California Preliminary Report on Specific Provisions of Federal Tax Reform

The Tax Cuts and Jobs Act of 2017 (the “Act”) will have many consequences for taxpayers in the State of California.

California’s Franchise Tax Board recently issued a preliminary report to discuss three specific provisions of federal tax reform and their applicability to California taxpayers:

1. Changes to the floor for unreimbursed medical expenses;
2. The limitation on state and local tax deductions; and
3. Repatriation.

Unreimbursed Medical Expenses

For taxable years prior to January 1, 2017, the federal threshold for deducting unreimbursed medical expenses was 10% of adjusted gross income (“AGI”) for most taxpayers under the age of 65. Under the Act, this percentage was reduced to 7.5% of AGI for all taxpayers for taxable years beginning after December 31, 2016, and ending before January 1, 2019. For federal tax purposes, the threshold is the same for both regular and alternative minimum tax computation. After January 1, 2019, the threshold returns to 10% of AGI. For tax year 2018, California conforms to the federal threshold of 7.5% of AGI for the deduction of unreimbursed medical expenses. For taxable year 2019 and after, the threshold for California tax purposes will differ from the federal threshold of 10% of AGI and remain at 7.5%. For alternative minimum tax, California will retain a 10% threshold of AGI for unreimbursed medical expenses.

State and Local Tax Deductions

As discussed in previous Marcum Tax Flashes, new provisions under tax reform have imposed a $10,000 limitation on the deduction for state and local income, sales, and property taxes paid. While California does not allow a deduction for state income or sales taxes, deductions for property tax are allowed. California does not currently conform to the federal $10,000 limitation. As such, there should be a difference between federal and California property taxes paid as an itemized deduction beginning in 2018 through 2025.

Repatriation

Congress enacted sweeping changes to international tax provisions, including repatriation of foreign earnings as a part of the Tax Cuts and Jobs Act. For California corporate taxpayers that compute their California tax using a worldwide unitary method, dividends paid from one member of the corporation to another are generally eliminated from tax computations. As an alternative to worldwide combined filing, California allows corporations to make an election to determine income of the combined reporting group on a “water’s-edge” basis, which generally excludes taxable income of foreign corporations. This election is binding on electing corporations for 84 months. Generally, California does not conform to the new international tax reform provisions. Taxpayers filing on a water’s-edge basis will continue report and pay tax on dividends as they are repatriated, subject to a 75% dividends received deduction, and then multiplied by their California state apportionment factor. The Franchise Tax Board included commentary in its report that California will likely benefit from the transition tax on an indirect basis, since many taxpayers will no longer see an incentive to keep funds overseas and will be more likely to repatriate funds, which in turn will increase California’s taxable income base.

The Franchise Tax Board is required by law to provide a report to the California Legislature on all enacted changes to the Internal Revenue Code from the previous year. This year’s report is due April 20, 2018, and will be made available on the state website.

For questions about how these changes may affect you or your business, please contact your Marcum advisor.