Chapter 3: Introduction to Form 540
Objectives
At the end of this lesson, the student will have an understanding of:
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Form 540
The difference between Form 540 and Form 1040
Resources
Form 540
Instructions Form 540
California Tax Rates and Exemptions
Introduction to Form 540
The California tax return does not follow the federal return line by line; California subtracts the exemption
amount from the tax owed. California begins by gathering the taxpayer’s and spouse’s personal
information. If the couple’s status is registered domestic partner (RDP) or same-sex married couple
(SSMC), you will enter the spouse’s information on Form 540. As on the federal form, the state
information needed is:
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First and last name as found on SSN or ITIN
Address (including city, state, and zip)
Date of birth
Prior name (if the taxpayer or spouse filed a prior California return with a different last name)
California is different than federal in asking for the taxpayer’s and spouse’s/RDP’s date of birth on the
front page of the form. The other line is different if the taxpayer or spouse/RDP used a different last name
on the 2013 tax return.
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Filing Status
Line 1 though 5: Check only one box and enter the additional information if box 3 or 5 was checked.
California filing statuses are:
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Single
Married/RDP filing joint
Married/RDP filing separate
Head of household
Qualifying widow(er)
Unlike the federal form, California asks for date of death next to box 5. The other line item that is
different is if the California filing status is different from the federal filing status. If so, the box needs to be
checked. If a joint tax return was filed on the federal, then the taxpayer and spouse may file separately for
California if either spouse was:
 An active member of the U.S. armed forces or any auxiliary military branch during 2014
 A nonresident for the entire year and had no income from California sources during 2014
If the taxpayer had no federal filing requirement, use the same filing status as if the federal form was filed.
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Exemptions
In this section the tax professional will need:
 Dependent(s) name (as it appears on the social security card, ATIN, or ITIN)
 Dependent(s) relationship to the taxpayer
California calculates the personal exemption amount prior to calculating the taxpayer’s income.
Line 8: Blind exemption: If this is the first year that the taxpayer or spouse is claiming an exemption for
being blind, attach the doctor’s statement to the back of Form 540 indicating who is the blind taxpayer or
spouse/RDP. If the taxpayer is claimed as a dependent on another return, the taxpayer does not receive the
additional credit.
Line 9: Senior Exemption: California conforms to federal when the taxpayer’s 65th birthday is January 1.
If the taxpayer is over the age of 65 on December 31, 2014, the taxpayer and spouse would receive an
additional credit. The additional credit cannot be claimed if the taxpayer is claimed as a dependent on
another return.
Line 10: Dependent Exemption: Although only four lines of the exemption section are given, like the
federal return, mark the box and follow the instructions to add an additional sheet for more dependents.
Line 11: Exemption Amount Add line 7-10 and enter the total dollar amount.
Income
California begins with the federal income and then adds or subtracts based on California law.
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Line 12: State wages. Enter the total amount of the state wages from all Form(s) W-2.
Line 13: Federal Adjusted Gross Income (AGI) from Form 1040, line 37; 1040A, line 21; or 1040EZ, line
4.
Line 14 California adjustments
Line 15: Subtotal
Line 16 California adjustments
Additions and subtractions to income are reported on Schedule CA (540) and flow to either line 14
(subtractions) or line 16 (additions).
Line 17: California adjusted gross income (AGI)
Line 18: California itemized deductions or standard deduction.
Line 19: Taxable Income
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Tax
This section determines the tax and the exemption credit based on the exemptions claimed on the tax
return. What is an exemption and dependent will be discussed later in the course.
Line 31: Tax, how was the tax figured, check the box.
Line 32: Exemption credits. Exemption credits reduce the tax.
Line 33: Subtract line 31 from line 32.
Line 34: Tax from Schedule G-1 and Form FTB 5870A
Line 35 Add lines 33 and 34 together.
Special Credits (On Form 1040 this is Tax and Credits)
As with the federal form nonrefundable credits can lower the tax to zero, but not below zero. A variety of
California tax credits are available to reduce the tax if the taxpayer qualifies. If the taxpayer qualifies for
any of the special credits, the form should be completed and attached to the return.
Line 40 Nonrefundable child and dependent care expenses credit. Form FTB 3506 should be attached.
Line 43 - 45 Additional Special Credits.
Line 46 Nonrefundable Renters Credit.
Line 47: Add line 40, and line 43 -46.
Line 48 Subtract line 47 from line 35. If less than zero, enter zero.
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Other Taxes
Other taxes may include:
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Alternative minimum tax (AMT) (line 61)
Mental Health Services Tax (line 62)
Taxes on Form 1099-R (line 63)
Taxes that need to be recaptured (line 63)
Payments
Payments made throughout the year are added up and then subtracted to arrive at the total payment.
Line 71: California income tax withheld. Do not include:
1.
2.
3.
4.
City, local, or county tax withheld, tax withheld by other states
Nonconsenting nonresident (NCNR) members tax from Schedule K-1 (568), line 15e
Withholding from Forms 592-B, Resident and Nonresident Withholding Statement
Form 593, Real Estate Withholding Tax Statement
Line 72: 2014 CA Estimated Tax and Other Payments. Include:
1. California estimated tax payments made using Form 540-ES, electronic funds withdrawal, Web
Pay, or credit card
2. Overpayment from the taxpayers 2013 California income tax return that was applied to 2014
3. Payment sent with Form 3519, Payment for Automatic Extension for Individuals
4. California estimated tax payments made on behalf of an estate, trust, or S corporation on Schedule
K-1 (541) or Schedule K-1 (100S)
If the taxpayer and spouse/RDP paid estimated taxes but are filing separate returns, the taxpayer and
spouse/RDP need to decide who and how they will claim the estimated payments on the separately-filed
returns. See Personal Income Tax Booklet 2014.
