Proposal to Provide for Automatic Conformity to Federal Legislative Changes to Income Tax Accounting Methods

• Publication year: 2022
• Author: Written by Annette Nellen

PROPOSAL TO PROVIDE FOR AUTOMATIC CONFORMITY TO FEDERAL LEGISLATIVE CHANGES TO INCOME TAX ACCOUNTING METHODS

2020 SACRAMENTO DELEGATION PAPER

Written by Annette Nellen

This proposal was prepared by Annette Nellen, member of the Tax Policy, Practice & Legislation Committee of the California Lawyers Association's Taxation Section.¹ The author thanks reviewers Mark Hoose and Roger Royse for their helpful comments.²

EXECUTIVE SUMMARY

California law should be changed to provide for automatic conformity to accounting method changes enacted by Congress. The accounting method rules deal with when income, deductions and additions to basis items are reflected in taxable income. Thus, these rules generally do not affect a taxpayer's lifetime income. In almost all cases, taxpayers, lawmakers and the Franchise Tax Board will want to follow the federal tax accounting method rules. This is because such conformity prevents the need for taxpayers to keep two sets of records for computing taxable income, prevents the Franchise Tax Board from having to maintain rules that are no longer needed by the Internal Revenue Service, avoids confusion and a greater likelihood of errors for taxpayers, and reduces the need for Franchise Tax Board auditors to have to do additional audit work because of different accounting method rules for federal and California purposes.

The legislation to make this change can specify any areas where conformity will not be automatic, such as for depreciation changes for corporations given that California has its own depreciation rules for these entities. Should there ever be a federal legislative accounting method changes that California lawmakers do not want to conform to, they would need to enact legislation to provide for that change.

Alternatively, California law could be changed to give authority to the Franchise Tax Board to state which

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federal legislative accounting method changes California will conform to. Such actions should be required within a specified time period after the federal law is enacted, such as 90 days. Lawmakers would still have authority to override this action, ideally doing so in a reasonable amount of time so taxpayers can comply and plan accordingly.

The revenue "cost" of this change should be minimal because it deals with timing of income and deductions rather than allowance or disallowance of income or deductions. There should be some cost savings for audits by the Franchise Tax Board and improved simplicity for taxpayers.

DISCUSSION

I. INTRODUCTION A. DEFINITION AND RELEVANCE OF METHOD OF ACCOUNTING

To measure taxable income for income tax purposes, two key sets of rules are needed. First, rules defining income, as well as allowable deductions and exclusions are needed. Second, accounting method rules are needed to explain when income is reported and when deductions are claimed. That is, in what tax year must the taxpayer report items of income and allowable deductions. These timing rules also govern when capitalizable expenditures should be added to the basis of property (for items not currently deductible). Tax rules governing depreciation and amortization are accounting method rules as well. Accounting method rules are also referred to as timing rules.

Timing rules do not affect a taxpayer's lifetime income but only the year when income and deductions are to be reported.³ In contrast, tax rules defining income, exclusions and deductions affect lifetime income. For example, if lawmakers change the rules to deny a deduction for the costs of advertising certain products, taxpayers with this expense will find that their lifetime income increases (due to not being allowed to claim the expense to reduce taxable income). In contrast, if lawmakers change the rules to require taxpayers to report income when earned rather than when received even if received in advance of earning it, lifetime income will not change. Instead, the amount of income reported in a particular tax year will change from what would be the situation before the change in the timing or method rule.⁴

Because changes in accounting methods do not affect a taxpayer's lifetime income, they generally do not affect lifetime tax liabilities. However, changes in...