States are aggressively expanding their tax bases, and it is becoming a huge area of risk for a lot of businesses. It is important to understand the many variables that go into multistate taxation, and it is important that you have an appropriate and effective plan for dealing with such issues.
Multistate taxes implications are far-reaching and extend into areas of your business operations that you might not even expect. Here are a few examples:
- You start doing increasingly more business in other states
- You start sending your sales force into other states
- You sell a product that needs installation so you need to send your employees or hire independent contractors to do the installations in other states
- You need to conduct training on your product in other states
- You start adding remote employees in other states
Any of these actions may occur in the course of your business operations.
The problem is that as companies start to develop more of an interstate presence, their leaders do not think about the multistate tax consequences that their companies are triggering.
The reality is that business owners and corporate executives need to stop thinking of their companies as only being based in one state, and start looking at themselves as multistate organizations. Such a shift in perspective is important because to the extent that a business creates nexus or establishes minimum contacts in a different state, complicated tax issues will arise.
Take for example what happened to Amazon in 2018. The State of California ruled that if a business is holding inventory through a third-party company in California has a sufficient state sales tax nexus and also likely state income tax nexus.
Suddenly, right in the fourth quarter of 2018, California sent letters to four-and-a-half million Amazon sellers — mostly small businesses — saying, "Hey, you owe us back sales taxes for the last five years." In 2020, the CDTFA had sent notices to out-of-state sellers claiming their income is derived from California. This is in addition to the 2018 sales tax push.
With the state pursuing not only sales tax on inventory in California, but now claiming income tax liability, the situation has gotten precarious for many small business owners.
That is why it is important to seek the advice of a qualified tax professional if you are planning to expand your business into another state or online.
What Triggers a Filing Requirement in California for a Corporation
The extent that out-of-state partners or members of limited liability entities are responsible for California taxes is an issue still with some uncertainty. The most recent precedent is the Swart Enterprises case from 2017. See Swart Enterprises Inc. v. Franchise Tax Bd., 7 Cal. App. 5th 497 (Cal. Ct. App. 2017).
In Swart, the California appellate court found that an Iowa corporation that acquired a 0.2% interest in a California limited liability corporation was not doing business in California for tax purposes based solely on its passive, minority ownership interest in an LLC. The court focused on the passive nature of the ownership specifically as the basis for not doing business in California.
After Swart, the Franchise Tax Board (FTB) took the position that the 0.2% interest was a threshold for doing business in California. This position was challenged in the administrative case of In the Matter of the Appeal of Jali LLC. See In the Matter of the Appeal of Jali LLC, OTA Case No. 18073414 (Cal. Off. Tax App. July 8, 2019). The Office of Tax Appeals (OTA) ruling rejected the FTB’s 0.2% rule, and put the emphasis on the need for the FTB to do a fact-finding review to determine if a nexus exists for the out-of-state taxpayer.
The OTA also took up another case in 2019 with Appeal of Wright Capital Holdings LLC. See Appeal of Wright Capital Holdings LLC, OTA Case No. 18010842 (Cal. Tax App. Aug. 21, 2019).
In this case, the OTA found that the 50% interest alone was sufficient that for the FTB to determine the out-of-state owning entity was conducting business in California. The OTA did not discuss the lack of any active control in the partnership in its decision.
Looking at the present case law and administrative law precedent, it appears that the FTB must do some fact-finding determination and cannot solely rely on passive ownership interest in a California entity alone.
However, a significant amount of ownership will likely also open you up to California taxes. It is important to evaluate your situation and understand where your facts place you. That is why it’s important to have an experienced tax attorney who can help you present your story to the taxing authorities.
When California believes that you or your business owes taxes to the state, you may receive a Demand for Tax Return letter. The letter will demand that the business submit an income tax return or indicate if a return has already been filed either under the business’ current name or a different name.
Attached to the demand letter is the Non-Qualified Business Entity Questionnaire, a form that the state asks those who have already filed a return and those who are unsure if they have a reporting requirement to fill out.
The form presents thirty questions for the recipient to answer in order to determine if taxes may be imposed for their activities. The questions inquire into rented or leased out personal property and real property in the state, services performed that benefited a California business or individual (in and out of the state), advertising in the State, consigned merchandise in the State, and inventory or merchandise held in the State.
The questionnaire also inquires into whether the entity held bank or investment accounts with a California institution, if the entity participated in trade shows in the State, if any contracts were executed in the State and if the entity had any California member, shareholder, officer, partner or representative sign checks on the entity’s behalf.
Other questions presented on the form are targeted at determining whether the entity offers services and warranties, solicits sales or does repair work in the state, among other activities.
The questions are clearly aimed to determine if nexus has been formed between the entity and the State so these are some of the types of activities businesses must be aware of that can trigger a filing requirement.
Residency for Corporations
Though the concepts of residency and domicile are traditionally associated with persons as taxpayers, there is a concept of being a “California corporation” that will impact your tax situation. Importantly, the type of entity you own is a critical factor.
We often see this in the context of businesses trying to relocate from California. It is important to understand how the taxing authorities view your business as a resident of California.
If your business is physically located in California, California will tax you on all of your income, regardless of where your sales may occur.
Nonresidents will pay taxes based on their income deemed earned in California.
For pass-through entities, the owners are taxed on their income generated in California. Dividend income from corporations will be taxed based on the location of the taxpayer, not where operations may have occurred.
It’s important to understand from a business standpoint, that the taxation rules on businesses focus more on the source of the income over the physical location of your business.
Clearly, if you are in California and incorporated here, it will be an easy determination that you are a California company.
But even if you are out-of-state, you will need to focus on what part of your sales comes from California and from which locales in the state.
Depending on the point within the State from which you are doing business, you may have to pay additional district taxes on top of the standard 7.25% sales and use tax imposed at the state level and some locales have more than one district tax.
For example, some locales in Los Angeles County such as Alhambra and Arcadia have a 10.25% tax rate. The local tax rates for the various California locales can be viewed on the CDTFA website.
If you run an out-of-state business that holds inventory in a place that imposes an additional local tax, you will be responsible for remitting that tax so it is not enough to simply be aware of the tax rates at the state level.
Furthermore, if you operate a pass-through entity such as an LLC or partnership but are deemed still a California resident personally, you will still have to pay California taxes as a resident. We have discussed many of these throughout this guide.