Ask the Advocate July 2019 Tax News

Market based sourcing

Susan Maples, Taxpayers' Rights Advocate.

Susan Maples, CPA
Taxpayers’ Rights Advocate
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For many of you, I’m sure this summer includes a well-deserved vacation before dealing with those returns that must now be filed by the extended due date. For me and my staff, summer time is when we have the opportunity to either speak or staff a table at some of the larger conferences and seminars many of you attend. One of the things I find most valuable about these events is having the opportunity to meet with you and hear your questions and concerns about filing tax returns and conducting business with the Franchise Tax Board.

One subject that comes up frequently when I’m out talking to tax professionals has to do with the sourcing of income for independent contractors who live and work out of California but may have done some work for a California-based company. If a California nonresident receives income for services from a California company, even if that nonresident never physically worked or lived in California during the tax year, such income may be California-source income taxable by California.

This is based on the January 1, 2013 change in the law and often catches out of state independent contractors and their tax professionals off guard. Effective that date, California law [1] provides that when an independent contractor is engaged in business within and outside of California, that services income is sourced to the location where the independent contractor’s customer received the “benefit of the services.” In many of these cases, FTB finds that the “benefit of the services” was in California.[2]

Nonresidents must file a return if they have any California source income and their income from all sources is more than the filing requirement amounts for residents. Many taxpayers living and working outside of California, but providing a service to a business in California are surprised to learn they may have a filing requirement and owe tax to California despite never having physically worked or lived here.

Your nonresident clients may also benefit by filing, especially if they have had California income tax withheld from their compensation. Under California law, any individual or entity must withhold when making payments of California source income to nonresident individuals, among others.[3]  Withholding is required at a rate of 7% unless the total payments of California source income for the calendar year is $1,500 or less, the income is not subject to withholding, or the payor has filed for a waiver or a request to withhold at a reduced amount.

The underlying rules for income sourcing and nonresident withholding are far more detailed than I could cover in one month’s column. We have helpful information about both of these topics available to you on our website. The important point to remember though is that for your nonresident clients who have California sourced income, it’s much better to file timely if they are required to than to ignore this obligation and possibly be subject to late-filing and late-payment penalties.

[1] Revenue and Taxation Code Section 25136.

[2] Regulations Sections 17951-4 & 25136-2.

[3] Revenue and Taxation Code Section 18662.