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Line 73: Real estate and other withholding. Enter the total amount of California withholding from:
1. Form 593
2. Form 592-B
Do not include federal tax withholding from:
1.
2.
3.
4.
Form W-2 box, 2
Form W-2G, box 4
Form(s) 1099
NCNR members tax from Schedule K-1 (568), line 15e
Line 74: Excess California SDI (or VPDI) withheld.
Line 75: Add lines 71-74. Total state withholding payments.
Overpaid Tax or Tax Due
To avoid delay in processing the tax return, make sure that all the lines are accurate. Refund or payment
due is reported on these lines.
Line 91: Overpaid tax.
Line 92: Amount of line 91 that should be applied to 2015 estimated tax
Line 93: Overpaid tax available this year.
The state refund can be dealt with in several different ways:
1. Rolled over to the following year, if the taxpayer needs to make estimated payments
2. The refund can be directly deposited into the taxpayer’s account
3. The taxpayer can receive a check from the Franchise Tax Board (FTB)
California conforms to the split-refund option and allows the taxpayer to deposit the return into two
separate accounts.
Line 94: Tax due.
Use Tax
Taxpayers who purchase items through the Internet, over the phone, by mail from out-of-state retailers,
and are not charged a sales or use tax may have to pay a sales or use tax. When those items are used in
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California, the end user has to pay the tax to California, if the tax was not paid on the purchase. Use the
tax worksheet that is found in Instructions for Form 540.
Contributions
This section covers voluntary contributions that can be made on the tax form to certain organizations.
These contributions will affect the taxpayer’s refund or balance owed.
Amount Owed
Line 111: Amount you owe.
Interest and Penalties
This section covers when the taxpayer owes state tax and the interest and penalties that a taxpayer may
need to pay.
Line 112: Interest, late return penalties, and late payment penalties
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Line 113: Underpayment of estimated tax
Line 114: Total amount due.
Refund or No Amount Due
If the taxpayer receives a refund and would like the money directly deposited into a bank account, enter
the information in this section.
Line 115: Refund or No Amount Due
Line 116 and 117: Direct Deposit Refund
Signature Section
This section is for the taxpayer and spouse/RDP to sign and date the return.
The paid preparer would enter his or her PTIN, business name, business address, FEIN (federal employer
identification number), and business phone number. The paid preparer should always sign the return in the
appropriate box; otherwise a penalty is charged to the paid preparer.
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Which Form to Use
As with the federal form, always use the simplest one possible. If the taxpayer was a resident all year in
the state of California, he or she would use one of the following common forms:
 Form 540 2EZ
 Form 540
Form 540 2EZ may be used if:
Filing Status:
1. Single
2. Married/RDP filing jointly
3. Head of household
4. Qualifying widow(er)
Dependents: Zero to three allowed
Amount of Income:
 $100,000 or less if single or head of household
 $200,000 or less if married, filing jointly, or qualifying widow(er).
Sources of Income:
 Wages, salaries, tips, taxable interest, dividends, pensions, capital gains from mutual funds, and
taxable scholarships and fellowship grants (only if reported on Form W-2)
 U.S. social security benefits, tier 1 and 2 railroad retirement payments, and unemployment
compensation or paid family leave (reported on Form 1099G)
Adjustments to Income: No adjustments to income
Standard Deduction: Allowed
Itemized Deductions: No itemized deductions
Payments: Only withholding shown on Form(s) W-2 and 1099-R
Tax Credits: Personal exemption credit, up to three dependent exemption credits, nonrefundable renter’s
credit, and senior exemption credit
Other Taxes: Only tax computed using the 540 2EZ Table
Form 540 may be used if:
Filing Status: Any filing status
Dependents: All dependents allowed by law
Amount of Income: Any amount of income
Sources of Income: All sources of income
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Adjustments to Income: All adjustments to income
Standard Deduction: Allowed
Itemized Deductions: All itemized deductions
Payments: Withholding from all sources, estimated tax payments, payments made with extension voucher,
and excess State Disability Insurance (SDI) or Voluntary Plan Disability Insurance (VPDI)
Tax Credits: All tax credits
Other Taxes: All taxes
If the taxpayer was a nonresident all year in the state of California, he or she would use one of the
following:
 Short Form 540NR
 Long Form 540NR
Each form has its own requirements and more research will be needed to know which one to use for the
taxpayer. The nonresident return is not discussed in this course.
What Must Be Included with the Mailed California Return
To correctly assemble a California state tax return, the preparer must staple copy 2 of each Form
W-2 and Form 1099-R to the front of the first page of the tax return. If the taxpayer is filing a Form 540 or
540NR, he or she must also include a copy of his or her federal return with the state return only if the
federal return has any other forms or schedules, other than Schedules A and B, attached to the federal
Form 1040. A copy of the completed federal Schedule A must also be included if the taxpayer did not
itemize on his or her federal tax return but will itemize on the California tax return.
When California Returns Are Due
For calendar year taxpayers, the filing deadline is April 15, the same as the federal. Taxpayers residing or
traveling abroad have until June 15 to file. Interest will accrue on any balance from April 15 until the date
of payment. Residents traveling in another state are not considered to be abroad. For more information,
see the instructions for Form 3519.
If the taxpayer cannot file his or her California tax return by April 15, he or she will be allowed an
automatic six-month extension without filing a written request. To qualify, the return must be filed by
October 15. To avoid late payment penalties and interest, 100 percent of the tax liability must be paid by
April 15 using Form 3519.
Summary
This chapter has given a line-by-line overview for Form 540. The following chapters will be covering the
sections in more detail.
