California State Taxes and Federal Regulations: Conflicts Between Federal and California Law
If you are a retailer in California, especially if you conduct business across states, you know that you need to collect and pay sales tax to the state. However, who do you need to collect sales tax from? At what point in the transaction? Who is tax-exempt?
Shopping online is more popular than ever, especially with more people staying home due to the pandemic and marketplace facilitators like Amazon, eBay and Etsy are seeing record sales. If you run a website similar to these companies, then you have a whole other set of sales tax regulations to deal with.
The California Department of Tax and Fee Administration (CDTFA) administers the state’s sales tax regulations and collections. California is not only known for its high tax rate (13.3%) but also for pursuing delinquent accounts with the same zeal as the Franchise Tax Board does with state income tax.
This chapter introduces you to California sales tax regulations, which are complicated and allow little margin for error. If you are a retailer who sells to other states or provides a platform for third-party vendors, then you need to clearly understand your sales tax responsibilities.
Our firm has helped many many small businesses interpret California’s sales tax regulations and how to comply with them. If you have questions about how these laws apply to your business, give me a call.
Sales to the Federal Government
Generally, sales to the federal government are tax-free. These sales require documentation that shows that the sale is exempt from taxes. Examples of appropriate documentation are purchase orders, copies of the U.S. government credit card or credit card number, documents showing direct payment by the U.S. government, and shipping information. See Publication 102, Sales to the United States Government.
It is important to note that sales to an individual member of the armed services do not qualify as exempt transactions. Furthermore, sales to contractors working for the federal government are not exempt unless they can show a valid resale certificate showing that the title to the property passes to the federal government before it is used by the contractor.
Sales involving the Diesel Fuel Tax, The Emergency Telephone Users Surcharge, Environmental Fee, and the Underground Storage Fee are not applicable to sales to the federal government. Most other taxes or fees will apply.
However, various exceptions to this rule exist and states have created their own statutes to cover transactions with their government as well as that of other states and locales. California taxes sales to and from the state government.
While the federal government enjoys full sales tax immunity, federal contractors do not. However, some states have implemented sales tax exemptions for these contractors.
California does not have such an exemption, although the state allows federal contractors to issue resale certificates for purchases, provided that title passes to the federal government before the purchase is used by the contractor.
For more information on which such items qualify for resale certificates, review Publication 102, Sales to the United States Government.
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E-Commerce and Marketplace Facilitators in California
A marketplace facilitator is an entity that serves as a platform for other merchants to sell goods or services. Marketplace facilitators list the products, collect payment and in some instances, also ship the orders. In some states, marketplace facilitators are required to collect and remit sales tax from third parties.
California recognizes marketplace facilitators and defines them as “a person who contracts with marketplace sellers to facilitate the sale of the marketplace sellers' products through a marketplace operated by the person.” Amazon and eBay are common examples.
California also defines a marketplace seller as a person who has an agreement with a marketplace facilitator and makes retail sales of tangible merchandise through a marketplace owned, operated, or controlled by a marketplace facilitator.
In California, both a marketplace facilitator and seller who are selling tangible personal property in the state are required to register with the CDTFA for a seller’s permit unless the seller’s goods are sold exclusively through a marketplace facilitator.
Any person or entity that meets the economic nexus requirements must register with the CDTFA for sales and use taxes.
Since 2019, California has shifted the burden of collecting sales tax and registering with the CDTFA to the marketplace facilitator as they are considered the retailer for tax purposes. Out-of-state businesses that sell tangible goods exclusively online through a marketplace facilitator do not need to register with the CDTFA.
The key word in this analysis is “exclusively.” Other actions may open yourself up to having an economic nexus in California, thus requiring you to register with the taxing authorities on your own. Common examples are holding inventory in the state or offering delivery in California via your own personal website.
California will view this as you conducting business in the state. It is important to know your company’s actions, and where you are availing yourself.
Federal Limits on California State Taxation
Following the decision of landmark case, Complete Auto Transit. v. Brady, the Court held that states have the power to regulate commerce that occurs in their state or impacts their state so long as such activity does not interfere with interstate commerce.
The Court's decision established four criteria for a state tax to be valid and not an unreasonable burden on interstate commerce.
The tax must be:
- On an activity connected to the state
- Fairly apportioned to be based on intrastate commerce
- Related to state services provided
Public Law 86-272
Another part of the federal government's oversight of state taxation is the application of Public Law 86-272 (15 U.S. Code §381). Congress passed this law to prevent a state from imposing a net income tax on income derived from the state by any person in the course of interstate commerce if their sales activities are limited to solicitation only, and that the orders are sent out of the state to be confirmed, and the shipment that is initiated outside of the state.
You might be asking, what does this mean? Essentially, out-of-state sellers may solicit and deliver in a state and retain protection from state income tax under PL 86-272.
Some basics on PL 86-272. The law only applies to sales of tangible personal property. Other types of property such as intangible property such as patents or trademarks as well as leasing or rental agreements are not protected.
Other associated activities which are deemed de minimis or minor are protected as well so long as the transaction is primarily solicitation and delivery in the state.
Companies who use independent contractors are given some protection as well for when the contractor solicits sales, makes sales, or maintains an office in the state.
California has bounced between two tests, the Joyce Rule and the Finigan Rule, to determine if the activities of a company are protected by PL 86-272 or not. Today, the Finigan Rule governs, but it is closely related to the Joyce rule.
The Joyce rule states that sale receipts from the sale of goods shipped to California customers by another out-of-state company could not be included in the sales factor numerator, unless the corporation itself was subject to California income tax, even though a member of the group of businesses (an in-state business) was taxable in the state. This is known as a “throwback.”
In 2011, California returned to the Finnigan rule, by adding RTC § 25135, and it remains the controlling precedent today. The Finigan Rule states that all sales not assigned to this state shall not be included in the sales factor numerator for this state if a member of the combined reporting group of the taxpayers or businesses are taxable in the state of purchase.
Generally, sales of tangible personal property should be assigned to the sales factor numerator of the destination state. The exception to this rule is if the taxpayer is not taxable in the destination state, then such sales are “thrown back” to the state from which the tangible personal property was shipped, and thus is included in the shipment state for tax purposes.
Receipts from sales of tangible personal property delivered or shipped to a purchaser in California will be assigned to the California sales factor numerator if the seller or any member of the seller’s combined reporting group is taxable in California.
In addition, all sales receipts from sales of tangible personal property delivered to a state other than California are not thrown back to the California sales factor numerator of the seller if any member of the seller’s combined reporting group is taxable in that state.
Your Next Steps with State Taxes and Federal Regulations
As you have deduced, sales taxation laws in California are very complex. Muddying the waters are laws surrounding E-commerce which has become much more widespread given the ease of online purchasing, especially during the pandemic. This has added a new category of taxation for marketplace facilitators.
Sales to the federal government are a little more straightforward as far as sales tax is concerned. Just be aware of who you are selling to as federal contractors and other third-party sellers are not exempt from sales tax.
If you are a California retailer who engages in interstate commerce, or marketplace facilitator, you need to stay on top of the ever-changing regulations. Dealing with the CDTFA about your sales tax liability is never fun and we have devoted an entire book to it.
This issue is complicated and is a highly fact-dependent situation. That is why it is important to consult with an experienced tax attorney when faced with challenging sales tax situations.
Our door is open to you. Give us a call to schedule a consultation.