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File Protective Claims for Municipal Bond Income Taxable in California

This article is reproduced with permission from Spidell Publishing, Inc.

Marty Dakessian has filed suit in Los Angeles Superior Court on behalf of Robert and Pamela Mass, challenging California’s law that states tax-exempt government bond interest passed through from a mutual fund invested less than 50% in U.S. government obligations or California municipal obligations is taxable for state purposes. The lawsuit means taxpayers who have been paying tax on this income can now file protective refund claims to protect their refund rights if the taxpayers ultimately succeed in this battle.

The California law
Under California Revenue and Taxation Code (R&TC) Section 17145, interest can only be excluded if at least 50% of the assets held by a mutual fund consist of interest-bearing obligations that are tax-free for California purposes. This includes U.S. and California obligations. Thus, if the fund holds less than 50% of these obligations, all distributions are taxable, even though this income is exempt under the U.S. Code and California Constitution. If the fund holds 50% or more in qualifying obligations, the flow-through character of the distributions is retained.

California law requires mutual fund firms and brokerage houses that report interest or dividends from bonds issued by another state that are exempt from federal taxation to file information returns with the California Franchise Tax Board (FTB); so taxpayers who fail to report this income properly will likely receive notices from the FTB.

Filing protective claims
If the taxpayer has paid tax on California-exempt muni bond income, the taxpayer could be entitled to refunds when the dust settles in this case. In order to protect those refund rights, file protective refund claims now.

A refund claim must be made prior to the expiration of the later of:

  • Four years from the date a return was timely filed, including extensions;
  • Four years from the last day prescribed for filing the return, determined without regard to any extensions; or
  • One year from the date of overpayment.

Currently, the FTB has not established any special procedures for accepting these protective refund claims. At this point, the FTB recommends that taxpayers follow the instructions for filing a protective claim on Form 540X, Amended Individual Income Tax Return:

  • Write “PROTECTIVE CLAIM” in red ink at the top of the completed form; and
  • On Part II, Line 5, specify that the claim is being filed in reference to the pending litigation in Ronald & Pamela Mass v. FTB, Los Angeles Superior Court, Case No. BC627648.

These claims will remain on hold until there is a final resolution of the case.

For more information about this article, please contact our tax professionals at or toll free at 844.4WINDES (844.494.6337).
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