chapter 1: general material€¦ · if only one spouse/rdp had income over the amounts listed. (see...

Copyright © 2019, The Income Tax School, Inc. – All Rights Reserved .1

Chapter 1: General Material

Overview

Chapter Description Upon the completion of this chapter, students will be able to determine who must file a California tax return, which filing status should be used, the taxpayer’s residency status, and which form is required to file the return. Students will learn when a return is due, how to assemble the return, and how to automatically receive an extension of time to file the return. Students will also understand the difference between a legal marriage versus a Registered Domestic Partnership (RDP), and how each affects the filing of a California tax return. The following content is based on 2018 tax law; however, discussions of prior year tax law will be addressed as applicable.

Learning Objectives

1) Determine who must or should file a return and which California form to use. 2) Determine the taxpayer’s California residency status. 3) Identify which filing status the taxpayer should use. 4) Identify return due dates, discuss how to assemble a return, and describe the extension

process.

Key Terms

Annulment Birth/Death California Adjusted Gross Income California Gross Income Community Property State Franchise Tax Board (FTB) Joint Custody Legally Married Multiple Support Agreement Nonresident Part-Year Resident Registered Domestic Partnership (RDP) Resident Safe Harbor State Disability Insurance (SDI) Temporary Absence Voluntary Plan Disability Insurance (VPDI) Widow(er)

Copyright © 2019, The Income Tax School, Inc. – All Rights Reserved Page 1.2

Objective #1: Filing Requirements and California Forms

Who Must File A taxpayer must file a return if either his California gross income or his California adjusted gross income was more than the amount shown for his filing status, age, and number of dependents. Even if he does not have a filing requirement based on the chart below, the taxpayer may find he is still required to file a return based on other factors, such as those listed on the following chart. Filing Requirements

Filing status on 12/31/18

Age as of 12/31/18 f

CA Gross Income a CA Adjusted Gross Income b Dependents Dependents

0 1 2 or more 0 1 2 or more Single or Head of Household c

Under 65 65 or older

17,693 23,593

29,926 32,768

39,101 40,108

14,154 20,054

26,387 29,229

35,562 35,569

Married/RDP Filing Jointly; Married/RDP Filing Separately d

Under 65 (both) 65 or older (one) 65 or older (both)

35,388 41,288 47,188

47,621 50,463 56,363

56,796 57,803 63,703

28,312 34,212 40,112

40,545 43,387 49,287

49,720 50,727 56,627

Qualifying Widow(er) with dependent child

Under 65 65 or older

29,926 32,768

39,101 40,108

26,387 29,229

35,562 36,569

Dependent of another person; any filing status Any age More than the taxpayer’s standard deduction e

a California gross income is all income the taxpayer received in the form of money, goods, property, and services from all sources that are not exempt from tax. Gross income does not include any adjustments or deductions.

b California adjusted gross income is the taxpayer’s federal adjusted gross income from all sources reduced or increased by all California income adjustments.

c See page 4 of the California 540 2018 Personal Income Tax Booklet. d The income of both spouses/RDPs must be combined; both spouses/RDPs may be required to file a return even

if only one spouse/RDP had income over the amounts listed. (See the definition of RDP – Registered Domestic Partner under Objective #3.)

e Use the California Standard Deduction Worksheet for Dependents on page 11 of the California 540 2018 Personal Income Tax Booklet to figure the taxpayer’s standard deduction.

f If the taxpayer’s 65th birthday is on January 1, 2019, he is considered to be age 65 on December 31, 2018.

1

The taxpayer is required to file a California tax return if he has a tax liability for 2018 or owes any of the following taxes for 2018:

Tax on a lump-sum distribution. Tax on a qualified retirement plan, including an Individual Retirement Arrangement (IRA)

or an Archer Medical Savings Account (MSA). Tax for children under age 19 or student under age 24 who have investment income greater

than $2,100. Alternative minimum tax. Recapture taxes. Deferred tax on certain installment obligations. Tax on an accumulation distribution from a trust. 2

The higher standard deduction for taxpayers due to the Tax Cuts and Jobs Act (TCJA) will lower the number of taxpayers who are required to file a federal return. However, taxpayers must review California filing requirements to determine if they must file a California return.

1 California 540 Personal Income Tax Booklet, page 3 2 California 540 Personal Income Tax Booklet, page 3


Who Should File Although a taxpayer may not be required to file a California state income tax return, it may still be beneficial to file. If the taxpayer experienced any of the following during the taxable year, he may be eligible for a refund and should file a California tax return even though he is not otherwise required to file:

Made estimated tax payments to the State of California Had California State income tax withheld from earnings Paid real estate withholding tax Had excess California SDI (State Disability Insurance) or VPDI (Voluntary Plan Disability

Insurance) withheld, had two or more employers during 2018, and received more than $114,967 in wages

Had earned income and qualifies to claim the California Earned Income Tax Credit (EITC)

Deceased Taxpayer Like Federal tax returns, the final California return for a deceased taxpayer is due on April 15th following the end of the calendar year in which the death occurred. If a return would normally be required, a final return must be filed for the deceased taxpayer. The administrator, executor, or beneficiary is responsible for filing the return and making sure that any tax due is paid. The word “Deceased” and the date of death should be printed next to the taxpayer’s name on the final return. If no administrator or executor was appointed and there is a surviving spouse/RDP, the surviving spouse/RDP should file a joint return. However, the surviving spouse/RDP is not eligible to file a joint return with the deceased taxpayer if he remarried or entered into another registered domestic partnership during the tax year. The surviving spouse/RDP would sign the return as usual and follow his signature with “Surviving Spouse/RDP.” If there was an administrator or executor appointed, the surviving spouse/RDP may still file a joint return; however, the administrator or executor will act on behalf of the deceased taxpayer. He must sign the return that is filed for the decedent. The surviving spouse must sign the return if a joint return is filed. For an estate or trust, the return must be filed within 3½ months after the close of the month in which the estate or trust was terminated; the same as federal law.

Which Form Should Be Used The main California filing forms for original individual tax returns and the requirements for each form are shown in the following chart.


Which Form Should Be Used

Form 540 2EZ Form 540 Filing Status Single, Married/RDP Filing Jointly, Head of Household,

Qualifying Widow(er) Any filing status

Dependents 0 – 3 allowed All dependents entitled to claim

Amount of Income

Total income of: • $100,000 or less if Single or Head of Household • $200,000 or less if Married/RDP Filing Jointly or

Qualifying Widow(er) Note: Form 540 2EZ cannot be used if the taxpayer (or his spouse/RDP) can be claimed as a dependent by another taxpayer, and his TOTAL income is less than or equal to $14,551 if Single; $29,152 if Married/RDP Filing Jointly or Qualifying Widow(er); or $20,652 if Head of Household.

Any amount of income

Sources of Income

Only income from: • Wages, salaries, and tips • Taxable interest, dividends, and pensions • Taxable scholarship and fellowship grants (only if

reported on Form(s) W-2) • Capital gains from mutual funds (reported on Form 1099-

DIV, box 2a only) • Unemployment compensation reported on Form 1099-G • Paid Family Leave Insurance • U.S. Social Security benefits • Tier 1 and Tier 2 railroad retirement payments

All sources of income

Adjustments to Income

No adjustments to income

All adjustments to income

Standard Deduction

Allowed Allowed

Itemized Deductions

No itemized deductions

All itemized deductions

Payments Only withholding shown on Form(s) W-2 and 1099-R • Withholding from all sources • Estimated tax payments • Payments made with an

extension • Excess State Disability

Insurance (SDI) or Voluntary Plan Disability Insurance (VPDI)

Tax Credits • California earned income tax credit • Personal exemption credit • Senior exemption credit • Up to three dependent exemption credits • Nonrefundable renter’s credit

All tax credits

Other Taxes

Only tax computed using the 540 2EZ Table All taxes

NOTE: Form 540 2EZ cannot be used when filing an amended return. 3

Student Note: The federal government does not tax interest from state and municipal bonds. However, California does not follow the federal rule and taxes all state and municipal bond interest from non-California sources.

Taxpayers may not file Form 540 2EZ if they have income from sources outside of California.

Student Note: Students need to be aware of which form can be used. However, in this course, we will ask students to use Form 540 for returns prepared in the Learning Activity section of each chapter.

3 California 540 Personal Income Tax Booklet, page 7


4 Form 540NR Form 540NR (shown below) is used when the taxpayer resided in California for only part of the tax year, or was not a resident at all, but had California source income.

5

4 Form 540 5 Form 540NR


Review Question 1 Bob, age 66, is retired, and his wife Judy, age 58, works part-time at the local arts and crafts store. Bob receives income from his pension plan. They want to file jointly and have no dependents. Their combined California gross income is $38,500 for the year. Are Bob and Judy required to file a state return and if so, which form(s) can they use to file? a) Yes; Form 540 only b) No, their gross income is below the filing requirement. c) Yes; Form 540 2EZ or Form 540 d) Yes; Form 540 2EZ only

Objective #2: Residency Requirements

Determining Residency Reasons for Determining Residency It is important to accurately determine the taxpayer’s residency status for the following reasons:

Residents of California are taxed on all income, including income from non-California sources (also known as “worldwide income”). California then allows a credit for taxes paid to other states. This is to prevent double taxation on the taxpayer’s income.

Part-year residents are taxed on all income earned while a resident of California and on income from California sources while a nonresident (Form 540NR).

Nonresidents are taxed only on income from California sources (Form 540NR). Form 540NR is used to divide total California source income by the total worldwide income to calculate the California ratio. Then, the taxpayer calculates the tax on his worldwide income on Schedule CA (540NR) as though he was a resident. He multiplies the tax by the California ratio. Factors for Determining Residency The taxpayer’s residence is generally the place where he has the closest ties. He’ll need to compare his ties to California with his ties elsewhere to determine his place of residency. In considering these factors, the strength of his ties, not just the number of ties, determines his residency. The following factors need to be considered when determining residency:

Amount of time spent in California versus amount of time spent outside California. Location of spouse/RDP and children. Location of principal residence. State that issued driver’s license. State where vehicles are registered. State where taxpayer maintains professional licenses. State where taxpayer is registered to vote. Location of the banks where taxpayer maintains accounts. Origination point of taxpayer’s financial transactions. Location of doctors, dentists, accountants, and attorneys. Location of social ties, such as place of worship, professional associations, or social and

country clubs of which taxpayer is a member. Location of real property and investments. Permanence of taxpayer’s work assignments in California. 6

6 FTB Publication 1031, page 5


Each taxpayer’s circumstances are unique; therefore, there may be additional factors to consider in determining residency. All factors must be considered to correctly identify the taxpayer’s residency status. Determining if an Absence is Temporary or Transitory If a California resident leaves the state for a temporary absence (vacation, temporary work, military assignment, or transitory purposes), he would still be considered a resident of California and should file a California Resident Income Tax Return (Form 540 or 540 2EZ) if he meets the filing requirements. Determining if the absence is temporary or transitory is based on the taxpayer’s intent when he leaves the state. Does he intend to move out of the state with no plans to return to his state of residence within a period of less than two tax years? If so, he becomes a nonresident of California at the time he leaves California. Otherwise, he remains a California resident and (if required) would file a tax return as a nonresident of the other state. California would tax his worldwide income and may allow credit for the taxes paid to the other state(s). However, if the taxpayer domiciled in California leaves the state and works outside of California for a period of at least 546 consecutive days under an employment-related contract, he is considered a nonresident. This is called the “safe harbor” and applies to the spouse/RDP who accompanies the employed taxpayer during those 546 consecutive days. (See the “Safe Harbor” section below for more details.) Entering/Leaving California If the taxpayer moved into or out of California during the tax year and had income attributable to a California source, he would be considered a part-year resident. As a part-year resident, the taxpayer would need to file a California Nonresident or Part-Year Resident Income Tax Return (Form 540NR). As a part-year resident, the taxpayer may qualify for some California tax credits that would reduce the amount of California taxes owed. Did Not Live in California If the taxpayer did not reside in the state of California during the tax year but received income from a California source, he is a nonresident of California and should file a California Nonresident or Part-Year Resident Income Tax Return (Form 540NR). A taxpayer spending more than nine months in California in any taxable year will be presumed to be a California resident. Although the taxpayer may have connections with another state, if his stay in California is for other than temporary or transitory purposes, he is a California resident. As a resident, his income from all sources is taxable by California.

Safe Harbor Certain taxpayers leaving California under employment-related contracts may qualify for “safe harbor.” Taxpayers who live in California and leave under an employment-related contract for an uninterrupted period of 546 consecutive days are considered nonresidents, according to the rules governing safe harbor, unless any of the following apply:

The individual has intangible income, such as stocks, bonds, and notes exceeding $200,000 in any taxable year covered by the employment-related contract.

The primary reason the taxpayer is leaving California is to avoid personal income tax. The individual makes temporary return visits to California that total more than 45 days in

any taxable year during which the employment-related contract is in effect.


Return visits to California are temporary as long as they do not exceed a total of 45 days during any taxable year if covered by an employment contract. The safe harbor rule also covers the spouse/RDP of the taxpayer if he/she is accompanying the taxpayer outside California for a minimum of 546 consecutive days. As with the taxpayer, the spouse/RDP would also be considered a nonresident of California. If the spouse stays in California during the safe harbor period, half of the nonresident spouse’s wages will still be taxable to California because the spouse is a resident of California due to community property rules (covered in Chapter 5). The taxpayer must determine his residency status based on facts and circumstances if he is not covered by the safe harbor rule. Residency status cannot be determined based only on the taxpayer’s occupation, vocation, or business. All activities must be considered when determining residency status. Two examples of using facts and circumstances to determine residency status follow.

Example 1: Jamie is a resident of California and has been accepted to attend a University in Mississippi on a 4-year scholarship. Jamie doesn’t automatically become a nonresident of California simply because he plans to attend college out-of-state. Example 2: Ophelia is a resident of Kentucky but she has decided to attend a California University to obtain a nursing degree as a part-time student. Ophelia doesn’t automatically become a California resident simply because she is attending college in California.

In the examples above, Jamie and Ophelia would need to examine all of the facts and circumstances to determine their residency status. If Ophelia decided to do the following, while in California, she would likely be considered a California resident:

Obtain a California driver’s license Purchase a principal residence in California Open a bank account in California Obtain a job in California Register her vehicle in California Register to vote in California

Even if the taxpayer had no income from California but he used a California address, it would be wise to file a Form 540NR with all zeros. This is to avoid getting a tax bill from California (FTB).

Student Note: See FTB Publication 1031, Guidelines for Determining Resident Status, for more information concerning residency requirements and safe harbor.

Review Question 2 Alice lives and works in California. Her company is opening a new division on the east coast. Alice has been offered a 36-month employment contract to manage the team responsible for opening the new division. Alice will return to California once a month for a 3-day period during which she will attend to personal matters and visit with family and friends. During the month of December, she will return to California for a 10-day period to spend the holidays with her family. What would be Alice’s California residency status for tax purposes? a) Resident b) Nonresident c) Part-year resident d) Nonresident alien


Objective #3: Filing Statuses for California Tax Returns

Same-Sex Married Couples IRS Revenue Ruling 2013-17 recognized same-sex marriages for federal income tax purposes. Generally, the IRS recognizes a marriage of same-sex spouses provided it was valid in a domestic or foreign jurisdiction whose laws permitted marriage between same-sex individuals.

Student Note: On June 26, 2015, a Supreme Court Ruling legalized same-sex marriages nationwide, striking down individual state bans on same-sex marriages. As a result of this ruling, a same-sex couple is now entitled to the same benefits and legal rights as a heterosexual married couple. All states are now required to issue same-sex marriage licenses and recognize same-sex marriages performed legally throughout the United States, its possessions, and territories.

Same-sex spouses must file federal returns using the Married Filing Separately or Married Filing Jointly filing status. This applies to all original or amended returns filed after September 16, 2013. Married same-sex taxpayers who filed returns and did not file as Married Filing Separately or Jointly, may choose to amend their federal returns to file using the Married Filing Separately or Jointly filing status, provided the statute of limitations has not expired. A California return that claims a refund may be filed up to 4 years after the original filing deadline or 1 year from the date of the overpayment, whichever expires later. If the original return was filed after the filing deadline, the 4 years is measured from the date of filing. If the return was filed after the original extended due date, the 4 years is measured from the original filing deadline. In general, if a taxpayer files an amended federal return, he must file California Form 540 to amend his original or previously filed CA income tax return within 6 months unless the changes made on the federal amended return do not affect his California tax liability. At the top of Form 540, check the box to indicate “AMENDED” return. Attach Schedule X and all supporting documents and required schedules. Married couples must use either the Married/RDP Filing Jointly or Married/RDP Filing Separately filing status when filing their California income tax returns. Same-sex couple marriages performed in California after 5:00 pm on June 16, 2008, and before November 5, 2008, have been recognized as valid marriages for California purposes.

