Business Income: Where Are We Today?
Over the past three years, California made several law changes that may affect your apportioning business clients that do business both in and out of California. Over the next few months, we will publish articles that focus on the changes and the effects for both individual and business entity taxpayers.
By now you are probably aware of the following changes:
- The definition of doing business in California changed. (R&TC Section 23101).
- There is a new definition of “gross receipts.” (R&TC Section 25120).
- You need to follow the new rule for assignment of sales to a state based on the nexus of any member of a unitary group (commonly referred to as the Finnigan rule). (R&TC Section 25135).
- That there are new rules for the assignment of sales of other than tangible personal property (commonly referred to as market rules or market-based rules). (R&TC Section 25136).
- Section 25136 regulations were amended, effective March 27, 2012, to add regulation 25136-2 providing guidance relating to the market-based rules of sales of services and intangible property.
- All trade or business income now must be apportioned to California based on sales (single sales factor), unless the apportioning trade or business predominantly engaged in qualified business activities described in R&TC Section 25128(b).
Also, new rules for the assignment of sales of other than tangible personal property, R&TC Section 25136 market-based rules, are no longer elective, effective for taxable years beginning on or after January 1, 2013 All apportioning trade or businesses must assign sales of other than tangible personal property under the new market-based rules.
Your clients or colleagues may be asking, “What does this mean? How does this work? Where are we today?” While we cannot cover all the questions being raised as a result of these changes, we provided the following information to assist you:
What did not change?
- If the business, trade, or profession is conducted wholly within California the entire net income will be sourced to California, and, unless otherwise provided, is taxable by California.
- If the business, trade or profession is conducted partly within California and elsewhere, you need to determine if the taxpayer has one line of business (unitary) that will then need to allocate and apportion (R&TC Section 25121) or two (or more) separate and distinct lines of business.
- If the business, trade, or profession has two (or more) separate and distinct lines of business, you will need to reconsider Items 1 and 2 again for each line of business.
- When Public Law 86-272 applies, it only protects an out-of-state business from an income-based tax, not California’s minimum franchise tax, annual tax, or the LLC fee.
- You still need to determine if there is business or nonbusiness income, property, and/or compensation.
- Nonbusiness income is allocated (R&TC Section 25123), and is not included in the taxpayer’s apportionment factors sales, property, or payroll. (R&TC Sections 25120, 25129, and 25132) This means nonbusiness income, property, and payroll are not to be considered when applying the new “Doing Business” thresholds.
- There are two tests used to determine if income is business:
- The Transactional test.
- The Functional test.
- Corporations are taxable pursuant to Part 11, Individual, Trust, and Estates, Limited Partnerships. Limited Liability Companies are taxable pursuant to Part 10. Administrative provisions can be found within Part 10.2 of the California Revenue and Taxation Code.
Keep in mind, there are different rules that should be considered based on the type of taxable entity. For example, on a sale of a partnership, an individual taxpayer, taxable under Part 10, will generally source the gain to their state of residence, unless their partnership interest has acquired a business status in California (R&TC Section 17952).
A taxpayer taxable as a corporation may have to pay California taxes on a gain from the sales of a partnership interest even if the taxpayer is a passive investor and the partnership interest was a nonbusiness asset. R&TC Section 25125(d) generally requires the nonbusiness gain or loss from the sale of a partnership interest to be allocated based on the ratio of the partnership’s tangible property in state to everywhere at the time of sale. This rule applies unless more than 50 percent of the value of the partnership’s assets consists of intangibles. If the partnership meets the more than 50- percent test, the gain from the sale will need to be allocated based on the partnership’s sales factor for the year preceding the sale.
When considering how to report the sale of a partnership interest by an S corporation and how to report the flow-through to the shareholders, you may need to source the sale differently for corporation tax purposes than you do for the shareholders. Regulation 17951-4(f) states the source of an S corporation’s items of nonbusiness income for purposes of tax on the S corporation will have no relevance in determining the source of the item for purposes of taxing a nonresident shareholder.
You should also be aware that when it comes to determining the LLC fee, you will need to follow the rules for assigning sales under Sections 25135 (i.e. tangible personal property) and 25136 (i.e. market-based rules for services and intangibles). Regulation 17951-4(c), (d), and (g) rules do not apply,
This change was the result of the Proposition 39.
R&TC Section 25136.1 (new law) provides special sales factor rules for certain cable system operations, but even these taxpayers must use the new market rules.
This includes check-the-box eligible entities that elect to be taxed as a corporation (C or S).
This would include C corporations, S corporations and any “eligible entities” that has made a federal election to be taxed as a corporation or S corporation (see our July Tax News discussion on What is the Difference Between an S Corporation and a Limited Liability Company (LLC)? Part 2 for more information on “eligible entities.”)
Imposed under Section 17942.
See Regulation 17951-4(e).