Expensing Service and Licensing Fees to Low and No Tax States

A Guide for Success

The wave of businesses leaving California is growing. The exodus will increase over the next two years due to contemplated state and federal tax increases. Short of physically moving a business out of California, many business owners are keeping a California location, but opening new businesses outside of California. There are often financial transactions between the California operation and the non-California operation. Those “transactions” take many forms such as loans, capitalization of a subsidiary, or possibly an expense item by the California entity. If a business operating outside of California receives a payment from a California company, the receiving business must determine if that receipt is taxable by California. Many California companies with operations in other states expense payments to non-California operations hoping to avoid California state tax without understanding the applicable California rules.

Proposed Tax Increases

To set the stage as to why businesses want to avoid California taxes as we progress through 2021, you should understand the proposed taxation of California businesses. California businesses currently pay some of the highest taxes in the country. According to the Washington, D.C. based Tax Foundation, California’s business tax climate ranks second worst in the United States. Only New Jersey was able to out-tax California with New York coming in as the third worst. Included in the top ten best states are Nevada, Florida, and Utah. I pull these three states out of the top ten because our firm has had an inordinate number of clients move their businesses and families to these states in recent years. Interestingly, Governor Gavin Newsom’s January budget has record reserves of $22 billion, including $15.6 billion in the state’s Rainy-Day Fund. California is estimated to have a $15 billion revenue windfall from higher-than anticipated tax revenue. Yet, not only the state, but every municipality is looking at ways to raise taxes on businesses. In particular, Assembly Bill 71 proposes to tax businesses $2.4 billion to fund an initiative to house the homeless. If passed, the tax increases will be implemented January 1, 2022. In Washington, President Biden has rolled out his American Families Plan (the “Plan”) which proposes the following:

  • Increased taxes on those making more than $400,000 a year as follows:
  • A 12.4% Social Security payroll tax, evenly split between employers and employees;
  • Limit the tax benefit of itemized deductions at 28% of value;
  • Restore limitations on itemized deductions; and
  • Phase out qualified business income deductions, also known as Section 199A pass-through deductions.

Additionally, the top income tax rate for high-income filers will be restored to 39.6%. Long-term capital gains and dividends will be taxed at a 39.6% tax rate on income above $1 million a year. The 3.8% tax on net investment income for individuals earning more than $200,000 and $250,000 for married couples will elevate the top rate on long-term capital gains to 43.4%. The Plan will raise the corporate tax rate to 28% from 21%. The Plan will impose a 10% tax penalty on corporations that ship jobs overseas along with numerous other tax increases on businesses. The increase in federal taxes puts a squeeze on businesses operating in high tax states as the combination of local, state, and federal taxes and fees becomes suffocating. If you add in elevated minimum wage requirements in the high tax state, the desire to move increases significantly. Excluding Washington, D.C.’s $15 hourly minimum wage, California currently has the highest in the country at $14 per hour.

Non-Resident California Sourced Income

If you are a non-resident of California or your company is in a state other than California, it does not mean you or your company do not have to pay California state taxes. California Franchise Tax Board Publication 1031 provides guidelines on the California nonresident tax rules:

  • Wages and salaries. Wages and salaries for services performed in California, regardless of the location of the employer or the employee (or where the payment was issued), are taxable to nonresidents.
  • Community property income. If your spouse is a California resident, their income is considered community property and is split equally between the two of you. Your community property share of that income is taxable to you in California even if you have never lived nor worked in the state.
  • Business income. Nonresidents may be taxed on any income from a business, trade, or profession that is carried out in the state. In addition, income from partnerships, S-Corporations, and trusts are taxed to nonresidents if it comes from sources within the state. If you are a nonresident with a business, trade, or profession that conducts business both within and outside California, the income generated from business you conduct within California is California source-income and is taxable in the state.
  • Real estate sales. The source of any gain or loss from the sale of real estate is the state in which the
    property is located. California therefore taxes nonresidents on gains from the sale of their California real estate.
  • Stocks and bonds. Gains and losses from stocks and bonds have a source where you reside at the time of the sale. If you are a nonresident, you will pay California tax on income from stocks, bonds, notes, or other intangible personal property if (1) the property has its business situs in California (meaning, it is located by here by law), or (2) you regularly, systematically, and continuously buy and sell such property in the State of California. California Revenue and Tax Code §17952.
  • Retirement income. In accordance with federal law, the State of California does not tax retirement
    income
    received by a California nonresident after December 31, 1995. This includes, but is not limited to: IRA distributions, SEPs, Keoghs, Roth IRAs, and qualified annuities.

Years ago, I was in a meeting with a business owner and several other professionals. A non-
California CPA/tax attorney attending the meeting informed the client that if he created an Indiana entity the client could expense all of the income out of the California entity to avoid California taxes and land in a much friendlier tax regime in Indiana. We were able to steer the client away from this horrible advice. I later read the Department of Justice filed a complaint against the advisor providing the bogus tax advice for tax fraud related to promoting charitable gifting schemes.
Navigating the California source income rules is not easy. Schemes to avoid paying California taxes are often ill-conceived and simply wrong. There are ways to follow the rules and optimize your tax obligation. Simply setting up an entity in another state is not sufficient.

