Why May Federal Tax Breaks Not Work in California?

Federal tax rules and California tax rules may appear similar, but taxpayers should never presume that they are the same. Not all changes in the Internal Revenue Code are automatically made to the California Code. Rather, the California Legislature determines which federal provisions to accept, amend, or reject.

That contrast can have an unanticipated two-system tax issue. A deduction or tax benefit that lowers federal taxable income may have to be included in California taxable income. Always look for an expert (like an attorney for payroll issues) who can help you manage tax difficulties with ease.

The Reasons Federal and California Taxes May Differ

If Congress makes changes to federal tax law, the IRS is likely to implement the changes based on federal law. California’s Franchise Tax Board (FTB), on the other hand, is subject to California’s Revenue and Taxation Code.

Consequently, taxpayers may have to keep two sets of federal and California calculations.

For instance, you may be able to take a specific deduction from your federal return, but find that the state of California does not allow the same deduction. This can lead to a higher California taxable income even though you had a lower federal income.

This is especially significant when significant federal tax law changes, such as new deductions, credits, depreciation rules, or other tax benefits, are enacted.

HSA Contributions: A Common Pain Point

For example, Health Savings Accounts (HSAs) are an excellent case study that illustrates the importance of looking at the California-specific rules.

Generally, tax law favors HSA contributions and distributions. That’s not the case for California, however.

This may involve California taxpayers submitting adjustments and keeping records that don’t need to be prepared for their federal tax return.

If you make a contribution to an HSA, please preserve proof of the contribution-

1. Net contribution from current income in the year.
2. Employer contributions
3. Distributions
4. Qualified and nonqualified expenses
5. Federal deductions and California adjustments.

If you don’t consider these differences, the California return process can be more complicated, and you may end up owing more taxes to the state.

Depreciation Has the Ability to Cause Two Sets of Books

Another big issue that small-business owners, freelancers, and gig workers may have is depreciation.

California may not include all the accelerated depreciation and other deductions available under the federal tax code. In this instance, the asset might be depreciated under federal rules and under California rules.

This means that the proprietor of a company could have to monitor:

• The Federal basis is the same amount as the Federal depreciation, which is equal to the Federal adjusted basis.

and separately:

• California basis is the same as California depreciation adjusted for basis.

This disparity may persist for many years, and proper bookkeeping is important when assets are sold, traded, or disposed of. Get an expert (similar to a sales and use tax attorney) when you are in trouble.

Alimony Rules: They Can Also Vary

Another area in which federal and California law may differ is in alimony payments, especially since the federal law has recently modified the tax treatment of certain divorce or separation agreements made post-2018.

Not all federal changes are necessarily reflected in California’s treatment. Providers of alimony or recipients of alimony should thus take great care in deciding which rules apply based on the agreement and tax year involved, and not simply presume that the federal result applies to California.

The Gig-Worker “Two Books” Problem

Freelancers and gig workers might be affected even more as they tend to do their own bookkeeping.

A federal return may include a business expense, depreciation method, or adjustment that California does not include. Taxpayers can keep one set of financial records and make federal and California tax adjustments all in one place.

Useful practices include:

• Keep good receipts and invoices.
• Use federal and California basis columns to track fixed assets.
• Maintain an ongoing list of state changes.
• Keep previous year California depreciation schedules.
• Ensure tax software includes California adjustments.
• Annually restate federal W-2 income to California income.

Tips on Not Paying Twice for Accounting

The objective does not have to be to produce two totally separate book sets. Rather, keep one reliable accounting system, and create a California tax-adjustment layer on top of it.

At the end of the year, determine what is different from the federal treatment, and record these items. This can eliminate redundant work and still maintain the records for future returns.

Most of all, do not presume that any federal tax break is available in California. If California does not meet the underlying requirement, then it will not be considered a federal deduction. Identifying nonconformity now will help you avoid the unpleasant surprises of tax bills, penalties, interest, and expensive corrections at a later time.