In addition, under Section 580b(a)(3), a “purchase-money loan” includes a loan used to refinance a purchase-money loan, or subsequent refinances of a purchase-money loan, except to the extent that the lender lends new principal that is not applied to an obligation owed or to be owed under the purchasemoney loan. California conforms to federal law and according to the IRS Information Letter dated September 19, 2013, the IRS has determined that California taxpayers who sell their principal residences where the lender has agreed to a short sale for less than what is owed on the home do not have cancellation of indebtedness income, which may have been taxable. Instead, the amount of cancelled debt is included in the amount realized in determining gain or loss on the sale of that residence. The IRS guidance is limited to short sales only involving a principal residence for tax years 2011 and forward. The IRS guidance did not specifically address other types of real estate transactions such as nonjudicial foreclosures. FTB guidance can be found on the FTB website at the Mortgage Forgiveness Debt Relief page. If the taxpayer is considering filing amended returns based on this new IRS letter, he or she should also file corresponding California amended tax returns. D – Summary In this chapter, you saw that a gain or loss on the sale of many assets is considered a capital gain or loss. We covered rules related to identifying capital gain and loss situations and learned the differences in tax treatment between capital income or loss and ordinary income. The chapter highlighted a key difference between California and federal tax: while both authorities tax short-term capital gains as ordinary income (with higher tax rates), only California also taxes long-term capital gains as ordinary income. The federal government applies lower capital tax rates to income from transactions involving capital assets. This course primarily covers the ins-and-outs of ordinary income, but it is important to see how capital gains tax rules fit in the overall scheme. 141 Chapter 14 Review Questions 1. Which statement is true with respect to withholding on California real property transactions? A. When there is a requirement to withhold taxes, the buyer withholds taxes. B. Withholding payments must be submitted within 20 days following the end of the month in which the real estate transaction occurred. C. There does not need to be withholding if the seller of the real property is a corporation. D. When a tax-exempt entity sells real property, the exemption applies only to property tax. 2. Which statement is true with respect to capital gains and losses? A. Federal and California law allow a deduction for carrybacks of certain capital losses. B. If there is a gain on the sale of a personal residence, a taxpayer serving in the Peace Corps during the five-year period before the date of sale is exempt from tax on that gain. C. If there is a gain on the sale of a personal residence, a taxpayer serving as a first responder in a disaster loss area is exempt from tax on that gain. D. A sale of real property that results in a long-term capital gain is taxed by the federal government and California as ordinary income. 142 Answers to Chapter 14 Review Questions 1. A. This answer is incorrect. It is the seller who would withhold taxes. B. That’s correct! When a real estate transaction occurs and there are withholding requirements, there are 20 days following the end of the month in which that transaction occurred to submit those withholding payments. C. This answer is incorrect. A corporation is not necessarily exempt from withholding. D. This answer is incorrect. There is no withholding requirement. 2. A. This answer is incorrect. Federal law allows a deduction for carrybacks of certain capital losses. California has no similar provision. B. That’s correct! If there is a gain on the sale of a personal residence, a taxpayer serving in the Peace Corps during the five-year period before the date of sale is exempt from tax on that gain. C. This answer is incorrect. If there is a gain on the sale of a personal residence, serving as a first responder in a disaster loss area has no effect on whether there will be capital gains tax on the sale of a personal residence. D. This answer is incorrect. A sale of real property that results in a long-term capital gain is taxed by the federal government at special capital gains tax rates but by California as ordinary income. 