Accounting - California 2014 Form 540

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 1 of 13

A tour of the primary forms used in a California individual income tax return.

Introduction

Before you read any further, I encourage you to download copies of Form 540 and

Schedule (CA) 540, along with the instructions. Refer to these as you read.

The biggest single difference between Federal and California tax forms is their starting

point: Federal forms take most of their information from the taxpayer’s records (“list

your dividends here”, “list your total charitable contributions here”). The starting point

for most California tax forms is the Federal tax return. The California form then shows

the Federal/California differences (if any), and then the same tax information but

according to California law.

Although most tax items per Federal law are treated the same under California law, there

are some differences. Note that there are some Federal/California tax differences which

are fairly unusual – those are beyond the scope of this class.

What follows is a section-by-section walk through of the two most frequently used forms

in a California individual tax return. Schedule CA (540) is a reconciliation schedule that

traces each type of income and deduction from a Federal 1040 and then shows the

adjustment amounts to get to those amounts per California tax law. What the schedule

does not show is how or when to adjust – this comes from the instructions and

researching the California law. Form 540 is California’s equivalent to the Federal 1040

but it does not look like a Form 1040: the California Form 540 only summarizes the

taxpayer’s income and deductions, dependents, taxable income, tax liability, tax

payments, and net refund or additional tax due.

When doing a California return, much of the detail we expect to see on a Federal

1040 is actually presented on a Schedule CA (540), not the Form 540 itself. The

Schedule CA (540) feeds information into the Form 540.

Because Schedule CA (540) feeds into Form 540, we discuss CA (540) first. The 2014

tax year of these forms are used.

(continued next page)

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 2 of 13

Schedule CA (540)

Part I – Income Adjustment Schedule

Section A – Income

Column A – Federal Amounts

Look at the snapshot of CA (540) Part I Section A- Income:

Take a minute to browse the row-by-row descriptions for this section – the first thing that

you should notice is that each row is in the same order as page 1 of Federal Form 1040.

Every separate type of income or adjustment for AGI which is shown on a 1040 is

reported here. Using the amounts as they are reported on federal Form 1040 is not a

suggested starting point, it is required. This provides an audit trail for the California

Franchise Tax Board to trace numbers from a taxpayer’s records to the Federal return and

then to the California return. It also makes it easier for you to prepare.

Reading the California forms, instructions, and law, you will notice that California tax

law frequently mentions Federal law “by reference.” This means California law

essentially says “California follows Internal Revenue Code Section 1234 as of January 1,

20XX.” Because California laws often start with Federal tax law, having California tax

returns also start with Federal amounts makes perfect sense.

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 3 of 13

CA (540) Section B – Adjustments to Income

Section B mirrors Lines 23 to 37 of Form 1040 – these are “Deductions FOR Adjusted

Gross Income (‘AGI’)”. Column A reports Federal law AGI adjustments but Columns B

and C report any “adjustments to the adjustments.” Notice in some rows, Columns B or

C (or both) are blacked out, indicating that no adjustment is ever allowed. Line 37 totals

are transferred to Form 540, Page 1.

In other words, preparing Column A of Page 1 of Schedule CA (540) is pretty simple –

you take the appropriate numbers directly from Federal Form 1040. There should be no

exceptions to this (that the instructors are aware of, anyway).

Look at the snapshot of CA (540) Section B below:

CA (540) Sections A and B -- Columns A, B and C

Each row of Section A and Section B is divided into three columns:

 Column A is Federal amounts – these should be the same as what is reported on Form 1040.

 Column B is any subtractions to get from Federal income to California income.

 Column C is any additions to get from Federal to California income.

Notice that the amounts “added to” and “subtracted from” go into separate columns; you

do not “net” your amounts in one column.

Example (for Line 8(a)): Lee receives $5,000 in U.S. Treasury Bill interest income –

which is taxable for Federal law but tax-exempt for California. Lee also receives $3,000

in City of Miami Florida Municipal bond interest – which is tax-exempt for Federal

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 4 of 13

purposes but taxable for California purposes. Lee should put $5,000 in column B and

$3,000 in column – Lee should NOT show a net $2,000 in column B.

Notice that there is no “Column D” on this form that shows the resulting California

income by line. Instead, you calculate totals by column and carry those totals to Form

540.

