Paying Tax Without Setting Foot In California

 

I expect that many tax practitioners would consider state taxes to be a bane in their professional practice. I – unsolicited and without trying – have known more than a few.

Let’s limit our discussion to state income tax.

Mind you, we are not discussing the right of a state to tax. I practice within a Tristate area (Indiana, Kentucky and Ohio) and all three states impose business and personal income taxes. Yes, it can get messy. Take bonus depreciation, for example. This is a federal tax provision allowing the accelerated deduction of equipment and similar asset purchases. Some states will follow along with the federal treatment, others will ignore it completely, and yet others will have some odd hybrid. Take a relatively simple business return with activities across multiple states, and depreciation alone can raise the difficulty level of the return.

Mind you, some states are user-friendly with their tax laws (at least, as much as possible), but some states do not even pretend to be.

I am going to crimp from a notorious California tax case, changing the underlying taxpayer just a smidge to someone you will recognize.

Let’s take a partially retired Cincinnati tax CPA. He has several California clients, both business and personal. He consults, prepares returns and assists with tax agency correspondence and issues.  He of course invoices for his work, and some of those California clients issue him a Form 1099 to memorialize the payment. Critically, he never sets foot in California, and he has not for decades.

Does our Cincinnati tax CPA need to file a California income tax return?

Let’s walk through this.

The California Franchise Tax Board (FTB) annually matches 1099s to filed returns to identify individuals who may not have filed required California returns. The FTB saw those California-origin 1099s and contacted our valiant protagonist, who explained that he did not live in California, had not been in California in years, and – given its current deterioration – had no intention to ever visit California for any reason.

The FTB rejected his explanation, explaining that he had performed services for California businesses and thus had California-source income. The FTB sent a Proposed Assessment for tax, penalty and interest.

Our scrappy hero protested the assessment.

The Office of Tax Appeals (a/k/a Vought) decided as follows:

California imposes a tax on the taxable income of every nonresident, broadly defined as “gross income and deductions derived from sources within this state.”

There is no dispute that appellant, as owner of a sole proprietorship … conducted his … business as a sole proprietor.”

Regulation 17951-4 does not define the term ‘unitary business,’ but the definition can be inferred from Regulation 17951-4(b) … applying to a nonresident’s business, trade or profession … conducted partly within and partly without the state, where the part conducted within the state and the part conducted without the state are not so separate and distinct from and unconnected to each other to be separate businesses, trades or professions.”

Here, appellant … conducted a one-service business …. Therefore, we find that appellant was conducting a unitary business.”

What is the point of all this gum flapping?

California wants to apportion the California invoices to California. They do not even care if you were ever there.

Under the statutory grant of authority of R&TC section 25136(b), the FTB promulgated Regulation 25136-2, which provides detailed market-based sales factor sourcing provisions that implement and interpret R&TC section 25136.”

Pray tell, oh Oracle. How shall R&TC section 25136 be interpreted?

Regulation 25136-2(c) states that sales from services are assigned to [California] to the extent the customer of the taxpayer receives the benefit of the service in [California].”

Here is the wrap:

       

I do not mean to distract the lofty legal minds at the big-building-with-marble columns, but don’t you have to start with more-than-one if you are uniting down to one? Is there a trick-of-the-language thing happening here? Asking for a friend.

The case we are discussing (with some literary license) is Appeal of Bindley (CA OTA, May 30, 2019, No. 18032402).

What got me thinking about Bindley is the (very) recent case of Xavier Garcia-Rojas v FTB, A172054, CA Ct of Appeal, First Appellate District, Division Three, 5/1/26.

Garcia-Rojas was a radiologist from Texas. He read images from around the nation, some of which came from California. The FTB wanted its pound of flesh, relying on Appeal of Bindley above.

This is, BTW, how bad tax law metastasizes. The first court misses the pitch altogether, and the next court just piggybacks.

The Court fortunately recognized the issue:

Here is the decision:

Bindley held that a “self-employed screenplay writer” in Arizona was a unitary business, and thus could be taxed under regulation 17951-4(c). (Bindley, at pp. 1, 4–5.) But in doing so, it focused on the tests to determine whether two different businesses are unitary. (Bindley, at pp. 4–5.) It ignored that there must be separate business activities to unite. (Ibid.; Bunzl Distribution USA, Inc. v. Franchise Tax Bd., supra, 27 Cal.App.5th at p. 991.) The Board also relies on regulation 25120, subdivision (b), but that regulation states it applies only if there are “two or more businesses of a single taxpayer.” Thus, the Board failed to show that Garcia-Rojas is a unitary business as a matter of law.

It took it a while but they eventually got it right. This did not help Bindley, however, who was robbed on an issue a second-year accounting student could spot.

This seems to be an awful lot of work just to determine if our winsome-CPA-hero-of-the-story needs to file a nonresident California tax return. It is also why many CPAs consider state tax to be the bane of their practice.

Should I Have A Separate Bank Account For …?

One of the accountants recently told me that a client had asked whether he/she should set-up a separate bank account for their business.

The short answer is: yes.

It is not always about taxes. An attorney might recommend that your corporation have annual meetings and written minutes – or that you memorialize in the minutes deferring a bonus for better cash flow.  It may seem silly when the company is just you and your brother. Fast forward to an IRS audit or unexpected litigation and you will realize (likely belatedly) why the recommendation was made.

I am skimming a case where the taxpayer:

·      Had three jobs

·      Was self-employed providing landscaping and janitorial services (Bass & Co)

·      Owned and operated a nonprofit that collected and distributed clothing and school supplies for disadvantaged individuals (Lend-A-Hand).

The fellow is Duncan Bass, and he sounds like an overachiever.

Since 2013, petitioner, Bass & Co …, and Lend-A-Hand have maintained a single bank account….”

That’s different. I cannot readily remember a nonprofit sharing a bank account in this manner. I anticipated that he blew up his 501(c)(3).

Nope. The Court was looking at his self-employment income.

He claimed over $8 thousand in revenues.

He deducted almost $29 thousand in expenses.

Over $19 thousand was for

·      truck expenses

·      payment to Lend-A-Hand for advertising and rental of a storage unit

He handed the Court invoices from a couple of auto repair shops and a receipt from a vehicle emissions test.

Let’s give him the benefit of the doubt. Maybe he was trying to show mileage near the beginning and end of the year, so as to establish total mileage for the year.

Seems to me he next has to show the business portion of the total mileage.

Maybe he could go through his calendar and deposits and reconstruct where he was on certain days. He would still be at the mercy of the Court, as one is to keep these records contemporaneously.  At least he would field an argument, and the Court might give him the benefit of the doubt.

He gave the Court nothing.

His argument was: I reported income; you know I had to drive to the job to earn the income; spot me something.

True enough, but mileage is one of those deductions where you have to provide some documentation. This happened because people for years abused vehicle expenses. To give the IRS more firepower, Congress tightened-up Code Section 274 to require some level of substantiation in order to claim any vehicle expenses.

And then we get to the $9,360 payment to Lend-A-Hand.

Let’s not dwell on the advertising and storage unit thing.

I have a bigger question:

How do you prove that his business paid the nonprofit anything?

Think about it: there is one checking account. Do you write a check on the account and deposit it back in?

It borders on the unbelievable.

And the Tax Court did not believe him.

I am not saying that the Court would have sustained the deduction had he separated the bank accounts. I am saying that he could at least show a check on one account and a deposit to another.  The IRS could still challenge how much “advertising” a small charity could realistically provide.

As it was, he never got past whether money moved in the first place.