California Developments and Opportunities.
Many tax trends continued to align with pre-pandemic frameworks in 2023, as well as several new developments for California taxpayers. In the following, you'll find more details on income tax changes, recent judicial decision updates, disaster declarations and a development related to unclaimed property enforcement.Income Tax Perspective
There are updates or updated guidance for some tax rules, including the elective pass-through entity (PTE) tax, nexus considerations and the enforcement of the Franchise Tax Board (FTB) treatment of certain transactions for nonresident taxpayers.
Interest Rates
Effective Jan. 1, 2023, the FTB pays 2 percent interest on corporate overpayments. This rate is effective through June 30, 2023. Effective June 31, 2023, the FTB pays 5 percent interest on corporate overpayments.
The interest rate for personal income tax underpayments and overpayments, corporation underpayments and estimate penalties is 7 percent, effective July 1, 2023. From Jan. 1, 2023 -- June 30, 2023, the interest rate for personal income tax underpayments and overpayments, corporation underpayments and estimate penalties was 5 percent.
For interest rates after Dec. 31, 2023, the FTB will provide more information at ftb.ca.gov/pay/penalties-and-interest/interest-and-estimate-penalty-rates.html as it becomes available. Historic interest rates can also be found on the same site.
One-Time Penalty Abatement
On June 30, 2022, Gov. Gavin Newsom signed Assembly Bill 194 into law, which included the addition of Section 19132.5 to the Revenue and Taxation Code (RTC).
Section 19132.5 gives the FTB the authority to grant California taxpayers a one-time abatement of timeliness penalties, including the failure-to-file penalty (RTC 19131) and a failure-to-pay penalty (RTC 19132). The relief applies only to individuals subject to personal income tax and is only for taxable years beginning on or after Jan. 1, 2022.
How to Request Penalty Abatement
The FTB began to accept abatement requests on April 17, 2023. The abatement can be requested verbally by calling 1 (800) 689-4776 or in writing by filing FTB 2918 (ftb.ca.gov/forms/misc/2918.pdf)
How to Qualify for Penalty Abatement
All the following requirements must be satisfied:
* The individual has not previously been granted a one-time penalty abatement, ever;
* The individual has filed all required income tax returns;
* The individual has paid in full, or is current on an approved installment agreement to pay, all outstanding liabilities other than the timeliness penalty.
Elective Pass-Through Entity Tax
California enacted a pass-through entity (PTE) tax regime in 2021 (mossadams.com/articles/2021/08/ca-income-tax-credit-for-ptes). For California, the election is administered by the FTB but provides federal benefits. The PTE program can be an avenue for qualifying taxpayers, which includes most partnerships or S corporations, to mitigate the tax impact of the federal $10,000 cap on the deductibility of taxes imposed at the state and local level on shareholders or partners. The PTE regime does this by shifting the incidence of tax off individual partners or shareholders and onto qualifying entities.
To participate in the PTE regime, a qualifying taxpayer must make a first payment of $1,000 or 50 percent of the prior year's PTE payment--whichever is greater--by June 15 of the taxable year of the election. A second payment of the remaining PTE tax is then due on or before the due date of the original return, without regard to extensions.
For the 2022 filing season, a severe winter storm disaster was declared for most of California. The disaster declaration extended payment due dates for qualifying taxpayers for several taxes, including the PTE deadlines associated with the first and second installments described above. For tax year 2023 filing purposes, those deadlines are expected to return to the regular deadlines, beginning June 15, absent some unexpected event.
Nexus
For California income tax purposes, "doing business" is defined as actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.
Economic-Nexus Thresholds
For taxable years beginning on or after Jan. 1, 2022, a taxpayer is seen as doing business in California for a taxable year if any of the following conditions are satisfied:
* The taxpayer is organized or commercially domiciled in California;
* The taxpayer's California sales exceed the lesser of $690,144 or 25 percent of total sales;
* The taxpayer's real property and tangible personal property in California exceeds the lesser of $69,015 or 25 percent of total real property and tangible personal property;
* The taxpayer's compensation amount paid in California exceeds the lesser of $69,015 or 25 percent of total compensation paid. The doing business thresholds for taxpayers are indexed for inflation and revised annually.