Same-Sex Marriages and Registered Domestic Partnerships (RDPs) California grants RDPs the same rights and responsibilities that were previously only available to married individuals. For California purposes, the same long-established rules that were once relevant to married individuals only, now apply to RDPs, such as those relating to community property income, filing status, etc. California law conforms to federal law when determining filing status; however, RDPs must continue to file as unmarried individuals on their federal returns because the federal government does not recognize RDPs as married individuals for federal income tax purposes. When filing a California state return, the taxpayer must use the same filing status used on his federal income tax return, unless he is in an RDP. If the taxpayer is a same-sex individual or an RDP and used Single as his filing status for the federal return, he must use one of the following as his filing status on the California return:

a) Married/RDP Filing Jointly; or b) Married/RDP Filing Separately.


If he did not meet federal filing requirements, the taxpayer must use the filing status he would have used had he been required to file, unless the taxpayer is an RDP. If the taxpayer is a same-sex married individual or an RDP and filed as Head of Household on his federal return, he may use the same filing status on his California return only if he meets the requirements to be considered unmarried or considered not in a domestic partnership. If the taxpayer entered into a same-sex legal union in another state, other than a marriage, and California determines that union to be substantially equivalent to a California registered domestic partnership, effective for taxable years beginning on or after January 1, 2007, the taxpayer is required to use either the Married/RDP Filing Jointly or Married/RDP Filing Separately filing status when filing his California tax return. For more information on which states have legal unions substantially equivalent to the California RDP, students should visit the California Franchise Tax Board website at www.ftb.ca.gov and search for “RDP.” Unless otherwise stated, references to a spouse, a husband, or a wife also refer to a California RDP for California income tax purposes. The initials, RDP, can stand for both a California Registered Domestic “Partner” or a California Registered Domestic “Partnership,” depending on the context in which the term is used. For more information on RDPs, see FTB Publication 737, Tax Information for Registered Domestic Partners. Registered domestic partners must register with the California Secretary of State’s office to qualify for the RDP filing status.

Exceptions to Using the Same Filing Status Used for Federal Filing If the taxpayer had no federal filing requirement, the taxpayer must use the same filing status for California that would have been used to file a federal return, unless the taxpayer is an RDP or at least one of the two exceptions listed below apply to the taxpayer. Exceptions: Married taxpayers who file a joint federal income tax return may file separate California returns if either spouse was:

An active member of either the United States armed forces or any auxiliary military branch during the tax year; or

A nonresident for the entire year and had no income from California sources during the tax year. 7

If the taxpayer or his spouse meet either of the requirements above, they may file Married/RDP Filing Separately on Form 540NR, California Nonresident or Part-Year Resident Income Tax Return.

Student Note: In a “community property state,” such as California, one-half of all income earned by one spouse belongs to and is taxable to the other spouse. If the taxpayer and spouse lived together, it may be in their interest to file jointly as California is only going to tax the California source income. Filing separately could require the spouse of the person with California source income to also file and claim their “community property share” of said income (2 MFS California returns vs. 1 MFJ California return). This will result in both spouses having California source income, which will disqualify them from the nonresident spouse exception, described above.



Income is not considered community property when: Taxpayer and spouse live together in a noncommunity property state; or Taxpayer and spouse live separate for the entire tax year with no immediate intention of

reconciliation. California is one of nine community property states. Others include Arizona, New Mexico, Texas, Washington, Idaho, Nevada, Louisiana, and Wisconsin. This forms the acronym CANT WIN LW.

Filing Status Definitions California’s five filing statuses are the same as federal, with one exception. California allows registered domestic partners (RDPs) the same tax benefits that a married couple enjoys. Conversely, federal law does not recognize RDPs as spouses for tax purposes. The filing statuses for California are Single, Married/RDP Filing Jointly, Married/RDP Filing Separately, Head of Household, and Qualifying Widow(er) with dependent child. Single The taxpayer is considered single if, on December 31, 2018, any of the following is true:

He is not married or an RDP; He is legally separated under a decree of separation, legally divorced under a final decree

of divorce, or the taxpayer’s registered domestic partnership was terminated; or He was widowed before the beginning of the tax year (January 1) and did not remarry or

enter into another registered domestic partnership during 2018. Married/RDP Filing Jointly The taxpayer may file Married/RDP Filing Jointly if any of the following is true:

He is Married/RDP as of December 31, 2018, regardless of whether he lived with his spouse/RDP at the end of 2018;

His spouse/RDP died in 2018 and he did not remarry or enter into another registered domestic partnership during the year; or

His spouse/RDP died in 2019 before the taxpayer filed the 2018 return. Married/RDP Filing Separately The following rules and guidelines apply to taxpayers who file Married/RDP Filing Separately:

When the taxpayer files Married/RDP Filing Separately, the division of his income is subject to the community property rules. For more information, see FTB Publication 1031, Guidelines for Determining Resident Status, FTB Publication 737, Tax Information for Registered Domestic Partners, or FTB Publication 1032, Tax Information for Military Personnel. When separate returns are filed, each spouse shall report the following:

One-half of the community income; and All his or her separate income.

A taxpayer filing Married/RDP Filing Separately may not claim a personal exemption credit for his spouse/RDP even if the spouse/RDP is not filing a return, had no income, and is not claimed as a dependent on any return.

If the taxpayer had a child living with him and he and his spouse/RDP lived apart during the last six months of the tax year, he may be eligible to file as Head of Household.

If Married/RDP Filing Separately status is used, be sure to record the taxpayer’s spouse’s full name and Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN) in the allotted space.


Head of Household The taxpayer can use the Head of Household filing status if he is unmarried or married/RDP but lived apart and provided a home for a qualifying person (child or relative). The taxpayer is entitled to file using the Head of Household filing status only if all the following apply:

The taxpayer was unmarried/considered unmarried and not in a registered domestic partnership at the end of the tax year;

The taxpayer’s spouse/RDP must not have lived in the taxpayer’s home at any time during the last 6 months of the tax year;

The taxpayer paid more than half of the cost of keeping up his home for the tax year; For more than half the year, the taxpayer’s home was the main home for the taxpayer and

for at least one specified relative who by law can qualify the taxpayer for Head of Household filing status; and

The taxpayer was not a nonresident alien at any time during the tax year. For Head of Household purposes, for a child to qualify as the taxpayer’s foster child, the child must be placed with the taxpayer by an authorized placement agency or by order of a court. The taxpayer must meet very specific requirements to use the Head of Household filing status and those who do must report how the HOH filing status was determined by submitting a completed Form FTB 3532, Head of Household Filing Status Schedule, with their tax return Starting in tax year 2018, the FTB will deny the taxpayer’s HOH filing status if Form FTB 3532 is not attached to the state tax return. Refer to the definitions in the Glossary if the taxpayer has experienced any of the following during the tax year:

Annulment Birth/Death Joint Custody Multiple Support Agreement Parent/Stepparent (father or mother) Widow(er)

For more information regarding HOH requirements which must be met according to California law, refer to FTB Publication 1540, California Head of Household Filing Status. Qualifying Widow(er) with Dependent Child The taxpayer may use this filing status and use the joint return tax rates for 2018 if all the following apply:

The taxpayer’s spouse/RDP died in 2016 or 2017 and the taxpayer did not remarry or enter into another registered domestic partnership during 2018;

The taxpayer has a child (stepchild, adopted child, or foster child) whom he can claim as a dependent. If the child cannot be claimed as his dependent, the taxpayer may still qualify to use the Qualifying Widow(er) filing status if he could have claimed the child as a dependent except that the child had gross income of $4,150 or more, the child filed a joint return, or the taxpayer could be claimed as a dependent on someone else’s return;

The child lived in the taxpayer’s home for the entire tax year. Temporary absences attributed to vacation or school are considered as time lived in the home;

The taxpayer paid over half the cost of keeping up his home; and The taxpayer could have filed a joint return with his spouse/RDP in the year of death, even

if he did not do so.


Filing Status Section of California Form 540

8

Legally Married Defined Since many states have different laws governing the conditions in which a couple may be married, the federal law acquiesces to the state and local law to govern the issue of legal marriages. If the marriage conforms to the state and local laws in both the jurisdiction where the ceremony is performed and where the taxpayer resides, then it’s a legal marriage. Common law marriages are only legal if a couple lives together in a state that recognizes common law marriages, for the prescribed period, after which they themselves must proclaim to be married. If the marriage violates state or local law, then it is not deemed to be a legal marriage. California does not recognize common law marriages. However, California does recognize the marriage of a person legally married in another state and who moves to California, as long as the marriage does not violate state law.

Example: A taxpayer lives together with his girlfriend in the state of Texas. After six years, they move to California. The state of Texas recognizes common law marriage after five years. If the couple had deemed themselves to be married in Texas before they moved to California, then the marriage would be legal in California.

See the section on “Same-Sex Married Couples,” earlier in this chapter.

Review Question 3 Helen was in an RDP for 5 years when her spouse suddenly passed away in December of 2015. Helen still cares for their legally adopted child, Katie, who is 6 years old now. She has not entered into a marriage or a registered domestic partnership (RDP) since then. What is the most advantageous filing status for Helen to use for the 2018 tax year? a) Single b) Married/RDP Filing Jointly c) Qualifying Widow(er) with dependent child d) Head of Household

8 Form 540, Side 1


Objective #4: Assembling a Return, Due Dates, and Filing an Extension

Forms Required to be Included with a California Return To correctly assemble a California State Tax Return, the taxpayer must staple a copy of his Form(s) W-2 and Form(s) W-2G to the lower front of his tax return. Also attach any forms showing California income tax withheld, e.g., Form(s) 1099, 592-B, and 593. If the taxpayer is filing a Form 540 or 540NR, he must also include a copy of his federal return with the state return, only if the federal return has additional forms or schedules, other than Schedule A or B, attached to the federal Form 1040. The tax return is assembled in the order shown below.

9

Caution: Form 540 has five sides. If filing Form 540, all five sides must be sent.

If the taxpayer did not itemize deductions on his federal tax return but will itemize deductions on his California tax return, he will need to complete and attach a copy of the federal Schedule A to his state Form 540.

Due Dates For calendar year taxpayers, the filing deadline is April 15. If April 15 falls on a Saturday, Sunday, or a legal holiday, the return is due on the next business day. Interest will accrue on any balance due from April 15 until the date of payment. Taxpayers residing or traveling abroad have until June 17, 2019 to file and pay the tax due. Residents traveling in another state are not considered to be “abroad.” For further information, see the instructions for Form 3519, Payment for Automatic Extension for Individuals.



If the taxpayer cannot file his California tax return by April 15, he will be allowed an automatic 6-month extension without filing a written request. To qualify, the return must be filed by October 15. However, to avoid late payment penalties and interest, 100% of the tax liability must be paid by April 15, using Form 3519.

10

Taxpayer Signature All returns are required to be signed by the taxpayer (and spouse if Married/RDP Filing Jointly) in the space provided on page 5 of California Form 540.

11

10 Form FTB 3519 (PIT) 11 Form 540, Side 5


Requirements for signing with a power of attorney for a deceased taxpayer or for a surviving spouse are the same as on the federal return. If the taxpayer wishes to designate a power of attorney, he may use Form FTB 3520. Beginning January 1, 2018, the power of attorney will remain in effect the lesser of six years from signature or when it is revoked. POAs filed prior to January 1, 2018 will remain in effect until revoked. Each spouse/RDP must submit a separate Form FTB 3520. Beginning January 1, 2019, the taxpayer may no longer use federal Forms 2848 or 8821, handwritten authority documents, or general or durable power of attorney declarations. Form FTB 3520 can grant the representative authority to both receive confidential information as well as represent taxpayers before the FTB. The designee may sign the taxpayer’s return, receive notices, and aid in tax-related issues for the taxpayer.

FTB Form 3520 (Part I)

12

Review Question 4 Marco traveled to Spain to visit relatives in November 2018. He plans to return in May of 2019. He anticipates that he will owe taxes and doesn’t want to file late or incur any penalties or interest.He also wants an extension of time to file his return. When is the original due date of his tax return, and what should he do to avoid late payment penalties and interest?

a) April 15; he should pay 100% of his tax liability using Form 3519 by April 15.b) June 17; he should pay 100% of his tax liability using Form 3519 by June 17.c) April 15; he should pay 100% of his tax liability by the extension due date if he was granted

a federal extension.d) June 17; he should pay 100% of his tax liability using Payment Voucher Form 3582.

Note: There are no Learning Activity problems for Chapter 1. Begin reading the California 540 Personal Income Tax Booklet, located in the Publications folder in the Resources and Downloads section of your online course or at www.ftb.ca.gov.

12 Form FTB 3520-PIT, Part I


Reading References for Chapter 1: 540 Personal Income Tax Booklet, pages 1-7 540NR Nonresident or Part-Year Resident Booklet, How Nonresidents and Part-Year

Residents Are Taxed, page 6 FTB Pub 737 – Tax Information for Registered Domestic Partners, pages 1-5 FTB Pub 1031 – Guidelines for Determining Resident Status, pages 1-6 FTB Pub 1032 – Tax Information for Military Personnel, pages 1-5 FTB Pub 1540 – California Head of Household Filing Status Form FTB 3519 with Instructions


This page intentionally left blank.


Chapter 2: Standard Deduction and Exemptions

Overview

Chapter Description Upon the completion of this chapter, students will understand when to use the standard deduction and how to calculate a dependent’s standard deduction. Students will be able to differentiate between the different types of exemptions available on the California tax return and determine when an exemption credit may be claimed. Students will determine whether a taxpayer is eligible for special credits, such as the Head of Household credits and the excess SDI/VPDI credit. Finally, students will learn important issues pertaining to estimated tax payments, due dates of returns and tax payments, as well as extensions of time to file state returns. The following content is based on 2018 tax law; however, discussions of prior year tax law will be addressed as applicable.

Learning Objectives

1) Determine how to calculate the standard deduction and when to use the standard deduction.

2) Identify what constitutes an exemption and when the taxpayer can claim an exemption credit.

3) Identify credits unique to the California taxpayer, such as special Head of Household credits and excess CASDI credit.

4) Determine when estimated tax payments are required, examine taxpayer penalties and statutes of limitation, and discuss taxpayer issues regarding extensions of time to file.

Key Terms

Dependent Estimated Tax Excess CASDI Credit Exemption Extension of Time to File Special Head of Household Credits Standard Deduction Taxpayer Penalties Tax Payments Tax Rates


Objective #1: Standard Deduction The taxpayer has the option to itemize deductions on the California return even if he did not itemize on the federal return. The taxpayer’s taxes will be less if he takes the larger of the California itemized deductions or the California standard deduction. If the taxpayer is married and files a separate return, both he and his spouse must either itemize or use the standard deduction.

1 California standard deduction amounts are less than federal. For that reason, it may be to the taxpayer’s advantage to itemize on his California return even though he did not itemize on his federal return. This is allowed by California law and will be covered in Chapter 9, “Standard and Itemized Deductions.” The TCJA increased the federal standard deduction amounts for 2018 to nearly double the 2017 rates. For tax year 2018, the federal standard deduction for Single and Married Filing Separately is $12,000, Head of Household is $18,000, and Married Filing Jointly is $24,000. For this reason, many taxpayers may be taking the standard deduction on the federal return and itemizing on the California return.

Dependent Standard Deduction If the taxpayer is claimed as a dependent on the tax return of another (a parent), his standard deduction may be limited. A dependent is required to file a California state tax return if his CA gross income or CA adjusted gross income exceeds the dependent’s standard deduction. The taxpayer must calculate his allowable standard deduction on the “California Standard Deduction Worksheet for Dependents,” shown below and on page 11 of the California 540 Personal Income Tax Booklet.



2

Nonresident Deductions The taxable income of California nonresidents and part-year residents determines the taxpayer’s tax liability. Deductions attributable to California are used in calculating nonresident and part-year residents’ income for California AGI and California taxable income. Deductions for the following examples are prorated for nonresidents and part-year residents.

Itemized deductions Standard deduction Alimony paid

Calculate the percentage used to determine the allowable deduction:

California AGI ÷ Federal AGI = % deduction allowed (not to exceed 1.0) When determining tax liability as a full-year resident, the taxpayer should use the greater of the standard deduction or itemized deductions. The total of the itemized deductions or the standard deduction is then multiplied by the percentage to achieve the deduction allowed. If itemizing deductions, the taxpayer will first need to complete the federal Schedule A and then complete Schedule CA (540NR), Part III, lines 1-30. If the taxpayer did not itemize on his federal return, then check the box located at the top of Part III, on Side 3 of the Schedule CA (540NR).



