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ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – INCOME RECEIVED OUT OF CALIFORNIA – HOW ARE NON-RESIDENT SOLE PROPRIETORS TAXED BY THE FTB?

By Robert S. Schriebman

2020

Introduction

If you are a non-resident sole proprietorship receiving California source income, the FTB wants you. The FTB will find you because it shares tax information with the IRS. If you have read my articles dealing with California source income and residency issues, you learned that income derived from California sources, for services directly benefiting those sources, must be reported on a California non-resident income tax return (Form 540-NR). If on the other hand, income derived from California sources for services outside of California, that indirectly benefit California-based companies, do not require the filing of any return. Let’s look at a couple of examples.

Example #1:  You live in Maine. Your occupation is a screen writer. You are retained by “Shoot-Em Up Studios” to write a pilot script for a new western. You are paid $25,000. Because your services directly benefit a California based business, you are required to file a California non-resident return.

Example #2:  You live in Utah. Your occupation is an environmental impact specialist. You are retained by “Skyhigh Oil Company” to inspect a site for Skyhigh’s possible merger with another company located in Canada. You travel to Canada, where you inspect, meet and confer with the Canadian company. You prepare a report for that Canadian company. You are paid $30,000 by Skyhigh. In this case, your services did not directly benefit Skyhigh’s California business.  You are not required to file an FTB return.

Suppose, however, that you reside outside of California and you are hired by a California-based company that has locations in other states and other countries. It is not clear where your services benefited any of these locations. What are your tax reporting requirements? In the Dakers case this is exactly what happened. Let’s take a look at this case and see how the Office of Tax Appeals (OTA) resolved the matter. (In the Matter of the Appeal of A. Dakers OTA Case No. 19034411, Feb. 20, 2020)

The Case of A. Dakers

Mr. Dakers provided staffing services. He was a head-hunter. In 2016 he resided in Texas. He was hired by Host Analytics, Inc. (Host) to meet their staffing requirements. Host was based in Redwood City, CA. Mr. Dakers, although residing in Texas, maintained a mailing address in California. His mail was consistently delivered to that mailing address. He rendered services to Host in 2016 and filled their staffing needs. However, Dakers did not keep any records as to the ultimate job assignment for anyone he found for Host. Host gave him a 1099 in 2016, and properly filed the 1099 with the IRS. The FTB notified Dakers that they obtained 1099 data from the IRS and requested he file a non-resident return declaring his California source income.  Dakers responded that he resided in Texas throughout 2016 and was not required to file a California FTB return. The FTB did not agree with Dakers and issued an assessment based upon $22,000 of income stated on the 1099, together with penalties and interest. Dakers appealed to the OTA.

The OTA Decision in Dakers

The Dakers’ decision is interesting and informative because it discusses not only the basic filing requirements, but also the burden of proof that must be met by the FTB in order to validate the proposed assessment.

The FTB’s Burden of Proof

When the FTB makes a proposed assessment of additional tax based on an estimate of income, the FTB’s initial burden is to show that its proposed assessment is reasonable and rationale. What does it take to establish this?  An assessment based on unreported income is presumed correct when the FTB, or any other California taxing agency, introduces a minimal factual foundation to support the assessment. Federal courts have held that the taxing agency need only introduce some evidence linking the taxpayer with unreported income. (Rapp v. Commissioner 9th Cir.1985 774 F.2d 932, 935). Basically, an assessment is presumed correct if it is backed by any supporting data. It is a minimal burden. On the other hand, a taxpayer attempting to attack the assessment, has a much higher and more demanding burden of proof. It is not a level playing field. In reviewing the Dakers case, I found it interesting how a state tribunal such as the OTA, can use IRS authority to make a point in its favor, but when the taxpayer attempts to do so, many times the argument is shot down.

The Merits of the Dakers Case

California imposes a tax on the entire taxable income of a non-resident, such as Dakers, to the extent that it is derived from California sources within the state, R&TC § 17041. Taxing a sole proprietor, such as Dakers, who does business both within and outside California is determined by regulations dealing with the conduct of a unitary business. The income must be apportioned under a four-part test:

  • The taxpayer must be a non-resident – Dakers was clearly a non-resident.
  • The taxpayer must be conducting business as a sole proprietorship – Dakers was clearly a sole proprietorship.
  • The taxpayer must be carrying on a “unitary business, trade or profession.”
  • A unitary business etc., must be conducted within and outside California.

A unitary business is a business, trade, or profession conducted both within and outside the state, where the parts conducted are not so separate and distinct from and unconnected to each other to be deemed to be separate businesses, trades or professions. Here Dakers only had one distinct business. Therefore, his business qualifies as unitary. It was also clear that Dakers’ sole proprietorship operated both within and outside California.

The Bottom Line

Once the OTA decided that Dakers did business in California, the OTA then had to decide how much of the $22,000 income did Dakers have to declare on his tax return. There were no records to determine where the workers found for Host actually rendered their services to Host. Where did those workers actually work?  Where did Host receive the benefit of Dakers’ services? There were no answers. The OTA decided to apportion Dakers income on how many places of business Host had. Host was headquartered in Redwood City, CA, had a satellite business in Nevada, and in India. So, the OTA apportioned only one third of Dakers’ income to California or $7,300. Dakers only had to report $7,300 as California source income.

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Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

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