Does My Business Owe California Tax?

Assume you operate a business as a tax professional in Las Vegas. Or Des Moines. Or Albany. Or anywhere outside of California. You’ve been in business for years, and don’t solicit new clients (other than having a website). Your only trips to California are to visit family members (nothing to do with your business). You do have clients in California, but you prepare all the tax returns in your office. Do you owe California tax?

In the view of the Franchise Tax Board (California’s income tax agency), you likely do. And in a ruling earlier this year, the Office of Tax Appeals upheld the Franchise Tax Board. In that case, a screenwriter who resided in Arizona was ruled to owe California tax because he was paid by California LLCs.

Here, appellant received income for his services as a self-employed screenwriter from Mindbender and Lakeshow, which are both California LLCs. Appellant was a resident of Arizona where he performed his services as a self-employed screenwriter. He also received $40,000 of gross income from his services as a self-employed screenwriter from California customers. Consequently, appellant’s trade or business as a self-employed screenwriter was carried on within and without the state. We find appellant was carrying on a business within and without California.

And using California’s approach, since he was conducting part of his business in California, he owes tax on the sale to Californians:

In sum, pursuant to the provisions of the UDITPA relating to the sale of servicesand the regulations thereunder, appellant’s physical presence does not determine whether he had income derived from California, but rather it is determined by where the benefits of appellant’s services were received.

Based on this decision, my business owes California tax based on having clients who happen to reside in California. However, I strongly suspect this ruling is wrong under federal constitutional precedents (which weren’t raised in the appeal noted above).

In order for a state to tax someone, there must be a minimum level of contacts with the state. See Shaffer v. Heitner, 433 U.S. 186 (1977) and International Shoe Co. v. Washington, 326 U.S. 310 (1945). The FTB and the Office of Tax Appeals believe that simply providing services to California entities even if all work is done outside the state brings sufficient contact to California. It’s possible that is true for a screenwriter (he could have solicited within California, so it’s theoretically possible he has such contacts), but it’s not true for my business (I don’t solicit within California), and I haven’t conducted business within the state since 2011 (when I moved to Nevada).

Consider if you’re a tax professional working in your office in Boston. Someone comes in from off-the-street to have you prepare their return. He or she happens to be from Los Angeles, so you prepare their straightforward return (let’s assume it only has a W-2 and a few investment 1099s), charge the customer $x (let’s assume it’s a relatively small amount, say $300). You may now owe $800 to California because your business entity is considered to be conducting business in the state. That doesn’t sound very reasonable to me–and it’s hard for me to envision any sort of “minimum contacts” with California coming from an unsolicited client who happens to walk into your office.

I strongly suspect that some case like this is headed to federal court (and possibly the US Supreme Court). This sure appears to me yet another example of California overreaching and thinking everyone owes tax to the Bronze Golden State.

Hat Tip: Robert Wood

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