Federal/California adjustments were previously discussed but they are worth reviewing

here. Common adjustments include:

 U.S. Treasury bond interest – taxable for Federal but exempt for California

 Non-California state, county, or municipal bond interest – tax-exempt for Federal but taxable for California. California only exempts bonds from political

subdivisions (i.e. cities, counties) inside California or from the State of California.

Note: some states exempt bonds from anywhere but others exempt only bonds

from within their state. If you prepare other state returns, you must check on a

state-by-state basis.

 State tax refunds included on a Federal 1040 – a refund is never taxable in California because the state income tax was never deducted on a California return

in the first place.

 Social security payments – completely tax exempt in California.

 Unemployment compensation – completely tax exempt in California.

 My personal favorite – “California Lottery” (the official state run lottery) prizes are tax exempt in California. I think this includes the multi-state gigantic jackpot

if California participates. Other types of gambling income (including winnings

from a casino inside the state [i.e. an Indian tribal casino] is taxable for California.

 A common adjustment for a self employed small business owner is depreciation expense for fixed assets (equipment, furniture, computers, etc).

Some types of business assets are depreciated under slightly longer lives for

California and the Section 179 expense limit is smaller for California than it is for

Federal. The 2014 limit for Section 179 is $500,000 for federal purposes but only

$25,000 for California purposes.

If you have an asset that you can fully expense for Federal purposes but not

California, then the remaining basis is depreciated for California purposes as a

mini-asset. These differences create different depreciation expense amounts for

federal and California, which results in an adjustment on Schedule CA (540) and

a different net business profit on the California return.

This difference is reported as an addition or subtraction to Line 12 (Business

Income) on Schedule CA (540).

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 5 of 13

Here is an example:

John Smith is a self-employed machinist with his own shop with $600,000 of net income

in 2014 before buying the following new asset. In 2014, he purchases a new milling

machine that costs $75,000****. Under Federal law, he can expense up to $500,000 of

purchased fixed assets as a Section 179 depreciation expense (limited to his business

income). Therefore, he can expense the entire $75,000 cost of the machine for Federal

purposes. California has a similar Section 179 depreciation expense option but only

$25,000 per year is allowed (the CA limit has not kept up with the Federal amount

because of CA budget problems).

So, the first two years of this depreciation expense will be as follows:

Year Federal expense California expense* Increase (Decrease)

to CA income

2014 $75,000 $35,000** $40,000

2015 $0 $16,000*** ($16,000)

Notice that in this example, (assuming Smith does not purchase any other depreciable

assets in 2014 and 2015), his California income will be higher than federal income in

2014 but then be lower in future years as the California depreciation expense becomes

larger than the Federal expense. The reason is the depreciation expense allowed.

For federal purposes, the depreciation is reported on federal Form 4562, then onto

Schedule C, then onto Form 1040. For California purposes, the depreciation adjustment

is reported on CA Form 3885A, then the difference goes onto Schedule CA (540), Line

12 - either Column B or Column C (depending on the whether the adjustment increases

or decreases the business income).

*Assumes 5-yr double-declining balance MACRS (see Ch. 7 & Pub 946)

**$25,000 California Sec. 179 exp. + $10,000 ($50,000 asset basis x 20%) = $35,000.

***$50,000 asset basis x 32% = $16,000.

****I don’t know what a milling machine really costs – it’s just an example.

There are other federal/California adjustments to income but most of them are pretty

unusual – it is not practical to discuss them in an introductory level tax class.

The schedule’s instructions provide a useful overview of common adjustments and how

to report them.

(continued next page)

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 6 of 13

CA (540) Part II – Adjustments to Federal Itemized Deductions

Part II is for converting your itemized deductions from federal amounts to California

amounts. Part II is formatted differently from Part I and it is actually simpler. The good

news about most common itemized deductions is that with one big exception (state and

foreign taxes), total federal itemized deductions before any high income limits are usually

the same for California.

On Line 38, add together each of the “category” sub-totals from federal Schedule A (i.e.

total deductible medical costs, total interest, total taxes, etc.). Notice that you do NOT

simply use the Federal Schedule A Line 29 grand total from the bottom of the

Federal Schedule A (this is a common error by students).

The reason that you add together all of the Federal itemized deduction sub-totals before

the Federal limitation of itemized deductions is because California calculates the itemized

deduction limitation differently. In fact, the federal itemized deduction limitation

returned in 2013 after several years of not being part of the law but the California

limitation has always been in force.

