The California Office of Tax Appeals (“OTA”) recently issued a decision finding that a nonresident sole proprietor, who performed all services outside of California but performed such services for California customers, was operating a “unitary” business and was therefore subject to California’s apportionment rules.[i] The Bindley decision was rendered in late May 2019, but the OTA had until early September to decide whether the case would have precedential effect. On September 10, 2019, the OTA updated the decision’s status to precedential.
Bindley involved a self-employed screenplay writer who resided in Arizona and performed services for companies headquartered and registered in California. The California Franchise Tax Board (“FTB”) matched income records from other sources to identify that the taxpayer had received approximately $40,000 of income from California companies, but had no record of receiving the taxpayer’s return for the year in question.
Whether a nonresident is subject to California’s rules for apportioning income depends on whether (1) the taxpayer is carrying on a trade or business within California, outside of California, or a combination thereof; (2) the type of entity conducting the business; and (3) whether such business is unitary.[ii] In Bindley, the OTA found that the taxpayer’s business as a self-employed screenwriter was “carried on within and without the state” because he was a resident of Arizona, where he performed the services, and because he received income for such services from California customers. There was no question as to whether the taxpayer carried on his business as a sole proprietor. As to the third requirement for application of the apportionment rules to a nonresident—that the sole proprietorship be carrying on a “unitary” business—the regulations only describe what is not a unitary business.[iii] The regulations explain, 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[.]”[iv] From this language, the OTA reasoned that a nonresident’s business is unitary simply where “the part conducted within the state and the part conducted without the state are not so separate and distinct from and unconnected to each other to be separate businesses[.]”[v] By this reasoning, the OTA determined that 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 sales of services is sourced to the place where the benefit of the service is received.[vi] To determine the place where the benefit of the service is received, the regulations provide rules which look first to the contract and then, if the contract does not specify the location where the benefit is received, then the FTB or the taxpayer may “reasonably approximate” the location where the benefit is received.[vii] In Bindley, since both companies contracting with the taxpayer were located in California, the OTA concluded that it was reasonable to conclude that the companies received the benefit of the services in California.
By the OTA determining that its decision in Bindley would carry precedential authority, the FTB may now rely on its decision and reasoning in applying these rules to other taxpayers. In other words, the FTB may now require sole proprietors selling services to California customers to file California returns, even if such services are performed wholly outside of California and the sole proprietor otherwise has no connection to California.
[i] In the Matter of the Appeal of Blair S. Bindley, OTA Case No. 18032402 (May 30, 2019).
[ii] See 18 Cal. Code Regs. § 17951-4.
[iii] 18 Cal. Code Regs. § 17951-4(b).
[iv] 18 Cal. Code Regs. § 17951-4(b).
[v] Appeal of Bindley, OTA No. 18032402, at 6 (May 30, 2019).
[vi] Cal. Rev. & Tax. Code § 25136.
[vii] See 18 Cal. Code Regs. § 25136-2(c).