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State of California Franchise Tax Board

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Business Income
Where are we Today – Corporations Part II (Example)

In our February 2014 edition, the Big Business article, Business Income Where are we Today – Part 4 Apportioning Corporations, we focused on apportioning corporations and summarized some of the recent changes in California law that may affect your business clients that do business both in California and elsewhere. While we cannot cover all issues, in this article, we will give you an example of an out-of-state corporation and what to consider for purposes of doing business and apportioning income.

Example: The ABC Corporation (ABC) is a Nevada corporation that sells widgets. ABC owns stock (10 percent) in corporation E (E) and is a limited partner (5 percent interest) in XYZ Limited Partnership.[2] ABC has $1,000,000 in property and $150,000 payroll in Nevada, but no property or payroll in California. ABC received all of its requests for widgets by phone, mail, or its website (over the internet) at its office in Nevada. ABC does, however, have employees who come to California who supervise and assist customers’ installation of widgets.

In 2013, ABC reported net income of $500,000 (all business income). ABC shipped via common carrier $350,000 worth of its $5,000,000 in widget sales to California customers.

Corporation E does business wholly within California. ABC acquired and maintained E stock for business purposes, but in 2013 decided (for business purposes) to sell the stock for $200,000 and realized a gain of $100,000.

XYZ Limited Partnership is engaged in qualified “extractive business activities” within and without California (see Revenue and Taxation Code (R&TC) Section 25128(c)(2)). The 2013 California Schedule K-1 from XYZ Limited Partnership reports on line 1, ordinary income in column (d) of $50,000 and $7,500 in column (e) computed using XYZ Partnership average apportionment factor of 15 percent, consisting of equal weighted property, payroll, and sales factor.

Table 2 – C

Partner's distributive share of the partnership's property, payroll, and sales reports:

Factors Total within and outside California Total within California

Property: Beginning

$500,000

$50,000

Property: Ending

$500,000

$50,000

Payroll

$100,000

$15,000

Sales

$150,000

$30,000

Based on the above facts: 1) Does ABC have a filing requirement in California? 2) If so, how is it taxed?

Filing Requirement

Every corporation that is organized in California, registered with the Secretary of State to do business in California, doing business in California or deriving income from California sources (subject to tax in California) has filing requirements in California.

For taxable years beginning on or after January 1, 2011, under R&TC Section 23101, a taxpayer is doing business in California if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California or if any of the following conditions are satisfied:

The taxpayer is organized or commercially domiciled in California.

Sales of the taxpayer in California exceed the lesser of $500,000 [1] or 25 percent of the taxpayer's total sales. Note that economic presence without physical presence is enough to be considered doing business in California as of January 1, 2011.

Real and tangible personal property of the taxpayer in California exceed the lesser of $50,000[1] or 25 percent of the taxpayer's total real and tangible personal property.

The amount paid in California by the taxpayer for compensation exceeds the lesser of $50,000[1] or 25 percent of the total compensation paid by the taxpayer.

For the conditions above, the sales, property, and payroll of the taxpayer include the taxpayer's pro rata or distributive share of pass-through entities. Pass-through entities means a partnership, an LLC treated as a partnership, or an S corporation.

Note: For taxable years beginning on or after January 1, 2013, the applicable amounts for sales, property, and payroll (without regard to percentage of each factor) that constitute doing business are: $518,162; $51,816; and $51,816, respectively.

ABC is Doing Business in California

ABC sends employees to California to supervise and assist in the installation of widgets in the customer's location. Through these employees, ABC is actively engaging in transactions for the purpose of financial or pecuniary gain or profit in California. Furthermore, although ABC's California sales are less than 25 percent of its total sales, ABC's total sales in California are $580,000 which exceeds the 2013 threshold of $518,162.