Review Question 1 Ricky, age 18, had a summer job working as a lifeguard at the community pool. His total wages were $4,100. Ricky’s parents qualify to claim him as their dependent. He wants to file a California tax return to receive a refund of state withholding. What would be the amount of Ricky’s California standard deduction? a) $4,100 b) $4,401 c) $8,802 d) $1,050 Review Question 2 Use the same situation as above, except Ricky also had $400 of net income from mowing his neighbor’s yard over the summer. His parents will be claiming Ricky as a dependent on their return. Is Ricky required to file a California tax return and, if so, what is his standard deduction? a) No b) Yes; his standard deduction is $4,500. c) Yes; his standard deduction is $4,401. d) Yes; his standard deduction is $4,100.

Objective #2: Exemptions/Dependency

Dependents California law conforms to the federal law when determining dependency. The same dependents listed on the federal return should be listed on the California Form 540. The name of each dependent, as well as their Social Security number and relationship to the taxpayer, should be listed in the space provided on the California return.

Exemptions This is an area where California differs from federal law. Under federal law, through tax year 2017, the exemption was used to further reduce taxable income. However, as a result of the TCJA, federal exemptions were suspended for tax years 2018 through 2025. The TCJA increased the child tax credit to $2,000 per child under age 17 which includes a refundable portion for select taxpayers. It also created a family credit for dependents over age 16. This is more similar to how California handles exemptions. California exemptions are nonrefundable tax credits that reduce tax liability. Furthermore, California allows additional exemption credits for taxpayers age 65 and older and/or blind, rather than additional standard deduction amounts for elderly and/or blind taxpayers. In California, there are 4 types of exemption credits:

1. Personal Exemptions ($118) – allowed for the taxpayer and his spouse/RDP. 2. Blind Exemptions ($118) – allowed for the taxpayer and/or his spouse/RDP if either or

both are visually impaired. The affected individual is considered visually impaired if he is not capable of seeing better than 20/200 while wearing corrective eyewear, or if the field of vision is not more than 20 degrees.

3. Senior Exemptions ($118) – allowed for the taxpayer and/or his spouse/RDP who is 65 years of age or older by January 1, 2019.

4. Dependent Exemptions ($367) – allowed for taxpayers who have dependents listed on their tax return.


Single ......................................................................................................................... $118 Single, senior.............................................................................................................. $236 Married/RDP, separate return .................................................................................... $118 Married/RDP, joint return ........................................................................................... $236 Married/RDP, joint return, both seniors, both blind .................................................... $708 Head of Household .................................................................................................... $118 Head of Household, one dependent .......................................................................... $485 Qualifying Widow(er) .................................................................................................. $236 Qualifying Widow(er), one dependent ........................................................................ $603 Dependent, each ........................................................................................................ $367

Form 540 “Exemptions” Section

3 Personal exemptions are subject to phase-out limits, called the personal exemption phase-out (or PEP). The personal exemption phase-out returned in tax year 2013 through 2017 for federal purposes. The TCJA suspended the federal PEP for tax years 2018 through 2025. For tax years 2010, 2011, and 2012, California did not conform to the federal practice which eliminated the phase-out of exemption amounts based on the taxpayer’s AGI. For 2018 California has retained the phase-out of exemption amounts even though it has been eliminated for federal purposes. The exemption amount will be phased out for taxpayers with federal AGI over:

a. Single or Married/RDP Filing Separately ...................................................... $194,504 b. Married/RDP Filing Jointly or Qualifying Widow(er) ..................................... $389,013 c. Head of Household ....................................................................................... $291,760

If the taxpayer’s AGI exceeds the limit for his filing status, his exemption credits will be reduced. The exemption credit amount is entered on line 32 of Form 540. To calculate the reduced credit amount, use the “AGI Limitation Worksheet,” shown below and on page 11 of the California 540 Personal Income Tax Booklet.

3 Form 540, Side 1


4

Review Question 3 Arthur, 65, and his wife Irene, 63, have been married for 40 years. Their daughter is incarcerated, so they had full custody of her 15-year-old son for the entire tax year. They will file a joint return like they do every year. What is the amount of exemption credits they will be allowed to claim on their California tax return? a) $354 b) $721 c) $839 d) $603



Objective #3: Credits Unique to California

Special Head of Household Credits for California California has three special credits for taxpayers who do not qualify as Head of Household. 1. CREDIT FOR JOINT CUSTODY HEAD OF HOUSEHOLD (Code 170): This credit is

designed to aid the parent having or sharing court-ordered joint custody of a child. The taxpayer must be filing Single or Married/RDP Filing Separately, and must have lived apart from his spouse the entire tax year. He must pay for more than half of the household expenses for his home that was also considered the main home of his child, stepchild, or grandchild for at least 146 days but not more than 219 days of the taxable year. The credit is the lesser of 30% of the net tax or $469. The worksheet below is used to figure the Joint Custody Head of Household credit. Amounts should be rounded to whole dollars.

Credit for Joint Custody Head of Household Worksheet

5

In addition, the custody arrangement for the child must be written into the decree of dissolution or legal separation. A written agreement between the parents will suffice as long as the proceedings of legal separation or dissolution have been initiated, but no official decree has been issued yet.

Some taxpayers may qualify for both the Credit for Joint Custody Head of Household and the Credit for Dependent Parent. Only one of these credits may be claimed and the credit that yields the maximum benefit should be claimed.

Student Note: Taxpayers using the Head of Household, Married/RDP Filing Jointly, or Qualifying Widow(er) filing status do not qualify. Taxpayers using the Single filing status, who were never married to the other parent, also do not qualify for this credit. Taxpayers using the Single filing status may qualify for the credit only if divorced or legally separated from the other parent.

2. CREDIT FOR DEPENDENT PARENT (Code 173): The taxpayer may not claim the Credit

for Dependent Parent if his filing status is Head of Household, Single, Qualifying Widow(er), or Married/RDP Filing Jointly.

The taxpayer can claim this credit only if all the following apply:

At the end of 2018, the taxpayer and his spouse were married/RDPs and used the filing status Married/RDP Filing Separately;

The taxpayer and spouse/RDP did not live in the same household during the last six months of the tax year; and

The taxpayer paid for more than half of all the household expenses for his dependent parent’s home. The taxpayer can claim this credit regardless of whether or not the dependent parent lived in the taxpayer’s home.



The taxpayers should use the Credit for Joint Custody Head of Household Worksheet to calculate this credit. The credit is the lesser of 30% of the net tax or $469. Again, if the taxpayer qualifies for both the Credit for Joint Custody Head of Household and the Credit for Dependent Parent, he should claim the one with the greatest benefit.

3. CREDIT FOR SENIOR HEAD OF HOUSEHOLD (Code 163): The taxpayer may claim this

credit if: As of January 1, 2019 *, the taxpayer was age 65 or older. The taxpayer qualified as Head of Household in 2016 or 2017 by providing a

household for a qualifying individual who died during 2016 or 2017; and The taxpayer’s adjusted gross income was below $76,082 for 2018.

* A taxpayer is considered to be age 65 on December 31, 2018 if his 65th birthday is on

January 1, 2019.

To claim this credit, the taxpayer does not need to qualify to use the Head of Household filing status as long as all of the conditions listed above are met. The credit is the lesser of 2% of the taxable income or $1,434. The worksheet below is used to figure the credit. Amounts should be rounded to whole dollars.

Credit for Senior Head of Household Worksheet

6

Excess CASDI Credit California State Disability Insurance (CASDI) is a partial wage-replacement program for California workers. It is funded through employee payroll deductions and mandated by the state. SDI provides temporary payments to workers who are unable to perform their usual work because of a pregnancy or a non-occupational illness or injury. In 2018, the employee SDI (State Disability Insurance) or VPDI (Voluntary Plan Disability Insurance) maximum rate is 1.0% of gross wages (applied to a maximum of $114,967), generating a maximum withholding for SDI of $1,149.67. If the taxpayer had more than one employer during 2018 and the individual employers withheld a combined total of more than $1,149.67 on combined wages of more than $114,967, the taxpayer may claim a credit on his return for the amount over $1,149.67. The taxpayer can calculate his credit on the “Excess SDI (or VPDI) Worksheet” which follows and can be found on page 14 of the California 540 Personal Income Tax Booklet. If any single employer withheld more than 1.0% of gross wages, the taxpayer must contact the employer for a refund. He may not claim excess SDI or VPDI on his tax return.



7 The excess SDI (or VPDI) on line 3 of the worksheet should be entered in the “Payments” section on line 74 of Form 540. If both the taxpayer and spouse/RDP have excess SDI, it should be combined before entering the amount on Form 540.

Form 540 “Payments” Section

8 If the taxpayer had only one employer and had SDI (or VPDI) withheld of more than $1,149.67, he will need to recover the excess SDI (or VPDI) withheld from the employer. In the case of a joint return, the taxpayer and his spouse would calculate any excess on an individual basis. This credit is treated in a similar manner as federal excess Social Security tax withheld, which is entered as a payment on Schedule 5 (Form 1040), line 72.

7 California 540 Personal Income Tax Booklet, page 14 8 Form 540, Side 3


Review Question 4 Michael would like to see if he is eligible to claim one of the Head of Household credits. He and the mother of his child, Teresa, are not married and do not live together. She qualifies to claim their child, Jadon, as a dependent on her tax return. Michael helped his elderly mother by paying for most of her household expenses during the year for her separate home 10 miles away. Michael shares custody of Jadon with Teresa. Jadon spent 175 days of the tax year at Michael’s home. His taxable income is $47,500 and the net tax shown on his state return is $1,338. Which Head of Household credit does Michael qualify for and what amount can he claim? a) Credit for Dependent Parent; $469 b) Credit for Joint Custody Head of Household; $1,338 c) Credit for Joint Custody Head of Household; $469 d) Credit for Joint Custody Head of Household; $401

Objective #4: Estimated Tax Payments, Interest and Penalties, & Extensions and Tax Rates

Estimated Tax Payments California requires taxpayers to make estimated tax payments if the taxpayer expects to owe at least $500 ($250 if Married/RDP Filing Separately) in tax for 2018. This is after subtracting any withholding and credits and if the taxpayer expects his withholding and credits to be less than the smaller of:

90% of the tax calculated on his 2019 return; or 100% of the tax shown on the taxpayer’s 2018 tax return, including AMT (alternative

minimum tax). California does not conform to federal law concerning the percentage which must be paid with each installment. Installments are required to be paid as follows:

30% of the required total annual payment for the first required installment; 40% of the required total annual payment for the second required installment; No payment is due for the third required installment; and 30% of the total required annual payment for the fourth required installment.

Once a California taxpayer makes estimated tax payments or extension payments that exceed $20,000 or files an original return with a total tax liability greater than $80,000 for any taxable year, then all future payments are required to be remitted electronically. These payments must be remitted electronically regardless of tax type, taxable year, or amount. Taxpayers who do not comply will be subject to a 1% noncompliance penalty. The first payment that initiates the mandatory e-pay requirement does not have to be submitted electronically. Taxpayers can make electronic payments using:

Credit card; Web Pay on the Franchise Tax Board’s (FTB’s) website; or Electronic funds withdrawal (EFW) with the e-filed return.

If the taxpayer and his spouse paid joint estimated tax payments and then decide to file as Married/RDP Filing Separately, they:

Can decide to let one claim the full amount paid; or May each claim part of the joint estimated payment(s).


If the taxpayers decide to divide their estimated tax payments before they file their separate returns, they must notify the FTB so that the payments will be applied to the appropriate accounts. Any divorce agreement (or court-ordered settlement) or a statement showing the allocation of the payments accompanied by a notarized signature of both taxpayers will be accepted in writing by the FTB. Statements should be sent to:

JOINT ESTIMATED CREDIT ALLOCATION MS F283 TAXPAYER SERVICES CENTER FRANCHISE TAX BOARD PO BOX 942840 SACRAMENTO, CA 94240-0040

Payment Due Dates California estimated tax payments are due on the same dates as federal estimated tax payments. For calendar year filers, quarterly installments are due on April 15, June 15, September 15, and January 15. The fourth estimated payment due January 15 can be filed with the tax return by January 31. For 2019, the first due date will be April 15. For fiscal year filers, the first and second installments are due by the 15th day of the fourth month and the 15th day of the sixth month of the taxable year, respectively. The third installment due date is the 15th day of the ninth month of the taxable year, although no payment is required. The fourth installment is due by the 15th day of the first month following the end of the taxable year. If the 15th is on a Saturday, Sunday, or legal holiday, then the due date is moved to the next day that is not a Saturday, Sunday, or legal holiday. There is a way to avoid a late payment penalty on the fourth installment. As long as the tax return is filed and the remaining balance due is paid by January 31, 2020 (the last day of the first month following the end of the tax year for fiscal filers), taxpayers do not have to pay their fourth installment on the fourth installment due date. If the taxpayer qualifies, farmers and fisherman can choose from two options to avoid paying any underpayment of estimated tax penalties. They can either pay all estimated tax payments by January 15, 2020 or file their 2019 tax return and pay all tax due by March 2, 2020. Penalties for Underpayment of Estimated Tax The taxpayer may owe an underpayment penalty on his estimated taxes if he owes $500 ($250 if Married/RDP Filing Separately) or more, or 10% or more of the tax liability and he underpaid his 2018 estimated tax liability for any payment period. To calculate the penalty, use Form FTB 5805, Underpayment of Estimated Tax by Individuals and Fiduciaries. To avoid paying underpayment penalties, the taxpayer should adjust his withholding or pay estimated tax payments throughout the year. Any penalty imposed is computed as a percentage of the underpayment for the period of the underpayment. For the 2018 computation period, the penalty rate for 4/15/2018 to 12/31/2018 is 4% and the penalty rate for 1/1/2019 to 4/15/2019 is 5%.


Extension of Time to File California allows an automatic six-month extension without written request if the taxpayer cannot file his return by April 15 and does not owe taxes for the year. The taxpayer qualifies for an automatic extension as long as his return is filed by October 15. If the taxpayer owes taxes and cannot meet the April 15 deadline, he will need to complete Form FTB 3519, Payment for Automatic Extension for Individuals, for the automatic six-month extension. An extension of time to file the return is not an extension of time to pay the tax. To avoid late payment penalties and interest, the taxpayer must pay 100% of his tax liability by April 15, 2019. Taxpayers living or traveling outside the United States on April 15, 2019, will have until June 17, 2019 to file their return and pay their tax. The extension of time to file does not include an extension to pay; therefore, interest will accrue from the original due date until the date of payment. If the taxpayer needs additional time to file the return, an automatic six-month extension will be allowed without filing a request. The taxpayer will qualify for the automatic extension if he files the return no later than December 16, 2019. 100% of the liability must be paid by June 17 to avoid late-payment penalties. When the taxpayer files his return, he should write at the top of the front page of his tax return in red ink, “Outside the USA on April 15, 2019.” If the 15th is on a Saturday, Sunday, or legal holiday, then the due date is moved to the next day that is not a Saturday, Sunday, or legal holiday.

Taxpayer Penalties and Interest Late filing of a tax return carries a maximum total penalty of 25% of the tax not paid if the return is filed after October 15. When a return is more than 60 days late, the minimum filing penalty is the smaller of $135 or 100% of the balance due. The penalty for late payment of tax may result in a penalty of 5% of the unpaid amount of tax due, plus ½ % for each month, or part of a month, that the tax remains unpaid. If the taxpayer has paid at least 90% of the tax shown on the return by the original due date of the return, the state will waive the penalty based on reasonable cause. However, the interest is mandatory and will not be waived. Taxpayers may also be penalized for a check returned for insufficient funds, negligence, substantial underpayment, tax fraud, and under/over valuation of taxes. See the charts on the following pages for penalty information.


Penalty Reference Chart

Penalty Name Penalty Reason Penalty Computation

Tax on Joint Return Exceeds Tax on Separate Returns

Tax on a joint return exceeds tax shown on separate returns, due to negligence or intentional disregard of rules, or fraud. In lieu of penalties provided by Section 19164(a) and (b). 20% of total amount of excess if attributable to

negligence/intentional disregard of rules.

75% of excess if attributable to fraud.

Exception – None.

Electronic Funds Transfer (EFT) Penalty

Any person required to remit payment by EFT, but who makes payment by other means.

10% of the amount paid by non-EFT.

Exceptions – Reasonable cause and not willful neglect.