143 Chapter 15 Procedural Issues A – Introduction As tax professionals, we are accustomed to seeing each year bring new and amended tax regulations, but the beginning of 2016 also brought with it a major upgrade in the functionality of the online portal MyFTB to aid us in our practice. In this chapter we will review the main features of the recently-released “enhanced MyFTB,” including details on existing and new Power of Attorney requests. We will also review some filing-related changes such as the new requirement to provide the Social Security number of dependents claimed on an individual tax return. B – Chapter Learning Objectives After successfully completing this chapter you will be able to:  identify the three user groups served by the enhanced MyFTB system and identify the steps required by pre-2016 users to gain access to the system  identify the actions required by tax professionals to ensure that they continue to receive copies of all FTB correspondence for their list of active POA clients  identify the new requirements for information to be provided with personal tax returns that include dependents and for those that claim the Head of Household filing status C – Filing California Tax Returns and Paying Tax As noted elsewhere in this course, the California counterpart to federal Form 1040 is Form 540. Various common schedules and worksheets have been discussed. As with federal tax, California income tax returns are due April 15, with an automatic six-month extension to file available on request. All tax due must be paid on or before April 15 in order to avoid penalties. Estimated Tax Payments California and the federal government both require a taxpayer to make quarterly payments of estimated tax if there is no employer to withhold and pay such taxes during the year (or part of it). Due dates correspond to federal due dates: April 15 (with 30% of annual estimated tax due), June 15 with 40% due, 0% due September 15, and the remaining 30% for the January 15 installment for calendar-year taxpayers. If actual tax for the preceding year was under $500, California will not impose an underpayment penalty. The federal threshold is $1,000. The tax code provides for a safe harbor for estimated tax payments. Most taxpayers may avoid underpayment and late penalties by paying the lesser of 90% of the current year’s tax or 100% of the preceding year’s tax. For the taxpayer whose AGI for the current year exceeds $75,000 (filing status MFS) or $150,000 (MFJ), the safe harbor provides protection as long as the taxpayer pays 110% of the preceding year’s tax. 144 D – Penalties If a taxpayer receives a demand letter from the FTB requesting that the tax return be filed or that additional information be provided, the taxpayer must respond according to the dates provided in the FTB letter or face a penalty of 25% of the tax on the state’s assessment of tax liability (calculated before any payments or credits are applied). If a return is filed late, a delinquency penalty will apply to unpaid taxes at a rate of 5% of the unpaid tax due for every month the return is late (up to a maximum of 25% of the unpaid tax). E – Claims for Refund A claim for refund of an overpayment must be filed by the later of: four years from the due date for filing the individual return (without extensions), one year from the date of overpayment, or four years from the date the return was filed. The federal statute of limitations is the earlier of three years from the date the return was filed or two years from the date the tax was paid. F – MyFTB Online Services As part of its initiative to improve its service to the taxpayer community, the California Franchise Tax Board continues to improve its online service offerings through its MyFTB portal and has released an enhanced version of the MyFTB system. This service is divided into three segments according to the population served by each:  individual taxpayers  businesses taxpayers  tax professionals All MyFTB accounts that were created before 2016 were deactivated in conjunction with the implementation of the enhanced version of the system. All users of the earlier MyFTB system will therefore need to create new accounts with the enhanced version of MyFTB if they desire to make use of its functionality. Benefits Offered The MyFTB system has benefits for all three types of users:  Individuals can access their tax account information, review past tax returns, get access to additional features in Web Pay, and file current and prior year returns in CalFile.  Business representatives can access business tax account information, view account activity, and get access to additional features in Web Pay for Businesses.  Tax preparers can view their clients’ tax account information and perform a number of operations on behalf of their clients. Tax preparers with a Power of Attorney (POA) can access additional tax account information and self-serve options. A variety of services are offered to each segment according to their specific needs, with most of the services offered to all three groups. 145 The following table summarizes the overall service offering. Individuals Businesses Tax Preparers As an individual, you can use MyFTB to access: As a business representative, you create one MyFTB account to access and manage all the businesses you represent. For each business you add to your account, you can access: As a tax preparer, you can use MyFTB to access tax account information and online services for your individual and business clients. On behalf of your clients, you can access: Account information Account information Account information View account balance and tax year details. View account balance and account period details. View account balance and tax year details. View estimated payments and credits before filing a return. View estimated payments and credits before filing a return. View estimated payments and credits before filing a return. View payment history. View payment history. View payment history. View a list and images of notices and correspondence. View a list and images of notices and correspondence. View a list of notices and correspondence. View images of notices and correspondence.