Public Law (PL) 86-272
Federal PL 86-272 protects businesses from state taxes based on net income where the business's contact with a state is limited to the solicitation of sales of tangible goods.
If a potential taxpayer's only physical connection with a state is the delivery of goods to in-state customers, they would be protected against income taxes. This, however, does not extend to gross receipts, franchise, or net worth taxes that other states may apply.
In 2021, the Multistate Tax Commission (MTC) adopted revised guidance to its interpretation of the application of PL 86-272 related to the online and digital economy. The MTC is an intergovernmental state tax agency charged with administering the Multistate Tax Compact. Commission members, acting together, attempt to promote uniform and consistent tax policy and administration among the states. The MTC's actions do not have the force of law, and member states may opt not to follow its recommendations.
MTC Guidance
The MTC's guidance states that a business whose customer is using the business's interactive website in the customer's home state is conducting an activity of the business in the customer's state. The guidance then describes the protections and limitations of PL 86-272 in this context.
The MTC's guidance concludes that most activities performed remotely over the internet, such as interactive chat and email features, could exceed the protections of PL 86-272.
By exceeding those protections, the business's protection under the PL is potentially removed unless those activities directly serve a sales purpose such as the solicitation of an order of tangible personal property (TPP). In the current internet-based economy, the MTC's guidance significantly limits the application of PL 86-272.
TAM 2022-01
In February 2022, the FTB adopted the MTC guidance through the issuance of a Technical Advice Memorandum (TAM), which means that both in-state and out-of-state businesses must analyze their website and online activities when assessing whether they are subject to tax.
TAMs are advice the FTB's legal team gives when it receives questions from FTB staff. The FTB did not issue direct public guidance. Moreover, unlike the regulatory process, it did not seek public comment. The FTB also incorporated the MTC guidance into a revised version of FTB Publication 1050, which covers the Application and Interpretation of PL 86-272. As with the TAM, this was initiated by the FTB and did not involve public comment.
What Exceeds the Protections?
The FTB hasn't provided a comprehensive list of activities that exceed the protections of PL 86-272. It has, however, advised that the following activities exceed those protections:
* A non-sales employee telecommuting from within California;
* Post-sale assistance to California customers via email or chat initiated from the business's website;
* Solicitation from California applicants of online applications for a branded credit card via the business's website--not a bank's--if that business will ultimately receive fees and interest from the card;
* Solicitation from California applicants of employment applications for non-sales positions;
* Use of internet cookies on California customers' computers to gather actionable business intelligence that isn't for the purpose of facilitating that customer's order(s);
* Remote repair or upgrading of a product in California via the internet;
* The offering for sale of extended warranty plans to California customers via the internet;
* Use of a marketplace facilitator that maintains inventory in California, if that inventory includes at least some of the business's products;
* Streaming of videos and music into California for a charge.
What Doesn't Exceed the Protections?
Websites used by California customers generally don't exceed the protections of PL 86-272 if they do not offer tangible goods and the business does not engage in any other California business activities. Websites also may not exceed the protections provided by PL 86-272 if only used to:
* Search for items;
* Read product descriptions;
* Select items for purchase;
* Choose delivery options;
* Request to buy items.
Cookies on a customer's computer do not, by themselves, disqualify a business from the PL protections if they are only used in California by that business to:
* Remember items in a cart;
* Store customer information so it doesn't need to be re-entered;
* Remind customers of items they previously considered.
Notably, California's TAM states that merely posting static FAQs on the business website, even if California customers access that information, stays within the public law's protections.
Application to Outbound and Inbound Transactions
The TAM applies the same standards to outbound and inbound transactions and speaks broadly in terms of destination state and origin state, rather than limiting itself to California specifically. This suggests California's guidance on the applicability of PL 86-272 could be beneficial for certain businesses and detrimental to others.
For example, by actively working to remove the protections provided by PL 86-272 on goods shipped from California, a corporate taxpayer could reduce its California apportionment factor by reducing its California-sourced throwback receipts. Alternatively, by actively working to remove the protections provided by PL 86-272, an out-of-state taxpayer could have a filing and tax obligation in California.
Although not explicit in the language of the memorandum, the TAM has been applied retroactively by the agency. As such, the application of this new guidance could, depending on a business's fact pattern, either reduce its California tax expense or result in an unreported tax liability.
