Tax and financial advice from the Silicon Valley expert.

How will businesses be affected by California’s Proposition 39?

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.

Will your taxes be changed by California Proposition 30?

Most California residents know that California Proposition 30 includes tax changes projected to raise about $6 billion a year which should mostly be used for funding public education but also to reduce California’s budget deficit.

Everyone who is a resident or visitor in California will be affected by the sales tax change. The California sales and use tax will increase 1/4% effective January 1, 2013. The increase expires after December 31, 2016.

Only a privileged few will be affected by the changes for California income taxes, which are retroactively effective January 1, 2012 and will expire after December 31, 2018.

The California income tax rate will increase from 9.3% to 10.3% for singles and married filing separately with taxable income over $250,000, heads of household with taxable income over $340,000 and married persons filing joint returns with taxable income over $500,000.

The California income tax rate will increase from 9.3% to 11.3% for singles and married filing separately with taxable income over $300,000, heads of household with taxable income over $408,000 and married persons filing joint returns with taxable income over $600,000.

The California income tax rate will increase from 9.3% to 12.3% for singles and married filing separately with taxable income over $500,000, heads of household with taxable income over $680,000 and married persons filing joint returns with taxable income over $1,000,000.

Remember the 1% Mental Health Tax also applies for taxable income over $1,000,000, so those taxpayers will have a total marginal tax rate of 13.3%. (Each dollar of taxable income over $1,000,000 will be taxed 13.3 cents.)

According to the California Franchise Tax Board, there will be no penalty for failure to pay the additional taxes in your 2012 estimated tax payments. The additional tax is due April 15, 2013. You might want to pay the additional tax by December 31 for a deduction on your 2012 federal income tax return, but watch the alternative minimum tax.

Tax and financial advice from the Silicon Valley expert.