* View a list and images of tax returns. View a list and images of tax returns. View a list of tax returns. View images of tax return.* View and update contact information. View and update contact information. Update contact information.* View proposed assessments. View proposed assessments. View proposed assessments.* 146 Individuals Businesses Tax Preparers View a list of authorized representatives (tax preparer or a tax preparer with a power of attorney) and manage who can access your account. View a list of authorized representatives (tax preparer or a tax preparer with a power of attorney) and manage who can access your account. Verify the exact entity name before filing a return. Verify the exact business entity name to use when filing a return. View a list of activities that occurred on your account, such as the last time you or your authorized representative accessed your account. View a list of activities that occurred on your account, such as the last time you or your authorized representative accessed your account. View California wage and withholding information. View California wage and withholding information – individual clients only. View FTB-issued 1099 information. View FTB-issued 1099 information – individual clients only. Add additional businesses. Options to communicate with the FTB Options to communicate with the FTB Options to communicate with the FTB Chat with an FTB representative about confidential matters. Chat with an FTB representative about confidential matters. Chat with an FTB representative about confidential matters. Send a secure message with attachments to FTB. Send a secure message with attachments to FTB. Send a secure message with attachments to FTB.** Choose to receive an e-mail when we send you a notice or correspondence. Choose to receive an e-mail when we send businesses you represent a notice or correspondence. * Tax preparers must have an active POA to access these services. ** In order to access an FTB response to a secure message you sent on behalf of your client, you must have an active POA. 147 Access to MyFTB Individuals who wish to use the MyFTB system must first register at the FTB website according to their respective role. Those users who wish to gain access to more than one section (e.g., both Individual and Business), must register separately for each section and thus create separate account with a unique username for each role. After completing the online registration process, users will receive a PIN by mail within 3–5 days at the address the FTB has on file for the user. After receiving the PIN, the user must login to MyFTB within 21 days and enter the PIN to activate his or her account. Note: MyFTB users who registered before 2016 are required to re-register before they will be granted access to the enhanced system. Tax preparers who register for the enhanced system will be asked to provide the following pieces of information about themselves:  a valid e-mail address  their Social Security number or Federal Employer Identification Number (FEIN)  one of the following identification numbers: o PTIN (Preparer Tax Identification Number) o EFIN (Electronic Filer Identification Number) o CTEC (California Tax Education Council) number o California CPA (Certified Public Accountant) number Individuals who do not have one of the identification numbers above cannot register as a tax preparer. Note: Starting from January 1, 2018, CTEC and EFIN numbers will not be accepted by MyFTB for registration of tax professionals. The following are the only professional ID registration numbers that will be accepted from that date:  Preparer Tax Identification Number (PTIN)  California Certified Public Accountant (CPA)  California State Bar Number  Enrolled Agent (EA) Number with CA addresses MyFTB for Tax Preparers Beginning on January 2, 2018, the MyFTB Tax Preparer registration role was renamed to Tax Professional. On the same date, the “Tax Preparer” access type was renamed to Tax Information Authorization (TIA) throughout MyFTB. TIA is a new formal relationship for authorized representatives that is recognized starting January 2, 2018. MyFTB will now display TIA as the relationship type. Tax professionals can establish a TIA in MyFTB (using the Add Individual TIA Client or Add Business TIA Client pages) or by mailing FTB 3534, Tax Information Authorization, to the FTB. When a user with this type of account logs in to MyFTB, the first screen displayed is the Client List. All taxpayers for whom the preparer has an active POA will automatically appear on the list. The preparer has the option to add other clients to the list by entering the details from any one of the clients’ tax returns filed during the last five years. However, the preparer must have written permission from the client to allow access to this information. Form FTB 743, Online Account View Access Authorization, can be used for this purpose. The completed form for each taxpayer does not need to be mailed to the FTB, but rather it is kept on file by the preparer. 