Electronic Payment Requirements for Individuals

Failure by individuals, whose tax liability is greater than $80,000 or who make an estimated tax or extension payment that exceeds $20,000, to remit their tax payments electronically.

1% of the amount paid.


Failure to File a Return/Late Filing Penalty

Any taxpayer who is required to file a return but fails to do so by the due date.

5% of the tax due, after allowing for timely payments, for every month that the return is late, up to a maximum of 25%. For fraud, substitute 15% and 75% for 5% and 25%, respectively. For individuals and fiduciaries, minimum penalty is the lesser of:

$135; or 100% of the tax required to be shown

on the return.


Failure to Pay Tax/Late Payment Penalty

Taxpayer failing to pay tax by the due date. This penalty is not imposed if, for the same tax year, the sum of failure to file a return penalty (section 19131) and failure to provide information requested penalty (section 19133) are equal to or greater than this penalty.

5% of the total tax unpaid plus 1/2 of 1% for every month the payment of tax was late up to 40 months. Not to exceed 25% of the total unpaid tax.


Failure to Provide Information Requested/ Failure to File a Return Upon Demand

Any taxpayer for failing to provide requested information or failing to file a return after notice and demand.

25% of total tax liability assessed without regard to any payments or credits.


Dishonored Payments

Any taxpayer who makes a payment by check that is dishonored. Includes payments made by credit card or EFT.

For payments received after January 1, 2011, the penalty will be:

An amount equal to 2% of the amount of the dishonored payment; or

If the amount of the check is less than $1,250, $25 or the amount of the check, whichever is less.

Exceptions – Reasonable cause and good faith.

Underpayment of Estimated Tax (Addition to Tax)

Any taxpayer who fails to pay estimated tax in the required installments.

An amount determined by applying the underpayment rate specified in Section 19521 to the amount of the underpayment for the period of the underpayment.

Exceptions – (1) Safe harbors under 6654 as modified, (2) Underpayment created or increased by any provision of law that is chaptered during and operative for the taxable year of the underpayment, or (3) Underpayment was created or increased by the disallowance of a credit under Section 17053.80(g) or 23623(g).


Penalty Reference Chart (cont.)

Penalty Name Penalty Reason Penalty Computation

Accuracy Related Penalty

Any underpayment of tax required to be shown on a return, attributable primarily to negligence or disregard of rules and regulations or a substantial understatement of income tax.

20% of the underpayment of tax. 40% unless certain exceptions apply for

amnesty eligible years, which are tax years prior to January 1, 2003.

Exceptions – The defenses to an accuracy related penalty include (1) Substantial authority, (2) Adequate disclosure and reasonable basis, or (3) Reasonable cause and good faith, depending on the grounds for imposing the penalty. In addition, see underlying regulation regarding unitary and business and nonbusiness income determinations.

Fraud Penalty

When there is clear and convincing evidence to prove that some part of the underpayment of tax was due to civil fraud. Such evidence must show the taxpayer's intent to evade tax that the taxpayer believed to have owed.

75% of the underpayment attributable to civil fraud.

Exceptions – Reasonable cause and good faith.

Reportable Transaction Accuracy Related Penalty – Disclosed Reportable Transaction

Any disclosed reportable transaction understatement for tax years beginning on or after January 1, 2005.

20% of the understatement attributed to the reportable or listed transaction if the transaction is adequately disclosed on the return.

Exceptions – Chief Counsel relief for reportable transactions other than listed transactions. The standards in R&TC Section 19772 apply.

9

9 https://www.ftb.ca.gov/forms/misc/1024.html


California Statute of Limitations California tax law has established final deadlines for the FTB to propose assessment or assess additional taxes known as the California statute of limitations. Assessments The general time limit for FTB to assess additional California state income and franchise taxes is provided by section 19057 of the Revenue and Taxation Code (renumbered from sections 18586 and 25663 of the Revenue and Taxation Code, effective January 1, 1994). Assessments may be allowed after the general time limit in special circumstances, such as if the Internal Revenue Service made federal adjustments, or if the taxpayer failed to report 25% or more of the gross income required to be reported on a tax return. 1. Returns Filed on or Before the Original Due Date of the Return

The law generally requires FTB to mail a proposed deficiency assessment to the taxpayer within four years after the filing date of the taxpayer's return. Returns filed before the original due date of a personal income tax return (April 15 of the year after the tax year) are considered as filed on the original due date (Revenue and Taxation Code Section 19066.)

For example, the original due date of a return for the 1992 tax year was April 15, 1993. If the taxpayer filed a return before this deadline, the return is considered as filed on April 15, 1993. The statute of limitations for FTB to assess tax for this tax year would therefore expire on April 15, 1997.

2. Returns Filed After the Original Due Date of the Return or on Extension, or Delinquent

Returns Depending on the tax year involved, the deadline may be computed from either the tax return's April 15 due date, October 15 extended due date, or the date a late tax return was filed, as follows:

a. For 1990 and prior tax years. The final due date for FTB to assess additional tax was four years from the original April 15 due date of the return. If the taxpayer received an extension of time to file the return, the final due date to assess tax was four years from the October 15 extended due date of the return. If an extension to file the return was not granted, and the taxpayer filed the return after April 15 but before October 15, FTB had four years from the date the late return was filed to assess tax. If an extension was granted, but the taxpayer did not file the return on or before October 15, FTB had four years from the date the late return was filed to assess tax.

b. For personal income taxpayers, the process of automatic "paperless" extensions began

in the 1991 tax year and remains in effect. Under this process, the taxpayer is no longer required to request an extension on a paper form. If the taxpayer files a return on or before October 15, an extension is automatically granted. If the taxpayer fails to file a return by October 15, no extension exists. Under the paperless extension process, the return is timely if it is filed on or before October 15.

(1) For the 1991 tax year only. If the taxpayer filed a return on or before April 15, 1992, FTB had until April 15, 1996 to assess tax. If the taxpayer filed a return after April 15, 1992 and on or before October 15, 1992, FTB had until October 15, 1996 to assess tax. If the taxpayer did not file the return by October 15, 1992, FTB had four years from the date the late return was filed to assess tax.

(2) For tax years 1992 and following. FTB must assess tax within four years from the original April 15 due date of the return, if the taxpayer filed the return on or before that date. If the taxpayer did not file the return on or before the original April 15 due date, FTB has four years from the date the return was filed to assess tax. 10

10 Law Summary – Statute of Limitation – Assessments: http://www.dicknorton.com/ftb-statute-of-limitations.pdf


Claim a Refund or Credit R&TC Section 19306 specifies that a claim for refund or credit must be filed no later than (a) four years from the original due date of the return, or (b) four years from the date the return is filed if the return was filed within the "automatic extension" period. Additionally, a claim for refund or credit is timely with respect to payments made within one year of the claim filing date (the "look back" provision). The postmarked date of the claim is the date it is considered "filed," and the taxpayer has the burden of proving the claim is timely filed. 1. How does the "look back" provision work?

The following example illustrates the "look back" provision of R&TC Section 19306. An individual taxpayer files a claim for refund for tax year 2003 on May 12, 2010. Since the taxpayer filed the claim more than four years after the original due date of the taxpayer's return (April 15, 2004), and more than four years after the latest date the taxpayer could have filed his return during the automatic extension period (October 15, 2004), the claim could not be allowed under the "four year" provision. However, if the taxpayer made any payments for tax year 2003 during the year prior to the date the claim for refund was filed, the claim, if meritorious, could be allowed to the extent of payments made during that one year period.

2. What is an "informal claim for refund?" How does the statute of limitations apply to an

"informal claim for refund?” Generally, a taxpayer must pay all tax and interest for a tax year before filing a claim for refund. If, however, a taxpayer files a claim for refund before all tax and interest for that tax year are fully paid, the claim may be considered an "informal claim for refund." (R&TC Section 19322.1). The statute of limitations will be tolled (paused) as of the date the informal claim is filed. The claim will not be deemed "perfected" and filed until all of the tax and interest for that year are paid. If the informal claim is perfected, the amount of a refund or credit is limited to the total payments made within seven years of the date the claim is "perfected."

3. Are there any other circumstances under which the statute of limitations for claims for

refund or credit will be tolled? Yes. An individual taxpayer who (a) suffers from a medical condition that is either terminal or expected to last at least one year, and (b) is unable to manage his financial affairs, and (c) has not authorized anyone to act on his behalf may be considered a "financially disabled" taxpayer. If a taxpayer has established that he or she is "financially disabled," the statute of limitations will be tolled during the period of the taxpayer's financial disability. (R&TC Section 19316.) The taxpayer must submit documentation of the condition, along with a physician's statement, to meet his burden of proof as to financial disability. This statute applies to claims for refund where the statute of limitations had not expired by September 23, 2002. FTB 1564, Financially Disabled – Suspension of the Statute of Limitations, provides more detailed information and forms concerning financial disability. 11

11 Statutes of Limitations on Claims for Refund or Credit (Tax News, July 2010)


Assessment Following Federal Action 1. Timing is everything! The date we are notified of an Internal Revenue Service (IRS)

adjustment determines when we may issue an assessment resulting from the federal adjustment. If the taxpayer or the IRS reports a federal adjustment to us, or if a taxpayer files an

amended California return reflecting the federal adjustment, within six months after the final federal determination date, we may issue a proposed assessment within the later of (1) two years after the date we received notice of the federal adjustment, or (2) the expiration of any other open SOL under California law. (Revenue and Taxation Code (R&TC) Section 19059)

If notice of the federal adjustment is reported to us more than six months after the final federal determination date, we may issue a proposed assessment within the later of (1) four years after the date we receive notice of the federal changes or corrections, or (2) any open SOL under California law.

If neither IRS nor the taxpayer reports a federal change or correction, we may issue a proposed assessment at any time. (R&TC Section 19060(a))

2. What is the SOL to file a claim for refund following federal action?

Pursuant to R&TC Section 19311, a taxpayer may file a claim for refund resulting from a federal adjustment within the later of the general four-year SOL (R&TC Section 19306) or two years from the final federal determination date.

3. Are there limitations on the scope of claim for refund following federal action?

Yes. There are three important limitations. First, a claim for refund under R&TC Section 19311 is limited to overpayments resulting from the federal adjustment. Generally, this means that the same issue or item adjusted by the IRS can be the basis of a California claim. Second, a claim for refund filed under R&TC Section 19311 must be based on a federal adjustment to an original or amended federal return, and the federal adjustment must affect the tax shown on an original or an amended California return previously filed with us. The original state or federal return of a non-filer does not result from a federal determination. Third, a federal adjustment may result in a claim for refund for a tax year different from the tax year in which the federal adjustment occurred. This commonly occurs where there is a federal carry forward or carryback that is not applicable under California law or where there is a California-only credit or credit carry forward in the year of the federal adjustment. 12

Tax Payments California may, at their discretion, grant an extension of time to pay the tax due. If an extension is granted, interest is charged from the regular due date through the payment date using the rate charged for deficiencies. The California Franchise Tax Board accepts credit cards for payment of the following:

A balance due on a current year tax return An extension payment (Form FTB 3519) An estimated tax payment (Form 540-ES) Any amount owed for prior years Any bill received that includes an insert about credit card payments

Caution: Do not use a credit card to pay a liability that is still pending based on a Notice of Proposed Assessment or Notice of Action, or to pay a tax liability resulting from filing an amended tax return.

12 Statutes of Limitations on Assessments and Refunds/Credits Following Federal Action (Tax News, August 2010)

http://www.zillionforms.com/2009/P4140078.PDF


There is a convenience fee for using a credit card to make payments. An additional 2.3% (rounded to the nearest cent) of the balance due is charged to offset the cost of the discount rate charged to the state. There is a minimum fee of $1. The taxpayer will be required to remit all payments electronically once he makes an estimated or extension payment exceeding $20,000 or he files an original return with a total tax liability over $80,000. Once the taxpayer meets this threshold, all subsequent payments regardless of amount, tax type, or taxable year must be remitted electronically. Taxpayers may request a waiver of the electronic payment requirements using Form FTB 4107, Mandatory e-Pay Election to Discontinue or Waiver Request.

Tax Rates The California Tax Table must be used with all California returns unless the taxable income exceeds $100,000 at which time the taxpayer will need to use the California Tax Rate Schedules to calculate his tax liability. Please see the California 540 Personal Income Tax Booklet for the California Tax Table and the California Tax Rate Schedules. Nonresidents and part-year residents are taxed using the same table or schedule that would be appropriate if they were residents. However, the tax computation (via the 540NR) is done according to the ratio of California source AGI to AGI from all sources. California AGI for nonresidents and part-year residents includes:

1. All items of AGI regardless of source for any period the taxpayer was a resident of the state; and

2. Income items attributable to California sources for any period the taxpayer was not a resident of the state.

Federal tax rates were adjusted from 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% in 2017 to 10%, 12%, 22%, 24%, 32%, 35%, and 37% in 2018 as a result of the TCJA.

Review Question 5 Brenda filed her California return as Head of Household on April 15. She showed a tax due at that time of $400. She could not afford to pay the tax to the FTB until July 15. What is the amount of her late payment penalty? a) $ 26 b) $100 c) $135 d) $ 22 Reading Reference for Chapter 2: 540 Personal Income Tax Booklet, pages 9-20


Chapter 3: Income

Overview

Chapter Description Upon the completion of this chapter, students will understand how differences between federal and California tax law affect common items of income. Based on the differences between federal and California tax law, students will be able to determine which items of income must be adjusted on the California return. Students will also learn how to report the necessary income adjustments on Schedule CA (540), California Adjustments – Residents. The following content is based on 2018 tax law; however, discussions of prior year tax law will be addressed as applicable.

Learning Objectives

1) Summarize how adjustments are made to federal AGI to arrive at California AGI. 2) Describe how California income tax law affects several types of income, either included in

or omitted from federal income, and determine how to report the necessary adjustments on California Schedule CA (540), Part I, lines 1-21.

Key Terms

Alimony California Adjusted Gross Income (AGI) California Lottery Winnings California Qualified Stock Option (CQSO) Dividends Employer HSA Contributions Employer Provided Meals Interest Military Pay Paid Family Leave (PFL) Ridesharing Program Social Security Benefits/Railroad Retirement Tier 1 Benefits State Tax Refunds Taxable Income Unemployment Compensation

Objective #1: Arriving at California Adjusted Gross Income (AGI)

Adjusted Gross Income (AGI) Defined Most states have a personal income tax. California income tax is a tax imposed on wages, tips, interest, capital gains, self-employment income, pensions, and other types of income; the same as federal income tax. For this reason, California starts the tax calculation with the federal AGI, then subtracts and adds the necessary adjustments to arrive at the California AGI. California AGI is different from federal AGI because California does not conform to (or agree with) the federal tax treatment of all tax items. As a result, adjustments can be made on the California return to treat certain tax items according to California law. Adjustments to federal income are made on


Schedule CA (540). The purpose of this schedule is to use California law to make adjustments to federal adjusted gross income and to federal itemized deductions. Items may be added or subtracted from California income. Some of the more common adjustments include: Nontaxable Subtractions

Interest on U.S. obligations Dividends on U.S. obligations State tax refunds Unemployment Compensation (UC) and Paid Family Leave (PFL) Social Security benefits/Railroad Retirement Tier 1 benefits California lottery winnings

Taxable Additions

Interest on non-California state municipal obligations Dividends on non-California state municipal obligations Certain HSA contributions Certain foreign source income Alimony received by a nonresident alien and not included in his federal income Some Net Operating Losses (NOLs)

Schedule CA (540), Part I, Income Adjustment Schedule

1

1 Schedule CA (540), Part I, Sections A and B


Adjusting federal income amounts to calculate California income amounts is done on Schedule CA (540), in Part I, Section A (Income from federal Form 1040) and Section B (Additional Income from federal Schedule 1 (Form 1040)), as shown above. Lines 1-5 correspond to the federal Form 1040 lines. Lines 10-21 correspond to the lines on federal Schedule 1 (Form 1040). Amounts from the federal return are entered in column A. California subtractions are entered in column B and California additions are entered in column C. All columns are then totaled on line 22, for each of columns A, B, and C. In similar fashion, federal adjustments to income are altered by California adjustments in Section C (Adjustments to Income from federal Schedule 1 (Form 1040)). Line 37 of Section C then computes the California adjustments. The positive number from column B, line 37, transfers to Form 540, line 14. A negative number from Column B transfers as a positive number to Form 540, line 16. The positive number from column C, line 37, transfers to Form 540, line 16. A negative number from Column C will transfer to Form 540, line 14. In other words, the numbers are placed on reverse lines if they are negative. Finally, the California AGI is figured on Form 540, line 17. California adjustments to income will be discussed in detail in a later chapter.