In years when federal has an itemized deduction limitation, the federal calculation uses

different dollar amounts and sometimes a different calculation method than for the

California itemized deduction limitation. Don’t blame California for this confusion--- the

California calculation has stayed the same for over twenty years while Congress keeps

changing the federal calculation for political reasons.

Line 39 and 40 calculate the biggest single difference between federal and California

itemized deductions. On Line 39, list any state income taxes (or state sales taxes)

deducted on the federal return, along with any California State Disability Insurance taxes

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 7 of 13

(some California employees have this on their paychecks – it is deductible for federal

purposes) and any foreign taxes which are deducted (rather than claimed as a “foreign tax

credit”).

Notice that real estate property taxes and personal property taxes (i.e. the

deductible part of CA DMV car registrations) which are deducted for Federal

purposes are also deducted for California purposes.

Line 40 is simply your total itemized deductions, less the Line 39 non-deductible taxes.

On Line 41, list any other adjustments to itemized deductions that are necessary. Items

here are unusual but not unheard of. One of the instructors actually used this space on his

return several years ago: there is a federal credit which allows pre-approved first-time

homebuyers to claim up to 15% of their mortgage interest as a tax credit, instead of as an

itemized deduction. In turn, only 85% of the mortgage interest is deducted on the Federal

Schedule A (otherwise, that 15% of the mortgage interest benefits the taxpayer twice).

On the instructor’s California return, that “missing” 15% of mortgage interest was

included on Line 41 as additional mortgage interest for California purposes because

California does not give a similar tax credit. This is an example of the kinds of odd

adjustments that tax preparers should be watchful for.

Lines 43 and 44 are fairly mechanical – taxpayers with a federal AGI exceeding a certain

amount have their total itemized deductions reduced. It is important to remember that

the California itemized deduction limitation for high AGI taxpayers might be

calculated differently than the limitation on federal tax returns. Always do the

California calculation separately – do not just use the federal calculation.

We will have a brief re-visit of the itemized deduction limitation briefly here. It is

actually a pretty “mechanical” calculation and there is a worksheet on page 7 of the

Schedule CA (540) instructions that is useful:

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 8 of 13

1. Start with your “gross” California itemized deductions (i.e. after you have removed the taxes that are only deductible for Federal tax purposes).

2. Check your California filing status and determine if your Federal AGI is above the stated amount (example: for MFJ, it is $352,830 in 2014)

3. Note that these amounts vary by filing status and are adjusted each year for inflation. If the answer is “no”, then your deductions are not limited.

4. Using the California calculated amount, you determine the total for any itemized deductions that are “exempt” from the high-AGI limitation. This

list includes medical costs, investment interest expense, casualty losses,

and deductible gambling expenses. Subtract this amount from your

“gross” California itemized deductions and you now have the total

California itemized deductions which may be reduced due to having a

high AGI. If all of your itemized deductions are “exempt”, then you have

no limitation (note that I have never actually seen this happen but it’s

possible).

5. Multiply the amount you determined in step 3 by 80%. This is the largest amount by which your California itemized deductions can be reduced. In

other words, even if you are Larry Ellison and make hundreds of millions

each year, you still get to claim at least 20% of your itemized deductions.

6. Subtract the stated amount you determined in Step 2 from your Federal AGI and determine the excess amount. For example, if you file MFJ and

your Federal AGI is $500,000, your “excess amount” is $147,170

($500,000 minus $352,830).

7. Multiply the “excess amount” from Step 5 by 6%. This amount is your potential reduction amount. Continuing the example from Step 5, the

reduction amount is $8,830 ($147,170 x 6%).

8. Compare the potential reduction amount from Step 6 with the 80% worst case reduction amount from Step 4. Use the smaller amount and subtract

it from your California itemized deductions which are subject to

limitation. That net amount is what is reported on Line 43 of Schedule

CA (540).

Example: Fred and Wilma file MFJ and have a Federal AGI of $500,000 and “gross”

California itemized deductions of $80,000 (that is, Federal itemized deductions less any

taxes which are not deductible for California). They have a $10,000 net medical expense

deduction from Line 4 of the Federal Schedule A but all of their other itemized

deductions are subject to the limitation. Therefore, their gross California itemized

deductions which may be limited is $70,000. 80% of $70,000 is $56,000 (the “worst case

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 9 of 13

scenario”). Their potential reduction amount is $8,830 (see steps 5 & 6 above for how

this was calculated). The smaller of $8,830 or $56,000 is used to reduce their California

itemized deductions. Thus, their “net” California itemized deductions is $71,170

($80,000 minus $8,830) which goes on Line 43 of Schedule CA (540).