148 Power of Attorney The recent enhancements and updates that the FTB has made to the MyFTB system have also resulted in some significant changes to the filing and execution of Power of Attorney (POA) declarations that affect both tax professionals and their clients. The major change of which all tax practitioners should be aware is:  As from January 4, 2016, the FTB has stopped mailing POA representatives paper copies of the notices that are sent to their clients. These notices are instead sent to the representative by e-mail at the address specified on the POA request. In the event that a POA representative changes to a different e-mail address, this information can be updated by the practitioner on his or her MyFTB page for each POA declaration. As discussed earlier, all taxpayers for whom the practitioner has an active POA will automatically appear on the Client List. As part of their initial transition to using the enhanced MyFTB system, practitioners are well advised to take the time at the outset to do a once-only review each of their active POA declarations to make sure that they each contain the practitioner’s preferred e-mail address for the receipt of copies of client notices. In addition to the sending of notices by e-mail, a copy of each notice sent to a client is also stored under the heading of “Client Notices” in the representative’s MyFTB account. All practitioners (including those who do not have a valid e-mail address) with active POA declarations are able to view the 200 most recent notices that were sent to their clients during the last 60 days. The MyFTB system allows for this list of notices to be sorted and filtered by client name, date, and type of notice. Example: Hans is named as the primary representative on POA declarations for three different clients from 2013, 2014, and 2015 respectively. All three cases are still active. Hans wants to make sure that he receives e-mail copies of all notices sent to his clients but he is worried because he is not sure whether he provided an e-mail address on any of the three POAs. How can he achieve his goal of ensuring that he does not miss seeing any notices sent to his clients? Answer: Hans must first resubmit the POA that was originally signed in 2013, making sure he provides all of the required information, including his current e-mail address. After logging in to the MyFTB system Hans will be able to see on his Client List the details of the POA submitted in 2015 (and also 2014 if it was processed on or after October 1st). He will then be able to enter his preferred e-mail address into the 2015 (and 2014, if visible) POA. If the 2014 POA was processed prior to October 1, Hans will need to resubmit that POA, making sure to include his e-mail address. Submitting POA Declarations Although a POA declaration can be submitted either by a client or tax professional, the procedure is different in each case and also depends whether the declaration is submitted online or on paper. Client Submits Online The simplest method is when the client submits the declaration online. In these cases the FTB reviews the declaration and processes the request after validating the information provided about the client and intended representative(s). 149 Tax Pro Submits Online In most cases it is likely that a POA declaration request would be submitted online by the tax practitioner. However, the subsequent approval of the client is needed before the FTB will process the request. This approval can either take place online or in written form.  Client Approval Online After the FTB has received the POA request and validated the information it contains, the client must sign in to his or her MyFTB account to approve (or reject) the request. If the client approves the request, the FTB will process the POA declaration and inform the client accordingly by letter.  Client Approval by Paper In this case the tax preparer enters the POA declaration request online and uploads a signed copy of Form FTB 3520, POA Declaration, or another form that contains the equivalent information. The FTB will accept the following forms for this purpose:  IRS Form 2848, Power of Attorney and Declaration of Representative  IRS Form 8821, Tax Information Authorization  California BOE Form 392, Power of Attorney  other POA declarations that contain the information equivalent to FTB 3520 After checking to ensure the completeness and validity of the information received, the FTB will process the POA declaration and inform the client accordingly by letter. Tax Pro or Client Submits by Paper Starting in 2016, the FTB prefers that POA declarations be submitted online through the enhanced MyFTB system. However, under