2 Once AGI is determined for both federal and California purposes, the calculations to figure taxable income are different. Itemized and standard deductions are used on the federal and California returns to calculate taxable income, but the amounts differ between the federal and California returns. California’s standard deduction amounts are lower than the federal standard deduction amounts for each filing status (see discussion in the previous chapter). California does not require taxpayers to itemize deductions, even if they itemized on the federal return. Conversely, some taxpayers may be able to itemize on their California return, even if they used the standard deduction on their federal return.

2 Schedule CA (540), Part I, Section C


California does not allow deductions for: Personal exemptions. Instead, California allows an exemption credit for filers and

qualified dependents. Additional standard deductions for age and blindness. Instead of an additional deduction,

California provides additional personal exemptions for age and blindness. Pass-through income (IRC Section 199A, Qualified Business Income)

Registered Domestic Partner (RDP) Adjustments For California income tax purposes, references to a spouse, husband, or wife also apply to a California RDP, unless otherwise specified. The “RDP” abbreviation refers to both a California registered domestic “partner” and a California registered domestic “partnership.” RDPs will compute their adjustments for lines 1 through 21, column A, based on the combined amounts from each partner’s individual federal income tax return, as filed. RDPs filing a California tax return using the Married/RDP Filing Jointly filing status, with no RDP adjustments between federal and California, combine their individual AGIs from their federal tax returns. The combined federal AGI is entered on Form 540, line 13. RDP adjustments include, but are not limited to, the following:

Division of community property Transactions between RDPs Capital losses Sale of residence Individual Retirement Accounts Rental real estate passive losses Dependent care assistance Investment interest Qualified residence interest acquisition loans and equity loans Expense depreciation property limits Education loan interest Rollover of publicly traded securities gain into specialized small business investment

companies RDPs filing as Married/RDP Filing Separately, former RDPs filing Single, and RDPs with RDP adjustments will use the California RDP Adjustments Worksheet in FTB Publication 737, Tax Information for Registered Domestic Partners, or prepare a Form 1040 recalculated (pro forma) as if the filing status was Married Filing Jointly. Amounts calculated on the RDP Adjustments Worksheet are then used to complete Schedule CA (540). At this time, students should read the Instructions for Schedule CA (540), located in the chapter Reading References. Review Question 1 Alan and Lisa are married California residents who received $400 interest on U.S. Treasury notes during the tax year and $150 interest from a Nevada state bond. What adjustments to the federal amounts will need to be made using Schedule CA (540)? a) Subtract $400 Treasury note interest; Subtract $150 Nevada state bond interest. b) Add $400 Treasury note interest; Add $150 Nevada state bond interest. c) Subtract $400 Treasury note interest; Add $150 Nevada state bond interest. d) Add $400 Treasury note interest; Subtract $150 Nevada state bond interest.


Objective #2: Reporting Adjustments to Income on California Schedule CA (540), Part I, Lines 1 – 21

California Conformity to the TCJA In general, California conforms to the Internal Revenue Code (IRC) as of January 1, 2015, with modifications. The Conformity Act of 2015 changed California’s specified date of conformity to the IRC to January 1, 2015. However, California has always had areas of nonconformity unless their lawmakers make an executive decision to conform. While some states choose to accept and implement federal changes automatically, California has chosen not to follow the majority of the tax changes put into place by the Tax Cuts and Jobs Act (TCJA); therefore, there are several more areas of nonconformity than previously, creating a bigger issue for California taxpayers. Following tax reform, there were significant changes made to the 2018 Schedule CA (540) to allow for certain adjustments due to the TCJA. Specific areas of conformity and nonconformity are discussed in California’s affected tax forms’ instructions, Schedule CA (540) instructions, and FTB Publication 1001, Supplemental Guidelines to California Adjustments.

Wages Wages are entered on line 1 of the federal return (1040). Adjustments may be required for the following types of income:

Active duty military pay Sick pay received under the Federal Insurance Contributions Act and Railroad

Retirement Act Ridesharing fringe benefits Compensation from exercising a California Qualified Stock Option (CQSO) Employer health savings account (HSA) contributions In-Home Supportive Services (IHSS) supplementary payments received Native American Income

For 2018, California has a higher minimum wage of $11 per hour for employers with 26 or more employees and $10.50 per hour for employers with 25 or fewer employees. 2019 minimum wage amounts are $12 (26 or more employees) and $11 (25 or fewer employees) per hour. On January 1 of each year, the state’s minimum wage will increase by $1 per hour until it reaches $15 per hour for employers with 25 or fewer employees in 2023. The yearly minimum wage increases are a result of the California State Legislature passing the “Fair Wage Act of 2016” ($15 Minimum Wage Initiative), which was signed into law on April 4, 2016.

Military Pay A taxpayer who is an active duty member of the military service is referred to as a servicemember, a term used throughout this discussion. The spouse of a servicemember is also known as the servicemember’s spouse. Military pay is taxable for federal returns, but only taxable to one state. The state that can tax military pay is based on the servicemember’s domicile (or home of record). Generally, the state in which the taxpayer entered the military is his domicile or home of record. However, under certain circumstances, a servicemember may change his home of record and thereby change his domicile.


For a servicemember domiciled in California, all military pay is included in income. However, military pay received while on permanent change of station (PCS) orders outside of California is not treated as California income; i.e., the income is not considered California source because the servicemember is considered a nonresident. Conversely, a servicemember on temporary duty assignments (TDY) outside of California is subject to tax on his military pay; i.e., the income is California source income. If the taxpayer is stationed in California and his domicile is other than California, he is considered a nonresident. California does not tax his military pay. If the taxpayer’s domicile is California, and he is stationed inside the state of California, he is a resident of California and his military pay along with all other (worldwide) income is taxable by California. In making tax calculations, the servicemember’s pay is always part of total income even when the pay may not be taxable. The tax computations would be performed on a Part-Year/Nonresident form under situations where the servicemember is outside California for some part of a tax year and/or when the servicemember’s spouse remains in California for the entire year. Military Spouses Residency Relief Act (MSRRA) Under prior law, the servicemember’s spouse was subject to tax in the domiciliary state, even when living with the servicemember in another state on PCS orders. Congress provided relief under the Military Spouses Residency Relief Act (MSRRA) for taxable years beginning January 1, 2009, which says (in part) that, “A spouse of a servicemember shall neither lose nor acquire a residence or domicile for purposes of taxation with respect to the person, personal property, or income of the spouse by reason of being absent or present in any tax jurisdiction of the United States solely to be with the servicemember in compliance with the servicemember’s military orders if the residence or domicile, as the case may be, is the same for the servicemember and the spouse.” 3 Thus, if qualified under the MSRRA, the spouse of a servicemember domiciled in another state and earning money in California while stationed with the servicemember is not subject to tax on that income. Effectively, the spouse’s income is treated as non-California source income. A California domiciled servicemember’s spouse who is “stationed” with the servicemember in another state on PCS orders pays no tax to California on money earned in the other state. If the spouse qualifies under the MSRRA, the spouse would not pay tax to the state of residence either. Early Distributions Not Subject to Additional Tax California conforms to the exceptions from the penalty on early withdrawals from retirement plans for qualified distributions made after September 11, 2001, to reservists while serving on active duty for at least 180 days. There is also an exception for early distributions to qualified public safety employees after separation from service on or after reaching age 50. Individual Retirement Plan Contributions California conforms to the federal Heroes Earned Retirement Opportunities Act. This act provides that members of the Armed Forces serving in a combat zone are allowed to make contributions to their individual retirement plans even if the contribution is made from compensation that is excluded from gross income. Because military pay issues can be varied and complex, please see FTB Publication 1032, Tax Information for Military Personnel, located in the chapter Reading References, for clarity.

3 §511 of the Military Spouses Residency Relief Act (MSRRA)

https://www.congress.gov/111/plaws/publ97/PLAW-111publ97.pdf


Sick Pay While federal law includes sick pay received under the Railroad Retirement Act and the Federal Insurance Contributions Act, California excludes sick pay received under these Acts from income. Therefore, the amount of sick pay included in the federal wages on Schedule CA (540), Part I, line 1, column A shall be subtracted on line 1, column B.

Ridesharing Program Qualified transportation benefits are excluded from gross income according to federal law and the provisions regulated by the Employment Development Department (EDD). As described in the California Revenue and Taxation Code (R&TC), there are no monthly limits for the exclusion of these benefits. Meanwhile, California’s definitions of these benefits cover a wider scope. California law provides an income exclusion for benefits received for participating in a California ridesharing arrangement (commuting in a third-party vanpool, a private commuter bus, or a subscription taxi-pool, subsidized parking, and monthly transit passes provided for employees and their dependents). Federal law allows $260 per month in 2018 as an exclusion from employee income; however, there is no cap on the amount of benefits that may be excluded in California. The federal exclusion limit increases to $265 per month in 2019. The amount of ridesharing fringe benefits included in federal income is a subtraction on Schedule CA (540), Part I, line 1, column B.

California Qualified Stock Options (CQSO) Compensation from exercising a California Qualified Stock Option (CQSO) may be excluded from California income. Any amount qualifying for the exclusion that was included in federal income should be entered on Schedule CA (540), Part I, line 1, column B. A taxpayer must meet all the following criteria to qualify for claiming this exclusion:

Had earned income of $40,000 or less from the corporation granting the CQSO; Had 1,000 or less total number of stock shares granted under the option; The fair market value of the shares on the grant date must have been less than

$100,000; The stock issued must be designated as a CQSO at the time the option is granted, by the

issuing corporation; Must have been employed by the company at the time the option was granted, or

employed within 3 months (1 year if permanently disabled) of the date the option was granted; and

The option must have been issued after January 1, 1997, and before January 1, 2002.

Health Savings Account (HSA) Employer Contributions Federal law excludes the amount of employer HSA contributions to an HSA plan; California has not conformed, so such contributions are taxable by California. The employer contribution is reported on Form W-2, box 12, code W. This amount should be reported on Schedule CA (540), Part I, line 1, column C as an addition to income. The amount of HSA deduction taken on the federal return is then entered on Schedule CA (540), Part I, line 25, columns A and B because California law does not allow a deduction for HSA contributions.


Native American Earned Income Beginning with taxable years after December 31, 2017, the earned income of federally recognized Indian tribal members living in California Indian country is exempt from California taxation if certain requirements are met. To qualify for the earned income exemption, the federally recognized tribal member must be an enrolled member of a federally recognized Indian tribe and earned reservation source income from the same California Indian country in which he resides and is an enrolled member. Military compensation is considered reservation source income. Taxpayers who have no other income from non-reservation sources and meet the exemption requirements must file Form FTB 3504, Enrolled Tribal Member Certification, with their California income tax return to prove they meet the tribal income exemption requirements. Earnings included in federal income that are exempt from California taxation are subtracted on Schedule CA (540), Part I, line 1, column B.

4

Employer Provided Meals Under both federal and California tax law, meals provided free of charge or at a reduced rate to an employee are wages. If employees are covered under an employment contract or union agreement, the taxable value of meals cannot be less than the estimated value stated in the contract or agreement. If the cash value is not stated in an employment contract or union agreement, the employer must use the table below for the value of the meals.

5

4 Form FTB 3504 5 2019 DE 44, California Employer’s Guide, page 12


Deductibility of Meals Provided for the Convenience of the Employer In general, subject to several exceptions, only 50% of the cost of business meals is allowed as a deduction (IRC §274(n)). The Tax Cuts and Jobs Act removed entertainment from the 50% allowable deduction (TCJA §13304). Entertainment expenses are no longer deductible on the federal return but are still allowed on California returns. Under the Tax Reform Act of 1997 (TRA of 1997) exception, meals excludable from employees' incomes as a de minimis fringe benefit (IRC §132(e)) were 100% deductible by the employer. As a result of the TCJA, the deduction for de minimis fringe eating facilities has been reduced to 50%. California does not conform. De minimis meals would include:

Coffee, snacks, or soft drinks Occasional meals or meal money provided to an employee so they may work overtime Occasional parties or other gatherings for employees and their guests

In addition, if substantially all of the meals were provided for the convenience of the employer in accordance with IRC §119, the cost of such meals was fully deductible on the federal return prior to 2018 because the employer was treated as operating a de minimis eating facility within the context of IRC §132(e)(2). In 2018, meals provided for the convenience of the employer are limited to 50% on the federal return. California does not conform to any of these provisions. The differences between these amounts should be listed on Schedule CA (540), Part I, line 12, column B or column C.

Interest Certain types of interest are treated differently on the federal tax return than on the California tax return. Interest from U.S. obligations, including savings bonds, treasury bills, notes, and bonds, are included in federal income. California exempts the interest from these obligations from state tax. This interest is a subtraction on Schedule CA (540), Part I, line 2, column B. State and municipal bond interest is generally exempt from federal tax. Interest from non-California issued municipal bonds is an addition to California income and is reported on Schedule CA (540), Part I, line 2, column C.

Dividends Dividends are generally subject to tax for both federal and California returns. The main difference is that mutual funds that own municipal securities report the income as tax-exempt dividends. Because this is municipal bond interest, the rules that apply to interest, apply to these dividends. Additional rules apply to certain types of dividends and will be discussed in the next chapter.

IRA Distributions Usually, no adjustments are made on Schedule CA (540), Part I, line 4 for IRA distributions on the California return. However, depending on when contributions were made to the IRA, there could be significant differences in the taxable amount of a distribution. If the taxable amount under federal law is greater than the amount under California law, a subtraction adjustment is needed. If the taxable amount under federal law is less than the amount under California law, an addition adjustment is needed. FTB Publication 1005, Pension and Annuity Guidelines, provides more information and worksheets for figuring the adjustment. This will be covered in more detail in a later chapter on retirement income.


Pensions and Annuities Usually, no adjustments are necessary on Schedule CA (540), Part I, line 4. Adjustments may be required if a taxpayer received partially taxable distributions from a pension plan or Tier 2 railroad retirement benefits during the tax year. If the taxpayer received a federal Form RRB-1099-R, Annuities or Pensions by the Railroad Retirement Board, for railroad retirement benefits and included all or part of these benefits in federal taxable income, the taxable benefit amount is reported on Schedule CA (540), Part I, line 4, column B as a subtraction from income. Nonresidents of California are not taxed on pension income. An adjustment may be required on Schedule CA (540NR), Part II, line 4.

Social Security Benefits U.S. Social Security benefits or equivalent Tier 1 Railroad Retirement (R.R.) benefits are exempt from state taxation and California conforms. Therefore, any amount reported on the federal return is a subtraction on Schedule CA (540), Part I, line 5, column B.

State Tax Refunds California state tax refunds are not taxed by California. The California state refund is reported on Schedule CA (540), Part I, line 10, column B as a subtraction from income.

Alimony Received Generally, the tax treatment for alimony income and deductions is the same under California law and federal law. However, if the taxpayer is a nonresident alien and received alimony that was not included in his federal income, he must enter the alimony on Schedule CA (540), Part I, line 11, column C. Alimony rules will change in 2019. The TCJA changes the tax treatment of alimony. Taxpayers should be aware that for divorces and legal separations executed after 2018, alimony will not be reportable by either the payer or the recipient. California has not conformed and will still require the recipient spouse to report alimony (spousal support) as income and allow the payer spouse to claim a deduction. For this purpose, to be considered alimony, California requires that payments meet the following criteria: (1) must be in the form of cash (i.e., checks, money orders), (2) cannot be designated as NOT alimony in the divorce decree, (3) cannot be treated as child support or property settlement, (4) the payor and payee must not live together at the time of payment and cannot file a joint return, and (5) there must not be any liability to continue payments after the death of the recipient spouse.

Business Income/Loss California law complies with federal law regarding self-employment income, and in most areas concerning expenses. The most common difference that may require an adjustment is depreciation. Depreciation methods, accelerated write-offs, and special credits differ between federal and California state tax law. Therefore, adjustments may be necessary. Later chapters that cover depreciation and self-employment Income, expand more on this topic.


Capital Gains/Losses There are not many occasions where adjustments are made on Schedule CA (540), line 13 for differences between federal and California law. The California basis of certain assets differs from the federal basis due to the differences between federal and state laws. When there are differences, Schedule D (540) must be used to figure the adjustments. There will be more discussion in a future chapter.

Like-Kind Exchanges A like-kind exchange is a tax-deferred transaction involving the exchange of property for other property of a “like-kind.” To qualify, the profit must be gained by the sale of the first property. Under the TCJA, IRC §1031 was amended to limit like-kind exchange treatment to real property that is not primarily held for sale. In addition, exchanges of personal property and intangible property no longer qualify for nonrecognition of gain or loss as like-kind exchanges. California does not conform to the TCJA amendments. Federal Form 8824, Like-Kind Exchanges, must be completed using California amounts. California Schedule D-1, Sales of Business Property, is then used to figure the proper adjustment to make on Schedule CA (540). This topic will be explained in greater detail in a future chapter.

