Are you a marketplace facilitator or out-of-state business who has received a tax return demand from the California Franchise Tax Board? If so, read this before you respond. We’ve provided the essential background information you need to formulate a plan prior to your response.
In recent years, a large portion of our practice has been devoted to helping individuals and businesses outside the state to get in compliance and defend themselves from California tax agencies. We have aided hundreds of businesses of all sizes and across industries to deal with this problem.
The most pervasive aspect in our experience is California will be as aggressive as possible in the assessment and collection of taxes. However, we’ve also found that when California takes the position that you owe them money, it doesn’t always mean their position is correct.
A Summary of the Problem
You may be familiar with the Supreme Court’s decision in Wayfair v. South Dakota. Although Wayfair is a case that dealt with South Dakota’s ability to collect sales/use tax from an out-of-state business, the court’s decision reaffirmed a concept called economic nexus.
Economic nexus is the principle that a certain amount of economic activity within a state can trigger enough minimum contacts for that state to be able to assert jurisdiction over a business and subject them to tax.
Although the Wayfair case doesn’t directly discuss the ability of states to subject out-of-state businesses to state income tax, the ultimate ruling in the Wayfair case coupled the refusal of the Supreme Court to address the issue directly, means that the state economic nexus laws on the books are the ones that are in control.
What this translates to is if the FTB makes a tax return demand, you need to file a California tax return, or deal with its administrative process in order to appeal their determination.
Why This Problem Has Gotten Worse
As the state with the largest economy, California was already aggressive towards out-of-state businesses. In fact, California is so zealous about collections that it has permanent district offices set up in New York, Texas and Illinois to serve as regional centers for pursuing out-of-state taxpayers. Expanding the tax base for the state of California has been a priority for quite some time.
Since the outbreak of COVID-19, we’ve noticed an intensification in the aggressive stance of California. The pandemic has caused a significant drop in state revenue, due in large part to decreases in California sales/use, payroll and tourism taxes that it normally collects.
At one point, it was estimated that California was facing a 52-billion-dollar budget shortfall. As far as options for raising revenue, the state can either 1) increase taxes, 2) expand its tax base (i.e. find new entities to tax, like out-of-state businesses), or 3) increase enforcement activity (i.e., more collections and audits).
Because it is deeply, politically unpopular to raise taxes in the middle of a pandemic, California has largely resorted to aggressively expanding its tax base and taking harder-line positions in their collections and examinations departments.
But My Business is in X State, What Can California Really Do to Me?
You may be thinking to yourself “So what? What can California really do to me? I live in X state and California is all the way over there, so even if they do make a tax return demand, it’s not like they will send someone after me.”
This type of thinking pervades online communities and business groups. It is often influenced by people who are not lawyers, who have no background in resolving California tax issues, and in general, simply do not have any idea what they are talking about.
The reality is this: California has a lot of tools at their disposal. If you received a letter demanding that you file a tax return, that should be proof enough that you don’t need to be in California for them to reach you.
The world’s fifth largest economy probably touches a lot of the same things that you touch. Everything from your bank account, your merchant account processor, your marketplace facilitator, and a variety of other entities you use probably have some connection to the state of California.
If this is the case, California won’t have to go across state lines to get you. They can seize your bank accounts, levy merchants/marketplace facilitators and basically do a lot of damage with the push of a button. California can also file liens against your business and potentially seize property located in the state.
I Received the FTB 4684B – Demand for Tax Return. What do I do?
First, do not ignore the notice – take it seriously! We have clients that have simply thrown the forms in the trash only to be confronted later with a much larger and more expensive issue – like having their bank account levied. This is where we have had to step in to save the day. So, ignoring the tax return demand is a very bad idea because California won’t just go away.
Second, you need to fully understand what you are walking into. Just because California is demanding a return does not actually mean you have a filing requirement. You should be very careful about filling out the attached questionnaire too, because you could inadvertently trigger an assessment.
The first rule of being in a hole is to stop digging. Then, take a look around the hole and measure the size of it. Once you do this, it’s much easier to find a way out.
Start by having someone assess whether you have an actual filing requirement. If you can defeat the filing requirement, you defeat the assessment of the tax. Game over for California.
Full disclosure, though – this can be pretty difficult. California’s laws are not written for the benefit of the taxpayer. California finds a thread and pulls on it as hard as it can until it has a ball of yarn or the thread runs out.
Many CPAs and compliance-oriented people will read the black letter of the law and tell you that you need to file a tax return as a default position. In our experience, it’s best to consider the facts and circumstances of a particular situation before jumping to the conclusion that you have a filing requirement.
Next, before you start filling out the questionnaire, you need to determine what California knows about your business. The demand for you to file a tax return doesn’t appear out of thin air.
The California Franchise Tax Board has information on file about you and based on that information, they believe that you need to file a tax return. You need to establish whether or not the information is correct. If it is not, you may have an opportunity to fix the error with the FTB representative over the phone, resolving the issue right then and there. Game over for California.
Adversely, if the information is correct, you need to ascertain that the information the FTB representative gives you matches any that you give them – both when you fill out the questionnaire and in any future communications. If you give them conflicting information, it will either solidify the FTB’s position that you must file a return or potentially trigger an audit of your return once it’s filed.
The person with full knowledge of the business’s operations should not call the FTB. Keep in mind that if you call the FTB, you will be speaking directly with a representative who will make a note of who is calling them as well as continue to take notes during the call.
Giving the filing enforcement unit a direct opportunity to cross examine you may not be the wisest approach. At the very least, if you do not plan on getting a tax attorney involved, we would suggest using a third-party representative to make the call.
How Do I Fill Out the Non-Qualified Business Entity Questionnaire - FTB 4694?
The short answer is very carefully. As you probably guessed, the form has a series of trap questions that are designed to establish connection with California and trigger a filing requirement under state law.
Understand that filling out the questionnaire is not as simple as answering “no” to each question. The important thing to do is respond to the notice while actively dissuading California from pursuing a filing enforcement.
This can be tricky. As previously outlined, make sure the information you give to them matches what California has on file.
In addition, don’t provide too much information about the company’s operations. Give the filing enforcement just enough friendly and factual information to close the case and go away.
Alternatively, if you do discover you have a filing requirement in California, be careful that the information provided is going to match whatever tax return you are going to file with the FTB later.
The California Franchise Tax Board is a powerful entity, and if they decide that your out-of-state business owes taxes, it’s a good idea to consult with a tax law professional. We have experience identifying the risks and can successfully represent you against California’s sprawling tax bureaucracy.