Collecting Taxes from Out-of-State Businesses by California's Tax Authority
Out-of-State Businesses Face California Income Tax Despite No Physical Presence
California's Franchise Tax Board (FTB) is taking aggressive positions regarding residency, income allocation, and apportionment, particularly concerning what it means to carry on or conduct a business within California. This assertiveness has led to out-of-state businesses without a physical presence in California being subject to California income tax.
The basis for this taxation lies in the concept of economic nexus. California, like many other states, has established economic nexus standards requiring remote sellers or service providers with substantial revenues or transactions in California to collect and remit taxes, and possibly pay income tax on California-sourced income.
Income from activities conducted in California, such as sales to customers in California, is taxable. Businesses must apportion income reasonably between California and other states based on where activities occur and customers are located. California uses methods like the unitary method and apportionment formulas to tax multistate and multinational corporations fairly.
The apportionment of business income to California by non-residents generally involves a two-step test. The second stage contains rules for how to apportion business income based on the type of business income received. Under the FTB's interpretation, merely having California customers can be sufficient to be considered carrying on a business in California, subjecting the taxpayer's business to California's apportionment rules.
The FTB's interpretation can be debated, as the terms "carrying on" or "conducting" a business "within California" are not defined by statute or regulation. However, the Office of Tax Appeals (OTA) sided with the FTB, stating that there were no authorities limiting the terms for the California's business apportionment rules to the physical location of the taxpayer.
This assertiveness by the FTB was highlighted in the case of In re Bindley, where a self-employed screenwriter working exclusively from Arizona was subject to business income apportionment in connection with screenwriting fee income he received from a California studio.
IRS Forms 1099 sent by California businesses to businesses or individuals outside of California can alert the FTB to potential non-compliance with the rules, triggering an audit. California can tax individuals who have no physical presence in the state but provide services to customers in California.
In conclusion, an out-of-state business with customers in California but no physical presence can have to pay California income tax if its sales or activities create an economic nexus, and part of its income is attributable to California sources under state tax rules. It is crucial for businesses to understand these rules to avoid potential tax liabilities.
- Despite not having a physical presence in California, out-of-state businesses may face income tax Audits from the California Franchise Tax Board (FTB) if their sales or activities create an economic nexus and part of their income is attributed to California sources, a phenomenon that could potentially lead to IRS penalties.
- Given the FTB's interpretation of "carrying on" or "conducting" a business "within California," which is not defined by statute or regulation, it is essential for businesses employing technology to track their sales and activities in California, lest they are mistakenly considered to be within the scope of California's tax apportionment rules, and potentially face tax leins or tax levies.
