Although California’s Proposition 39 was “sold” as closing a tax loophole for out of state businesses, it’s not quite as simple as that. Some California businesses will also be affected.
The allocation and apportionment rules apply to all businesses that are “doing business” in California, including corporations, S corporations, partnerships, sole proprietorships and limited liability companies.
The new rules are effective for taxable years beginning on or after January 1, 2013.
Businesses are considered to be “doing business” in California and therefore subject to the allocation and apportionment rules subjecting some of their income to California tax if any of these apply:
1. The taxpayer is organized or commercially domiciled in California.
2. Sales of the taxpayer in California exceed the lesser of $500,000 or 25% of the the taxpayer’s total sales. Sales of the taxpayer include sales by an agent or independent contractor of the taxpayer.
3. The real property and tangible personal property of the taxpayer in California exceed the lesser of $50,000 or 25% of the taxpayer’s total real property and tangible personal property.
4. The amount paid in California by the taxpayer for compensation exceeds the lesser of $50,000 or 25% of the total compensation paid by by the taxpayer.
(California Revenue and Taxation Code Section 23101(b).)
Before the changes, California businesses had a choice to either compute the share of their income taxable by California based on (1) the share of their sales in California divided by their total sales, or (2) a formula based on the share of sales, payroll and property in California.
Under Proposition 39, the second alternative is eliminated.
The reason for eliminating the second alternative is businesses could reduce their California tax by locating their property and employees outside of California. In addition to avoiding California tax, this feature made the second alternative appear to be a “job killer” for California. Of course, there are other disincentives for locating a business in California that are beyond the scope of this article.
There is another feature of this change that hasn’t been widely discussed. It is the definition of whether income from services are “sourced” to California. Under alternative (1), which will now be the only alternative, income from services are allocated according to where the purchaser of the services received the benefit of the services. For example, if a CPA firm prepares income tax returns for a New York client, the income will be sourced to New York. Under the old rules of alternative (2), income from services were allocated according to where the services were performed. For example, if a employees of a CPA firm located in a California office prepared income tax returns for a New York client in the California office and never went to New York, the income would be sourced to California.
(The rule under alternative (1) is at California Revenue and Taxation Code Section 23136(a).)
This change in the source rules for income from services is being adopted in many states, which means more service businesses will have to file income tax returns in many states. This can be a burden, but smaller businesses might fall under an exception like 2. above, having less than $500,000 of gross receipts in the state and less than 25% of total gross receipts in the state.
See your tax advisor for more details about how your business is affected.