Doing Business Everywhere California Percent

ABC Sales Factor

     

   Widgets

$5,000,000

$350,000

 

   Stock Sales *

200,000

200,000

 

Subtotal

$5,200,000

$550,000

 
       

Distributive share - XYZ Limited Partnership Sales

150,000

30,000

 

Total Sales

$5,350,000

$580,000

10.84%

       

ABC Property Factor

     

Widgets

$1,000,000

0

 

Distributive share - XYZ Limited Partnership Property

500,000

50,000

 

Total Property

1,500,000

$50,000

3.33%

       

ABC Payroll Factor

 

 

 

Widgets

$150,000

0

 

Distributive share - XYZ Limited Partnership Payroll

100,000

15,000

 

Total Payroll

$250,000

$15,000

6%

ABC has California Source Income

ABC has income from California sources from flow through income from XYZ Limited Partnership. XYZ provided a CA Schedule K-1 which reports $50,000 of ordinary income (column d), of which $7,500 (column e) are from sources within California (computed according to the XYZ's apportionment factor).

The type of tax the ABC will pay depends on whether ABC is “doing business” in California. A corporation that is not doing business in California, but which has net income derived from sources within California, is required to file a tax return and pay the Corporate Income Tax imposed under Chapter 3 (commencing R&TC Section 23501), according to or measured by its net income. A corporation that is “doing business” in California is required to file a return and pay the Corporate Franchise Tax imposed under Part 11, Chapter 2 (commencing with R&TC Section 23101) of the California Revenue and Taxation Code.

ABC is both doing business and has CA source income; therefore, it is subject to the franchise tax on all of its income.

Computation of the Franchise Tax

If a corporation has income from sources both within and without California, it is required to allocate and apportion its income as provided in Chapter 17, Part II of the R&TC. For taxable years beginning on or after January 1, 2013, R&TC Section 25128.7 requires all business income of an apportioning trade or business, other than an apportioning trade or business under R&TC Section 25128(b), to apportion its business income to California using the single-sales factor formula.

When a taxpayer is a partner in a partnership, the portion of distributive share (constituting business and nonbusiness income) that has its source in California, or that is included in the taxpayer's business income, is determined in accordance with California Code of Regulations, title 18, Section 25137-1.

Distributive Share of Partnership Income

Generally, the first step is to look at the income (or loss) and partnership items being distributed to determine which are business or nonbusiness to the partnership. Nonbusiness items are then directly allocated (see R&TC Sections 25123 to 25127). Business income (or loss) of the partnership retains its business character when distributed to the corporate partner so the corporate-partner will report the income (or loss) as business income/loss. How the corporate partner reports its distributive share of partnership business income (or loss) will depend on whether the partnership activities and those of the corporate partner are unitary and therefore a single trade or business or treated as a separate apportioning trade or business of the corporate partner (that is, the corporate partner is considered to have one or two or more apportioning trades or businesses).

The determination of whether the partnership activities and those of the corporate partner are a single trade or business or treated as a separate trade or business of the corporate partner depends on the facts of each case. To determine if the partnership activities and those of the corporate partner are unitary you will need to evaluate the facts and apply the established standards for determining if the businesses are unitary, disregarding the ownership requirement (more than 50 percent).

The flow through item of income is XYZ's ordinary income; therefore it is business income to the partnership and business income to the partner. Given the stated facts that ABC and XYZ Limited Partnership failed the tests for unity, ABC’s distributive share of XYZ Limited Partnership income (loss) and other partnership items will be treated as a separate apportioning trade or business from ABC’s widget business. ABC will report the $7,500 flow through income from the partnership using the California Schedule K-1; in column (e). This is ABC's distributive share of the partnership income of $50,000 apportioned to California using the partnership factors.

ABC's Business Income

ABC's business income consists of the $500,000 net income from the sale of widgets and the $100,000 gain from the sale of Corporation E's stock. The sales factor consists of California gross receipts from the sales of widget (assigned under R&TC Section 25135) and stock sales (assigned under R&TC Section 25136).

Widget Sales

ABC's activities in California go beyond solicitation to sell personal property. Only the solicitation to sell tangible personal property is afforded immunity under Public Law (P.L.) 86-272. As explained in our Publication FTB 1050, Application and Interpretation of P.L. 86-272, the installation or supervision of installation at or after shipment or delivery are not protected activities under P.L. 86-272.[3] Once unprotected activities occur, ABC has no immunity (that is ABC would not be protected from taxation) under P.L. 86-272. As such, the $350,000 of California sales receipts from widget sales are assigned to ABC's California sales factor numerator.