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Chapter 4: Business Income and Depreciation
Objectives
At the end of this lesson, the student will have an understanding of:
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How California treats self-employment income
The legal difference between employees and independent contractors
Differences in California and federal depreciation
Differences in California and federal section 179 deductions
How California does not conform to ACRS or MACRS
Resources
FTB Form 3885
FTB Form 3805V
FTB Form 3885A
Form DE 231
Schedule CA (540 or 540NR)
FTB Publication 984
FTB Publication 1001
FTB Publication 1005
FTB Publication 1060
Instructions Form 3885
Instructions Form 3805V
Instructions Form 3885A
Instructions Schedule CA (540 or
540NR)
Self-Employment Income
California law conforms to federal law regarding self-employment income and most expenses. The most
common difference that could require an adjustment regards depreciation. Use Form FTB 3885A to figure
the adjustment for the difference between the amount of depreciation and amortization allowed as a
deduction using California law. The difference is carried to Part I of California Schedule CA (540 or
540NR).
Self-Employment Tax
California has no self-employment tax or social security.
Federal and State Differences for Depreciation Purposes
Use Form FTB 3885A only if there is a difference between the amount of depreciation and amortization
allowed as a deduction using California law and the amount allowed using federal law. California law and
federal law have not always allowed the same depreciation methods, special credits, or accelerated writeoffs. As a result, the recovery periods or the basis on which the depreciation is figured for California may
be different from the amounts used for federal purposes. There will probably be reportable differences if
all or part of the assets were placed in service:
 Before January 1, 1987. California did not allow depreciation under the federal accelerated cost
recovery system (ACRS), and the taxpayer continues to figure California depreciation for those
assets in the same manner as in prior years.
 On or after January 1, 1987. California provides special credit and accelerated write-offs that affect
the California basis of qualifying assets. California did not conform to all changes to federal law
enacted in 1993, and this causes the California basis or recovery periods to be different for some
assets on or after September 11, 2001. California has not conformed to the federal Job Creation
and Worker Assistance Act of 2002, which permits a 30 percent additional depreciation for federal
purposes and allows taxpayers to take an additional first-year depreciation deduction and
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alternative minimum tax (AMT) depreciation adjustment for property placed in service on or after
September 11, 2001.
 California generally conforms to the federal 2003 increase (IRC section 280F) for the limitation on
luxury automobile depreciation. California does not conform to IRC section 168(k) provisions (30
percent and 50 percent additional first-year depreciation). In addition, SUVs and minivans that are
built on a truck chassis are not included in the definition of trucks and vans when applying the
6,000-pound differences between depreciation on the federal and California gross weight limit.
Differences may occur for other less-common reasons, and the instructions for Schedule CA (540NR) lists
them on the line for the type of income likely to be affected. See FTB Publication 1001 for more
information about figuring and reporting these adjustments.
Start-up Expenses
A new business can deduct up to $5,000 of salaries, marketing, and market analysis and $5,000 of
organizational costs such as legal services and fees paid to the state for incorporating.
Net Operating Loss (NOL)
In general, California law conforms to the Internal Revenue Code as of January 2005. There are
continuing differences between California and federal law. California does not always adopt all of the
changes made at the federal level.
For more information regarding California and federal law, visit the FTB website at www.ftb.ca.gov and
search for conformity. However, taxpayers with an adjusted gross income of less than $300,000 or with
disaster loss carryovers were not affected by the NOL suspension. Additional information can be found in
FTB Publication 1001.
Nonresident Withholding Issues
A nonresident self-employed taxpayer is subject to required withholdings for California state taxes. The
entities making payments to the self-employed individuals are known as the withholding agents.
Withholding is required when making payments to nonresident independent contractors for services
performed in California.
Withholding agents are required to withhold from all payments or distributions of California source
income made to a nonresident when the payments or distributions are greater than $1,500 for the calendar
year. The only time the withholding agents may not withhold is upon receiving authorization for a waiver
or a reduced withholding rate from the California Franchise Tax Board. The rate at which the withholding
agent is required to withhold is 7 percent of gross payments made to nonresident independent contractors
for services performed in California.
The Common Law Test for Employees
The Employment Development Department (EDD) has created guidelines to determine when a worker is
legally considered an employee. These guidelines should be followed by all contractors and should also be
used by taxpayers who are actually employees and are being treated as independent contractors.
The key to determining whether or not someone is legally an employee is in whether the principal or the
worker has the right to control the manner and means in which the work is done. When it is not clear
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whether the principal (proprietor) has the right of control, the actual working relationship between
principal and worker must be examined.
If one or more of the following conditions exist, there may be an employment relationship:
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The principal has the right to discharge the worker at will and without cause.
The worker is not in a distinct trade or occupation.
In the geographic area and in the occupation, the work is usually done under direction by
employees rather than by independent specialists without supervision.
The work is not highly skilled and specialized.
The worker does not provide the tools, equipment, and place of work.
These services are provided on a repetitive or long-term basis.
The worker is paid based on the time worked or a piece rate.
The work is not separate from the regular work, business, or services provided by the principal.
There is not a written contract showing the intent of the parties to create an independent
relationship.
The nature of the work is such that the worker has little or no meaningful discretion over how to
do the job.
These conditions are based on the determining factors articulated by the California Supreme Court and on
the regulations of the department implementing those factors. The regulations may be found in Title 22,
California Code of Regulations, §4304-1. The conditions in the list here do not substitute for, supersede,
or amend the regulations. They only point out in simple, direct language the issues raised by the
regulations.
Statutory Employees
A statutory employee is defined as an employee by law under specific statutes, whereas most individuals
are determined to be an employee under common law (see Form DE 231). Certain groups of workers have
been specifically covered by the law for unemployment insurance, employment training, tax, and
disability insurance purposes.
California personal income tax withholding is not required if a statutory worker does not meet the
common law tests for an employee, except for statutory employees in the construction industry and
corporate officers who are residents of California or nonresidents performing services in California.
