Market-based sourcing for independent contractors November 2019 Tax News

Under the market-based sourcing rules that went into effect January 1, 2013, a nonresident independent contractor's income is sourced to the location where the customer received the "benefit of the services."

If the nonresident performs services from her or his home state, and the benefit is received in California, an independent contractor operating as a sole proprietor will have California source income under California Code of Regulations (CCR), title 18, Section 17951-4(c), when the business is unitary.

Unitary business

The independent contractor who operates as a sole proprietor has a unitary business within and without California when there is an interrelationship between in-state and out-of-state activities.

A business is deemed unitary by satisfying one of two tests to determine whether the activities in and out-of-state are sufficiently interrelated, dependent upon, or contributory to one another. First, under the 3 unities test there must be unity of:

  1. Ownership
  2. Operations in a central manner
  3. The centralized executive operation and systems
    Under the alternative contribution or dependency test, a business is unitary if the operation of the business within California depended upon or contributed to the operation of the business outside of the state.

For example, a nonresident writer who lives in Arizona and contracts to write screenplays for California LLCs is operating a unitary business within and without California as the owner of a sole proprietorship. (Appeal of Blair S. Bindley, 2019-OTA-179P, May 30, 2019.)

Benefit of the service

Once the sole proprietor qualifies as operating a unitary business, the amount of income sourced to California depends upon where the purchaser of the service receives the benefit of it, according to R&TC Section 25136-2(a)(1). Regulation 25136-2(a)(1) provides instructions and examples for determining the location of the benefit of the service.

Corporate or business entity customer

When a corporate or business entity is the customer of an independent contractor, the analysis starts with the first of the cascading rules at Regulation 25136-2(c)(2)(A).

First, under (A): the location shall be where the contract or the taxpayer's books or records indicate the benefit of the services occurs. (CCR 25136-2(c)(2)(A). If the benefit cannot be ascertained, or if the presumption of where the benefit is received can be overcome by the taxpayer or the FTB, proceed to (B).

Under (B): the location where the benefit is received shall be reasonably approximated. If the benefit cannot be reasonably approximated or determined under (A), then the analysis proceeds to (C).

Under (C): the location where the benefit of the service is received shall be presumed to be in California, if the location from which the taxpayer's customer placed the order for the service is in California. However, if the location cannot be determined under (A), (B), or (C), then the analysis proceeds to (D).

Under (D): the benefit of the service shall be in California if the billing address of the taxpayer's customer is in this state.

For example, a nonresident independent contractor graphics and web designer contracts with a California hospital with multiple facilities throughout the state. His contract is to redesign the internal corporate communications for the administrators and medical staff located in California so he would have California source income to report. More examples of scenarios can be found at CCR 25136-2(c)(2)(E).

Location of customer's customer

The current version of Regulation 25136-2 focuses on the taxpayer's direct customer's location as the location of the benefit and does not include a look-through provision for establishing the benefit of the service at the location of the customer's customer.

Revision of Regulation 25136-2

Amendments to Regulation 25136-2 have been proposed, but the governing regulation remains the current version until any amendments are finally adopted. Go to our Regulatory activity webpage for more information on the proposed regulations.