California Tax Developments: The Implications of New Regulations with Michael Cataldo: Part 2

Meredith: 00:01:02

Welcome to SALTovation.

The SALTovation show is a podcast series featuring the leading voices in SALT where we talk about the issues and strategies to help you make sense of state and local tax.

Intro: 00:01:14

he implications of Public Law: 86272

We also explore several key developments including market based sourcing and the Bindley case remote accountants and the Luber case, Governor Newsom's budget proposals and practical advice for SALT compliance in California's challenging tax environment.

Stacey: 00:01:41

TAM and publication about PLD: 6272

And then what then what's the process after that?

Michael: 00:02:12

Well, it could go a variety of ways. My suspicion is they're going to just proceed to the Office of Administrative Law and get them final and it'll be done.

And these will be the regs we'll be stuck with for another 10 years. And I suspect within a year or so there's going to be another interested parties meeting to suggest some amendments to it.

Because I mean it's really difficult to apply these things just statically in the world we know now. You know, advances in technology, the way things change, how business gets done changing.

It's going to be constant sort of reevaluation and trying to get some guidance for people to figure out how to comply. What is the right way to comply. Seems like there's a lot of gray area.

Stacey: 00:03:02

Sure.

Meredith: 00:03:03

Yeah.

Stacey: 00:03:03

I mean I think that the point right. Of those regulations is to try to give guidance, but it's a lot of information and they can't anticipate everything.

Michael: 00:03:13

It's almost like they tried to and then they said never mind, we're not going to be, I mean if you look at how many examples they have. Yes, there's so many examples and they're not always consistent. And it's like well in that example you said this, in this example you say this, this.

Stacey: 00:03:28

I know it.

It's as a practitioner with, you know, lots of service based companies, we really have to do we really have to pour through those and just make sure that we understand how our clients facts might fit into an example or two or three, you know, in those regs.

Meredith: 00:03:48

And sometimes you need just like kind of a conspiracy theory board of like, here's a picture with all the, like the red string linked.

Because it's like, well, if the facts are the same in example four, but for this piece and example five, and now we're in example ten and you're like, I'm sorry, where are we? And like, what are our actual facts that we're trying to outline? Some examples in any reg are just sometimes not good, not well written.

Michael: 00:04:17

There's going to be a new episode to csi. Csi.

Stacey: 00:04:23

There you go. There you go. I like it, I like it.

Meredith: 00:04:26

That's the Accountant too. Think Ben Affleck can get on board the tax version?

Michael: 00:04:32

Yes. Can we get a salt version of the Accountant? We could get five.

Stacey: 00:04:36

There you go.

Meredith: 00:04:36

I think all five of our listeners, thank you to our loyalists.

Stacey: 00:04:42

I think you, you guys might be onto something.

Meredith: 00:04:46

We're going to claim those rights. Mike, write it up. You're make it somewhere in Hollywood.

Michael: 00:04:51

Screenwriter, right? Screenwriter, yes, that's right. So that's, that's kind of where that's heading. What. Oh, so I don't. Do you have any more questions on that?

We can always circle in and circle back to it if I think of other things.

Stacey: 00:05:05

But no, I, I mean, again, it was more. I just thought it'd be good for the, you know, kind of our listeners to hear about process. Right.

been following, you know, PLA: 6272

And we now know with this regulation that there's. It is in process and. Well, has been ad nauseam. But there is a process.

Michael: 00:05:34

Yes, there is a process.

Stacey: 00:05:35

It's just a lengthy one. A lengthy one.

Michael: 00:05:37

Yeah, it is. They have to. The staff has to get permission from the board, the Franchise Tax Board, the actual people who are the board, to proceed with this.

And they got that back in: 2020

I, one of the things I said is why don't we take a step back and kind of incorporate the legal rulings, which one is into the reg. But they don't. They. Well, at least as of yet, haven't responded to that. And I don't think they're going to. But they have gone through the process.

They're going through this last part of the process. Maybe they will go back to the drawing board. And change some things. Maybe not, but we'll see.

But I think they're getting close to just, here's the next set of final regulations and these will be the things that you have to apply going forward until they change it again.

Stacey: 00:06:36

Okay.

Michael: 00:06:37

So watch out for those. Those are coming up and that'll be for 20, 25.

Stacey: 00:06:42

Okay, good to know. We might not be able to apply them, but good to know.

Michael: 00:06:49

Yeah.

Stacey: 00:06:50

Are we going to need help applying them?

Michael: 00:06:53

Yeah, it's like, how do you apply them? And it's not like a Scantron test where there's one absolutely correct answer. Maybe this, maybe this.

So you have to kind of do some weighing, balancing, figuring out which, which is the best way to go. Also thinking about, okay, if we do it this way this year, they're going to expect us to be doing it this way next year.

And the next year doesn't mean you're necessarily stuck with it. I think I've always taken the position that a tax return can be prepared incorrectly.

