Where California Does Not Follow Federal Tax Law

Federal tax law changed a great deal in 2025. California adopted very little of it. If you own a business here, your federal and California returns start from the same books and end in different places.

That gap matters most in the fourth quarter. A move that cuts your federal tax may do nothing for your California bill, and a few California rules can cost real money if nobody is watching for them. Here are the differences that surprise owners most, and why we keep separate California schedules.

California follows an older federal code

California does not adopt federal tax changes automatically. Its tax code follows the Internal Revenue Code as of a fixed date, and that date moves only when lawmakers move it. A law enacted in October 2025 moved it from January 1, 2015 to January 1, 2025, starting with 2025 tax years. Your 2025 return is the first one under the new date.

The federal tax law signed on July 4, 2025 came after that date, so in general California does not follow it. California also keeps its own versions of many older rules. The result is two sets of numbers that have to be tracked for years: depreciation, gain on a sale, loss carryovers and deferred gains. We keep a California schedule for each one.

Some deductions follow a different clock

The equipment rules are in our year-end checklist. What owners forget is that the difference does not end at year end. An asset written off in full on the federal return is often still being depreciated on the California return years later. When you sell it, the federal and California gains will differ. Real estate investors who use cost segregation studies see the same split.

Research costs work the same way. California never adopted the federal rule that, starting in 2022, made businesses spread domestic research costs over five years, so those costs were generally deductible in California all along. The federal catch-up deductions now being claimed for 2022 through 2024 costs need a California adjustment.

New deductions stop at the state line

The 2025 law created temporary federal deductions for qualified tips and overtime pay, interest on certain new car loans, and taxpayers 65 and older. They run from 2025 through 2028. California has not adopted any of them, and bills to add California tip and overtime deductions stalled in committee in 2026. An employee whose W-2 shows qualified overtime may get a federal deduction and no California one.

Health savings accounts are an older example. California does not recognize them. Contributions are not deductible on the California return, employer contributions are added back to California wages, and interest and gains inside the account are taxed each year.

Investment gains are taxed in full

California taxes capital gains as ordinary income, with no lower rate. It also skips two federal breaks investors count on. There is no California exclusion for qualified small business stock, so a founder who owes no federal tax on a sale can still owe California tax on the entire gain. And California does not allow the federal deferral or exclusion for gains invested in qualified opportunity zone funds.

Exchanges across state lines

A like-kind exchange of real property still defers gain in California. The catch comes when you trade California property for property in another state. You generally must file Form FTB 3840 for the year of the exchange and every year after, until the deferred gain is taxed. When you sell the replacement property, California taxes the deferred California gain, even if you have moved away. Nonresidents who stop filing can receive a proposed assessment for that gain, plus penalties and interest.

Loss and credit limits

For 2024 through 2026, California suspended net operating loss deductions for taxpayers with $1 million or more of business income. The losses are not forfeited; the carryover period is extended. California also caps business credits at $5 million a year, and a 2026 law extended that cap through 2029, with a looser permanent limit after that. Of the two, the loss suspension is the one owners are more likely to run into, but only in a year when business income reaches $1 million. It bites when a loss year is followed by a strong one.

Entity taxes and front-loaded estimates

The federal government does not tax most pass-through entities directly. California does. An LLC owes an $800 annual tax even in a loss year, plus a fee once its California gross receipts reach $250,000, rising to $11,790 at $5 million. The fee is based on receipts, not profit. An S corporation pays the greater of $800 or 1.5 percent of its California net income. A 2026 law cuts the first-year tax to $400 for new LLCs, limited partnerships and LLPs for tax years beginning in 2027 through 2029. The elective pass-through entity tax now runs through 2030.

California's estimated payments are front-loaded: 30 percent of the year's amount is due April 15, 40 percent June 15, nothing in September, and 30 percent January 15. If your adjusted gross income is $1 million or more ($500,000 if married filing separately), last year's tax is not a safe harbor; payments must be based on this year's tax. Taxable income over $1 million also carries an extra 1 percent behavioral health services tax, formerly called the mental health services tax.

What to do before year end

Ask for a California projection alongside the federal one. Bring last year's California return, not just the federal return, so we can see carryovers, depreciation and any deferred gains. If you have exchanged California property for out-of-state property, confirm Form FTB 3840 has been filed every year since. If you have employees with tips or overtime, let them know the new deductions are federal only. Then compare your California payments so far with what the year will produce before the January 15, 2027 payment.

Book a planning call

If you want your federal and California numbers side by side before December 31, book a time with our team at calendly.com/kirkcole/15-minute-meeting.

This article is general information, not tax advice for your situation. Tax rules change, and the right move depends on your facts.