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.

Taxing A 5-Hour Energy Drink

 

I am skimming a decision from the Appeals Court for the District of Columbia. I am surprised that it is only 15 pages long, as it involves a gnarly intersection of partnership tax and the taxation of nonresident aliens.

Let’s talk about it.

In general, partnerships are not treated as a taxable entity. A partnership is a reporting entity; it reports income and expenses and then allocates the same to its partners for reporting on their tax returns. Mind you, this can get mind-numbing, as a partner in a partnership can itself be another partnership. Keep this going a few iterations and being a tax professional begins to lose its charm.

A partner will - again, in general - report the income as if the partner received the income directly rather than through the partnership. If it was ordinary income or capital gain to the partnership, it will likewise be ordinary income or capital gain to the partner.

Let’s introduce a nonresident alien partner.

We have another tranche of tax law to wade through.

A nonresident alien is fancy talk for someone who does not live in the United States. That person could still have U.S. income and U.S. tax, though.

How?

Well, through a partnership, for example.

Say the partnership operates exclusively in the United States. A nonresident alien generally pays tax on income received from sources within the United States. Let’s look at one type of income: business income. We will get to nonbusiness income in a moment.

The tax Code wants to know if that business income is “effectively connected” with a U.S. trade or business.

The business income in our example is effectively connected, as the partnership operates exclusively in the United States. One cannot be any more connected than that.

The partnership will issue Schedules K-1 to its partners, including its nonresident alien partner who will file a U.S. nonresident tax return (Form 1040-NR).

Question: Will any nonbusiness income on the K-1 be reportable on the nonresident?

The tax Code separates business and nonbusiness income because they might be taxed differently for nonresidents. Nonbusiness income can go from having 30% withholding at the source (think dividends) to not being taxed at all (think most types of interest income).

What if the Schedule K-1 reports capital gains?

I normally think of capital gains as nonbusiness income.

But they do not have to be.

There is a test:

If the income is derived from assets used or held for use in the conduct of an effectively connected business – and business activities were a material factor in generating the income  – then the income will taxable to a nonresident alien.

Think capital gain from the sale of farm assets. Held for use in farming? Check. Material factor in generating farm income? Check. This capital gain will be taxable to a nonresident.

Forget the K-1. Say that the nonresident alien sold his/her partnership interest altogether.

On first impression, I am not seeing capital gain from the sale of the partnership interest (rather than assets inside the partnership) as meeting the “held for use/material factor” test.

Problem: partnership taxation has something called the “hot asset” rule. The purpose is to disallow capital gains treatment to the extent any gain is attributable to certain no-no assets – that is, the “hot assets.”

An example of a hot asset is inventory.

The Code does not want the partnership to load up on inventory with substantial markup and then have a partner sell his/her partnership interest rather than wait for the partnership to sell the inventory. This would be a flip between ordinary and capital gain income, and the IRS is having none of it.

Question: have you ever had a 5-hour Energy drink?

That is the company we are talking about today.

Indu Rawat was a 29.2% partner in a Michigan partnership which sells 5-hour Energy. She sold her stake in 2008 for $438 million.

I can only wish.

At the time of sale, the company had inventory with a cost of $6.4 million and a sales price of $22.4 million. Her slice of the profit pending in that inventory was $6.5 million.

A hot asset.

The IRS wanted tax on the $6.5 million.

Mind you, Indu Rawat did not sell inventory. She sold a partnership interest in a business that owned inventory. That would be enough to catch you or me, but could the hot asset rule catch a nonresident alien?

The Tax Court agreed with the IRS that the hot asset gain was taxable to her.

That decision was appealed.

The Appeals Court reversed the Tax Court.

The Appeals Court noted that there had to be a taxable gain before the hot asset rule could kick in. The rule recharacterizes – but does not create – capital gain.

This capital gain does not appear to meet the “held for use/material factor test” we talked about above. You can recharacterize all you want, but when you start at zero, the amount recharacterized cannot be more than zero.

Indu Rawat won on Appeal.

By the way, tax law in this area has changed since Rawat’s sale. New law would tax Rawat on her share of effectively connected gain as if the partnership had sold all its assets at fair market value. Congress made a statement, and that statement was “no more.”

Our case this time was  Indu Rawat v Commissioner, No 23-1142 (D.C. Cir. July 23, 2024).

Taxing Foreign Investment In U.S. Real Estate

One of the Ps buzzed me about a dividend item on a year-end brokers’ statement.

P:      “What is a Section 897 gain?”

CTG: It has to do with the sale of real estate. It is extremely unlikely to affect any of our clients.

P:      Why haven’t I ever seen this before?

CTG: Because this is new tax reporting.

We are talking about something called the Foreign Investment in Real Property Tax Act, abbreviated FIRPTA and pronounced FERP-TUH. This thing has been around for decades, and it has nothing to do with most of us. The reporting, however, is new. To power it, you need a nonresident alien – that is, someone who is not a U.S. citizen or resident alien (think green card) – and who owns U.S. real estate. FIRPTA rears its head when that person sells said real estate.

This is specialized stuff.

We had several nonresident alien clients until we decided to exit that area of practice. The rules have reached the point of absurdity – even for a tax practitioner – and the penalties can be brutal. There is an encroaching, if unspoken, presumption in tax law that international assets or activities mean that one is gaming the system. Miss something – a form, a schedule, an extension, an election - and face a $10,000 penalty. The IRS sends this penalty notice automatically; they do not even pretend to have an employee review anything before mailing. The practitioner is the first live person in the chain, He/she now must persuade the IRS of reasonable cause for whatever happened, and that a penalty is not appropriate. The IRS looks at the file - for the first time, mind you - says “No” and demands $10,000.

And that is how a practitioner gets barreled into a time-destroying gyre of appealing the penalty, getting rejected, requesting reconsideration, getting rejected again and likely winding up in Tax Court. Combine that with the bureaucratic rigor mortis of IRSCOVID202020212022, and one can understand withdrawing from that line of work.

Back to Section 897.

The IRS wants its vig at the closing table. The general withholding is 15% of selling price, although there is a way to reduce it to 10% (or even to zero, in special circumstances). You do not want to blow this off, unless you want to assume substitute liability for sending money to the IRS.

The 15% is a deposit. The IRS is hopeful that whoever sold the real estate will file a nonresident U.S. income tax return, report the sale and settle up on taxes. If not, well the IRS keeps the deposit.

You may wonder how this wound up on a year-end brokers’ tax statement. If someone sells real estate, the matter is confined to the seller, buyer and title company, right? Not quite. The real estate might be in a mutual fund, or more likely a REIT. While you are a U.S. citizen, the mutual fund or REIT does not know whether its shareholders are U.S. citizens or resident aliens. It therefore reports tax information using the widest possible net, just in case.