If the taxpayer’s “net” California itemized deductions are smaller than the California

standard deduction, they may claim a standard deduction for California purposes. Notice

that the California standard deductions amounts are different from the Federal amounts.

Is it legal for a taxpayer to itemize deductions on the Federal return and claim a standard

deduction on the California return or the other way around? YES -- the form instructions

discuss how to address this unusual situation. The net deduction amount is then

transferred to Form 540, Page 1, Line 18.

Many students have complained about how confusing this Schedule can be. An example

of a prepared Schedule CA (540) (“John & Mary Smith) is posted in the module for you

to see.

Form 540

As discussed before, Form 540 is very different from Federal Form 1040 in that it does

not list taxable income by category – Schedule CA (540) does that. Instead, the form

starts with Federal AGI and summarizes the various adjustments determined on Schedule

CA (540).

We will walk through Form 540 section-by-section, highlighting differences with the

Federal Form 1040.

Filing Status

Generally speaking, California filing status conforms to Federal rules for filing status.

Prior to the 2013 Supreme Court decision striking down the Defense of Marriage Act, a

same-sex couple could not file a married-filing-jointly tax return for federal purposes but

could do so for California purposes. From 2013 onward, a same-sex couple will be able

file MFJ for federal and California purposes. Note that this issue varies on a state-by-

state basis; if you prepare a state return for another state, different rules may apply.

If you become a tax preparer and encounter this situation with one of your clients, be sure

to check for the most up to date information on this area.

Exemptions – a California tax credit (not a tax deduction)

Generally speaking, California conforms to the Federal rules for qualifying to claim

personal and dependent exemptions. The big Federal/California difference is in how the

actual calculations are performed so that exemptions reduce your final tax liability.

There are two notable differences in how these benefits impact the final tax liability:

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 10 of 13

 Instead of a deduction from taxable income (like Federal), in 2014 the exemption is given as a $108 tax credit per taxpayer and as a $333 per dependent. The final

impact is essentially the same (a reduction in the gross tax liability) but for some

reason, California uses a credit. In other words, the exemption “benefit” is in a

different place in the tax calculation formula.

 In 2014 taxpayers over 65 and/or blind receive an extra $108 tax credit, instead of a larger standard deduction. On the Federal return, the blind and/or over 65

receive a benefit only if they claim a standard deduction. In California, a taxpayer

can itemize deductions and still get these extra tax benefits.

Just like the itemized deductions, these exemption credits are subject to a phase-out for

high AGI taxpayers. The cut-off amount depends on your filing status and it adjusts

every year. For 2014, the cut-off begins at $176,413 for single/married (or RDP) filing

separate, $352,830 for married (or RDP) filing jointly, and $264,623 for Head of

Household (I believe these cut-off amounts are the same as those used for itemized

deductions).

There is a calculation worksheet on Page 9 of the Form 540 instructions – it essentially

reduces the amount of the exemption credits as the taxpayer’s AGI increases. It is a good

idea to try doing a quick self-study of this calculation with sample numbers.

(continued on next page)

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 11 of 13

Page 2

Taxable Income

Lines 12 – 19 are really pretty straightforward because the taxpayer is simply transferring

summary data which is reported on their Form W-2, Federal 1040, and California

Schedule 540 (CA).

Note – the Form 540 and instructions available from the FTB website completely

omits Lines 20 to Line 30, Line 36 to 39, Lines 41 to 42, Lines 49 to 60, Lines 65 to

70, Lines 76 to 90, and Lines 96 to 109. In other words, the form just skips from

Line 19 to Line 31, and so on. A similar format was used last year. There is no

explanation for why these line numbers are missing. The good news is that it is only

the line numbering that seems strange – the “flow” of the form itself is still

presented in a logical fashion.

Tax

Line 31 is where most California taxpayers will report their income tax. If taxable

income is under $100,000, use the tax table – not the tax rate formulas. FTB Form 3800

and 3803 are applicable for taxpayers who include their child’s taxable income on their

return under California equivalent of the “Kiddie Tax.” Consult the form instructions for

more details should this situation arise.

The exemption credits are deducted from the taxpayer’s gross tax liability on Line 32.

Line 34 - Schedule G-1 and Form 5870A taxes are from lump-sum retirement

distributions and distributions from foreign trusts (consult the instructions). Any

discussion of those issues is beyond the scope of an introductory income tax class.

