- a summary of the major corporate income tax changes that went into effect beginning with the 2013 tax year;
- an explanation of the sourcing rules for the gain on the sale of a partnership interest; and
- the repeal of the enterprise zone credits.
All of these changes will undoubtedly have ramifications for any company doing business in the state of California, particularly those investors with west coast dealings.
Corporate Tax Changes
The following corporate tax changes went into effect beginning with the 2013 tax year:
- Change in the definition of “doing business”
“Doing business” means actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. An out-of-state taxpayer that has less than the threshold amounts of property, payroll and sales in California may still be considered to be “doing business” in California if the taxpayer actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California. A taxpayer is doing business in California for a taxable year if:
- The taxpayer is organized or commercially domiciled in California, or
- California sales exceed the lesser of five hundred thousand dollars ($500,000)1 or 25 percent of the taxpayer’s total sales. “Sales” includes sales by an agent or independent contractor of the taxpayer, or
- The real property and tangible personal property of the taxpayer in California exceed the lesser of fifty thousand dollars ($50,000) * or 25 percent of the taxpayer’s total real property and tangible personal property, or
- The compensation paid in California exceeds the lesser of fifty thousand dollars ($50,000) * or 25 percent of the total compensation paid by the taxpayer.
*For taxable years beginning on or after 1/1/2013, the amounts are $509,500, $50,950 and $50,950, respectively.
Note that the sales, property, and payroll of the taxpayer include the taxpayer’s pro rata or distributive share of pass-through entities (partnerships or “S” corporations).
2. Adoption of a new definition of “gross receipts”
- “Gross receipts” means the gross amounts realized (the sum of money and the fair market value of other property or services received) on the sale or exchange of property, the performance of services, or the use of property or capital (including rents, royalties, interest, and dividends) in a transaction that produces business income. Amounts realized on the sale or exchange of property shall not be reduced by the cost of goods sold or the basis of property sold.
3. Adoption of the “Finnigan rule” for assignment of sales
- The general rule for determining which state a sale of tangible personal property should be apportioned (the numerator assignment) is the state of destination. An exception to this rule is where the taxpayer shipping the goods is not taxable in the state of destination perhaps due to PL 86-272 (no nexus with the destination state). Under the destination rule that is normally used to assign sales, this restriction on a state’s ability to tax could result in sales being assigned to a destination state in which the taxpayer would be immune from taxation. Under the Finnegan rule, the unitary group is the taxpayer. Accordingly, under the Finnigan rule, sales are not thrown backed (assigned) to the state of origination if any member of the unitary group is taxable in the destination state. (The Finnigan rationale only applies to combined reporting group members).
- Sales of tangible personal property are in California if:
- The property is delivered or shipped to a purchaser, other than the United States government, within California regardless of the f.o.b. point or other conditions of the sale.
- The property is shipped from an office, store, warehouse, factory, or other place of storage in California and (A) the purchaser is the United States government or (B) the taxpayer is not taxable in the state of the purchaser.
- For purposes of determining whether sales are in California and included in the numerator of the sales factor, all sales of the combined reporting group properly assigned to California are included in the sales factor numerator regardless of whether the member of the combined reporting group making the sale has nexus with California.
4. The requirement to use market-based sourcing rules for assigning sales of other than tangible personal property are no longer elective – all apportioning trade or businesses must assign sales of other than tangible personal property under the new market-based rules.
Market Based sourcing rules impact California taxpayers such as financial institutions that are required to switch from cost-of-performance for sales of other than tangible personal property (services or intangibles). Sales, other than sales of tangible personal property, are in California as follows:
- Sales from services are in California to the extent the purchaser of the service received the benefit of the service in California.
- Sales from intangible property are in California to the extent the property is used in California. In the case of marketable securities, sales are in California if the customer is in California.
- Sales from the sale, lease, rental, or licensing of real property are in California if the real property is located in California.
- Sales from the rental, lease, or licensing of tangible personal property are in California if the property is located in California.
5. The enactment of the single-sales factor apportionment formula for all apportioning trade or businesses unless the business is predominantly engaged in specified qualified business activities.
- Under the former rules, multistate businesses had an option to choose a tax liability formula that provides favorable tax treatment for businesses with property and payroll outside California.
- The option for specified taxpayers to elect the single sales factor apportionment is repealed, and instead requires specified taxpayers, unless specifically exempted, to apportion their income to California using only the sales factor of the unitary apportionment formula, beginning January 1, 2013. Taxpayers exempted from mandatory single sales factor apportionment include entities engaged qualified businesses, meaning they derive more than 50 percent of their gross business receipts from agricultural, extractive, savings and loan, or banking or financial business activities.
6. Sale of Partnership Interest
- On a sale of a partnership, an individual taxpayer will generally source the gain to their state of residence, unless their partnership interest has acquired a business situs in California. A corporate taxpayer may have to pay California taxes on a gain from the sale of a partnership interest even if the taxpayer is a passive investor and the partnership interest was a nonbusiness asset. Under California law the nonbusiness gain or loss from the sale of a partnership interest must generally be allocated based on the ratio of the partnership’s tangible property in California to the partnership’s tangible property everywhere at the time of the sale. However, if more than 50% of the value of the partnership’s assets consists of intangibles, the gain from the sale must be allocated based on the partnership’s sales factor for the year preceding the sale.
- For S corporations, the sale will be sourced differently for the corporation than for the shareholders. In addition, for purposes of determining the LLC fee, taxpayers must follow the corporation franchise and income tax apportionment rules for assigning sales for tangible personal property and the market-based sourcing rules for services and intangibles.
7. 1031 Exchanges
- If a gain or loss from the exchange of property in California is deferred under Section 1031 of the Internal Revenue Code (IRC), and the property acquired in that exchange is located outside of California, the taxpayer shall file an information return with the Franchise Tax Board for the taxable year of the exchange and for each subsequent taxable year in which the gain or loss from that exchange has not been recognized. If the required reporting is not done, then the deferred gain is accelerated, regardless of whether the replacement property has been sold. This new law applies to exchanges of property that occur in taxable years beginning on or after January 1, 2014.
8. Enterprise Zone Credits Repealed
- Although the enterprise zone credits are repealed beginning with the 2014 tax year, unused hiring and sales and use tax credits may be carried over for 10 years after 2013. This 10-year carryover limitation applies to flow-through entity owners as well. As always, the credit carryover is subject to the business income limitation. Even though the enterprise zones are repealed beginning January 1, 2014, the credit carryover may only be used against the net tax that would have been imposed on the income attributable to activities within the respective former enterprise zone.
- Qualifying and vouchered employees hired prior to January 1, 2014, will continue to generate enterprise zone hiring credits for any remaining portion of the 60-month period from the commencement of employment.
- In the coming weeks, information and frequently asked questions about the new California Competes Tax Credit and the New Employment Credit, which were both enacted by A.B. 93 and modified by S.B. 90, and the repeal of the enterprise zones will be available at ftb.ca.gov.
For more information on how these changes will affect your business, please contact me or call (513) 241-8313.