Tax Basis Capital Account Reporting Now Required by California

• November 14, 2023
• Carey M. Heyman, CPA

Beginning with the 2023 tax year, and for every taxable year thereafter, the California Franchise Tax Board (FTB) will require taxpayers who file Form 565 or Form 568 to report its partners’ or members’ capital accounts on the Schedule K-1 using the tax basis method as determined under California law.

The FTB instructs taxpayers to look to the information provided on the partners’ or members’ tax basis capital accounts in the instructions for the Federal Schedule K-1 (Form 1065).  We interpret this to mean that taxpayers must make California adjustments to the tax basis capital account numbers that are reported on the Federal Schedule K-1 (Form 1065).

The thought of recreating partners’ (or members’) California tax basis capital accounts can seem daunting, but there are a couple things to keep in mind:

• Under the Federal rules (which California follows), small partnerships are exempt from the filing requirement.  To qualify as exempt, the partnership must:
  • Have less than $250,000 gross revenue for the tax year;
  • Have less than $1,000,000 in total assets at the end of the year;
  • Timely file K-1s (including applicable extensions) with the Internal Revenue Service (IRS) and FTB and furnish copies to the partners or members; and
  • Not be required to file Schedule M-3, Net Income (Loss) Reconciliation for Certain Partnerships.
• Taxpayers can use the Federal tax basis amounts reported on Federal tax returns as a starting point.  The FTB recognizes the safe harbors that the IRS permits to recreate tax basis on the Federal returns (the modified outside basis method or the modified previously taxed capital method).  The same method must be used to report partners’ or members’ capital accounts. 
• If the only differences between the Federal and California tax basis involve depreciation amounts (i.e. bonus depreciation, Section 179 deductions, depreciable life differences), taxpayers could convert the Federal tax basis capital accounts to California tax basis capital accounts by using the Federal and California accumulated depreciation balances as of January 1, 2023, and then running these amounts through the increases (decreases) on the Schedule M-2.

Other key differences that may impact California tax basis capital accounts that should be accounted for include:

• Income exempt under California law but not Federal law (i.e. California COVID-19 Small Business Relief Grants);
• Charitable contribution amounts;
• Interest income on government bonds;
• Treatment of foreign income;
• Investments in Qualified Opportunity Zones;
• Wage expense deductions related to taking federal and/or state tax credits;
• Differences in the treatment of research expenses between the Federal and California tax returns;
• Differences in the treatment of independent contractors (if considered as an employee for California tax purposes); and
• Business interest expense, which could be limited for Federal tax purposes but not for California tax purposes, for post-Tax Cuts and Jobs Act of 2017 tax years.

Statements are required to be filed in the following circumstances:

• Taxpayers must attach a statement to the partners’ or members’ California Schedule K-1 indicating the method used to determine beginning capital accounts.  If the modified previously taxed capital method is used, the statement must also include the method used to determine the partnership’s net liquidity value [i.e. fair market value, Section 704(b) book value].  The method used to determine the partnership’s net liquidity value must be adopted for all partners or members in the partnership.
• A statement must also be attached indicating whether the tax basis method used in 2021 or 2022 was determined using Federal or California amounts.  If they were determined using California amounts, the same method should be used.

A big thanks to Megan Asselin and Olga Zarney for authoring and collaborating, respectively, on this blog post.

Source: Franchise Tax Board

Tags: California, Franchise Tax Board, Tax Capital, Tax Capital Reporting Requirements, Federal and state taxation, including proposed regulations, Year-end tax planning | Comments Off on Tax Basis Capital Account Reporting Now Required by California