California Bills Acknowledge Federal Tax Changes, Don’t Conform

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By Laura Mahoney

California lawmakers are proposing ways to get around some parts of the new federal tax law at the same time they are making plans to capture possible windfalls and spend revenue it might bring in.

But they have shown no signs of conforming state tax law to the federal changes.

Although some of the bills responding to federal tax law changes are already stalled, others are starting to pick up steam. A new attempt to get around the $10,000 cap on federal deductions for state and local taxes and a bill to impose a state tax surcharge on carried interest are among the bills getting their first hearings in legislative committees in April and May.

A.B. 2217, by Assembly Revenue and Taxation Committee Chair Autumn Burke (D), is a new twist on the SALT cap workaround. It joins S.B. 227, by Sen. Kevin de Leon (D), which passed the Senate in January and could be taken up again this summer. De Leon has said at least 3 million Californians who pay more than $10,000 combined in state income tax and property tax would benefit from his measure.

Both measures are an attempt to get around part of the 2017 federal tax act ( Pub. L. No. 115-97) that allows taxpayers to deduct up to $10,000 of property taxes, and state and local income or sales taxes. The previous law placed no limit on the amount of state and local taxes that could be deducted—and many high-tax states are exploring options to combat the slashed tax break.

Nonprofits, Schools

Under Burke’s proposal, California nonprofit organizations, school districts, community colleges, and colleges and universities that serve students who receive state grants could buy Golden State Credits from the California treasury for 90 cents.

They would sell the credits for $1 to any interested buyers. Those who buy the credits would get a state tax credit equal to 80 percent of their purchase amount, and the purchases would be considered a charitable donation for federal tax purposes.

Burke’s bill is similar to de Leon’s pending Senate bill, under which taxpayers would make charitable contributions directly to the state treasury’s California Excellence Fund and receive a state tax credit of 85 percent. They could deduct the state credit on their federal income tax returns.

Burke told Bloomberg Tax May 2 her bill would help taxpayers facing the SALT cap and encourage civic engagement through charitable donations. The mechanism to purchase the credits from nonprofit organizations, schools, and universities creates a benefit for those organizations that may be on stronger legal footing than S.B. 227 and bills in other states that allow taxpayers to make their contributions directly to the state, she said.

Lawmakers in Illinois are considering a similar workaround. New York recently became the first state to enact legislation minimizing the impact of the federal deduction limit through a deduction for charitable contributions, and New Jersey followed suit May 4.

However, U.S. Treasury Secretary Steven Mnuchin has cast doubt on such workarounds and has threatened to audit taxpayers who use them. IRS Publication 526 says that taxpayers can’t deduct as a charitable contribution any payment for which they receive a benefit in return.

It’s Cooked

Burke said she took her time crafting the bill as the new chair of the Revenue and Taxation Committee following de Leon’s introduction of his measure in January. She became chair in January, introduced the bill April 5, and amended it May 2.

“I didn’t want to be impulsive,” she said. “This is a policy idea that is cooked.”

The Senate bill, which is similar to the New York measure, is on solid legal footing, Darien Shankse, law professor at University of California, Davis School of Law, told Bloomberg Tax May 2. The new Assembly bill broadens the circle of who benefits, he said, and could therefore address some criticism of the Senate bill that its benefit to the state negates its charitable purpose.

The Internal Revenue Service could curb either proposal for political reasons despite their legal footing, he said.

“We are kind of shadow boxing,” Shanske said.

Shanske and Daniel Hemel, assistant professor at the University of Chicago Law School, helped craft the Assembly proposal.

Still a Problem

Jared Walczak, senior policy analyst with the Tax Foundation, told Bloomberg Tax in a May 2 email that Burke’s approach to the SALT cap would still create transactions that are primarily not charitable in purpose.

“This proposal doesn’t solve problems inherent in existing schemes to reclassify tax payments as charitable contributions; it only creates new ones,” he said.

Burke’s bill is scheduled for its first hearing May 14 in the Revenue and Taxation Committee. De Leon’s bill hasn’t yet been referred to the Assembly committee for a hearing since it passed the Senate in January, but it can be heard in July or August and make it to the desk of Gov. Jerry Brown (D) by the end of session Aug. 31.

A Republican take on the SALT deduction cap already failed its first committee test in April. A.B. 1864, by Assemblyman Kevin Kiley (R), would have allowed Californians to deduct their federal taxes on their state returns.

