California Does Things Its Own Way
California’s failure to conform completely to some federal tax changes is leading some experts to warn taxpayers to be careful about making certain tax moves this year.
Even taxpayers who aren’t affected would be wise to pay attention to the many potentially costly differences between state and federal law, accountants and other tax experts say.
“There are enough important differences that you really have to pay attention,” said Lynn Freer, president of Spidell Publishing Inc., which provides tax information to accountants and other tax preparers. “Any of these differences could end up in an audit . . , [and] you could end up with a big bill for penalties and interest in three or four years.”
At the same time, California offers special tax breaks and incentives that can lower state taxes.
California takes a hybrid approach to tax law, which makes tax preparation complicated for amateurs and professionals alike. Whereas some states pick up the information on a federal return nearly line for line and others force taxpayers to start from scratch, California includes most federal tax return data but imposes enough modifications, exemptions and exceptions to make even veteran tax preparers tear their hair out.
“California has its own codes, and it picks and chooses what it wants to include,” said Mike Bryant, head of the state and local tax group at the accounting firm Ernst & Young in Los Angeles.
The complications are so numerous, in fact, that many professional tax preparers let their commercial tax preparation software do the work of compiling a California tax return, accountants say.
“Most accountants know what the right answer should be on the federal return, and they just assume the state will be right too,” Freer said. “That’s not always the case. It [the software] is only as good as what you input.”
Knowing what the state considers taxable and deductible, and what it does not, can save headaches--and a potential audit bill. Here are the major factors affecting individual returns, including changes for 1998 tax returns:
Income
California ignores many items that the IRS includes as income. California lottery winnings, certain types of investments and state tax refunds are not included as income on your state form.
Unemployment insurance payments are not taxable on a California return, and neither are Social Security benefits. Both may be taxed on a federal return under certain conditions.
U.S. Treasury bond income is taxable by the federal government but not the state. Mutual funds that invest in Treasury bonds and other tax-exempt securities can also avoid California taxation, although the rules can be tricky.
Other direct federal obligations, such as Federal Home Loan Bank securities, qualify for tax-exempt status. Income from bonds issued by Fannie Mae or Ginnie Mae, the quasi-government agencies until fairly recently known officially as the Federal National Mortgage Assn. and the Government National Mortgage Assn., doesn’t qualify.
A fund must have more than 50% of its assets in the qualifying securities for any of its interest payments to escape tax. The amount of interest you can exempt is proportionate; in other words, if your fund invests 60% of its assets in qualifying securities, you can exempt 60% of the interest you received from the fund.
Fortunately, mutual funds typically will inform you of the relevant percentage of tax-exempt securities, although it may be tucked in the back of a publication or footnote along with percentages for other states. But particularly if you have large amounts of income from such bond funds, you or your accountant might want to make sure that the fund properly categorized Fannie Mae and Ginnie Mae income so that you pay the proper state tax, said Joel Framson, a Los Angeles certified public accountant.
Renters Credit
The IRS offers tax breaks to homeowners but nothing to renters. California has revived after a hiatus the renters credit, but only for low- and some middle-income taxpayers. It offers a $60 tax credit to single taxpayers with California adjusted gross incomes of $25,000 or less and a $160 credit for married taxpayers with California adjusted gross incomes of $50,000 or less. To claim the credit, taxpayers must have lived in the state for at least half of 1998 and must not have claimed a homeowners’ property tax exemption during the year. In other words, someone who sold a home in June and rented for the rest of the year would not qualify. Unlike in its previous incarnation, the credit is nonrefundable--that is, it can only be used to offset other tax owed, not to generate a refund.
Roth IRA Conversions
California treats the conversion of regular IRAs to Roth IRAs much the same way the federal government does. Taxpayers with adjusted gross incomes under $100,000, whether single or married filing jointly were allowed to convert their traditional IRAs to Roths in 1998 and to opt to spread the resulting taxable income over four years.
But, naturally, there are some exceptions. The federal government gives taxpayers the option of including all of the conversion income for tax year 1998 rather than spreading it out over four years. The state does not.
Furthermore, if a taxpayer converts a regular IRA to a Roth IRA but dies before the four-year period is up, federal law allows the surviving spouse to continue the payments on the original schedule. State law requires that all of the remaining distribution be included on the deceased taxpayer’s final return.
Both of these exceptions could disappear if a bill now in the Legislature passes, Freer said. “We’re recommending that taxpayers who might be affected file an extension” and wait to see what the Legislature does, she said.
Single Parents
Unmarried taxpayers who support a child or other relative can often claim head of household filing status, which means a lower tax rate than for a single filer. But proving head-of-household status can be difficult, especially for divorced parents with joint custody.
California, however, offers a unique credit for such parents that can save them as much as $281.
To qualify, the divorced taxpayer must not qualify for head of household status, must file a separate return and must not have lived with the ex-spouse for any of 1998. The taxpayer’s child or children must have lived at the taxpayer’s home for at least 146 days but no more than 219 days last year, and the taxpayer must have provided at least half the cost of maintaining the home. The tax credit equals 30% of the tax bill up to a maximum $281.
Offers in Compromise
Both the IRS and the Franchise Tax Board are accepting more taxpayer offers to settle for less than the full amount of a tax bill when a taxpayer can prove that he or she can’t pay. The FTB, which in past years accepted less than 4% of such offers in compromise, now accepts 45%, said Pat Hill, FTB spokesman.
The FTB, unlike the IRS, has no formula to determine which offers will be accepted, but Spidell’s Freer says offers that can be paid off within five years are more likely to be accepted. The state also takes into account the taxpayer’s job, health and age, whereas the IRS relies largely on net worth and income. The state usually requires the taxpayer to sign a collateral agreement that will allow the FTB to take more money should the taxpayer starts to earn more or should the taxpayer’s financial situation improve in other ways.
Electronic Filing and Credit Cards
The state offers completely paperless filing, whereas the IRS still requires that most electronic filers send in a paper signature form with W-2s and other required documents attached.
Taxpayers who are filing electronically can choose to get their refund checks deposited directly into their accounts in as little as seven days from the time they file, Hill said.
People who file electronically and who owe money can now opt to have the amount of the bill taken directly from their bank accounts. Only a select number are being allowed to charge their tax bills to a credit card, but the FTB expects to expand that program by next year.
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Reconciling state and federal returns may be a pain, but typical taxpayers are likely to find most of the answers they need close at hand, tax experts said. Better software manufacturers, including San Diego-based Intuit, which makes Turbotax and MacIntax, can guide taxpayers through most of the minefields, Freer said. And the state also provides help.
“One of the best sources of information is the instructions to the [state] form,” said Michael S. Fredlender, the Woodland Hills director of Ernst & Young’s personal financial counseling services for the Pacific Southwest region.
Liz Pulliam can be reached by e-mail at liz.pulliam@latimes.com.
* MONEY TALK
Liz Pulliam’s Money Talk column will focus on tax questions next Sunday. The column does not appear today.
