Expert Insight: California’s Proposition 26 and IRC Conformity

California’s adoption of Proposition 26 in November 2010 has a created a great deal of uncertainty for individuals and businesses subject to tax in the state. A lingering question in California is the date by which the state conforms to the Internal Revenue Code. Some say that although the state’s conformity statute indicates conformity as of Jan. 1, 2009, the correct date is actually Jan. 1, 2005, since Prop. 26 provides that any legislation previously passed had to be readopted with the requisite two-third vote. California has yet to take this vote. Furthermore, California withdrew from the MTC compact in 2012, and it is unclear whether this withdrawal is valid under Prop. 26. Professor Annette Nellen of San José State University answers our questions on the subject.

BBNA:  Do you think that the correct date of conformity for California is still Jan. 1, 2005, or do you think it is Jan. 1, 2009?

Annette Nellen: This is a great question. The ballot materials from November 2010 included this information about Prop. 26: "Repeal Requirement. Any state law adopted between January 1, 2010 and November 2, 2010 that conflicts with Proposition 26 would be repealed one year after the proposition is approved. This repeal would not take place, however, if two-thirds of each house of the Legislature passed the law again." 

This summary in the ballot guide is not exactly how Prop 26 changed Article XIIIA, Section 3 of the California Constitution, though. The change to the Constitution was as follows:

"(c) Any tax adopted after January 1, 2010, but prior to the effective date of this act, that was not adopted in compliance with the requirements of this section is void 12 months after the effective date of this act unless the tax is reenacted by the Legislature and signed into law by the Governor in compliance with the requirements of this section."

The language at 3(c) along with the change to 3(a)—“any change in state statute which results in any taxpayer paying a higher tax"—might imply that only the provisions that result in a higher tax need to be re-voted, rather than the entire legislation.

The conformity items in SB 401 included both tax increases and tax decreases. An example of a tax increase is California conforming to the higher age for when a child with unearned income is taxed at the parent's higher rate (the "kiddie tax").  This change is a tax increase for affected children in the expanded age group (under age 24, rather than only under age 14).

In 2011, the FTB raised the question about the legal status of SB 401 in Legal Division Guidance 2011-01-01. The FTB noted that there was some ambiguity in the Prop 26 language. The FTB also noted that administrative agencies do not have the authority to find a statute invalid; only an appellate court can do that.

So, again, I say that it is a great question.  Does California only conform to the IRC as of January 1, 2005?  Does California conform to some IRC provisions as of January 1, 2009 (those covered by SB 401 that are not tax increases)? Do we conform to all provisions covered by SB 401 (with the possible interpretation that 3(c) only applies to a new tax adopted in 2010)?

It is unfortunate that the question was not resolved prior to the upcoming filing season. Assume a taxpayer takes the position on their 2011 or 2012 return that California conforms to the IRC at January 1, 2005, rather than at 2009 and the FTB takes the position that the taxpayer should have followed the IRC as of Jan. 1, 2009. If litigation results in a court finding that all or part of SB 401 should have been re-voted to get a 2/3 majority vote, there would be chaos.  Others would amend returns. There would be added confusion as to exactly what the law is.  Or, perhaps a court would find that only a new tax adopted between Jan. 1, 2010 and passage of Prop 26 is invalid if not re-voted with a 2/3 majority vote, and that if SB 401 did not include any new tax, it is valid.

BBNA: Do you know what position the Franchise Tax Board takes on this issue?

Nellen: I have not seen anything official from the FTB regarding the impact of Prop. 26 and SB 401, other than the 2011 Legal Division Guidance noted above. However, the instructions to the 2012 Form 540, which are written by the Franchise Tax Board, state that California law conforms to the federal tax law as of January 1, 2009. So, it would seem that the position of the FTB is that SB 401 is in effect.

BBNA:  Another question involving Prop. 26’s voting requirement is the passage of S.B. 1013, which was enacted in 2012 and withdraws California from the MTC compact. The validity of S.B. 1015's statutory repeal of the MTC compact comes into question because it likely results in taxpayers paying a higher tax. Do you agree that this is the case?

Nellen: Another good question.  SB 1015 notes that the doctrine of election applies so that a taxpayer is bound by the apportionment formula they used when they filed their original return.  So, no amended return can be filed. I am not convinced that the doctrine of election did apply, though, because that doctrine might require a clear choice of apportionment options.  In TAM 200252059, the IRS explained the "doctrine of election" as follows: “The doctrine of election, as it applies to Federal tax law, consists of two elements: (i) a free choice between two or more alternatives, and (ii) an overt act by the taxpayer communicating the choice to the Commissioner; i.e., a manifestation of choice."  Does it apply differently outside of federal law?  I believe that since the enactment of the double-weighted sales factor in 1993, affected taxpayers were told there was one apportionment formula, namely, three-factor, double-weighted sales. Arguably, removing the possibility of amending returns is a tax increase. Also, leaving the Compact might involve at least one taxpayer having a tax increase, thus meaning that SB 1015 should have had a 2/3 majority vote.  This question also points out possible difficulties of knowing if legislation might result in any taxpayer having a tax increase. Sometimes it will be obvious, such as with a rate increase, but other times it might not be obvious due to unusual taxpayer facts, perhaps.

BBNA:  Do you think it is likely that California’s legislature will re-enact the IRC conformity and/or MTC withdrawal now that the democrats have a supermajority in both houses of the legislature?

Nellen: I think it would be wise for the legislature to revote SB 1015 with a 2/3 majority vote to avoid issues for the long term as to its legality. 

Because any conformity legislation can result in a tax increase for at least one taxpayer, the current 2/3 majority of Democrats has a unique opportunity to enact conformity legislation. I encourage the legislature to look carefully at the IRC as of January 1, 2013 to determine where it makes sense to conform and where it does not make sense (from a budget perspective as well as from the perspective that certain rules might make more sense at the federal level rather than also at the state level).

Annette Nellen, CPA, Esq. is a tax professor at San Jose State University. She runs the 21st Century Taxation website and blog, focusing on tax system weaknesses, possible solutions, and the need to modernize tax systems and follow principles of good tax policy. She is an active member of the tax sections of the AICPA, ABA and California Bar.

By Melissa A. Fernley

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