Workers covered under specific statutes include individuals working for an employer in a continuing
relationship as:
 An agent driver or commission driver engaged in distributing meat, vegetable, fruit, bakery
products, beverages (other than milk), or laundry and dry-cleaning services for the principal
 A traveling or city salesman (other than an agent or commission driver) working full time on
behalf of the principal (except for sideline activities on behalf of some other person), taking orders
from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar
establishments for merchandise for resale or supplies to be used for their own business operations
 A homeworker performing work (according to specifications furnished by the person for whom the
services are performed) on materials or goods furnished by that person that are required to be
returned to that person
Services provided by the groups listed above are covered if:
 A substantial amount of the work is personally performed
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 The person performing the work does not have a substantial investment in the facilities used in the
performance of those services (other than the facilities for transportation)
 The services are not in the nature of a single transaction
Independent Contractor Reporting Requirements
If a business is required to file federal Form 1099-MISC for services performed by an independent
contractor, it should follow the reporting requirements for independent contractors.
Food Trucks and Sales Tax
Food truck operators and other mobile food vendors must register with the BOE (Board of Equalization)
and file sales and use tax. If the vendors include sales tax in the price of the menu item, there must be a
notice posted for customers that states, “All prices of taxable items include sales tax.” Sales tax should be
reported at the rate in effect at the location of the sales.
Depreciation and Amortization
Depreciation is the annual deduction allowed to recover the cost or other basis of business or incomeproducing property with a determinable useful life of more than one year (as with federal depreciation,
land is not depreciable). Amortization is an amount deducted to recover the cost of certain capital
expenses over a fixed period.
In general, California law conforms to the Internal Revenue Code as of January 2010; however, there are
continuing differences between California and federal law. When California conforms to federal law
changes, California law does not always adopt all of the changes made at the federal level.
For more information regarding California and federal law, visit the FTB website and search for the term
conformity. Additional information can be found in FTB Publication 1001, Supplemental Guidelines to
California Adjustments; the instructions for Schedule CA (540 or 540NR); and the Business Entity tax
booklets.
Section 179 Expense Deduction
Federal law allows an expense election up to $500,000 of the cost of certain business property in lieu of
depreciation. California allows an expense election up to $25,000 and the California phase out begins at
$200,000. The federal section 179 property cost phase out begins at $2,000,000. For qualified section 179
Gulf Opportunity Zone property, the maximum deduction is higher than the deduction for most section
179 property.
Federal law allows a section 179 expense election for off-the-shelf software and certain qualified real
property. California does not conform. To report the deduction difference, use Form 3885A.
Depreciation and Amortization Adjustments
Use Form 3885A to figure the adjustment for the difference between the amount of depreciation and
amortization allowed as a deduction using the California law. Carry the difference to Part I of California
Schedule CA (540 or 540NR).
Do not use Form 3885A to report depreciation expense from federal Form 2106, Employee Business
Expenses.
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ACRS or MACRS Depreciation
California has not adopted the federal depreciation methods known as accelerated cost recovery system
(ACRS) and modified accelerated cost recovery system (MACRS). If those systems are used for federal
purposes, state adjustments are required to adjust depreciation to the amount allowable under California
law. To figure the adjustments use Form 3885A, which is then used on Schedule CA (540 or 540NR).
The specific rules for both ACRS and MACRS should be researched if additional information is
necessary.
Accrual Basis Rule
The taxpayer should be aware when moving in or out of California to apply the accrual basis rule. The
taxpayer needs to know what the basis (when using the accrual method) is of any and all assets, inventory,
and incoming and outgoing cash for the period in which the taxpayer was a resident of California.
California Nonconformity to Depreciation
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Bonus depreciation
Fifteen-year federal depreciation on qualified restaurant property (for California use 39 years)
Fifteen-year federal life for leasehold improvements (for California the life remains 39 years)
Fifteen-year federal depreciation for qualified retail property (for California use 39 years)
Accelerated depreciation for qualified disaster assistance property, including nonresidential real or
residential rental property in a federal disaster area
IRC section 167(g)(5)(E), which provides that distribution costs are not included when computing
the income forecast method
Inclusion of participations and residuals in the adjusted basis when computing depreciation under
the income forecast method of depreciation
Election to expenses up to $15 million per production of qualifying film and television production
expenditures
California limits for IRC section 179 expense and the threshold limit for the phase-out of the
deduction are different
Numerous historical differences that might affect current-year depreciation or basis
IRC section 168(j), which provides for reduced recovery periods for “qualified Indian reservation
property”
Señor 1040 Says: When the taxpayer has depreciation differences,
make sure that the differences are tracked. If the taxpayer has a large
subtraction from income on 540 Schedule CA, the taxpayer could get a
letter from the FTB questioning the difference.
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Chapter 5: Capital Gains and Losses
Objectives
At the end of this lesson, the student will have an understanding of:
 How basis is different between the federal and California
 How California treats the sale of a taxpayer’s primary residence
 The withholding rate for sales of real property
Resources
FTB Form 3805-E
FTB Form 593-I
FTB Form 593-B
FTB 593-E Booklet
FTB Publication 1016
FTB Publication 1004
FTB Publication 1017
Instructions Form 593-I
Instructions Form 593-C
Instructions Form 3805E
Schedule D (540 or 540NR)
Capital Gains or Losses
With regard to capital gains and losses, California law complies with federal law and no adjustments are
needed. If the California basis of the taxpayer’s assets differs from the federal, adjustments would be
required.
Complete California Schedule D, California Gain or Loss Adjustment, and carry the difference to Part I of
the California Schedule CA (540 or 540NR).
Capital gains rates are the same for California and federal law. The amount of capital loss limitation for
California taxpayers is the same as the federal limitation.