Rental Income/Loss Like other business activities, rental activities are subject to federal and California differences in depreciation methods, accelerated write-offs, and special credits. This is because the recovery period or basis used to figure California depreciation may differ from the recovery period or basis used for federal. California rental activities conducted by individuals have the same passive activity limitations as the federal. Adjustments are reported on Schedule CA (540), Part I, line 17. Rental Property is covered in depth in a later chapter.

Unemployment Insurance/Paid Family Leave (UI/PFL) Unemployment Insurance and Paid Family Leave payments are reported to the taxpayer on Form 1099-G. California does not tax unemployment benefits. Any unemployment compensation which was included in the federal adjusted gross income is a subtraction on Schedule CA (540), Part I, line 19, column B. Paid Family Leave (PFL) is pay received from the California Employment Development Department (EDD). Compensation paid from the PFL program is taxable for federal purposes but is not taxable by California. Any PFL reported on the federal return is a subtraction on Schedule CA (540), Part I, line 19, column B. In 2013, California expanded family leave rights, providing partial pay to employees for up to six weeks for those who have a new child (including adopted or fostered), or to care for a seriously ill spouse, child, parent, or other eligible family member. In 2014, California expanded the paid family leave definition to include caring for seriously ill siblings, grandparents, grandchildren, and parents-in-law. For tax years 2018 and 2019, federal law will allow an employer credit for wages paid to qualifying employees while on family and medical leave for up to 12 weeks per year. There are some limitations but, in general, the minimum credit is 12.5% of wages paid with a maximum of 25%. The paid leave cannot be less than 50% of the wages paid to the employee on a regular basis. For employers, it is a general business credit on the federal return.


California Lottery Winnings California excludes California lottery winnings from taxable income, but not lottery winnings from other states. California lottery winnings included on the federal return is a subtraction on Schedule CA (540), Part I, line 21a, column B. Winnings from other state lotteries are taxable on the federal return, so no adjustment is required (or allowed) on the California return.

Student Note: Schedule CA (540), line 21, column A is a single entry for several different kinds of income from the federal return. Columns B and C provide separate fields for different adjustment types and amounts.

Foreign Earned Income and Housing Expense Exclusion California does not recognize the federal election to exclude certain foreign earned income and/or foreign housing allowance from taxable income. Beginning in 2018, California does not conform to the combat zone foreign earned income exclusions in regular combat zones or Egypt’s Sinai Peninsula. These amounts (from federal Form 2555) are reported as an addition on Schedule CA (540), line 21f, column C.

Wrongful Incarceration Exclusion This is an area of federal law to which California conforms. For taxable years beginning before, on, or after January 1, 2018, certain amounts received by wrongfully incarcerated persons can be excluded from income. If the taxpayer included income for wrongful incarceration on a tax return for a tax year prior to 2018, he can file an amended California return for that year. If the normal statute of limitations for filing an amended return for the affected tax year has expired, he must file his claim by January 1, 2019. Review Question 2 Andrew, a U.S. Marine, and his wife, Audrey, intend to file a joint return. He and his wife are domiciled in California. He was stationed in California for the first 4 months of the tax year and then he and his wife moved to Virginia for the rest of the tax year, on military PCS orders. His military pay was $25,000 while he was stationed in Virginia and $15,000 while he was stationed in California. Audrey worked part-time while he was stationed in California and earned $6,500. They also had $500 of interest income from their California bank account. How much of their total income is taxable by California? a) $47,000 b) $21,667 c) $ 6,833 d) $31,667


Review Question 3 Jessica had the following income items for 2018 and she filed a 2018 federal income tax return:

(1) Wages from her employer (2) Ridesharing benefits that exceeded the federal excludable amounts (3) A state refund of $70 (Jessica did not itemize deductions last year.) (4) $150 interest from her savings account at the local bank (5) $5,000 winnings in the California lottery

Which lines will be affected by these income items on Schedule CA (540), Part I? a) Lines 1, 2, 10, and 21 b) Line 21 c) Lines 1, 2, and 21 d) Lines 1 and 21 Reading References for Chapter 3: FTB Pub 1001 – Supplemental Guidelines to California Adjustments FTB Pub 1032 – Tax Information for Military Personnel Schedule CA (540) Schedule CA (540) Instructions


This page intentionally left blank.


Chapter 4: Interest and Dividend Income

Overview

Chapter Description Upon the completion of this chapter, students will understand the difference between federal and California taxation of interest and dividend income. Students will also understand how to report the differences between federal and California interest and dividend income. Finally, students will learn the two methods used to report a child’s investment income on a California tax return. The following content is based on 2018 tax law; however, discussions of prior year tax law will be addressed as applicable.

Learning Objectives

1) Discuss the reporting of different types of taxable and nontaxable interest. 2) Describe the reporting of dividend income and nondividend distributions. 3) Identify the methods used to report a child’s investment income.

Key Terms

California Adjusted Gross Income Dividends Interest Kiddie Tax Nondividend Distribution

Objective #1: Types of Interest Income Generally, all income (wages, interest, alimony, installment sales, etc.) taxable by the federal government is also taxable by California; however, there are a few exceptions. California has several adjustments to income. These adjustments are reported on Schedule CA (540). California starts with the federal AGI, then subtracts income not taxable by California, and adds income taxable by California that was not taxable by federal law, to arrive at California Adjusted Gross Income. The six most common subtractions from federal AGI which are allowed on the Schedule CA (540) include:

1. State income tax refunds 2. Unemployment compensation 3. Social Security or equivalent Tier 1 railroad retirement benefits 4. California nontaxable interest or dividend income 5. California IRA distributions 6. California pension and annuities

In this chapter, we will look at interest and dividend income. The taxpayer should complete the federal tax return before completing California Form 540 (Form 540NR). The adjustments will be made on Schedule CA (540). Form 540 2EZ cannot be used if the taxpayer has income from a source outside of California.


California Tax-Exempt Interest California exempts interest income from U.S. obligations and other sources. Interest reported on the federal return as taxable, but exempt from California tax, is subtracted on Schedule CA (540), Part I, line 2, column B (reduces California income). The following types of interest are tax-exempt on the California return:

U.S. savings bonds (excluding interest from series EE savings bonds issued after 1989 which qualified for the Education Savings Bond Program exclusion)

U.S. Treasury bonds, bills, and notes Other obligations or bonds of the U.S. (the obligations listed below are not considered

U.S. obligations for California purposes: Federal National Mortgage Association (Fannie Mae), Government National Mortgage Association (Ginnie Mae), and Federal Home Loan Mortgage Corporation (Freddie Mac))

Interest income from Ottoman Turkish Empire Settlement Payments Interest income from a child, under age 19 or age 24 if a full-time student, which was

reported on a child's federal return and the parents elected to report the child’s same interest income on their California return, using Form FTB 3803 (child will not have to file a California return)

“Exempt-interest dividends” from mutual funds under the following condition:

If the mutual fund has at least 50% of its assets invested in California or its municipal obligations or tax-exempt U.S. obligations, dividends attributable to those obligations is exempt from California tax. The mutual fund company will issue an annual statement with Form 1099-DIV, which provides the percentage of dividends that are exempt from California tax.

California does not tax its own state or municipal obligations. However, it is not necessary to subtract interest on these obligations on Schedule CA (540), Part I, line 2, column B since interest from these obligations is already excluded from federal taxable interest (Form 1040, line 2b).

California Taxable Interest Interest exempt from federal taxation is identified on the taxpayer’s federal tax return but may taxable by California. Interest not taxed on the federal return but taxable to California should be added to California income on Schedule CA (540), Part I, line 2, column C. The following are taxable on the California return:

Federally exempt interest from obligations issued by other states and their subdivisions “Exempt-interest dividends” from mutual funds that do not meet the 50% rule (all interest

is taxed by California – see above) Interest from non-California state bonds Interest from non-California municipal bonds issued by a city, town, county, or other local

government Interest from obligations of the District of Columbia issued after December 27, 1973 Interest and dividends from non-California bonds if the interest was passed through to the

taxpayer from S corporations, trusts, estates, and partnerships (including LLCs) Interest on obligations issued by the American Samoa Government

California taxes the dividends attributable to non-California states and municipalities. If exempt from tax on the federal return, the excluded amount must be added on Schedule CA (540), Part I, line 2, column C (increases California income).


As mentioned above, the following obligations are not considered U.S. obligations for California tax purposes: Federal National Mortgage Association (FNMA; commonly known as Fannie Mae), Government National Mortgage Association (GNMA; commonly known as Ginnie Mae), and Federal Home Loan Mortgage Corporation (FHLMC; commonly known as Freddie Mac). Interest income from these obligations is taxable. Since interest from these sources is taxed on the federal return, no adjustments are needed on Schedule CA (540).

Other Taxable Interest Items as Additions to Federal Income

Interest earned from a Health Savings Account (HSA) is excluded from federal tax. California does not conform to federal law, so the earnings are taxable by California. Interest that was excluded on the federal return is added on Schedule CA (540), line 2, column C (increases California income).

Interest income from a child, under age 19 or age 24 if a full-time student, which was excluded on the parents’ federal tax return and is being reported on the parents’ California tax return; or interest income from a child which was excluded from the child’s federal return but is being reported on his/her California return. (See “Interest and Dividend Income from Children,” later in this chapter.)

If interest was received from either of the sources above, students should consult FTB Publication 1001, Supplemental Guidelines to California Adjustments. Interest reported as taxable on the federal return should be included on Schedule CA (540), Part I, line 2, column A. Interest which is exempt from California tax is reported on line 2, column B (as a subtraction). Interest that was not included on the federal return but is taxable in California is reported on line 2, column C (as an addition). Review Question 1 During the tax year, Joseph, a CA resident, received the following:

$ 540 interest from a Los Angeles municipal bond $ 200 interest from his savings account at the local bank $1,000 in interest dividends from Fannie Mae bonds $ 150 interest from Oregon state bonds

Which interest income must be included on Schedule CA (540) and how should it be reported? a) $540 interest from a Los Angeles municipal bond reported on line 2, column B. $150 interest

from Oregon State bonds is reported on line 2, column C. $1,000 interest from Fannie Mae bonds is reported on line 2, column B.

b) $150 interest from Oregon State bonds is reported on line 2, column C. $1,000 interest from Fannie Mae bonds is reported on line 2, column B.

c) $150 interest from Oregon State bonds is reported on line 2, column C. d) $540 interest from a Los Angeles municipal bond is reported on line 2, column B. $150

interest from Oregon State bonds is reported on line 2, column C.


Objective #2: Dividend Income and Other Distributions For most dividends, federal and California taxation rules are the same. However, as with interest income, there are some differences.

Subtractions from Federal Income Subtractions from federal income amounts for dividends received from the following should be entered on line 3, column B of Schedule CA (540):

Dividend income from a child, under age 19 or age 24 if a full-time student, which was reported on the parents’ federal return, but it is being reported on the California return by the child, or which was reported on the child’s federal tax return, but it is being reported on the parents’ California tax return. (See “Interest and Dividend Income from Children,” later in this chapter.)

Controlled Foreign Corporation (CFC) dividends included in federal income in the year earned. (California taxes these when distributed.)

Regulated Investment Company (RIC) capital gains included in federal income in the year earned. (California taxes these when distributed.)

Because Form 1099-DIV only requires the reporting of dividends paid, this is a very uncommon situation.

Additions to Federal Income Additions to federal income amounts for dividends received from the following should be entered on line 3, column C of Schedule CA (540):

Dividends earned from a Health Savings Account (HSA) are excluded from federal tax. California does not conform to federal law so the earnings are taxable by California.

Controlled Foreign Corporation (CFC) dividends distributed in the current year but earned in the prior year are not included in federal income. They need to be added to the California return in the year they are distributed. (They were taxable in a prior year on the federal return in the year earned.)

Regulated Investment Company (RIC) capital gains not included in federal income because they were reported on the federal return in the year earned. (California taxes these when distributed)

This situation is not common because Form 1099-DIV only requires the reporting of dividends paid.

Distributions of pre-1987 earnings from an S corporation: A distribution from pre-1987

earnings occurs when distributions from the S corporation exceed the California balance in the accumulated adjustments account (AAA). Before 1987, California did not recognize federal S corporations and thus, treated them as C corporations for tax purposes. Therefore, when a federal S corporation initially becomes a California S corporation, its accumulated adjustments account (AAA) has a zero balance regardless of the federal balance. Distributions from earnings for years prior to 1987 or in later years for corporations that were federal S corporations and California C corporations, must be included on Schedule CA (540), line 3, column C. This is a very uncommon occurrence.

Dividend income from a child, under age 19 or age 24 if a full-time student, which was excluded on the parents’ federal tax return and is being reported on the parents’ California tax return; or dividend income from a child which was excluded from the child’s


federal return but is being reported on his/her California return. (See “Interest and Dividend Income from Children,” later in this chapter.)

Dividends attributable to non-California states and their municipal obligations are taxed by California but exempt from federal taxation.

Non-cash patronage dividends from farmers’ cooperatives or mutual associations Undistributed capital gains for RIC shareholders

More information on these and other Federal-California differences can be found in FTB Publication 1001, Supplemental Guidelines to California Adjustments. Review Question 2 Patricia, a California resident, owns 500 shares of stock in Cervezas, a controlled foreign corporation in Spain. She purchased the stock in 2012 for $3 per share. She earned $600 in dividends during the tax year and received $400 in distributed dividends during the same tax year. How will she report these occurrences as adjustments on Schedule CA (540)? a) Report $1,000 on line 3, column C b) Report $400 on line 3, column C c) Report $1,500 on line 3, column B d) Report $600 on line 3, column B; Report $400 on line 3, column C

Objective #3: Interest and Dividend Income from Children Unearned income includes taxable interest, ordinary dividends, capital gains (including capital gain distributions), unemployment compensation, rent, royalties, taxable scholarship and fellowship grants not reported on Form W-2, the taxable part of Social Security and pension payments, and certain distributions from trusts. If a child’s unearned income exceeds $2,100, there are two options for filing their federal tax return. One option requires the parent to include the income on their return. The other option is for the child to file their own tax return. Children who have earned income as well as unearned income have to file their own return. Since the tax is calculated differently from regular tax, it is often dubbed the “kiddie tax.” There are two different federal forms used to compute the “kiddie” tax on the unearned income; Form 8814 or Form 8615. Form 8814 is used if the parent elects to report the unearned income for their children on their return. Form 8615 is used to calculate the tax if the child files their own return. For tax years 2018-2025, unearned income above the threshold of $2,100 for children is taxed using rates for estates and trusts on federal returns. Federal law allows parents to elect to report their child’s interest and dividend income on their own return. This would not be beneficial unless the child is required to file a return (more on that later). The requirements to make this election are:

The child was under age 19 or a full-time student under age 24. The child's gross income was less than $10,500. The child’s only income was from interest, dividends, capital gain distributions, and

Alaska Permanent Fund Dividends. The child is required to file a tax return for 2018. The child does not file a joint tax return for 2018. No estimated tax payments were made for the child for 2018 (including any overpayment

of tax carried over from his/her 2017 tax return to 2018 estimated tax). No federal income tax was withheld from the child’s income. The parent(s) must also qualify for making this election.


California conformed to the election starting with 2010 tax returns. The election is made on federal Form 8814 and California Form FTB 3803.

Parents can make the election separately between federal and California; i.e., make the election on the federal return but not on the California return, or vice versa. If the parents make the election on both their federal and California returns, the child will not have to file a tax return. The child will file a return when the parents do not make the election to include the child’s income.

Because the California return is based on the federal return, the child still needs to complete the federal return even if only required to file the California return. If the child files a separate California return, he/she may need to make adjustments to correctly report interest or dividends.

The interest income adjustment is reported on line 2 of Schedule CA (540). Enter interest income which was taxable on the federal return on line 2, column A. Enter interest income which is exempt from California tax in column B as a subtraction. Enter interest income which is taxable by California but was not included on the federal return in column C as an addition.

The dividends income adjustment is reported on line 3 of Schedule CA (540). Report the dividend income which was taxable on the federal return on line 3, column A. Report dividends which are exempt from California tax in column B as a subtraction. Report dividends which were not included on the federal return but are taxable in California in column C as an addition.

