California Conformity Bill Conforms Selective State Tax Laws to Federal Tax Reform Modifications  

Published by Kevin Wilson on Friday, September 6, 2019 - 12:00am

In July, California Gov. Gavin Newsom signed Assembly Bill 91, Loophole Closure and Small Business and Working Families Tax Relief Act of 2019 (A.B. 91). A.B. 91, authored by Assemblywoman Burke, Chair of the Assembly Committee on Taxation, selectively conforms California law to certain changes introduced in the 2017 federal tax reform bill (H.R. 1).  It is estimated that A.B. 91 will raise revenue by roughly $1.6 billion by closing a series of tax breaks, as further detailed below, and provide support to the state’s neediest families by dramatically expanding the California Earned Income Tax Credit (CalEITC).

About Modified Conformity

California state income tax laws generally apply a “modified conformity” to federal income tax law, whereby the state law mirrors federal statute, with certain exceptions and modifications. This modified conformity approach gives the state flexibility to customize state tax policy to satisfy local budgetary or policy objectives. Noteworthy exclusions from the list of tax conformity measures include the IRC 163(j) interest deduction limitation and state income tax incentives for Opportunity Zone (OZ) investments, which is discussed in more detail below.

Some significant conformity changes under A.B. 91 include:

  • Cash method of accounting: A.B. 91 Section 14 conforms to the increase of average annual gross receipts to $25 million on use of cash method of accounting under HR 1 for taxable years beginning on or after Jan. 1, 2019. Taxpayers are permitted to elect to apply these changes to taxable years beginning on or after Jan. 1, 2018 and before Jan. 1, 2019.
  • Excess business losses on non-corporate taxpayers: A.B. 91 Section 13 adopts the H.R. 1 limitation on excess business losses on non-corporate taxpayers, with certain exceptions. This new provision will apply to taxable years beginning after Dec. 31, 2018 without a sunset date as included in H.R. 1. In addition, under the new provision, any disallowed excess business loss is treated as a carryover excess business loss for the following taxable year, whereas under H.R. 1, any disallowed excess business loss is treated as a NOL carryover.
  • Net operating loss (NOL) carryback rules: A.B. 91 Section 10 disallows NOL carrybacks for NOLs attributable to taxable years beginning after Dec. 31, 2018 and before Jan. 1, 2013. A limited two-year carryback is allowed for NOLs attributable to taxable years beginning on or after Jan. 1, 2013 and before Jan. 1, 2019.
  • Repeal of technical terminations: A.B. 91 Section 16 adopts the federal repeal of technical terminations for taxable years beginning on or after Jan. 1, 2019. Taxpayers are permitted to elect to apply these changes to taxable years beginning on or after Jan. 1, 2018 and before Jan. 1, 2019. This provision eliminates the requirement to file two separate short period tax returns due to technical terminations, similar to what H.R. 1 did at the federal level.
  • 1031 like-kind exchange: A.B. 91 Section 18 conforms to H.R. 1 by limiting the like-kind exchange tax treatment to exchanges of real property held for productive use or investment, effective for exchanges completed after Jan. 10, 2019. This provision only applies to taxpayers with adjusted gross income of $250,000 or more filing an individual return, or taxpayers with adjusted gross income of $500,000 or more filing a joint return or as a head of household or a surviving spouse.
  • Earned income tax credit: A.B. 91 Section 2 expands access to CalEITC against personal income tax for eligible individuals for taxable years beginning on or after Jan. 1, 2015. The purpose of CalEITC is to reduce poverty. The credit is a percentage of the earned income of the eligible taxpayer, and is phased out as income increases. The credit is refundable to the eligible taxpayer if the allowable CalEITC exceeds the tax liabilities.

A Significant Exclusion

OZ conformity was not included in A.B. 91. The state legislature continues to explore opportunities for OZ conformity. California is presently one of about five states that continue to tax capital gains invested in qualified opportunity funds. Earlier this year, Gov. Newsom indicated that the state will provided a state level OZ tax incentive, specifically for investments in affordable housing and clean energy property. To limit the impact that OZ conformity would have on the state’s budget, California will likely cap the amount of OZ investment eligible for the state tax incentive at $5 billion, with a per fund limit of $100 million. As the legislature works to address this approach, several issues will need to be addressed, including, but not limited to the following:

  • What types of housing will qualify? A trailer bill that introduced earlier this year suggested that only property qualifying for the federal low-income housing tax credit (LIHTC) would qualify for the state tax incentive. Some have suggested that the scope of the trailer bill is too narrow, and that the OZ tax incentive could be used more effectively if it could be used to finance workforce housing. To that end, the state is exploring other benchmarks that can be used to define qualified California OZ property. For example, one possibility could be to include housing that is constructed to meet the requirements of the state’s density bonus law.
  • How will the state administer the $5 billion and $100 million caps? Presumably the Franchise Tax Board will implement some tracking measures.
  • Can the definition of qualified California OZ property be expanded to include operating businesses that address critical social utility based on a particular neighborhood, including, but not limited to access to fresh produce in food deserts, or proximity to affordable healthcare services?

Novogradac will continue to track the progress of these discussions. Stay tuned.