Sale or Exchange of Personal Residence
For sale or exchanges after May 6, 1997, federal law allows an exclusion of gain on the sale of a personal
residence in the amount of $250,000 or $500,000 if married filing jointly. The taxpayer must have owned
and occupied the residence as a personal residence for at least two of the last five years before the sale.
California conforms to this provision. California taxpayers who served in the Peace Corps during the fiveyear period ending on the date of the sale may reduce the two-year period by the period of service, not to
exceed 18 months.
If there is a difference between the amounts excluded (or depreciated, if recapture applies) for federal and
state purposes, complete California Schedule D (540 or 540NR). Transfer the amount from California
Schedule D to Schedule CA (540 or 540NR).
Installment Sales
When a taxpayer reports sales under the installment method, gains are reported in periods subsequent to
the year of sale. In contrast, because the apportionment factors are intended to reflect the activities that
give rise to income, the entire gross receipts from installment sales are included in the sales factor in the
year of sale. In the subsequent periods when the gains from the installment sales are recognized, those
gains are apportioned using the factors from the year of sale. The taxpayer should use form FTB 3805-E
to report an installment sale.
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The taxpayer must allow for withholding on an installment sale in the amount of 1.33 percent of the total
sales price when escrow closes unless the buyer agrees to withhold 3.33 percent of each installment
principal payment. The buyer must file this form to the escrow company. The escrow company will
withhold 3.33 percent of the down payment and attach Form 593-I to Form 593-B when the withholding
on the down payment is sent to the FTB.
Withholding on Resident and Nonresident Sales of Real Property
The following FAQs are found in FTB Publication 1016.
1. What are the steps in the withholding process?
The steps are:
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The nonresident sells the California property.
Tax is withheld by the buyer on the sale and remitted to the Franchise Tax Board (FTB).
The nonresident seller files a California tax return claiming credit for the withholding.
If withholding exceeds the actual tax liability, FTB refunds the overpayment to the nonresident
seller. If withholding is less than the actual tax liability, additional tax is due.
2. Who is required to withhold tax on sales of California real estate by a nonresident seller?
Revenue and Taxation Code Section 18662 requires the buyer (transferee) to withhold the tax on the sale
of the property.
3. What is real estate withholding?
Real estate withholding is a prepayment of California state income tax for sellers of California real
property.
4. What is the withholding rate?
The withholding rate for the property is 3.33 percent of the total sale price, or an optional gain on sale
withholding based on the maximum tax rate on the gain on sale as follows:
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9.3 percent for individuals
8.84 percent for corporations
10.84 percent for banks and financial corporations
1.5 percent for S corporations
3.5 percent for financial S corporations
5. When is withholding required?
Withholding is required on sales or transfers of California real property when the total sale price exceeds
$100,000 and meets one of the following conditions:
 The seller is a corporation with no permanent place of business in California immediately after the
sale.
 The seller is an individual or any other type of entity except for a partnership.
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6. When is withholding not required?
Withholding is not required when any of the following are true:
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The total sale price does not exceed $100,000.
The seller is a bank acting as a fiduciary for a trust.
The property is being foreclosed upon.
The seller meets a full exemption on FTB Form 593-C.
7. What is a buyer?
A buyer is the transferee of the property.
8. What is a seller?
A seller is the transferor of the property.
9. Can sellers whose withholding payment is more than their tax liability receive an early refund from
FTB?
No, the taxpayer needs to file his or her state tax return to claim the amount withheld.
10. Is real estate withholding an additional tax on the sale of California real property?
No, real estate withholding is not an additional tax on the sale of real estate. It is a prepayment of the
income (or franchise) tax due on the gain from the sale of California real property.
11. Does withholding relieve sellers from the requirement to file California tax returns?
No, sellers must file California tax returns if they meet the filing requirements. If withholding is more than
the actual tax liability, FTB will refund the overpayment. If withholding is less than the actual tax liability,
additional tax will be due.
12. If sellers are exempt from withholding, are they still required to file California tax returns?
Yes, sellers must file California tax returns if they meet the filing requirements.
For more FAQs, see FTB Publication 1016 and 1017.
Real Estate Foreclosures and Short Sale Transactions
Withholding is required for real estate foreclosures and short-sale transactions unless any exemptions
certified on Form 593-C apply or the sale qualifies for one of the following exclusions:
 The total sale price is $100,000 or less
 The seller is a bank acting as a trustee, other than a trustee of a deed of trust
 The buyer is acquiring the property as part of a foreclosure
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In the case of a foreclosure, the buyer must be acquiring the property under one of the following
conditions for the seller to be excluded from withholding:
 A power of sale required under a mortgage or deed of trust
 A decree requiring foreclosure
 A deed in lieu of foreclosure
Withholding Rates
California requires a withholding of 3.33 percent of the total sales price on all real estate transactions. The
taxpayer may elect to withhold on the gain of the sale and apply the following rates:





12.3 percent for individuals and non-California partnerships
8.84 percent for corporations
10.84 percent for banks and financial corporations
13.8 percent for S corporations
15.8 percent for financial S corporations
Certain sellers may be exempt from the withholding. For more information, see Form 593-C and 593-E
Booklet.
Undistributed Capital Gains for Regulated Investment Company (RIC) Shareholders
Federal law requires certain undistributed capital gains reported on federal Form 2439 to be included in
the gross income of the mutual fund shareholder and allows a tax credit for the capital gains tax paid by
the RIC. California does not have a similar provision. Do not enter the amount of undistributed capital
gains on California Schedule D (540 or 540NR). California taxes the undistributed capital gain from a
RIC in the year distributed rather than in the year earned.
Inherited Property
Capital gain or loss on inherited property prior to January 1, 1987, may have depreciation differences. For
property that was inherited on or after January 1, 1987, the depreciation will be the same. Report the
amount of California capital gains and losses on California Schedule D (540 or 540NR).