certain conditions, either the tax practitioner or client can submit Form FTB 3520 by mailing it to the FTB at the address specified in the instructions for the form. The exceptions that allow for the lodgment of the form by mail include the following:  Either the taxpayer or representative: o does not have computer availability o is located in a declared disaster area o is an active duty military member in a combat zone  The taxpayer either: o is filing in California for the first time o has a documented physical/mental impairment o is an estate or trust  The assigned representative either: o is an attorney who does not have a PTIN, EFIN, or California CPA number o does not have a professional designation (e.g., taxpayer’s relative, friend, etc.) The FTB will process the POA declaration and inform the client accordingly by letter, after first checking to ensure the completeness and validity of the information received. 150 Rejection of POA Declarations Any form or other letter that appoints Power of Attorney for the tax matters of an individual or company must necessarily contain very specific information about the appointed representative and the areas in which authority is being granted to him or her. Form 3520 has many fields and check-boxes into which information can be entered to assign the desired powers to the taxpayer’s representative(s). As discussed earlier, the FTB carefully reviews the information it receives in the form of POA declarations before processing each request. Any declarations that are incomplete, incorrect, or contradictory will be rejected. Given that there is so much information to be provided with each POA request, there is a great deal of scope for such rejections to take place. Common reasons for rejecting POA declarations include the following:  mismatch between information filed in an online POA request and the associated uploaded Form FTB 3520  signature(s) missing from FTB 3520 or equivalent form  tax years specified in the paper POA are either missing or incorrect One of the advantages of lodging the declaration online is that during the process of entering the relevant information, the MyFTB system provides immediate feedback and helps to identify possible errors that can be quickly corrected, thus avoiding possible rejection. Processing Times The amount of time required by the FTB to process a POA declaration depends on the method used for its submission to the agency:  online—The estimated processing time for a POA declaration lodged online is 30 business days or less.  mailing (with an exception)—The estimated processing time for a POA declaration with an exception that allows it to be lodged by mail is 45 business days or less.  mailing (with no exception)—For POA declarations lodged by mail without an exception, the estimated processing time is 90 business days or more. 30-Day Deferral Option Now Available for MyFTB Users Effective from September 25, 2017, users were be able to request the 30-day deferral Quick Resolution option for Individual Filing Enforcement Notices of Proposed Assessments. This option was initially only available for individuals, but will likely be extended later for businesses. A new radio button was added to the Response to Proposed Assessment section, “I do not wish to protest – I request a 30-day deferral to file the required valid tax return,” if the deferral option is available. When this option is selected the user will be provided with the updated date a valid tax return is due by. Note: To protest or respond to a proposed assessment online, the user must have an active Power of Attorney (POA) Declaration for the year of the assessment. 151 G – Dependent Social Security Number (SSN) Starting with taxable years that begin on or after January 1, 2015, the SSN of each dependent for whom a taxpayer wishes to claim an exemption credit must be entered in the spaces provided on the form being used for the taxpayer’s return, that is:  on line 10 of either: o Form 540, California Resident Income Tax Return o Long Form 540NR, California Nonresident or Part-Year Resident Income Tax Return o Short Form 540NR, California Nonresident or Part-Year Resident Income Tax Return  on line 8 of Form 540 2EZ, California Resident Income Tax Return. H – Amended Return E-Filing for Individuals Beginning with tax year 2017, the FTB has decided to eliminate the paper Form 540X, Amended Individual Income Tax Return, for amending individual tax returns and replace it with the 540 series forms, each adapted to allow for amended return filing. Starting in January 2018, the FTB’s e-file program will accept e-file amended returns for individuals on tax year 2017 Forms 540, 540NR Long, 540NR Short, and 540 2EZ, as well as new Schedule X. At the same time, the new Schedule X, California Explanation of Amended Return Changes, will be introduced. This schedule will reconcile the difference between the original return and amended return to determine any additional amount owed or refund due and to provide reasons for amending. For tax year 2016 and prior years, amended individual