California can tax you, even if you never set foot in California

If you live or do business in California, state taxes are a significant part of the overall taxes you pay. Your tax bill with the IRS may be bigger overall, but state taxes are high, up to 14.4% for individuals and 8.84% for businesses set up as corporations. Does that 14.4% rate sound even higher than you remembered? For years, the top rate in the Golden State was 13.3%, but it was hiked by 1.1% to 14.4% starting in January, 2024.

The new 14.4% rate is the result of no limit on California's 1.1% employee payroll tax for State Disability Insurance. It translates to a top 14.4% rate for those earning over $1 million. However, there is a modest tax break for capital gain, so small it seems hard to call it a break. California's 13.3% rate still applies to capital gain, and that very high rate has long been an irritant to California investors. The federal capital gain tax break is much more significant.

The new top 14.4% state rate might stick for years, though in the past, there have been several failed attempts to raise the top tax rate in the Golden State to an astounding 16.8%. Not surprisingly, California is always trying to draw people into its tax net. When you add the state's notoriously aggressive enforcement and collection activities, California rakes in the cash. California's tax system is complex too. Rather than adopt federal tax law wholesale, California's legislators pick and choose, adopting some rules, not others. Often, if a federal rule favors taxpayers, California will not conform.

California's attempts to tax nonresidents often lead to controversies, as evidenced by the well-publicized tax disputes that many people seem to face after they leave the state. But there are other tax traps too, even if you were never a resident. A Form 1099 from a California company can trap a non-California independent contractor in California's sticky tax net. In the Matter of Blair S. Bindley, OTA Case No. 18032402 (May 30, 2019), a nonresident sole proprietor performed all services outside of California.

However, some of his customers were located in California. Is that enough for the poor guy to attract California tax liability? The California taxing authorities said he was operating a "unitary business" that was being conducted in both Arizona and California and was subject to California's apportionment rules. Exactly what was the unfortunate Mr. Bindley's tax offense in California? He is a self-employed screenplay writer living in Arizona.

He performed services for a few companies headquartered and registered in California and collected $40,000 from one. Bindley did not file a California tax return, so California's statute of limitations never even started to run. That itself is a useful lesson. Starting the statute of limitations is a reason that many non-residents of California file a return to report a small amount of California source income. That's a useful lesson too, but what exactly makes a business "unitary" anyway?

California's tough tax regulations only describe what is not a unitary business. California says that a business being conducted in both California and another state is not unitary where the part within the state is so separate and distinct from (and unconnected to) the part outside the state that their respective activities represent separate businesses. Here, the Golden State said that this screenwriter ran a unitary operation, since the part conducted inside California and the part conducted outside the state were not separate and distinct.

If your business is unitary, the income derived from services is sourced to the place where the benefit of the service is received. To determine the place where the benefit of the service is received, California law provides rules looking first to the contract between the taxpayer and the service recipient. If the contract does not specify the location where the benefit is received, then California or the taxpayer can try to approximate the location where the benefit is received. California said it was reasonable to conclude that the companies that paid the screenwriter and were located in California received the benefit of the services within the state.

Does this screenwriter's unfortunate tax flap mean that other businesses that sell into California could face tax troubles? Yes, non-California taxpayers may need to file California returns and pay California taxes. That is so even if all the services are performed outside of California, and even if the business has no connection to California, so long as a beneficiary of the services is located there.

Selling shares or membership interests

Is there any room left to steer clear of California taxes if you are a nonresident? Many people try. Consider sales of interests in companies or LLCs. If you are a resident of Texas and sell your stock in Amazon, you are just taxed by the IRS, since Texas does not have a state income tax. Shares of stock are considered intangible assets that are sourced where you live. But how about a sale by an out-of-state person of an LLC or partnership interest?

It turns out that can trigger a California tax notice. For years, many non-California residents have tried to avoid California tax when selling interests in California businesses and California property. They often preferred selling an interest in an entity that holds California real property or business assets. Selling an interest in an entity seemed better tax-wise than having the entity sell the California assets and distribute the proceeds to the owners. The idea is that the former is a sale of an intangible, sourced to the residence of the seller of the intangible like a stock sale.

The latter, of course, is a sale of California property so it is California source income. If you sell your interest in an S corporation, LLC, or partnership that owns California property, shouldn't that get you the same treatment as selling Amazon stock? Many taxpayers say yes, but California's Franchise Tax Board is not happy with what it perceives as an end run.

In Legal Ruling 2022-02, the FTB found a way to tax a portion of the taxpayer's gain from the sale of a partnership conducting business in California. In The 2009 Metropoulos Family Trust, et al. v. Franchise Tax Bd., 79 Cal.App.5th 245 (2022), the FTB successfully contended that it could issue regulations that essentially displaced a long-standing statutory provision sourcing income from sales of intangibles to the taxpayer's state of residence. As a result, the FTB moved to collect California tax from nonresident shareholders of an S corporation that had sold an intangible asset (goodwill) for $600 million.

There are other cases too. In a precedential decision from the California Office of Tax Appeals, In the Matter of the Appeal of L. Smith, OTA Case No. 20036033 (Dec. 7, 2022), the taxpayer was a California nonresident. He held an indirect membership interest in a holding company that was a partnership for tax purposes. The FTB argued that California taxes applied even to the nonresident owner, and it won here too.

Looking ahead

The FTB has a long history of making novel arguments to extend California taxes to nonresidents. In the past, its efforts were sometimes blocked by the courts, but that appears to be changing. Whether the expansion of California's tax jurisdiction will materially affect investment in California businesses and properties remains to be seen, but the FTB and the California courts are apparently betting that nonresident investors will still pour money into California.

As to sales of businesses or business assets, it is worth drilling down carefully on the structure you have, and considering whether there is a way to restructure the business with a view to any upcoming sale transaction. No one likes an unexpected tax bill several years after a deal closing. That is particularly true if you are a nonresident who assumed (or was told) that they would not have to pay California tax on their gain.

How long are you at risk when it comes to the California Franchise Tax Board? The normal California tax statute of limitations is four years (one year longer than the usual three years the IRS generally has to audit). The four years run from the date you file your California tax return. But if you did not file one because you thought you were not taxable, that statute would never start to run.