Resident of California on Date of Stock Sale Qualifying or Disqualifying Disposition
If the taxpayer exercises an option under an employee stock purchase plan while a nonresident and later
sells the stock in a qualifying or disqualifying disposition while a California resident, the ordinary income
and capital gain are taxable by California.
For more information, see FTB Publication 1004.
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Qualified Stock Options
California Revenue and Taxation Code (R&TC) section 17502 states that a stock option specifically
designated as California qualified will receive the favorable tax treatment applicable to incentive stock
options and employee stock purchase plans. In order to receive this treatment, the following conditions
must be met:
1. The option was issued after January 1, 1997, and before January 1, 2002.
2. The earned income of the employee to whom the option was issued did not exceed $40,000 in
the tax year in which the option was issued.
3. The number of shares of stock granted under the option does not exceed 1,000 and the value of
the shares does not exceed $100,000.
4. The employee must be employed by the company at the time the option was granted or must
have been employed within three months (one year if permanently disabled) of the date the
option was granted.
If the provisions of R&TC section 17502 are met, federal law treats a California qualified stock option as
a nonstatutory stock option. The taxpayer should make an adjustment to his or her federal adjusted gross
income for the California qualified stock option wage income included on his or her federal return. Make
the adjustment on one of the following schedules:
 Schedule CA (540), California Adjustments—Residents
 Schedule CA (540NR), California Adjustments—Nonresidents or Part-Year Residents
In the year the taxpayer sells the stock, he or she should report any capital gain or loss differences on
California Schedule D, California Capital Gain or Loss Adjustment.
If the provisions of R&TC section 17502 are not met, the stock option is treated as a nonstatutory stock
option.
Exclusion of Deferral and Gain on the Sale of Qualified Small Business Stock
Federal code allows deferral and exclusion under IRC section 1045 and IRC section 1202 of 100 percent
of the gain on the sale of qualifying small business stock originally issued after August 10, 1993, that was
held for more than five years. California does not conform. To report the exclusion deferral from the
federal return, use California Schedule D (540 or 540NR).
Summary
The reduction of a previously reported capital gain is a capital loss and subject to the same limitations as
other capital losses. California law generally follows federal law with respect to basis. To report sales or
exchanges of property other than capital assets, including the sale or exchange used in a trade or business
and involuntary conversions (other than casualties and thefts), it would be reported on California Schedule
D-1, Sales of Business Property. California does not have a special capital gain tax rate. California basis
may be different from the federal return, based on the differences in the federal and state law, which will
affect the gain or loss on a disposition.
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Chapter 6: IRA, Pension, Annuity, and Social Security Distributions
Objectives
At the end of this lesson, the student will have an understanding of:
 The differences between federal and California pension taxation
 How to handle lump-sum distributions
 Treatment of early distributions
Resources
FTB Form 3805P
Schedule G-1
Publication 1001
Publication 1005
Publication 1004
Instructions Form 3805P
Instructions Schedule G-1
Introduction
California conforms to certain provisions of the Internal Revenue Code related to pension plans and
deferred compensation. Federal law prohibits the states from taxing the retirement income of nonresidents.
If the taxpayer has an IRA basis and was a nonresident in prior years, he or she may need to restate the
California basis. For more information, see Publication 1005.
There are some differences between federal and California law for:
 Social security and railroad retirement benefits
 Retirees using the “three-year rule” whose annuity date was after July 1, 1986, and before January
1, 1987
 Some prior-year IRA deductions
 Health savings accounts
California conforms to federal law in the following:








The “general rule”
The “simplified general rule” sometimes referred to as the “safe harbor method”
IRA rollovers
Roth IRAs
Archer medical savings accounts (MSAs)
Coverdell education savings accounts (ESAs)
Current-year IRA deductions
Lump-sum credit received by federal employees
Social Security and Railroad Retirement Benefits
California does not tax U.S. social security benefits or tier 1 and tier 2 railroad retirement benefits.
Railroad retirement benefits that are paid by individual railroads are taxable in California. The taxable
benefits are reported on Form 1099-R. Federal tax treaties with other countries that treat the individual
country’s social security benefits as nontaxable do not apply in California; the benefits are taxable in
California.
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California Residents Receiving an Out-of-State Pension
California residents are taxed on all income, including income from sources outside California. Therefore,
a pension attributable to services performed outside California but received after the taxpayer became a
California resident is taxable in its entirety by California. See FTB Form 593-I.
Example 1: Jose worked 10 years in Texas, moved to California, and worked an additional 5 years for the
same company. Jose retired in California and began receiving his pension, which is attributable to his
service performed in both California and Texas. The taxable amount of his pension for federal purposes is
$10,000.
Determination: Jose is a full-year resident of California. As a California resident, Jose is taxed on all his
income, regardless of its source. Therefore, the amount taxable for California purposes is $10,000, even
though a portion of the pension is for services he performed in Texas. No adjustment is made on Schedule
CA (540) or Form 540 to exclude any of the pensions from his income.
Example 2: Carmen worked in New York for 20 years. Carmen retired and moved permanently to
California on January 1. While living in California, Carmen begins receiving her pension attributable to
services performed in New York.
Determination: Carmen is a full-year resident of California. As a California resident, she is taxed on all
her income, regardless of its source. Her pension is taxable by California even though the pension has a
New York source. No adjustment is made on Schedule CA (540) to exclude any of the pensions from her
income.
Example 3: In December 2013, Susie retired and moved permanently to California. Prior to her move, she
elected to receive her pension as a lump-sum distribution. Susie’s pension is attributable solely to services
performed in Washington prior to her move. Susie received the lump-sum distribution in February 2014,
after she became a California resident. The taxable amount of the lump-sum distribution for federal
purposes is $80,000.