Parents’ Reporting of Child’s Investment Income

Qualifications If the parents qualify, they may elect to report the child’s income on their California tax return by completing Form FTB 3803, Parents’ Election to Report Child’s Interest and Dividends. To make this election, the child’s income must be only from interest and/or dividends, including capital gain distributions. A separate Form FTB 3803 must be used for each child whose income the taxpayer elects to report. The qualifications for making this election are the same as for the federal Form 8814.

Who Can Make the Election? The parent with the higher taxable income qualifies to make the election if the parents are unmarried and lived with the child during the tax year.

Parent Reporting Child’s Investment Income on the Federal Return If the parent elected to report his child’s investment income on the federal return using Form 8814 and he elects to report his child’s investment income on his California return, he will need to adjust the investment income amount by differences between the federal and state tax law on what is taxable versus tax-exempt. Form FTB 3803, line 1a, is for reporting the taxable interest and line 1b is for reporting the tax-exempt interest. In addition, an adjustment will be necessary on Schedule CA (540) for the difference.

Parent Not Reporting Child’s Investment Income on the Federal Return If the parent did not elect to report the child’s investment income on the federal return because a separate return was filed for the child to report his/her income, but the parent chooses to report his child’s investment income on his California state return, the parent will need to file Form FTB 3803 to figure out the additional tax that must be entered on line 31 of Form 540 with the “FTB 3803” box checked. On Schedule CA (540), adjustments must be made to account for the increase in investment income and reported on line 21f, column C. “FTB 3803” should be written on line 21f.


1 The Tax Cuts and Jobs Act made changes to the tax rates assessed on children’s investment income on the federal return. Instead of being taxed at the parents’ rate, it will be taxed at the rate for estates and trusts beginning in 2018 through 2025. Calculations may need to be done to see which option for reporting the income generates the least amount of tax.

1 Form FTB 3803


Child’s Reporting of Unearned Income Earned income includes wages, tips, and other amounts received for performance of personal services (e.g., self-employment). Unearned income is everything the child receives that is not earned income (e.g., capital gains, interest, dividends, rents, royalties, etc.).

Student Note: The child’s unearned income over the threshold amount of $2,100 is no longer taxed at his parents’ tax rate on the federal tax return from 2018 through 2025. All net unearned income over $2,100 for 2018 is taxed using the brackets and rates for estates and trusts. California has not conformed to the new tax law. California still taxes the child’s net unearned income over the $2,100 at the parents’ tax rate if the parents’ tax rate is higher.

Kiddie Tax Reported on Federal Form 8615 and Form FTB 3800 Dependent children may have to pay tax on their unearned income (generally, interest and dividends) at a higher tax rate than they would otherwise qualify for. Federal Form 8615 and California Form FTB 3800 are used to compute the tax and are required when all the following conditions are met for each child:

The child had more than $2,100 of unearned income. The child is required to file a tax return. The child was either:

o Under age 19 at the end of 2018 and did not have earned income that was more than half of the child's support; or

o A full-time student at least age 19 and under age 24 at the end of 2018 and did not have earned income that was more than half of the child's support.

At least one of the child's parents was alive at the end of 2018. The child does not file a joint return for 2018.

Child Reporting His Investment Income on the Federal Return If the child reports his interest, dividend, and/or capital gain income on the federal return and uses Form 8615 to determine the tax, only income taxable by California will be entered on Form FTB 3800. In most cases, the federal amount will be the same as the California interest, dividend, and/or capital gain income amount. Any investment income that is federally tax-exempt, but not tax-exempt by California law, must be included on Form FTB 3800. Child Not Reporting His Investment Income on the Federal Return If the child does not report his interest and dividends on a federal return (because his parents reported the income on their tax return) but reports his interest and dividends on the California return, he will need to file Form FTB 3800 to determine the tax. He will also use Schedule CA (540), Part I, line(s) 2 and/or 3, column C, to add the income not reported on the federal return. The tax computation figured on Form FTB 3800 is reported on Form 540, line 31 in lieu of the regular tax. The “FTB 3800” box must also be checked.


2 Since the child’s parents would not be reporting his/her investment income on their California return, their income would need to be adjusted on Schedule CA (540), line 21f, column B, by the amount of the child’s income they reported on their federal return.

3 Review Question 3 David and Michelle are married California residents and they filed a joint federal return. Their son, Hunter, is 12 years old and had interest income of $3,350 during the tax year. Hunter’s investment income is 100% taxable in California. David and Michelle elected to report Hunter’s investment income on their federal return. Can they file a separate California return for Hunter to report his income and, if so, what adjustment must be made on their California joint return? a) No, they must report Hunter’s investment income on their California return since they

reported it that way on their federal return. b) Yes, but they must make an adjustment on their California return on Schedule CA (540), line

21f, column B. c) Yes, but they must make an adjustment on their California return on Schedule CA (540), line

2, column B. d) Yes, but there is no adjustment needed.

2 Form FTB 3800 3 Schedule CA (540), Part I, Section B


Review Question 4 Rita and Ron are married and file joint federal and state returns. They have a 16-year-old daughter, Ashley, who had investment income of $2,750 during the tax year. She also earned $950 from babysitting the neighbor’s children. Ashley filed a federal return reporting her income. Rita and Ron wish to elect to report Ashley’s investment income on their California return. What adjustment will need to be made on their joint California return? a) They will enter $2,750 on Schedule CA (540), line 21f, column C. b) They can report her investment income but not her babysitting income. c) They do not qualify for the election to report her income on their California return. d) They will enter $2,750 on Schedule CA (540), line 2, column C. Reading References for Chapter 4: FTB Pub 1001 – Supplemental Guidelines to California Adjustments, pages 5-6 Form FTB 3800 Form FTB 3800 Instructions Form FTB 3803 Form FTB 3803 Instructions Schedule CA (540) Instructions, pages 2-3


Chapter 5: Community Property

Chapter Note: We feel that Community Property is an important subject with regard to California tax law; therefore, instead of introducing California Earned Income Tax Credit in Chapter 5, it will be covered in Chapter 6, Common Tax Credits.

Overview

Chapter Description Upon completion of this chapter, students will understand community property, community income, and separate property. Students will be able to determine how community and separate income should be reported in a community property state, regardless of whether the taxpayer lives in a community or separate property state. In addition, students will determine how filing a separate return impacts federal and California exemptions, deductions, taxable income, and credits. Students will learn how to report state taxes withheld from California and other states. Lastly, students will be able to identify certain situations where prenuptial agreements are not enforceable. The following content is based on 2018 tax law; however, discussions of prior year tax law will be addressed as applicable.

Learning Objectives

1) Identify the differences between community property and separate property. 2) Report income, deductions, and credits when filing a separate return. 3) Determine the classification of property when moving to or from other states. 4) Identify when a credit is allowed for state taxes withheld. 5) Recognize the validity of prenuptial agreements.

Key Terms

Backup Withholding Community Income Community Property Community Property State Domicile Prenuptial Agreement Separate Property State Tax Withheld


Objective #1: Community Property and Separate Property

Community Property Community property is all the property acquired by a husband, a wife, a same-sex spouse, or an RDP while domiciled in a community property state that is not separate property (defined later). Each spouse/RDP owns one-half of all community property. Property which cannot be specifically identified as separate property is considered community property. Most property acquired during the marriage or registered domestic partnership is owned jointly by both spouses. The exceptions are for gifts, inheritances, or exchanges for other separate property. The jointly owned community property is divided upon the occurrences of death, divorce, or annulment. Community property originated in civil law jurisdictions and is now found in certain common law jurisdictions. In the U.S., most of the states that recognize community property are located in the West. In theory, the community property system recognizes equal contributions of both spouses to the original creation and the ongoing operation of the family unit. Under California statute, a strictly adhered to 50/50 division of community property is assigned. Community Property States and U.S. Territories Below is a list of all the community property states and U.S. territories:

Arizona California Idaho Louisiana Nevada New Mexico Texas Washington Wisconsin American Samoa Guam Northern Mariana Islands Puerto Rico Virgin Islands

Alaska is a separate community property state that allows couples to consent to a community property arrangement. Quasi-Community Property California, New Mexico, Arizona, and Washington recognize what is referred to as “quasi-community property.” Quasi-community property is essentially property that was acquired while domiciled in a noncommunity property state, which would be considered community property once the married parties/RDPs become domiciled in a community property state. However, in California, this property does not become community property simply because the married/RDP spouses move into a community property jurisdiction. The events of death or divorce while domiciled in California are what allow such property to be treated by the state as quasi-community property. It is important to be aware this category of property exists, even though it is beyond the scope of this course as far as the application of state tax law applies.


Community Income Income that is generated from community property is treated as community income. It is possible that a property could be a combination of community property and separate property. Community income also includes compensation from wages, salaries, self-employment, and other services performed if the spouse/RDP who earned the compensation is domiciled in a community property state. Community income also includes real estate which is treated as community property under the laws of the state where the property is located. Community income must be divided equally between the taxpayer and his spouse/RDP when separate returns are filed. When Does Community Status End? California is a community property state. The community status with regards to income and property ends when either:

1. The marital/RDP partners physically separate with no immediate intention to reconcile; or 2. Upon the death of either spouse.

The income earned after the community status ends is considered separate income.

Definition of Domicile For tax purposes, domicile is the place where an individual has voluntarily established himself and his family for more than just a limited or special purpose. There must be a current intention of making it a fixed, permanent, and principal establishment. The intention to return, whenever absent, is a key component in determining whether a location is a true domicile. The maintenance of a marital abode in California is a significant factor in establishing domicile in California. 1 Many states consider the terms “domicile” and “residence” to mean the same thing. The term “domicile” is used often as a legal definition which differs from the definition of “residence.” Even though the meanings of the two words coincide, California views them as two separate notions. For example, an individual may be domiciled in another state but be a California resident for income tax purposes or an individual may be domiciled in California but not be a California resident for income tax purposes. Once a domicile is acquired, that domicile is retained until a new one is acquired. A person can only have one domicile at a time. A domicile change requires an individual to:

1. Abandon his prior domicile; 2. Physically move to and reside in the new location; and 3. Intend to stay in the new location permanently or indefinitely.

Separate Property Separate property is:

Property owned separately by a spouse/RDP before marriage or entering into a registered domestic partnership.

Property purchased with separate property funds. Property received separately, such as gifts or inheritances, money earned through

wages, salary, or self-employment while domiciled in a separate property state. All property declared separate property in a legitimate agreement (prenuptial, postnuptial,

or RDP agreement).



Separate Income In most instances, income generated from separate property belongs to the spouse/RDP who owns the property. When filing separate California tax returns, each spouse/RDP must report his or her separate income which was generated from his or her separate property, if applicable. Separate property must be maintained separately. Taxpayers should be aware of property or the income from the property being used for community purposes or commingled. It could lose its separate property status, thereby overriding any agreements. Review Question 1 During the tax year, Richard and his wife, Amanda, were residents of and domiciled in California. Richard earned $27,000 in wages. Amanda earned $23,000. Richard inherited 3,000 shares of HOPE, Inc. stock from his great uncle, which is in Richard’s name only. He keeps the dividend income separate from the marital community funds. He received $7,000 in dividends during the tax year. Richard and Amanda decided to file separate income tax returns. What is the amount of the total income on Richard’s California return? a) $34,000 b) $28,500 c) $32,000 d) $57,000

Objective #2: Identifying Income, Deductions, Credits, and Tax Payments When Filing a Separate Return

Income Community property laws treat certain items of income as follows: Wages, earnings, and profits – Community income includes a spouse’s wages, earnings, and net profits from a sole proprietorship. They must be divided equally. Dividends, interest, and rents – Community income also includes dividends, interest, and rents from community property. They must be divided equally. In California, dividends, interest, and rents from separate property are separate income. But in some states, these items of income from separate property are community income. Alimony received – Alimony or separate maintenance payments made prior to divorce are taxable to the payee spouse only to the extent they exceed 50% (his or her share) of the reportable community income. Gains and losses – Gains and losses are classified as separate or community depending on how the property is held. Withdrawals from individual IRAs and ESAs – IRAs and ESAs by law are deemed to be separate property. Therefore, taxable IRA and ESA distributions are separate property, even if the funds in the account would otherwise be community property. Pensions – Generally, distributions from pensions will be characterized as community or separate income depending on the respective periods of participation in the pension while married (or during the registered domestic partnership) and domiciled in a community property state or in a noncommunity property state during the total period of participation in the pension.


Partnership income – If an interest is held in a partnership, and income from the partnership is attributable to the efforts of either spouse (or registered domestic partner), the partnership income is community property. If it is a separate property partnership and the income from the partnership is not attributable to the efforts of either spouse, the partnership income will be characterized as separate income in California. 2 Income from separate property – Some states, such as Arizona, California, Nevada, New Mexico, and Washington, treat income from separate property as separate income. Other states, such as Idaho, Louisiana, Texas, and Wisconsin, characterize income from separate property as community income. For more information, please refer to IRS Publication 555, Community Property.

Deductions When expenses are incurred to earn or produce community business or investment income, those expenses are generally divided evenly between the taxpayer and his spouse/RDP. Each spouse/RDP is permitted to deduct half of the expenses of the business or investment expenses on his separate return. The following pertains to spouses/RDPs with separate business or investment income: As long as the spouse/RDP with the separate income pays the related expenses from his separate funds, the expenses to earn or produce the separate business or investment income are deductible by the spouse/RDP who owns the income-producing business or investment property. Expenses that cannot be allocated to any specific income, such as medical expenses, are deductible by the spouse/RDP who pays them. Expenses paid from community funds will result in a deduction that must be divided equally between the taxpayer and his spouse/RDP. As in the case of federal tax law, in California, if one spouse/RDP itemizes deductions, the other spouse/RDP must itemize deductions. This is true even if the other spouse’s/RDP’s standard deduction is greater than his itemized deductions.

Exemption Credits When the taxpayer and his spouse/RDP file separate returns, he and his spouse/RDP must each claim his/her own personal exemption credit. When the taxpayer has more than one dependent supported by community funds, he and his spouse/RDP may claim the dependent exemption credits between them in any way they choose, provided they agree on the division. If there is just one dependent, however, the taxpayer and spouse/RDP may not split the credit for that dependent. With multiple dependents, the taxpayer and spouse/RDP may not split the credit for any one dependent. It is important to note that exemptions have been suspended on the federal return but they are still allowed by California.

2 IRS Publication 555, pages 4-5


Withholding Credit Withholding credit from various income sources must be claimed in the same way the taxpayer reported the income.

1. If the income is community income, each spouse/RDP reports one-half of the withholding associated with one-half of the community income on each spouse’s/RDP’s separate tax return.

2. If the income is separate income, the spouse/RDP who earned or received the separate income and contributed the withholding, reports all the withholding associated with the separate income.

Estimated Tax Payments Estimated tax payments are treated in the same way as withholding credits. However, if the couple made joint estimated tax payments but file separate tax returns, the taxpayer or spouse/RDP may not allocate the payments evenly without notifying the other person before filing their own separate tax return.

Income Division When Filing a Separate Return If the taxpayer filed Married/RDP Filing Separately, he must follow community property rules for dividing income and deductions. Generally, each spouse/RDP must report half of the community income, plus his/her separate income on his/her individual separate return. Property which is not specifically identified as separate property shall be considered community property. Community status in California ends when married or RDP partners physically separate and have no immediate intention to reconcile. Therefore, income earned after community status terminates is treated as separate income. However, when filing Married/RDP Filing Separately, community property rules will still apply for income earned during the year if the intent for the partners to reconcile in the future exists. For example, living separately because of an employment opportunity or to take care of a sick family member in a separate location with the intent of living together again once the employment or personal family situation changes does not allow either partner’s income to be excluded from community property rules during the physical separation.

Caution: Taxable income, as well as exemptions and deductions, may be different if the taxpayer filed Married Filing Separately instead of Married Filing Jointly on the federal return. Some of these differences may also apply on the California return. See the guidelines for Married/RDP Filing Separately taxpayers on the following page.


If Taxpayer Files Married/RDP Filing Separately Instead of Married/RDP Filing Jointly

Federal Return California Return 1 Interest income from U.S. savings bonds used for higher

education is taxed by Federal. California does not tax interest income from U.S. savings bonds.

2 Social Security and Railroad Retirement benefits may be taxed on the Federal return.

California does not tax Social Security and Railroad Retirement benefits.

3 Student loan interest deduction cannot be taken. California conforms. 4 Generally, taxpayer cannot claim his spouse if he files a

separate return. However, if his spouse has no gross income for the tax year and is not a dependent of another taxpayer, the taxpayer may claim his spouse on his separate return. In addition, taxpayer may claim a higher standard deduction on his separate return if (a) his spouse is age 65 or older or blind, and (b) his spouse is not a dependent of another taxpayer.