California's Interpretation
The application of PL 86-272 to a specific set of facts is a complex undertaking and is subject to uncertainty. The TAM outlines California's interpretation of a federal law, though California's interpretation may or may not align with the intent of the US Congress. FTB's interpretation of a federal statute is unlikely to be given the same weight as an interpretation of the state's own statute.
However, taxpayers that have historically claimed they don't have an income tax filing obligation in California because of the protections provided by PL 86-272 should re-examine their activities to determine if that still applies in light of the new guidance.
Legislative and Judicial Update for Income Tax
In late 2022, the American Catalog Mailers Association (ACMA) filed a request for declaratory and injunctive relief against the FTB on the basis that TAM 2022-01 was invalid, specifically because it was inconsistent with federal law protecting sellers of tangible goods and violated the United States Constitution.
In addition, ACMA also alleged that the FTB's new guidance was an improper "underground regulation," and that the FTB did not follow the required rule making process for a regulation in California prior to publishing TAM 2022-01.
The trial court has denied ACMA's motion for summary judgment, but it also communicated a willingness to determine that the TAM was effectively an underground regulation and, thus, was impermissible on FTB's part.
Appeal of L. Smith and California's Increasing Reach on Income of Nonresident Individuals
In a recent precedential decision by the California Office of Tax Appeals (OTA), a nonresident individual was determined to be liable for personal income taxes on a distributive share of gain from the sale of a partnership interest due to that gain constituting California source income.
In the precedential decision of Appeal of L. Smith, 2023-OTA-069P, appellant was a California nonresident who owned an indirect membership interest in an LLC (Holdco). That LLC sold its own membership interest in another entity (Shell), classified as a partnership for California income tax purposes. Holdco realized a net gain on the sale of Shell. In turn, Holdco passed on its share of the gain to appellant.
Appellant contended that the gain passed through to them via Holdco was a gain from the sale of an intangible asset (a partnership interest), and that this gain should be sourced to their (appellant's) state of residency under long standing authority, California Revenue and Taxation Code Section 17952 and the Appeals of Ames, et al., (87-SBE-042) (Ames).
The OTA rejected appellant's position and affirmed FTB's position, which was that the gain should be sourced at the entity level, as opposed to the individual level, thus making the gain business income subject to apportionment. As such, the business' level of California activity is ultimately the determinative means of assessing whether a nonresident partner or shareholder is subject to tax on the gain.
This Appeal of L. Smith decision only further increases California's ability to tax income of nonresident individuals, as highlighted in the earlier matter of Metropoulos Trust. However, it is worth noting that the OTA also has recently held that Ames may still be relied upon (see the Appeal of Buehler, 2023-OTA-215P).
As such, how a nonresident individual holds an interest in a pass-through entity (directly versus indirectly) may be relevant in determining how a gain they recognize upon the sale of that interest is sourced for California personal income tax purposes. Taxpayers with such transactions on the horizon should consult with their tax professionals.
Disaster Loss Deductions
California taxpayers may deduct losses in any event declared a disaster by any United States president or California governor.
In this regard, the state generally follows federal law regarding the treatment of losses incurred as a result of a casualty or disaster (ftb.ca.gov/file/business/deductions/disaster-loss.html), though relevant nonconforming provisions still apply.
Extended Deadlines
The FTB generally follows the IRS's extended deadlines to file or pay taxes until the date indicated for the specific disaster. As of this writing, the current extended disaster deadline for qualifying California residents and California domiciled businesses for the 2022 tax year was Nov. 16, 2023.
Taxpayers should write the disaster name in dark ink at the top of their tax return to alert the FTB of the disaster to which the return is related.
Additional Designated Areas
The IRS disaster relief webpage (irs.gov/newsroom/tax-relief-in-disaster-situations) lists additional designated areas eligible for a postponement period.
If a taxpayer qualifies for the postponement period, any interest, late-filing, or late-payment penalties that would otherwise apply will be cancelled. The FTB also will follow these stipulations.
Other 2022 and 2023 Disasters
Taxpayers may deduct a disaster loss sustained in a California city or county where the governor declares a state of emergency.
