California Decision Highlights State’s Aggressive Stance on Taxing Non-Resident Sole Proprietors

In a decision that has impacts well beyond the state, the California Office of Tax Appeals (the OTA) ruled in favor of the California Franchise Tax Board (the FTB) in Blair S. Bindley v. FTB (Bindley). This decision, which OTA designated as precedential, provides FTB the authority to pursue non-resident individuals who have never set foot in the state and impose tax upon their income apportioned to the state based upon revenues generated from California-sourced business dealings.

The Case and Its Impact

The FTB received income records from two California LLCs that reported they paid the taxpayer a combined total of $40,000 during 2015 for screenwriting services. Taxpayer did not file a 2015 California tax return and was therefore requested to file a return for the year in question or explain why he was not required to file.

Taxpayer responded that he had no California-source income because he was an Arizona resident during 2015 and had performed all screenwriting services from his home state. FTB rejected the taxpayer’s argument and sent him a Notice of Proposed Assessment. The taxpayer appealed to the OTA where he waived his right to an oral hearing. As a result, the OTA’s decision was based on the briefs submitted.

The OTA’s three-member panel began by identifying three elements to address:

1. Whether appellant (taxpayer) was carrying on a business within and without California;
2. Type of entity conducting the business; and
3. Whether the business was unitary.

OTA determined that the taxpayer was conducting his business within and without California, running a sole proprietorship, and that it was unitary. A unitary business is a business, trade, or profession conducted both within and without the state, where the part conducted within the state and the part conducted outside the state are sufficiently interrelated or dependent upon one another as to be considered a single business. As applied to this taxpayer, the OTA determined that the taxpayer’s screenwriting services provided to California clients and non-California clients constituted a single unitary business.

After addressing each of these three factors, the OTA determined that, since the taxpayer operated a multistate unitary business operation his business income must be apportioned via application of the Uniform Division of Income for Tax Purposes Act (UDITPA, Cal. Rev. & Tax. Code Secs. 25120 to 25139, inclusive). And specifically, as relates to the taxpayer’s provision of services, applied the state’s market-based sourcing rules for assigning business revenues. California’s regulation mandates sales from services are assigned to California to the extent the taxpayer’s customer has either directly or indirectly received value from delivery of that service within the state. After establishing the taxpayer was operating a unitary multistate business that generated income from business activity, the OTA concluded the taxpayer derived income from California business activity that was properly assigned to the state.

Notably, this decision may not be limited to business conducted within the U.S. A citizen of a foreign country performing services for a California customer derives income from a California source regardless of where the business is conducted. Such foreign businesses and individuals typically rely on the US income tax treaty with their home country which allocate taxation of US-source income to the country where the business or individual is a resident. California does not recognize U.S. income tax treaties. A non-U.S. citizen with no U.S. federal income tax filing requirement may nonetheless be subject to California income tax.

The Takeaway

Entrepreneurs and sole proprietors not residing in California should be aware of the FTB’s posture toward pursuing and taxing nonresidents that provide services to California businesses.

It is also worth noting that even though the OTA applied UDITPA to determine the filing and tax obligations of an individual sole proprietor, the OTA’s analysis did not discuss economic nexus. In California, the economic nexus threshold for business sales during 2015 was $536,446. Bindley’s California sourced income was well below this sales threshold, but, since the case was taken up on briefs alone, it is unclear whether the thresholds were discussed.

Please contact Andersen for more information and to discuss whether a protective filing or other action should be considered in light of this case development.