California new tax basis reporting may challenge partnerships: PwC

In brief

UPDATE: On January 30, 2023 the FTB issued Notice 2023-01 allowing taxpayers to again report capital accounts on either a federal or California tax basis for the 2022 tax year, however, for the 2023 tax year the California tax basis method must be used. The notice provides that the 2022 California Forms 565 and Form 568 instructions, for partnership and limited liability companies, provide methods to compute the beginning tax basis capital account. The methods are similar to those provided in the 2020 IRS Form 1065 instructions. The combination of detailed historical records required to determine California tax basis as well as effort required to perform the tax basis analysis could be a significant burden on California tax return filers. 

In early 2022, when the California Franchise Tax Board (FTB) released 2021 tax forms and instructions for partnerships (Form 565) and limited liability companies (Form 568), taxpayers first learned that the FTB was requiring them to report tax basis capital amounts on a California basis rather than using the federal tax basis amounts. 

Recognizing the difficulties for taxpayers to comply with the new reporting requirement, the FTB issued Notice 2022-01 on March 8, 2022, allowing taxpayers to report the capital accounts on either a federal or California tax basis for the 2021 tax year. Partnerships have been challenged in recent years with new reporting requirements by the IRS, such as tax basis capital and Schedule K-2 and K-3 reporting; California’s tax basis reporting requirement adds to the burdens. California is the first state to require state-specific tax basis reporting for partnerships; however, other states may follow suit. 

Action item: Even though California has delayed its tax capital reporting requirements until the 2023 tax year, partnerships should start to assess with their tax providers how these reporting requirements will be implemented to allow time to plan, collect, and reconcile data.

In detail

The California tax basis capital reporting requirement follows the IRS requirement for the 2019 tax year requiring partnerships to report partner capital accounts on a tax basis. On December 9, 2019 the IRS released Notice 2019-66 suspending the federal requirement to report tax capital until tax year 2020. 

The IRS indicated that the changes “aim to improve the quality of the information reported by partnerships both to the IRS and the partners of such entities.” The FTB’s action may reflect similar objectives taking into account that there may be substantial differences between California and federal tax basis amounts. 

Observation: Although the temporary relief provided by FTB Notice 2023-1 was welcome news, partnerships should not delay in determining how they will approach the California tax capital calculations for 2023 and beyond. Additional time could be needed to collect information and perform the necessary calculations.

Due to the IRS tax capital reporting requirement effective for 2020, a significant portion of the California tax basis reporting already has been completed, since California generally conforms to the Internal Revenue Code (IRC). However, California’s non-conformity to certain provisions of the IRC and differences that exist due to the timing of California’s adoption of the current IRC will create federal/California differences. For example, California currently selectively adopts the majority of the IRC in effect as of January 1, 2015, which would exclude the application of the majority of the provisions enacted as part of the 2017 federal tax reform legislation with the exception of limited provisions specifically adopted. 

The following is a non-exhaustive list of common federal/California differences for partnerships that may require an adjustment to the computed federal tax basis. NOTE: Partnerships are governed under the California personal income tax laws (Part 10) of the California Revenue and Taxation Code (CRTC), which is separate and different from the California corporation tax laws (Part 11) of the CRTC.

Depreciation - While California under the personal income tax laws generally adopts MACRS depreciation under IRC Section 168, California has not adopted any of the bonus depreciation provisions.
IRC Section 179 - California currently allows a $25,000 expense deduction while the federal deduction currently is $1 million. 
Subpart F income - California only taxes actual distributions, not deemed dividends. 
Passive Foreign Investment Companies - California does not conform to QEF elections and only taxes actual distributions.
Qualified Small Business Stock (QSBS) - Up until 2013, California partially conformed to the federal QSBS exclusion; however, from 2013 forward the state no longer conformed.
Interest expense - While California does not conform to the post-2017 federal tax reform’s interest expense limitations of IRC 163(j), it does conform to pre-tax reform 163(j) limitations.

Observation: Partnerships will face challenges to comply with the California tax basis reporting, however one of the biggest challenges will be the need to collect data going back to the inception of the partnership to do the calculation. Collecting this information can be difficult for older funds, and could be impossible if records no longer exist (e.g., because of destruction required by data retention policies). Funds that have changed tax preparers will face additional challenges if old records were not transferred. 