State & Local Tax Bulletin (January 2003)
California Income Tax Developments
By Craig A. Becker, a tax partner in the Palo Alto office of Pillsbury Winthrop Shaw Pittman LLP. If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our January 2003 State & Local Tax Bulletin (a 503K pdf file), containing a printed version of this article and also available via ftp at:
Assembly Bills 1122, 1768 and 2065 and Senate Bill 657Deferral of 2002 and 2003 California Net Operating LossesIncrease in Allowable 2004 Losses
California has eliminated net operating loss ("NOL") deductions for tax years beginning in 2002 and 2003, with the deduction reinstated in 2004. California's ten-year NOL carryforward period will be extended two years for pre-2002 losses to account for this temporary NOL disallowance. However, 100 percent of losses incurred in tax years beginning after 2003 will now be eligible for carryforward, eliminating California's previously scheduled 35 percent haircut to such losses. California will continue to allow 100 percent of the California losses incurred in eligible "new businesses" and "small business" for years beginning before 2004 (for other pre-2004 losses it will continue its 40 percent disallowance of 2002 and 2003 losses, 45 percent disallowance of 2000 and 2001 losses and 50 percent disallowance of earlier losses). Revenue & Taxation Code ("R&TC") §§ 17276, 17276.3, 24416, 24416.3.
Repeal of California Residency Exemption for Real Estate Withholding
California law requires that buyers of California real estate withhold 3 1/3 percent of the sales price for the seller's California income taxes. Previously these withholding requirements only applied when the seller was a nonresident individual, or a corporation without any California location. However, effective January 1, 2003 this withholding requirement will be extended to individual California residents, unless the real estate is the seller's principal residence or the seller can otherwise demonstrate the sale would not draw any California income tax (e.g., a tax-free 1031 exchange, or a sale at a loss). For those individuals (residents and non-residents) who have any taxable gain on California real estate sales, the full 3 1/3 percent withholding rate will be applied to the full sales proceeds, regardless of the actual California tax liability. The withholding provisions do continue to allow sellers, who are not individuals, to apply for a reduced rate of withholding by demonstrating that the 3 1/3 percent rate overstates the California tax liability. R&TC § 18668. The Franchise Tax Board has prepared a comparative chart for the new withholding rules, an 89K Acrobat pdf file, also available via ftp at
Repeal of Reserve Based Bad Debt Deduction for Large Banks
Effective January 1, 2002 California will conform to federal provisions limiting bad debt deductions for large banks and savings and loans (assets in excess of $500 million) to actual losses rather than the increment to its bad debt reserve. Banks that had been using the reserve method for California purposes will be required to recognize 2002 income of 50 percent of the existing bad debt reserve, with no adjustment required for the remaining bad debt reserve. R&TC § 24348.
California's Interest Reductions on Corporate Overpayments
Effective July 1, 2002, California will reduce the statutory interest rate on corporate overpayments from the federal overpayment rate (under Internal Revenue Code section 6621(a)(1)) to the lesser of 5 percent or the rate on 13-week Treasury bills. California has also repealed its incorporation of Internal Revenue Code section 6621(d) which eliminates any interest charges for offsetting underpayments and overpayments in the same periods. Effective July 1, 2002 California will be out of conformity with the Internal Revenue Service and will levy interest charges on offsetting overpayments and underpayments equal to the difference between the overpayment and underpayment interest rate (currently 4 percent).
Incorporation of the January 1, 2001 Internal Revenue Code for the 2002 Tax YearCalifornia makes a wholesale incorporation of many provisions of the Internal Revenue Code. However, prior to this legislation, California's incorporation only included federal amendments through January 1, 1998. For tax years beginning in 2001, California's incorporation of Internal Revenue Code provisions is now updated to include all federal amendments through January 1, 2001. R&TC §17024.5, R&TC § 23051.5.
California also affirmatively repealed pre-existing nonconforming provisions in the following areas:
Conforming Individual Estimated Payment Requirements to Federal Provisions
Under the annualized income method for determining an individual's estimated tax payments, the percentage of "annualized tax" to be paid after each installment deadline is increased to align with the federal requirements (up to 22.5 percent, 45 percent, 67.5 percent and 90 percent, rather than the previously established 20 percent, 40 percent, 60 percent and 80 percent). California also eliminated pre-existing estimated penalty exemptions applicable when eighty percent (80 percent) of the estimated tax (or last year's income tax) was paid through withholding or eighty percent (80 percent) of the taxpayer's income consisted of items subject to wage withholding. R&TC § 19136.
While these provisions are stated to be effective as of January 1, 2002, the legislation also provides that there will be no 2002 estimated tax penalties for underpayments resulting from 2002 legislative changes. Accordingly, California should continue to apply its pre-existing schedule for estimated payments (i.e., 20 percent, 40 percent, 60 percent, 80 percent) through 2002. R&TC § 19136.8. This approach is confirmed for the annualized income method by the Franchise Tax Board's 2002 Form 5805 (Underpayment of Estimated Tax by Individuals and Fiduciaries).
Conformity of Qualified Small Business Stock Rollover Provisions to Internal Revenue Code Section 1045
California now conforms to the federal provisions specifying that qualified small business ("QSB") stock status and Internal Revenue Code section 1045 rollover eligibility extend to (a) QSB stock held by pass-through entities (i.e., partnerships, LLCs and S corporations), (b) QSB stock distributed from pass-through entities to their partners, members or shareholders and (c) stock received in exchange for QSB stock in a tax-free reorganization or upon conversion of QSB stock and QSB stock transferred by gift or through an estate. This conformity is a technical correction effective as of the 1997 effective date of Internal Revenue Code section 1045. R&TC § 18038.5.
Conformity of Federal and California S Corporation Elections
Prior to 2002, federal S corporations with minimal California income would often elect to be taxed as C corporations for California purposes in order to prevent nonresident shareholders from being required to file California income tax returns. Effective January 1, 2002, inconsistent California elections are no longer allowed, with all existing federal S corporations with California C elections reclassified as S corporations as of January 1, 2002. R&TC § 23801. The Howard Jarvis Taxpayer's Association has brought suit challenging this provision as an unconstitutional tax increase passed without the Proposition 13 mandated two-thirds approval.
Conformity to Internal Revenue Code Denial of Lobbying Deductions
Effective January 1, 2002 California incorporates Internal Revenue Code section 162(e), which allows only a limited deduction for lobbying expenses associated with legislation of local governments. California's Revenue & Taxation Code section 24343.7 had previously allowed broader expense deductibility extending to lobbying for state and federal legislation.
Conformity to Internal Revenue Code Section 162(m) Limits on Compensation Deductions
Effective January 1, 2002 California incorporates Internal Revenue Code section 162(m), which limits deductible compensation for the chief executive officer and the highest paid officers of publicly traded corporations to $1 million a year (with additional deductions allowed for shareholder-approved performance based compensation). California had previously allowed deductions in excess of the section162(m) limits.
Conformity to Internal Revenue Code Denial of Deductions for Club Dues
Effective January 1, 2002 California incorporates Internal Revenue Code section 274(a)(3) which prevents any deduction for membership dues in any club organized for business, pleasure, recreation or other social purpose. California had previously allowed this deduction.
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