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 12 of 13

Special Credits

Lines 40 to 48 is where you deduct other California tax credits. While some are similar

to credits at the Federal level (adoption costs or dependent care expenses, for example),

there are numerous California only credits. You can view the list of credits on the FTB

website – there are too many to discuss in any detail and many of them target very

specific groups (dependent parents, renter’s credits, and so on).

Page 3

Other Taxes

Like Federal, California has an Alternative Minimum Tax. The good news is that it is

computed in almost the same manner as the Federal AMT (please consult Federal

Chapter 6 in your textbook and modules for a discussion of AMT). The California AMT

is computed on Schedule P (540) and any AMT is reported on Line 61.

We will not do a line-by-line discussion of Schedule P (540) because the California AMT

concept is almost the same as the federal AMT concept.

There is one big difference between the Federal AMT and California AMT:

The “AMTI Exclusion” (Line 17 on Schedule P (540)): California has a special

AMT benefit for small-business owners’ which does NOT exist in the Federal

AMT world. Those with $1 million or less gross receipts from their small

business can exclude their self-employment earnings from the CA AMT

calculation. In other words, having a small business in California will almost

certainly NOT cause you to pay CA AMT. California has a reputation as an

unfriendly place for business, so this is a really nice benefit to small business

owners.

Line 62: Mental Health Services tax: California levies an extra 1% tax on any taxable

incomes greater than $1 million (the first $1 million is not subject to this tax).

On Line 63 you report any other miscellaneous taxes, such as extra taxes on non-

qualified retirement plan distributions, or recaptures of tax credits.

Lines 71 to 73 are for tax withholdings (from a paycheck, certain real estate transactions)

and quarterly tax estimate payments.

Line 74 is for excess SDI/VPDI payments. Basically, a taxpayer should pay SDI tax on

only the first part of their salary each year and after that amount is earned, the employer

stops collecting the tax. What if you change jobs during the year? Your new employer

basically “starts over” as if you haven’t earned anything during the year – you wind up

paying SDI tax twice. These excess payments can be claimed as payments toward your

income taxes or refunded. The Federal 1040 has a similar line for excess social security

ACTG067 Introduction to Federal & California Taxation

California Form 540 and CA (540) – step by step

Foothill College, Los Altos Hills, CA (revised 2/2015) Page 13 of 13

taxes. For 2014, excess SDI payments apply to your CA income tax only if you have

paid more than $1,016.36 in SDI taxes. If this happens, only the amount in excess of

$1,016.36 can be applied to your income taxes. Consult the instructions for how to

calculate this credit.

Page 4

Use Tax and Contributions

Form 540 has a line for “Use Tax” (line 95). Under California law (and in most other

states), if you make a purchase where the seller is “out of state,” no sales tax is collected.

In this case, the purchaser is required to pay “use tax” (which is simply a sales tax when

“sales tax” isn’t collected). Example: Many internet retailers arrange their operations to

be outside major states (like California) for various tax reasons, including not being

required to collect sales tax. Simply put, you are supposed to voluntarily pay use tax

when sales tax isn’t collected and this line is where you pay it. Admittedly, this is

difficult to enforce for now but there have been multi-state projects to simplify sales tax

law that may change this someday (Large online retailers like Amazon.com are starting to

collect sales tax in California now).

On page 4 are “contributions.” Contributions are what they sound like – certain

charitable causes have been favored by the state government with a place on the tax form

where you can donate. Participation is voluntary but you cannot change your mind once

the return is filed – meaning you cannot amend your tax return and take back the

contribution.

Page 5

The remainder of Form 540 is essentially the same as Form 1040 with sections for

amounts owed or refunds due, interest and penalties, direct deposits, and a signature

under penalty of perjury.

Conclusion

In addition to Form 540 and Schedule CA (540), the Franchise Tax Board has many other

tax forms that may be required. For example, Schedule P (540) is for California

Alternative Minimum Tax and is almost identical to federal Form 6251. While we don’t

have the time to cover other California forms, keep in mind that they are either closely

modeled after their Federal equivalent or (like the Schedule CA (540)) they use the

federal tax amounts as a starting point. A good understanding of federal tax forms makes

it fairly easy to understand California (or other state) forms.

CA_540_examples/ACTG067 Sample CA _540_ Smith Schedule CA _540_.pdf