returns will need to continue to be paper filed using Form 540X. I – New Office of Tax Appeals Beginning January 1, 2018, the new Office of Tax Appeals (OTA) will hear and determine all appeals that involve corporate income tax, corporate franchise tax, personal income tax, sales tax, and use tax. If a taxpayer disagrees with the FTB or the California Department of Tax and Fee Administration (CDTFA) on a Notice of Action or a Notice of Determination, the taxpayer may appeal with the new OTA by the “appeal date” listed on the notice. As of October 1, 2017, the FTB has included an insert in all notices containing information about appeal rights and OTA’s contact information. As of October 1, all appeals must be filed with OTA, and beginning January 1, 2018, OTA’s three-member panels will hear and determine all appeals. The OTA may be contacted through e-mail at info@ota.ca.gov or mail: STATE OF CALIFORNIA OFFICE OF TAX APPEALS P.O. BOX 98880 WEST SACRAMENTO, CA. 95798-9880 152 J – Business Entity E-File Requirement As from January 1, 2015, California law requires business entities (except estates and trusts) that use tax preparation software to prepare an original or amended return to electronically file (e-file) their returns. This law applies for taxable years beginning on or after January 1, 2014. However, the law allows a business entity to annually file a Business Entity e-file Waiver Request to receive exemption from the e-filing waiver, provided it can show the inability to e-file is due to reasons such as:  technology constraints  undue financial burden  other circumstances that constitute reasonable cause and not willful neglect Since this is a new requirement for businesses, the FTB will approve waiver requests made during the 2016 calendar year when submitted. In subsequent years, requests for waivers may be subject to review prior to approval. The law also allows for the imposition of penalties for failing to e-file in cases where the failure is due to willful neglect and not reasonable cause. The amount of the penalty is:  $100 for the initial e-file failure  $500 for each subsequent failure This penalty took effect January 1, 2017. K – Summary The main emphasis of this chapter was the enhanced MyFTB system which will continue to have a major impact on tax professionals who represent clients by Power of Attorney. We also saw that a number of procedural changes have come into effect: most notably the elimination of Form 540X for filing amended returns. Another change on the horizon is the new industry that is being formed based on the legalization of marijuana for recreational use, but many questions remain regarding how the industry will evolve. 153 Chapter 15 Review Questions 1. Melinda has just been engaged by a new client to represent him during an audit by the FTB. She realizes she will need to file a Power of Attorney for the client. Which of the following methods should she use to achieve this goal as quickly and efficiently as possible? A. Assisted by Melinda, the client submits the POA from his own MyFTB account. B. Melinda files the POA online and the client later approves the request online. C. Melinda files the POA online and the client later approves the request by paper. D. The client files the POA by paper. 2. Which statement is true with respect to filing an amended return in California for tax year 2019? A. The taxpayer should file 540X electronically. B. The taxpayer should file Schedule X. C. The taxpayer should file the amended return on paper. D. The taxpayer has to file the 540X on paper. 154 Answers to Chapter 15 Review Questions 1. A. That’s correct! This is the fastest way to get the POA request into the FTB’s processing system. Any errors in the application will be detected prior to lodgment, thus avoiding any possible delays caused by rejection of the request. In addition, the fact that the client is filing the request means that he automatically grants permission for Melinda to represent him and there is no need for him to later approve her role as his representative. B. This answer is incorrect. The problem with this approach is that there may be a delay before the taxpayer gets around to approving Melinda as his representative. C. This answer is incorrect. There will inevitably be some delay with this method because of the time it takes for a paper document to make its way from the client to the correct person at the FTB. D. This answer is incorrect. This method introduces potential problems such as the form being filled incorrectly and causing the application to be rejected. There is also the delay caused by the mail system that delivers the paper POA form to the right department and person at the FTB. 2. A. This answer is incorrect. The 540X cannot be used at all for tax year 2019. B. That’s correct! Schedule X is the correct form to be filed to amend a return. C. This answer is incorrect. Starting in 2018, California allowed e-filing of amended returns. D. This answer is incorrect. The 540X cannot be used at all for tax year 2019.

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