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.

Tomato Supplier Must Change Accounting Method

 

Let’s talk about when we can deduct something on a tax return.

We are talking about accrual accounting. Cash accounting would be easy: you are not allowed to deduct something until it is paid.

Not surprisingly, there is a Code section for this.

Code § 461 - General rule for taxable year of deduction

            (h) Certain liabilities not incurred before economic performance

(1) In general

 

For purposes of this title, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

We see two key terms: the all-events test and economic performance.

First, a potential deduction must pass the all-events test before it can even think of landing on a tax return.

Second, that potential deduction must next pass a second test – economic performance – before it is allowed as a deduction.

Let’s spend time today on the first hurdle: the all-events test.     

Back to the Code:

            All events test

For purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.

There are two prongs there:

·       The fact  

·       The amount  

Much of the literature in this area concerns economic performance, which is the next test after the above two are met. One might presume that the all- events test is a low bar, and that an expense accrued under GAAP for financial reporting purposes would almost automatically meet the all-events test for tax reporting purposes.

You would be surprised how often this is not true, and tax accounting will not give the same answer as financial reporting accounting.

I was reviewing a case this past week. It comes from the Court of Appeals for the Ninth Circuit, a circuit which includes California.

Morning Star Packing Company and Liberty Packing Company appealed their Tax Court decisions. Both are based in California, and – combined – they supply approximately 40% of the U.S.’s tomato pastes and diced tomatoes. 

Tomato season in California lasts approximately 100 days – from June to September. During this period Morning Star runs its production facilities at maximum capacity 24 hours a day. When the season ends in October, the equipment has been traumatized and needs extensive reconditioning before going into production again. For assorted reasons, Morning Star normally waits near the start of the following season before doing such reconditioning.

Let’s assign dates so we can understand the tax issue.

Say that the frenetic 100-day production activity occurred in 2022.

Morning Star will recondition the equipment before the start of the next production cycle – that is, in 2023.

Reconditioning costs are substantial and can be north of $20 million.

Morning Star deducts the anticipated reconditioning costs to be incurred in 2023 on its 2022 tax return.

What do you think? Can Morning Star clear the all-events test?

Here is the taxpayer:

·       Our customers generally require that the tomato products meet certain quality and sanitary standards. Many customers require independent testing. The facilities are also inspected by the U.S. Department of Agriculture, the Food and Drug Administration and the California Department of Public Health.

·       An obligation to refurbish the equipment is strongly implied by the need to meet governmental regulations.

o   Failure to meet such standards could result in the company being required to pay farmers for spoiled tomatoes and/or paying customers for failure to provide tomato products. Any such payments could be catastrophic to the company.

·       The company has credit agreements with several banks. These agreements include numerous covenants such as the following:

o   Each borrower and its respective Subsidiaries shall (i) maintain all material licenses, Permits, governmental approvals, rights, privileges, and franchises reasonably necessary for the conduct of its business ….

o   Each borrower and its respective Subsidiaries shall … conduct its business activities in compliance with all laws and material contractual obligations applicable ….

o   Each borrower and its respective Subsidiaries shall …keep all property useful and necessary in its business in good working order and condition, ordinary wear and tear excepted….

·       An obligation to refurbish the equipment can be inferred from the “all property useful and necessary in its business in good working order” covenant.

Here is the IRS:

·       The credit agreements do not specifically fix the company’s obligation.

o   The agreements do not specify which laws or regulations must be complied with.

o   The agreements do not specify which property must be kept in good working order.

o   The term “wear and tear” refers to ordinary use; “ordinary” wear and tear is excepted; the agreements therefore do not require the company to refurbish its equipment because it would meet the “ordinary wear and tear” exception.

·       The customer agreements are production specific and do not directly require reconditioning costs. Granted, failure to perform could be financially catastrophic, which implies a high degree of certainty that reconditioning will occur, but a high likelihood is different from a certain obligation.

Both the Tax Court and the Appeals Court agreed with the IRS.

I am divided.

I believe that the IRS is technically correct. There was no explicit obligation, requirement, or guarantee that Morning Star will recondition its facilities before the start of the next season’s production run. I however consider that a false flag. Economic and business reality assures me that it will recondition, because a failure to do so could invite business and financial ruin. Would the USDA or FDA even allow them to start next year’s production run without reconditioning?

Decisions like this unfortunately pull tax practice closer to a wizard’s incantation. The practitioner must be certain to include the magic words, intonating appropriately at proper moments to evoke the intervention of unseen eldritch forces. Fail to include, intone, or evoke correctly and lose the spell – or tax deduction.

Here is Judge Bumatay’s dissent:

The Internal Revenue Service (“IRS”) has a shocking view of taxpayer’s money. According to the IRS’ counsel at oral argument, any disagreement on when a tax payment is due constitutes ‘an interest-free loan from the government' to the taxpayer. That’s completely wrong. Simply, the income of everyday Americans is not government property.”

In fact, Morning Star has used this method since its founding. And the IRS had endorsed this practice – it audited Morning Star in the early 1990s and concluded that this practice was acceptable. But now, after Morning Star’s deductions for years, the IRS changes its mind and demands that Morning Star alter how it recognizes the reconditioning costs.”

Morning Star’s liability was fixed at the end of each season’s production run.”

… the law does not require the taxpayer to prove the fixed obligation to a metaphysical certitude.”

You go, Judge B.

I am not impressed that the IRS previously looked at the accounting method, found it acceptable and now wants to change its mind. That is not the way it works in professional practice, folks. The CPA cannot be reviewing every possible accounting issue de novo every year.

And I am less than impressed that an IRS representative argued that the change was necessary because the government was assuming the risk that the company would not be able to pay its taxes should it encounter a bad harvest or other financial malady.

Seriously? The owners of Morning Star face multiple business dangers every day and the government is “assuming the risk?” We cannot DOGE these people and bureaucracies soon enough.

But then again, Morning Star could have boosted its case with a minor change to its credit agreements. How? Include annual reconditioning as a requirement to retain its credit facility. If Morning Star is going to recondition anyway, making it a requirement might be the magical incantation we need.

Our case this time is Morning Star Packing Company L.P., 9^th Circuit, No. 21-71191.