Generally, taxpayer cannot claim his spouse’s/RDP’s personal, blind, or senior exemption credits if he files a separate return. However, he may claim a personal exemption for his spouse/RDP on his separate return if the spouse/RDP is blind, has no gross income for the year, and is not a dependent of another taxpayer. When determining gross income, community or separate property rules apply.

5 The couple must either both itemize or both take the standard deduction. If one spouse takes the standard deduction, the other must also take the standard deduction, even if his itemized deductions are greater the standard deduction. If one spouse itemizes, the other must also itemize, even if his itemized deductions are less than the standard deduction.

California conforms. Includes spouse/RDP.

6 Taxpayer can only claim the child and dependent care expenses credit on his separate return if either: (1) taxpayer and his spouse are legally separated, or (2) taxpayer did not live with his spouse at any time during the last six months of the year, his home was the main home for his qualifying person for more than half the year, and he provided more than 50% of the cost of maintaining his home during the year.

California conforms. Includes spouse/RDP.

7 Taxpayer can claim the credit for the elderly or the disabled only if he lived apart from his spouse all year.

California does not have comparable credits.

8 Taxpayer cannot claim the American Opportunity and Lifetime Learning education credits if filing separately.

California does not have comparable credits.

9 Taxpayer’s child tax credit may be reduced. California does not have a comparable credit. 10 On a separate return, taxpayer can claim the credit or

exclusion for an adoption only if either (1) he and his spouse are legally separated, or (2) the couple did not live together at any time during the last six months of the year, his home was the eligible child’s home for more than half the year, and he paid more than 50% of the cost of keeping up his home for the year. As long as he doesn’t use the same expense to claim the credit and the exclusion, taxpayer can claim both the credit and the exclusion. To apply the exclusion, do not include qualified adoption assistance payments made by taxpayer’s employer in the amount he reports as taxable income.

Taxpayer can claim the adoption credit on his separate return. Or, he can claim the exclusion for an adoption on his separate return if either (1) taxpayer and his spouse/RDP are legally separated, or (2) the couple did not live together at any time during the last six months of the year, his home was the eligible child’s home for more than half the year, and he paid more than 50% of the cost of keeping up his home for the year. As long as he doesn’t use the same expense to claim the credit and the exclusion, taxpayer can claim both the credit and the exclusion. To apply the exclusion, do not include qualified adoption assistance payments made by taxpayer’s employer in the amount he reports as taxable income.

11 Taxpayer is not eligible for the earned income credit. California conforms. Married/RDP couples filing separately are not eligible for the California EITC.


Review Question 2 Evan and Robin are RDPs and are domiciled in and residents of California for the whole tax year. Evan is a mechanical engineer and earned wages of $55,000 during the taxable year. Robin is a part-time dog groomer and earned wages of $20,000. Evan purchased stock with a basis of $40,000 before they became Registered Domestic Partners. The stock remains his separate property and is registered only in his name. His dividends from that stock for the tax year were $4,000. They want to file separate federal and state returns. What will be Evan’s California taxable income on his separate state return? a) $59,000 b) $39,500 c) $57,000 d) $41,500

Objective #3: Classification of Property When Moving To or From Other States Community and separate property generally keep their characterization when a couple moves to a state with different marital property laws. In some states, “quasi-community” principles apply. Quasi-community property was introduced earlier on page 5.2.

Moving From a Community Property To a Noncommunity Property State Generally, property obtained as community property in a community property state does not automatically convert into separate property when moving to a common law state. Community property keeps its classification when a couple moves from a community property state to a noncommunity property state. In the new state, if community property is exchanged for other property, the new property will usually be considered community property. Similarly, if community property is sold and the proceeds are used for a purchase, that purchase will also be considered community property.

Moving From a Noncommunity Property To a Community Property State Property acquired by a spouse/RDP in a noncommunity property state is considered separate property. When a couple moves to a community property state that property remains classified as separate. It is not automatically converted into community property simply because the couple has moved into a community property state. If separate property is exchanged or sold in the new community property state, any new property obtained from the proceeds will be considered separate property of the spouse/RDP originally owning the property. Some community property states follow rules pertaining to “quasi-community property.” Property may be considered this type of property in some cases where property was obtained by a couple living in a common law state that would have been treated as shared property had they been living in a community property state. This type of property will be treated like community property if a couple moves into a community property state.

Student Note: For more information about domicile, community and separate property, and division of income, please see FTB Publication 737, pages 5-6 and FTB Publication 1031, pages 10-13, both included in the chapter Reading References.


Splitting Community Property Income on Long Form 540NR Use the chart below as a guide on how to split community income with a spouse/RDP on Long Form 540NR. The method used depends on the domicile of the taxpayer and spouse/RDP and whether the taxpayer is Married/RDP Filing Jointly or Separately. All separate income in addition to the half of the community income should be included.

3



Using Schedule CA (540NR) to Adjust California Taxable Income The purpose of this schedule is to determine a nonresident’s or part-year resident’s California taxable income by making certain adjustments. Federal amounts of income and deductions are the starting point in column A. These amounts are then adjusted for differences in California tax law and taxpayers’ residency. Part I of Schedule CA (540NR) is used for residency information. Domiciles are identified along with current and past residency information. FTB Publication1031 and FTB Publication 1032 can help in the preparation of Part I. Columns A through C of Schedule CA (540NR) are the same as Schedule CA (540). Column D is for total amounts using California law as if the taxpayer was a California resident. Column E is for only California amounts of income earned or received as a California resident and income earned or received from California sources as a nonresident. In Column A, enter all the amounts shown on the taxpayer’s federal return on the corresponding lines. For married/RDP filing a separate return, in Column A, enter the amount the taxpayer would have reported on a separate federal return. Attach a statement to the tax return to show how the income and expenses were divided between the spouses/RDPs. In Column B and Column C, enter subtractions and additions to federal amounts in Column A which are necessary adjustments between federal and California law. Enter all amounts as positive numbers. Only enter the amounts due to the difference in tax law between federal and California. Do not deduct income earned while a nonresident of California or from sources outside of California. In Column D, enter the amounts after subtractions or additions if the taxpayer has made any adjustments in Column B or Column C. Column D = Column A – Column B + Column C In Column E, enter the amount that is taxable in California. For a full-year California resident, he is taxed on all income from all sources. For a full-year nonresident, he is taxed on income only from California sources. For a part-year resident, he is taxed on all income from all sources while a California resident and on income only from California sources while a nonresident. For more detailed information, please review the Instructions for Schedule CA (540NR), located in the chapter Reading References.


4 Review Question 3 Fred and Jennifer Wayward are full-year residents of Arizona. Fred earned wages of $50,000 from his bookkeeping job in Arizona. Fred also sold property (land) in California that he inherited from his father at a gain of $20,000. Jennifer received income from her pension plan of $15,000 for the tax year. Her pension plan is from past employment in California. Jennifer purchased a rental property in California years before they met. The net rental income from the house during the tax year was $500/month. They wish to file separate federal and state tax returns this year. On Schedule CA (540NR), how much total income will Fred report in column D and how much will he report in column E? a) $70,000 in D; $20,000 in E b) $52,500 in D; $20,000 in E c) $55,500 in D; $30,500 in E d) $70,000 in D; $35,000 in E Review Question 4 Use the same information from Review Question 3 (above), except in this scenario, the Waywards live in Colorado, a noncommunity property state. With this change, on Schedule CA (540NR), how much total income will Jennifer report in column D and how much will she report in column E? a) $21,000 in D; $ 6,000 in E b) $46,000 in D; $21,000 in E c) $38,500 in D; $13,500 in E d) $21,000 in D; $21,000 in E

4 Schedule CA (540NR)


Objective #4: Taxes Withheld by California and Other States California state withholding is essentially a prepayment of California state income or franchise tax. Withholding that is not from W-2 and 1099-R forms is frequently from backup withholding, discussed in the next section. Enter on line 71 of Form 540, the total California income tax withheld from the taxpayer’s:

Form(s) W-2, box 17 Form(s) 1099-INT, box 17 Form(s) W-2G, box 15 Form(s) 1099-DIV, box 15 Form(s) 1099-MISC, box 16 Form(s) 1099-OID, box 14 Form(s) 1099-R, box 12 Form(s) 593

Form(s) 1099-MISC do not usually include California withholding because these payments are normally reported on Form 592-B. Form 593 reports required withholding from sales of California real property.

Student Note: Do not include city or county tax withheld or tax withheld by other states on Form 540, line 71 or Form 540NR, line 81.

Backup Withholding Taxpayers who are required to remit backup withholding to the IRS are also required to remit backup withholding to the FTB unless specifically excluded for California purposes. The backup withholding rate for California is 7%. Payers report backup withholding to the FTB on Form 592. Form 592-V is used to remit backup withholding payments to the FTB. The payer is the person or organization that makes a taxable distribution to a taxpayer (also referred to as the “payee”). The payee receives Form 592-B from the payer, reporting the total amount of income (payments) subject to withholding and the total backup withholding, as reported to the FTB on Form 592. Backup withholding replaces all other types of withholding for income items where both backup withholding and other types of withholding apply. Tax withheld on payments must be remitted to the FTB in four specific periods. The period due dates are April 15, June 15, September 15, and January 15. Federal backup withholding was reduced from 28% to 24% effective January 1, 2018.

State Taxes Paid to Another State With tax years beginning on or after January 1, 2009, if a California taxpayer receives taxable income in another state that is taxed by both California and the other state (double-taxed income), he may qualify for a credit. Taxes paid to the other state do not necessarily have to be paid in the same year that the income was taxed by California, as long as the income taxes were assessed in the same year and relate to the same income. The credit can be claimed on returns filed within one year from the date tax was paid to the other state or within the general California statute of limitations, whichever is later. The credit does not reduce California AMT. Schedule S, Other State Tax Credit, is the form used to compute and claim the credit. Schedule S can be filed by an individual filing a California personal income tax return or an estate or trust filing a California fiduciary income tax return. A separate Schedule S must be completed for each state for which a taxpayer is eligible to claim the credit.


5 Generally, residents of California may claim a credit only if the income taxed by the other state has a source within the other state under California law. No credit is allowed if the other state allows California residents a credit for net income taxes paid to California. Nonresidents of California may claim a credit only for net income taxes imposed by and paid to their states of residence and only if such states do not allow their residents a credit for net income taxes paid to California. 6 California residents who incur double taxation situations in certain states claim the credit on the nonresident return. For example, the sale of land for a profit in Arizona by a California resident would generate the credit on the Arizona nonresident return instead of on the California resident return. The states and U.S. possessions where this applies are listed below.

Arizona Guam Oregon Virginia

5 Schedule S 6 Instructions for Schedule S, page 1


Note: Beginning with the 2017 tax year, Indiana is no longer treated as a reverse state for California tax purposes. So, California residents with double-taxed income from Indiana sources may now claim the other state tax credit on their California returns; however, California nonresidents may not claim this credit for net income taxes paid to Indiana.

How to Calculate the Other State Tax Credit When figuring the other state tax credit, do not include any of the following taxes paid:

1. Taxes paid to a local government, such as a city or county tax; 2. Taxes paid to the federal government; 3. Taxes paid to a foreign country; 4. Tax paid to another state that is comparable to California’s alternative minimum tax

(AMT); or 5. Tax paid to another state on net passive income, built-in gains, gross income, and any

special tax. On Schedule S, the Other State Tax Credit is the smaller of line 6 or line 11. Line 6 is the portion of California’s total tax liability attributable to the double-taxed income. Similarly, line 11 is the portion of the other state’s total tax liability attributable to the double-taxed income. The credit allowed is the smaller of the two tax amounts figured on lines 6 and 11. While the equations below are useful for illustration purposes, taxpayers should always follow the line-by-line instructions for Schedule S to compute the credit. The California tax attributable to the double-taxed income (line 6) is figured as follows:

𝐶𝐴 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑎𝑡𝑖𝑜Double Taxed Income Taxable by CA

CA Taxable Adjusted Gross Income AGI

CA Tax on Double-Taxed Income CA Income Ratio × CA Tax Liability Form 540, line 48

The same method is used to calculate line 11 (the other state’s tax attributable to the double-taxed income). Replace “CA” with the other state’s name in the equations. The other state’s tax on the double-taxed income is usually identical to the total income tax paid to the other state. Review Question 5 Lauren, 32 years old and single, was domiciled in northern California for the entire tax year. For the first 2 months of the year, she traveled to a temporary job in Idaho during the workweek, spending her time in California on the weekends. She earned wages of $10,000 from her job in Idaho and paid income tax of $572 to Idaho. That same income is also taxable by California. For the remaining 10 months of the year, Lauren was employed in California, earning $40,000 in wages. Her California AGI is $50,000. Suppose she has a California tax liability of $1,513 on Form 540, line 48. How much will Lauren be allowed to claim for the Other State Tax Credit on her California tax return? a) $0; She should claim this credit on her Idaho tax return. b) $572 c) $303 d) $378


Objective #5: Prenuptial Agreements

A Valid Prenuptial Agreement In the U.S., prenuptial agreements (also known as premarital agreements) are recognized in all 50 states and D.C. The following 5 elements are required for a prenuptial agreement to be valid:

1. The agreement must be in writing (oral agreements are rarely enforceable); 2. It must be entered into voluntarily; 3. There must be full and/or fair disclosure at the time of enactment; 4. The agreement cannot be unconscionable or unjust; and 5. It must be executed by both parties (not their attorneys) using a valid legal instrument

and acknowledged before a notary public.

Prenuptial Agreements in California Generally, prenuptial agreements are enforceable in California. Family Code Sections 1610-1617 of the California Family Code adopted the Uniform Premarital Agreement Act. In California, a prenuptial agreement is very powerful. A couple can waive their rights to share community property. It can limit spousal support, although, in a court of law the limitation can be deemed unconscionable after the fact. It can act as a contract requiring a spouse to provide for the other upon death. It can even limit probate rights at death. Exceptions However, there are some exceptions. An agreement to not seek child support is invalid and will not be upheld. Also, the entire premarital agreement will be invalid if it is not executed voluntarily. California courts have not allowed penalties written in prenuptial agreements that punish or sanction people for recreational drug use or infidelity. Courts will also not enforce issues such as the assignment of one spouse to do the dishes or that children will be raised in a particular religion. In addition, the agreement will not be enforced if it is very unfair and all of the following are true:

The first party did not disclose his (or her) finances; The second party did not sign anything saying she (or he) did not care about the first

party's finances; and The second party did not already know about the first party's finances (or could easily

have known). A prenuptial agreement will be deemed entered into voluntarily, by the party against whom enforcement is sought, if the court finds in writing or on record that all of the following occurred:

The party was represented by his or her own legal counsel, or after being advised of the right to legal counsel, waived that right;

The party had at least 7 days from the time he or she was initially presented with the agreement and advised of his or her right to legal counsel and the time the agreement was signed;

The party, if not represented by legal counsel, was completely informed of the terms and overall effect of the prenuptial agreement, along with an explanation of the rights and obligations given up by signing the agreement;

The agreement and any related writings were not executed under a state of duress, undue influence, fraud, or lack of mental/emotional capacity; and

Any other factors deemed relevant by the court. Registered Domestic Partners (RDPs) may also enter into prenuptial agreements. A prenuptial agreement is only valid if it is executed before the marriage or the RDP was entered into. After the fact, a post-nuptial agreement would have to be drawn up.


California Family Code Section 1614 – When a marriage or an RDP ends, a prenuptial agreement can be amended or revoked only by a written agreement signed by both parties, which is then enforceable without consideration. Review Question 6 Ethan and Amy were married during the tax year. They voluntarily drew up and signed a written prenuptial agreement before a notary public. In the prenuptial agreement, they included a penalty in the case of spousal infidelity, an agreement to not seek child support, an agreement to waive their rights to share community property, and an agreement on the division of household chores. Which of these written agreements would be deemed enforceable in a California court of law? a) The agreement to a penalty to sanction a spouse for infidelity b) The agreement to waive their rights to share community property c) The agreement not to seek child support d) The agreement on the division of household chores Reading References for Chapter 5: IRS Pub 555 – Community Property FTB Pub 737 – Tax Information for Registered Domestic Partners, pages 5-6 FTB Pub 1031 – Guidelines for Determining Resident Status, pages 10-13 FTB Pub 1051A – Guidelines for Married/RDP Filing Separate Tax Returns Schedule CA (540NR) Schedule CA (540NR) Instructions Schedule S Schedule S Instructions

chapter 1: general material€¦ · if only one spouse/rdp had income over the amounts listed. (see...

Documents