Kiley called the bill some “pepper” to help those facing the SALT deduction cap reduce their overall tax burden. With an annual price tag of $27 billion in 2018-19, the bill failed on a party line vote April 9.

Carried Interest

A.B. 2731, by Assemblyman Mike Gipson, (D) would tackle the so-called carried interest loophole that Congress didn’t touch in the new law despite President Donald Trump’s calls during his campaign to end it.

Under Gipson’s bill, California would impose a 17 percent tax on income from investment management services interest. Gipson said during a Revenue and Taxation Committee hearing April 23 that he wants the bill to apply to partners at hedge funds and private equity firms who typically receive 20 percent of profits from investments they manage when they exceed their return targets.

Those payments are taxed at the long-term capital gains rate, which is typically under 20 percent, rather than at personal income tax rates, leading many critics to call the tax treatment a loophole. The 17 percent state tax would be added on top of the capital gains tax the fund managers pay.

The bill passed the committee 7-3 April 23, and must pass the Assembly Appropriations Committee by May 25 to make it further.

Gipson said he is willing to amend the bill to address concerns from the Securities Industry and Financial Markets Association that it is too broad and, for example, would impose the tax on employees with any equity interest in an investment company, including those who don’t receive the carried interest tax break.

State by State

A.B. 2731 is similar to bills pending in Maryland, New Jersey, New York, Massachusetts, and Rhode Island, and is backed by the group Patriotic Millionaires.

Morris Pearl, chairman of the group, told Bloomberg Tax May 2 the idea is to combine federal tax and state tax to equal the amount of regular income tax others pay on earnings. The group agrees that Gipson’s bill should be narrowed so that it only applies to those who own the fund management companies, he said.

“It’s only a tiny fraction of people who take advantage of this loophole,” he said.

The bill could increase state revenue by $700 million in the 2018-19 fiscal year and by more than $450 million in future years, according to the California Franchise Tax Board.

Other Federal-Related Bills

Few California lawmakers supported the new federal tax law, but a number are looking for ways to create a tax benefit for the state or its taxpayers regardless of whether they supported the law. Their proposals include:

  • A.C.A. 22, by Assemblymen Phil Ting (D) and Kevin McCarty (D), would impose a “windfall tax surcharge” on half of the federal tax cut for corporations with more than $1 million in revenue. The money would go to education, health care, taxpayer rebates, and expansion of the state earned income tax credit. The measure needs voter approval because it would amend the state Constitution. It hasn’t yet been referred to a committee for hearing.
  • S.B. 1253, by Sen. Hannah-Beth Jackson (D), would expand an existing tax credit for builders of low-income housing and allow projects within new opportunity zones created under the federal law to qualify for the credit regardless of whether they get available federal credits. The bill passed the Senate Transportation and Housing Committee May 1 and will be heard next in the Senate Governance and Finance Committee.
  • S.B. 1384, by Senate Minority Leader Patricia Bates (R), would send state tax revenue resulting from corporate repatriation of offshore income to a special fund earmarked for transportation projects. The bill failed in the Senate Governance and Finance Committee April 25, but committee members said it can be reconsidered. An FTB analysis released March 20 said the interaction between the repatriation provisions and state tax law will mean about $350 million in new income for the state, which is far less than lawmakers first anticipated.
  • S.J.R. 21, by Sen. Jeff Stone (R), would encourage anyone who disapproves of the new federal law to donate their tax savings under it to the California general fund. The resolution will be heard in the Senate Governance and Finance Committee May 9.

Costs of Nonconformity?

Missing from responses to the new federal tax law are proposals that would conform California law to its provisions. California doesn’t automatically conform to federal changes and most recently conformed to some federal changes as of Jan. 1, 2015.

“Workarounds and protests are a dime a dozen,” Walczak said. “Failure to conform to the new tax law increases compliance costs and introduces additional uncertainty. Opposition to the new federal tax law needn’t manifest itself in a refusal to keep the state’s tax code up-to-date.”

Shanske agreed that conformity, especially in the area of international tax and repatriation, is a good idea.

“There are all kinds of places where it would make sense in a technical, nonpartisan way to make things cleaner and fairer,” he said.

Facing a two-thirds vote threshold in both houses to approve measures that increase taxes on even one taxpayer, lawmakers may not have the appetite to tackle complex tax issues raised by the new law without clear support, Shanske said.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif. at lmahoney@bloomberglaw.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

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