Stock Sales

When determining how much of the receipts from the stock sale are assigned to the California sales factor numerator, there are three items to consider:

  1. The sales factor includes the total sales price rather than only the gain. R&TC Section 25120 defines “Sales” as all gross receipts not allocated, and specifically states amounts realized on the sale or exchange of property shall not be reduced by the basis of the property sold.

  2. Do special rules apply? Regulation Section 25137(c)(1)(A) requires receipts from substantial occasional sales be excluded from the sales factor (numerator and denominator). For this rule to apply the sale must be both substantial and occasional. In this example we do not have sufficient facts to determine if the stock sale would be considered an occasional sale, but we can see that the amount of receipts from the stock sold does not meet the definition provided in the regulation for what is considered "substantial." Excluding the $200,000 in receipts from the stock sale decreases the sales factor denominator 3.73 percent which is less than the minimum decrease of 5 percent. So in this case, this rule would not apply for purposes of excluding the sale from the sales factor determination.

  3.  If the sale is not excluded from the sales factor, is it included in the California sales factor numerator? For taxable years prior to 2011, sales of intangibles are always assigned to the California sales factor numerator according to the income producing activity/cost of performance rules at R&TC Section 25136 and Regulation Section 25136. For taxable years beginning on or after January 1, 2011 and before January 1, 2013, sales of intangibles use the income producing activity/cost of performance rules if there were no single-sales factor election; if there were a single-sales factor election, then market assignment is used (Regulation Section 25136-2).

    For taxable years beginning on or after January 1, 2013, sales of intangibles are assigned to the California sales factor numerator using market assignment. Under Regulation Section 25136-2(d)(1)(A)(1), for sales of shares of stock in a corporation or sale of an ownership interest in a pass-through entity, other than sales of marketable securities, you need to consider when the sale occurred and what type of assets were held by the entity represented by the shares/interest sold. Generally, the Regulation provides that if the corporation or pass-through entity held assets consisting more than 50 percent real and/or tangible personal property, the amount of California sales receipts from the sale of the shares/interest is based on the average of the corporation or pass-through entities' property and payroll factors. If the corporation or pass-through entities' assets consist more than 50 percent intangible property, the amount of California sales receipts would be based on the entity's sales factor. Whether to use current year or prior year's factors depends on when the sale occurred. In this case, since E does business wholly within California, regardless of the date of sale or the asset values, 100 percent of the receipts from the sale ($200,000) is assigned to California.

ABC's California net income and tax is computed as follows:

Income Everywhere California Percent  

ABC

       

Widgets

$5,000,000

$350,000

   

Stock Sales

200,000

200,000

   

Sales Factor

$5,200,000

$550,000

10.57%

 
         

Widget Income

     

$500,000

Capital Gain

     

$100,000

Total Business Income

     

$600,000

Sales Factor

     

10.57%

CA Business Income

     

$63,461

         

ABC's Distributive share of XYZ Limited Partnership income/loss

(Schedule K-1, line 1 column (e))

     

$7,500

Total California Taxable Income

     

$70,961

California Tax ($73,500 x 8.84%)

     

$6,273

Note: If the partnership and a partner are engaged in a single unitary business, the income information shown on the California schedule K-1 in column (e) is not used. Instead, the partner’s distributive share of business income is combined with the partner’s own business income. The combined business income is apportioned using an apportionment formula that consists of an aggregate of the partner’s share of the apportionment factors from the partnership and the partner’s apportionment factors (Regulation Section 25137-1.) The determination of whether a single-sales factor or a three-factor apportionment formula applies to the combined income is made at the partner level.

[2]For purposes of this example ABC fails all tests for unity with corporation E and XYZ Limited Partnership.
[3] There is an exception for de minimis activities. For more information on the de minimis activities, see our Publication FTB 1050.

Back to May 2014 Tax News

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