Expense Deductions Not Sourced to California

To avoid California state tax, some of our clients pack up their business and family and move to another
state. Some slowly migrate by opening-up new stores or branch operations in other states. With time, they loosen their ties to California until completely severing ties becomes palatable. Others are glued to California either because of the nature of their business or because of family ties. The business owners falling in the second and third scenarios often seek to shift income from their California business to a low or no state tax state to eliminate the California state tax obligation.
Funneling money in the form of an expense deduction from a California business to an entity in a state with no income tax like Nevada will likely not work. If you are a California resident, it does not matter that you own a Nevada company. California will tax all of your income with some exceptions or credits no matter where it is derived. If you are a California non-resident and own a California company, you will be taxed on California source income as noted above in most situations. There are some legitimate deductible expenses a California entity can pay to a business in another state which will not end up as California source income to the receiving business. Examples of deductible expenses which do not end up as California sourced income include some services receipts where the benefit is received outside of California and certain intangible licensing fees. Service Receipts: California uses the “market-based” sourcing rules to determine if income from a non-resident service provider is taxable by California. Market-based sourcing is not based on where the service is performed, but where  the benefit of the service is received or used by the customer. California’s sourcing regulations define “benefit of a service is received” as “the location where the taxpayer’s customer has either directly or indirectly received value from delivery of that service.” These regulations provide that when a corporation or other business entity is the taxpayer’s customer, receipt of the benefit of the service is determined under  specific cascading rules. The first rule provides that the location of the benefit is presumed to be in California to the extent the contract between the taxpayer and its customer indicates the benefit of the service is in California. The presumption may be overcome by the taxpayer or the FTB showing, by a preponderance of evidence, that this was not the actual location where the benefit of the service was received.

Although the regulations focus on the location where the taxpayer’s direct customer receives the benefit of the services, the Office of Tax Appeals recognizes there are certain situations which warrant looking to the indirect customer. As an example, if a CPA in Nevada performs accounting services for a California client, fees are sourced as California income even if the CPA performs all services in Nevada. If the CPA worked as an independent contractor for a California firm performing accounting services for a Nevada client, the indirect customer would be the Nevada client so the income to the Nevada CPA would not be sourced to California.
If you intend on having a non-California company provide services to a California entity which will benefit a non-California business or resident, you must have a contract in place specifying the location of the direct or indirect customer being in a place other than California. This contract creates a presumption which must be supported by reality. Planning with Intangibles: California Revenue and Tax Code §17952 states that income of non-residents from stocks, bonds, notes, or other intangible personal property is not income from sources within the state unless the property has acquired a business situs in California. The corresponding 18 California Code of Regulations (“CCR”) § 17952 states that intangible personal property has a business situs in the State if: 1. It is employed as capital in this State; or 2. The possession and control of the property has been localized in connection with a business, trade, or profession in the State so that its substantial use and value attach to and become an asset of the business, trade, or profession in the State. The CCR provides examples, including, for instance, if a nonresident pledges stocks, bonds, or other intangible personal property in California as security for the payment of indebtedness or taxes incurred in connection with a business in the State, the property has a California business situs. If the intangibles do not have situs in California, then income derived from the intangibles are not taxed by California. To illustrate, if a nonresident owns California real property in an LLC and the LLC sells the real property, the transaction will be taxable by California, even though the owner of the membership interest in the LLC is not a California
resident. Conversely, if the nonresident sells the membership interests of the LLC which owns the California real property, the transaction will likely not be taxed by California unless situs has been created. The word “likely” is used because there are factors which could cause the transaction to be taxed by California.
There are many different types of intangibles and different ways in which to employ the use of intangibles. “Marketing Intangibles,” includes “license of a copyright, service mark, trademark, or trade name where the value lies predominantly in the marketing of the intangible property in connection with goods, services or other items.” Royalties or other fees paid by licensees for the use of Marketing Intangibles are sourced to the location of the licensees’ “ultimate customers.” The license of “Non-Marketing and Manufacturing Intangibles” includes “the license of a patent, a copyright, or trade secret to be used in a manufacturing or other non-marketing process, where the value of the intangible property lies predominately in its use in such process.” Licensing fees paid for the use of Non-Marketing Intangibles are sourced to the location where the intangibles are used.

Finally, “Mixed Intangibles,” includes the license of intangible property “where the value lies both in the marketing of goods, services or other items . . . and in the manufacturing process or other non-marketing purpose.” The rules for Mixed Intangibles focus on the locations of “ultimate customers” and locations where intangible property is used.

Conclusion

The above concepts related to a California business being able to deduct payments made to a non-resident business and the income not being considered California income to the California business have many rules, exceptions, and limitations which need to be considered. The California income sourcing rules are some of the most complicated in the country and source income positions are heavily audited by the California Franchise Tax Board. If you have concerns about California source income or would like to discuss these concepts further, please contact our office so we can discuss potential strategies specific to your business.

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