Navigating California's tax landscape requires careful planning and professional guidance. For businesses, one complication in California is its unitary system of taxation.
Unitary taxation affects businesses that operate through related entities. In fact, it may start with even a small corporate business that acquires a substantial interest in another business.
Unitary taxation, in California and other states, requires business income to be taxed as if all entities were reporting as a single entity. The combined income is then subject to apportionment, allocating within and without California, usually by sales revenue allocated within and without California. The objective is to keep businesses from shifting income to low-tax jurisdictions. This system affects not only C corporations – those that report tax at a corporate level but also includes reportable income from partnerships and limited liability companies in which such entities hold an interest.
Unfortunately, it is not always easy to know if related businesses are unitary. California and most states perform two tests: the Three Unities Test and the Functional Integration Test. The Three Unities Test examines whether entities share three common elements: unity of ownership, operation, and use. The Functional Integration Test examines its namesake and whether the entities are "functionally integrated." Simple examples are companies that are horizontally or vertically integrated, but integration can also extend to other substantial, material integration of activities such as coordinated equipment acquisitions, financial assistance, corporate expansion support, technical support, and general guidance from one company to another.
Because many businesses do not realize how easily these tests may be triggered, and how dedicated examiners are to finding revenue by claiming or disclaiming unitary taxation, whether during examination, administrative appeals, or in court, having an experienced tax representative is critical to reporting, planning, and avoiding adverse rulings.
Common mistakes leading to unexpected California tax liabilities
California, standing at a 13% personal income tax rate, has become one of the highest taxing states in the country, and the result is that a number of individuals mistakenly believe it is simple to end California residency and taxation by simply moving or acquiring a home in another state. Unfortunately, even individuals who claim they have moved to another state may still be taxed as California residents. And it is worth noting that California does not follow federal law on residency.
Because there is no simple list of items, like changing one's driver's license, or a fishing license, or where one works, it is important to confer with a tax professional familiar with residency rules. Moreover, even where one is successful in changing residency, California can still tax nonresidents owning rental properties or other income-generating property in California. Even persons working from home while living out-of-state but delivering goods and services to California residents and businesses may become subject to California taxation. Given these intricacies, hiring a tax representative can help avoid unexpected surprises.
Proactively avoiding California's tax net
For businesses avoiding California taxes, there are some simple steps to follow but one must be careful about California's long-arm rules. For example, an older federal law exempts sellers of goods from state income taxation who use outside contractors who solicit sales and carry samples, but not much else. This does not, however, avoid sales taxes, where total annual sales exceed certain thresholds.
For individuals avoiding California taxes, it is suggested that those individuals permanently sever most ties to California. This includes no longer holding or owning property within California that produces income and limiting your return visits. Nonresidents must report income from California sources on Form 540NR. Wages earned while working in California will be taxed, as will income from markets sourced within the state.
On the other hand, as a non-California resident, interest and dividends from bonds, banks, and certificates of deposit and stock investments are generally not taxed by California. Additionally, nonresidents working remotely for California companies can mitigate tax liabilities by asking their employer to cease both California wage reporting and withholdings, although this may require further discussions.
Key differences between California and federal tax laws
When addressing California law, it is important to know the computation of income diverges from federal tax law. The state and federal governments may measure income differently, resulting in varied standard deductions and treatment of deductibles. California also handles net operating losses and other tax elements differently. Notably, California's Pass-Through Entity (PTE) election provides opportunities to lower personal income taxes.
It is also important to correctly file and report all required returns where California taxation applies. Where there are no substantial understatements, California typically has four years to assess a filing. But non-filers have no limit. In addition, where there are federal adjustments, these should be reported to California within six months to limit the right for California to make an assessment in two years; otherwise, the standard four-year period applies. Last but certainly not least, avoid submitting fraudulent or improper returns, as this can void the statute of limitations.
By understanding these principles and seeking expert advice, businesses, and individuals can better manage their tax obligations and avoid potential pitfalls.
Originally published in Sacramento Business Journal
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.