Determination: Susie is a full-year California resident in 2014. As a California resident, Susie is taxed on
all income, regardless of its source. Although the lump-sum distribution is attributable to services
performed in Washington, the full $80,000 is taxable by California because she was a resident when she
received the distribution.
Example 4: Jacob worked in Georgia for 20 years. Jacob retired and began receiving his monthly pension
on January 1, 2014, while he was still living in Georgia. His pension is $2,000 a month. Because he did
not contribute to the plan, his pension is fully taxable. On May 1, 2014, Jacob moved permanently to
California.
Determination: Jacob is a part-year resident of California. At the time when Jacob is a nonresident, only
his California-source income is taxable by California. When Jacob is a California resident, all of his
income, regardless of its source, is taxable by California. Because Jacob’s pension is attributable to
services he performed in Georgia, his pension has a Georgia source. None of the pension received while
he was a nonresident of California is taxable by California. The pension received during the period that
Jacob is a California resident (May 1 through December 31) is taxable in California. Therefore, $16,000
($2,000 × 8 months) is the taxable portion of the pension to enter on Schedule CA (540NR), line 16b
column E. Do not make an adjustment on Schedule CA (540NR), column B, to exclude any portion of the
Georgia pension from total income.
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Example 5: Daniel is a California resident receiving his military pension. He served 20 years in the
military. Daniel was never stationed in California during his military career. Daniel’s military pension
included in his federal AGI is $30,000.
Determination: Daniel’s military pension of $30,000 is taxable by California even though his pension
does not have a California source. As a California resident, Daniel is taxed on income from all sources.
Military Pension
If the taxpayer is a California resident, the military pension is taxable by California, regardless of where
the service was performed.
Nonresidents of California Receiving a California Pension
California does not impose tax on retirement income received by a nonresident after December 31, 1995.
For this purpose, retirement income means income from any of the following:











A qualified plan described in Internal Revenue Code (IRC) section 401
A qualified annuity plan described in IRC section 403(a)
A tax-sheltered annuity described in IRC section 403(b)
A governmental plan described in IRC section 414(d)
A deferred-compensation plan maintained by a state or local government or an exempt
organization, described in IRC section 457
An individual retirement arrangement described in IRC section 7701(a)(37), including Roth IRA
and SIMPLE
A simplified employee pension described in IRC section 408(k)
A trust described in IRC 501(c)(18)
A military pension, even if the military service was performed in California
A private deferred-compensation plan, program, or arrangement described in IRC section
3121(v)(2)(c) if the income is:
o Part of a series of substantially equal periodic payments (not less frequently than annually)
made over the life expectancy of the participant or those of the participant and the designated
beneficiary for a period of not less than 10 years
o A payment received after termination of employment under a plan program or arrangement
maintained solely to provide retirement benefits for employees in excess of the limitations on
contributions or benefits imposed by the IRC
Any retirement or retainer pay received by a member or former member of a uniformed service
computed under Chapter 71 of Title 10, US Code
California Individual Retirement Account Distribution
The method of taxing IRA distributions is generally the same for California and federal purposes. There
may be a significant difference in the taxable amount, depending on when the taxpayer made his or her
contributions. Before 1987, the maximum California IRA contribution allowed was $1,500. Because the
federal allowed a maximum contribution of $5,500 ($6,500 for taxpayers age 50 and over), the California
basis for the IRA could be different. This will cause the amount of the IRA taxable by California to differ
from the federal amount. See Publication 1005 for more information.
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Coverdell Education Savings Account
California conforms to the federal rules regarding contribution limits, income phaseout limits, and the
treatment of distributions. If the taxpayer has a taxable distribution from a Coverdell ESA, use federal
Publication 970 and FTB 3805P instructions for more information.
California Pensions and Annuities
If the taxpayer received a lump-sum distribution from a profit-sharing or retirement plan, the taxpayer
may pay less tax on the distribution if he or she chose the 10-year averaging method. See Form 540 and
Schedule G-1, Tax on Lump-Sum Distributions, for more information.
Pension and Profit-Sharing Plans
While the concept of taxing income from pension and profit-sharing plans is the same under both
California and federal law, there are some significant differences in how the distributions are taxed that
depend on when the contributions that created the distributions were made.
Benefits received from qualified pensions of profit-sharing plans are taxed by both California and federal
only when actually distributed to the recipient. They are usually treated as an annuity for tax purposes.
For pensions that are invested in U.S. government securities or in mutual funds that are invested in U.S.
government securities, the taxpayer may not reduce the taxable portion of his or her pension distribution
by the amount of interest attributable to the U.S. government securities.
Annuities, SEPs, and Nonqualified Plans
California law conforms to federal law. No adjustments are required.
Lump-Sum Distributions
These are treated the same as federal except that California allows tax-free recovery of:
1. Contributions that were not allowed as California deductions
2. Interest on certain retirement bonds
Taxpayers may need to use Schedule G-1 to calculate their distributions.
Premature Distributions
California law conforms to federal law, except that the penalty is 2.5 percent. Use FTB Form 3805P,
Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to figure the
additional tax. California does not conform to the one-time rollover from an IRA to an HSA. The taxpayer
is liable for the 2.5 percent additional tax.
Early Distributions
California taxes early distributions from IRAs, qualified retirement plans, annuities, and modified
endowment contracts at a rate of 2.5 percent rate. SIMPLE plans during the first 2 years, beginning on the
date the taxpayer first began participation, have a tax rate of 6 percent rather than the federal 25 percent
rate. California does not have taxes like the federal on excess contributions, excess accumulations, and
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excess distributions. California conforms to the age 59½ for the early distribution rules. Some of the more
common exceptions are:
 The portion of the distribution that is a return of basis
 Distributions made due to total and permanent disability
 Distributions made as a part of a series of substantially equal payments made for life (or joint
lives) of the taxpayer and designated beneficiary
There are more exceptions that can be found in FTB Publication 1005.