The list of California Qualified Disasters (ftb.ca.gov/file/business/deductions/disaster-codes.html) was published on the FTB website on Aug. 31, 2023. The list is regularly updated as new events occur. Visit the FTB website and Publication 1034, Disaster Loss How to Claim a State Deduction (ftb.ca.gov/forms/misc/1034.pdf), for more information regarding California disaster losses.
Unclaimed Property
Tax professionals may have noticed a new set of questions on their business entity clients' income tax returns. Specifically, California has started inquiring as to whether corporate and pass-through entities have filed unclaimed property (mossadams.com/articles/2022/02/unclaimed-property-on-business-tax-returns) reports with the state and, if so, when the last reported was filed.
Financial assets left inactive by a legal owner beyond a set deadline--which varies depending on the property type--are transferable to the state. This can include uncashed checks, refunds, annuities, or security deposits.
For some taxpayers, these assets can accumulate and remain on financial records for several years even after they should have been reported, and paid over, to the state to administer on behalf of the public using a unified search tool. A historically under-reported area of tax law across all states, unclaimed property is now in California's sights as an area to promote increased compliance.
In connection with this change, California has established a program to encourage compliance by otherwise-delinquent taxpayers by offering an opportunity to mitigate the potential impact associated with failing to report unclaimed property from prior periods.
Voluntary Compliance Program
Gov. Newsom signed AB 2280 into law on Sept. 13, 2022. AB 2280 authorizes the controller to:
* Establish the California Voluntary Compliance Program (VCP) and,
* Waive the 12 percent interest payable for untimely unclaimed property reports for certain qualifying taxpayers.
At this time, California's VCP is up and running, and applications for the program can be submitted at the California State Controller's Office website at https://sco.ca.gov/upd_vcp.html.
Eligibility
An unclaimed property holder that hasn't reported unclaimed property can request to enroll in the program using a form prescribed by the controller.
The Controller, at their discretion, can enroll eligible holders in the program.
Ineligibility
Some unclaimed property holders are ineligible for enrollment in the VCP. A property holder is ineligible for enrollment if, at the time the holder's request to enroll is received by the Controller, the holder is the subject of:
* An examination of records or has received notification from the controller of an impending examination.
* A civil or criminal prosecution involving compliance with California Unclaimed Property Law.
Additionally, property holders are ineligible if the Controller:
* Notified the property holder of interest due within the previous five years and the interest remains unpaid at the time of the holder's request to enroll. A property holder subject to an outstanding interest assessment may file or refile a request to enroll after resolving the outstanding interest assessment.
* Waived interest assessed against the property holder within the previous five years. If a property holder acquired or merged with another entity within the five-year period, the holder may request to enroll in the program to resolve unclaimed property that may be due as a result of the acquisition or merger.
Disclosure of Records
The Unclaimed Property Division will not require the disclosure of records and information provided to the Controller's office related to statements of personal worth or financial data, or related to personal information, as defined by Section 1798.3 of the Civil Code.
Next Steps
The California tax landscape continues to evolve each year, with the state exploring new means of revenue collection, while revising existing policies once expected to remain unchanged.
Due to these changes and updates, taxpayers are always advised to stay on top of the most recent developments, whether they be legislative updates, the latest court decisions, or instructions from the respective tax departments responsible for administering these regimes.
BY NICK WEST & OSSIE RAVID
Nick West has practiced public accounting since 2014. He provides state and local consulting and compliance services for income and franchise taxes matters as well as sales and use tax issues. You can reach him at (408) 558-3265 or [email protected]. Ossie Ravid has practiced public accounting and law since 1995, specializing in state and local tax. You can reach him at (628) 267-6014 or [email protected].
Assurance, tax, and consulting offered through Moss Adams LLP. ISO/IEC 27001 services offered by Cadence Assurance LLC, a Moss Adams company. Wealth management offered through Moss Adams Wealth Advisors LLC.
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| Title Annotation: | 2023 Tax Season Toolkit |
|---|---|
| Author: | West, Nick; Ravid, Ossie |
| Publication: | California CPA |
| Date: | Dec 1, 2023 |
| Words: | 3105 |
| Previous Article: | New PCAOB Staff Report Sheds Light on Rising Audit Deficiencies. |
| Next Article: | Federal Tax Update. |
| Topics: | |