Traditionally a sole proprietor learns — with the help of his CPA, accountant, tax attorney, tax preparer, accountant, or just through experience — to approximate what estimated taxes he or she will owe to the state of California each quarter. Each state varies in its tax laws, so it’s important to learn the general requirements of your own state, for the crucial purpose of financial planning.
Perhaps your taxes seem straight-forward. As long as you did the work solely within California as a sole proprietor, most folks would assume that you owe state income taxes only to California, right?
Sorry, but that may no longer be the case, thanks to a decision made by the California Office of Tax Appeals (OTA) last year in the Matter of Blair S. Bindley, OTA Case No. 18032402. Bindley, a sole proprietor with a screenwriting business in Arizona evidently received $40,000 from various California based clients and the FTB learned of this when it reviewed 1099-MISCs that were filed with the IRS. Bindley, on the other hand, did not work within California; so, he believed he had no California income tax return filing responsibility nor any obligation to pay California income taxes.
The FTB disagreed and notified him that he must file a California income tax return (Form 540-NR). In other words, although he did all his work in Arizona, the FTB believed he owed income taxes based solely on the fact that his clients were located in the Golden State.
The OTA’s Decision
Bindley protested the FTB’s assessment of income taxes, interest and penalties arguing that all of his work was performed in Arizona. However, California’s FTB disagreed, and when the case was appealed to California’s Office of Tax Appeals, the three-member panel of Administrative Law Judges sided with California’s FTB.
They cited several reasons, one of which was that the “Appellant Was Carrying on a Business Within and Without California.” It went on to further note that the “‘taxable income of a nonresident is broadly defined as ‘gross income and deductions derived from sources within this state.'”
The OTA also determined that the “Appellant Was Carrying on a Unitary Business.” A “unitary business” is sadly defined in the regulations by telling us what is not a unitary business. Essentially, it provides that with respect to a nonresident’s business conducted within and outside of California, that a business is not unitary where the part within the state is so separate and distinct from and unconnected to the part without the state such that the respective businesses are not part of a unitary business. Based on this language, the OTA reasoned that Bindley’s screenwriting business was conducted within Arizona and California and the part conducted in California was not so separate and distinct from and unconnected to the business conducted in Arizona to be considered separate businesses. In brief, the California OTA determined the taxpayer’s business was unitary, and therefore subject to apportionment and the market-based sourcing rules.
Under California’s market-based sourcing rules, the income derived from the sale of services is sourced to the place where the benefit of the service is received. To determine the place where the benefit of the service is received, California regulations provide rules which look first to the contract terms and if the contract does not specify the location where the benefit is received, then the FTB or the taxpayer may “reasonably approximate” the location. In Bindley, since some of the companies contracting with the taxpayer were in California, the OTA concluded that it was reasonable to conclude that these companies received the benefit of the services in California.
A Precedent is Set
The Bindley decision was made in late May 2019, and — equally impactful — the OTA updated its decision in early September 2019 and advised that the Bindley decision will be precedential. This means that the Bindley case will set a precedent for other cases — other sole proprietors — facing a similar situation.
In a recent article in Inc. magazine, writer Erik Sherman summed up the decision precisely. “In other words,” he wrote, “if you provide goods and services to a person or company in California, from the state’s view, you have income from there and have to file a state tax return. Oh, and pay for it.”
California’s Bindley case has brought up questions and criticisms about the long-term effects of making the case precedential. The short-term benefits for California in terms of taxable income are obvious, but a strategy that targets smaller, proprietary business owners for additional tax revenue has raised eyebrows.
For years, we have heard about the benefits of an economy without borders, enabled by technology. But should small business proprietors carry the majority of the burden of being taxed in multiple states?
Also, the long-term economic effects of the Bindley decision have yet to be fully considered. Will small businesses hit by additional taxes be wary of doing business in California, and could this have a negative impact on California businesses looking for the best economic options? These questions may lead to further legislative tinkering with the precedent set by the Bindley decision.
Taxes and Big Data
Another interesting facet of the Bindley decision is that it brings up the role big data may have played in detecting Bindley’s California income to begin with. Now that tax return and information return filings, e.g., 1099-MISCs, 1099-Rs and 1099-Ks, 1040s are predominantly digital, the IRS can rather effortlessly use big data analytics as a means of detecting and fighting tax fraud.
California’s tax collection agency — the Franchise Tax Board — already has a reputation as the most aggressive tax collector in the nation. Don’t doubt for a moment that the FTB is not also employing big data tactics to find tax evaders, untaxed income and more revenue for the state’s coffers.
The fact is, going forward, that many more small businesses with California-sourced will find themselves in Bindley’s situation, i.e., required to file California income tax returns and California income taxes, even if they’ve never been to California. Finally, watch for this trend to spread to other states which will cause major compliance headaches for small business.
Help You Can Trust
If you are a sole proprietor who works outside the state of California, and you have earned income from client’s in California, you may be responsible for filing California state income tax returns and paying California income taxes.
Tax compliance in a quickly changing economy and taxation landscape can be complicated, confusing and full of pitfalls. At times, you will, no doubt, need help from a tax firm or tax professional that fully understands California’s current tax compliance burdens and that has the extensive experience that you can trust.
Rex Halverson and Associates has that experience and a proven track record of advocating for their clients. Call our office today for a free initial consultation. You can reach us at 916-444-0015, or by filling out our contact form. We look forward to answering your questions and helping solve your tax problems.