Distributions
There may be differences in the taxable amount of the distribution depending on when the contributions
were made, if the taxpayer changed residency status after he or she first began making contributions to an
IRA, or if she or he made different deductions for California because of differences between California
and federal self-employment income. See FTB Publication 1005 for more information.
Rollovers
California law conforms to federal law regarding the following pension and annuity income:
1.
2.
3.
4.
5.
6.
7.
8.
The general rule
The simplified general rule (sometimes called the safe harbor method)
IRA rollovers
Roth IRAs
Archer medical savings accounts (MSAs)
Coverdell education savings accounts (ESAs)
Current-year IRA deductions
Lump-sum credit received by federal employees
No adjustments are required.
Differences between federal and California law are:
1. Social security and railroad retirement benefits
2. Retirees using the three-year rule whose annuity date was after July 1, 1986, and before January 1,
1987
3. Some prior-year IRA deductions
4. Health savings accounts (HSAs)
Pensions that are invested in U.S. government securities or in mutual funds that invested in U.S.
government securities may not reduce the taxable portion of the taxpayer’s pension distribution by the
amount of interest attributable to the securities. California does not impose tax on retirement income
received by a nonresident after December 31, 1995. This includes military pensions, IRA distributions,
Roth IRA conversions, Roth IRA distributions, SEPs, and Keoghs. For more information, see FTB
Publication 1005.
Health Savings Account
Because California does not conform to federal legislation for HSAs, a contribution to an HSA is not
deductible. Interest and other earnings of an HSA are not tax-deferred and must be included in taxable
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income. A rollover from an MSA to an HSA constitutes distributions and is subject to state income tax
plus the additional 10 percent tax. Any distribution from an IRA to an HSA must be added to AGI on the
tax return and would be subject to an additional 2.5 percent tax since this distribution is considered to be a
premature distribution.
Compensation for Injury or Sickness and Amounts Received Under Accident and Health Plans
California law conforms to federal law. No adjustment is required.
Summary
California treatment of pensions, annuities, and IRAs is generally the same as the federal. There are some
differences between California and the federal law that may cause the amount of the taxpayer’s California
distribution income to be different than the amount reported on the federal return. Always complete the
federal return prior to completing the state return.
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Chapter 7: Rental Real Estate
Objectives
At the end of this lesson, the student will have an understanding of:
 California law regarding substandard rentals
 California conformity to federal passive activity loss
 California depreciation basis different than federal
Resources
Schedule CA (540)
FTB 3801
FTB 3885A
FTB Publication1001
Instructions Schedule CA (540)
Instructions FTB 3801
Rental Property
California does not conform to the federal law that treats certain passive income as nonpassive. The loss
for California purposes must be recalculated on Form FTB 3801.
The two major differences in the law governing rental property in California are:
 In 1994, the federal government decided that rental real estate activities conducted by persons in a
real property business are not automatically treated as passive activities; California did not
conform to this provision in the federal law
 Determining depreciation basis could be different
Form FTB 3885A is used to figure the adjustment for the difference between the amount of depreciation
and amortization allowed as a deduction using California law. Calculate any adjustment for the passive
activity, then carry the difference to Part I of California Schedule CA (540).
Substandard Rental
Under the current law, when the state of California or a local regulatory agency declares California rental
real estate in violation of health, safety, or building codes and the substantial rental housing has not been
brought up to the standard within six months, a notice of noncompliance may be issued to the owner by
the regulatory authority. The same law applies to employee housing in violation of the Employee Housing
Act, but in this case the housing must be brought up to standard within 30 days.
A copy of the notice is also sent to the FTB. The notice of noncompliance includes an explanation of the
tax consequences for an owner deriving income from substandard housing and is recorded with the
appropriate county recorder. The regulatory agency charges the substandard housing owner a fee to
recover the cost of recording and releasing the notice of noncompliance.
Upon receipt of a notice of noncompliance, the FTB must identify the taxpayer. The FTB then audits the
corporate, partnership, fiduciary, or individual income tax return and disallows any deductions for interest,
taxes, depreciation, or amortization that are claimed on the substandard rental property for the period of
noncompliance. If the period of noncompliance is less than a year, the expenses are disallowed on a
prorated basis.
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Passive Activity Losses
In general, California law conforms to the Internal Revenue Code (IRC) as of January 2005. However,
there are continuing differences between California and federal law. When California conforms to federal
tax law changes, they do not always adopt all of the changes made at the federal level. Passive activity
losses are reported on FTB 3801.
The following passive-loss rules in IRC section 469(c)(7) may affect the computation of the corporation’s
passive activity loss and credit limitation:
Beginning in 1994, and for federal purpose only, rental real estate activities of taxpayers
engaged in a real property business are not automatically treated as passive activity.
California did not conform to this provision.
For California purposes, all rental activities are passive activities regardless of the level of participation as
per IRC section 197 on the amortization of certain intangibles:
Property classified as IRC section 197 property under federal law is also IRC section 197
property for California purposes; there is no separate California election required or
allowed. For California purposes, in the case of IRC section 197 properties acquired before
January 1, 1994, the California adjusted basis as of January 1, 1994, must be amortized
over the remaining federal amortization period.
Material Participation in Real Property Business IRC Section 469(c)(7)
Beginning in 1994, and for federal purposes only, rental real estate activities of taxpayers engaged in real
property business are not automatically treated as passive activity. California did not conform to this
provision. For California purposes, all rental activities are passive activities.
Summary
California has conformed to the Internal Revenue Code concerning passive activity loss since
January 1, 2010. California generally conforms to the federal law concerning passive activity loss
limitations. Differences may arise when taxpayers are real estate professionals. Their California passive
activity loss may be different than the federal.
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