It doesn't mean you have to stay with an error just because you made one before. They'll fight that and say, no, you're stuck with it. But if it's wrong, it's wrong and you just have to correct it.

Meredith: 00:07:37

Yeah, there are federal method changes where if you have two bad things, it's now a method and you got to change that. Not really in our framework here.

Michael: 00:07:49

Yeah. The one area I think about when I think about this is unity. Are you a unitary group or not?

I see a lot of companies who are, you know, during the years their, their income tax is like, eh, not a huge deal. They've got a lot of different entities and it's just easier to file on a combined basis.

And I don't know if people really examine whether there is unity or not. There's, I mean I've had a few clients where we just want to file all combined. We just want to file all combined.

We don't want to do all these separate return states. And yeah, it's fine until you have a big sale that creates a bunch of taxable income, a giant gain.

Then you're like, oh, maybe we should examine this. And perhaps, maybe you weren't unitary. You got to look at the facts and apply them. And the law of unity is the law of unity.

If you mess it up earlier on, you're not going to be stuck with it. You got to correct it.

So here's another one that I just want to mention here because it's pretty timely and I don't know if it's going to happen, but it's a pretty good chance. So Governor Newsom put out his. It's sort of like a proposal for the budget and what kind of tweaks they've made.

So California is a single sales factor state generally. However, there are certain industries that are still required to use three factories, property, payroll and sales.

If you're in a financial or extractive or agricultural and they have a whole bunch of tests for those, then you use three factor. But Newsom is suggested for financial to pull them out and have financials be single sales factor.

So this would be good news for financials in California and not good news for financials outside of California because no longer can you rely on your payroll and property to dilute your apportionment percentage. I haven't seen anything else on it. It's just this is pretty, pretty recent. It came out a couple days ago.

So that's something to, to keep a lookout for.

Stacey: 00:10:00

Okay, so at this point it's just proposed, right?

Michael: 00:10:02

Just proposed.

Stacey: 00:10:03

Okay.

Michael: 00:10:04

It is in the budget, though. So it's not just like necessarily a throwaway. I think there's going to have to be some serious opposition because money talks.

Meredith: 00:10:14

One, isn't that the perfect plan where your constituents get a break but you're out of state, your non voters don't. And especially with the state of California and the size and we're talking financial institutions and money and that is the play. Seems like the.

Seems like the perfect, the perfect resolution for, you know, fundraising.

Michael: 00:10:36

Yeah, that's kind of how the whole single sales factor started.

Meredith: 00:10:39

Yeah, that.

Michael: 00:10:41

And then you're a state that. Because, I mean, forever ago, the Willis report times like when the feds were like, hey, you know what?

We're thinking about just taking this whole area over. And then the states were like, ooh, we don't like that.

Let's create the multistate tax commission and let's create udipta and let's have everyone say we're going to accept all of these rules the same. So there's uniformity. We don't have the risk of double taxation. Look how good we're doing.

And then the Feds backed away and then we had UDIPTA and three factor formulas. A fair way to evaluate where you're doing business and where your income should be taxed.

And then, you know, time passes and the threat of the Feds taken over and preempting the states and they start saying, hey, let's do single sales factor, because that's really it's like another way of doing like credits, kind of like, hey, invest in the state, we'll give you credits. Well, you know, we don't really have to do credits if we just tweak the formula.

So basically you property and payroll, you're hiring here, you're investing in property here. We're going to take that out of the equation of how much income tax you have.

And then once one state does it, then another state does it and then you have a whole nother reason why you have to do it. It's like you're not competitive anymore and suddenly all your businesses are leaving so you join in and that's kind of where we're at now.

Stacey: 00:12:16

Yeah, well, in California was obviously a very, very early adopter of that.

Michael: 00:12:20

Yes.

Stacey: 00:12:21

So out on the forefront.

Michael: 00:12:22

Yep. And then New York, it's like California, New York. We watch these two states and yep, New York did what California did, had done.

Like New York was separate company state forever. They had some weird rules for combination which were difficult.

And then they finally said, yeah, single sales factor, economic nexus and unitary combined reporting, that's profit maximizing.

Meredith: 00:12:48

All right, so what was one of the other topics that you were going to bring up, I think before we circle back and got into unity, what else is occupying your time these days?

Stacey: 00:13:03

Where do you want to start?

Meredith: 00:13:05

Let me pull out my timesheet and just really pinpoint all those real specific issues.

Michael: 00:13:11

Well, you, you mentioned the REG project 17,951, 5 and 8. And this is about directors, non residents, non employee directors.

And this is because I look as thinking about this and this is kind of emblematic of what California is doing as far as we want to get everyone to use market based sourcing.

you look at the existing reg.: 17951

ry clear that the rules under: 17951

But if you're an entrepreneur, you're going to go into udipta. So that's kind of where they're going with that.

And then their Dash 8 is really specific to the non resident, non employee director and they're basically what they're saying without saying as much is the benefit of the service provided. Well, the benefit of the service is where your, where the corporation is headquartered.

So it's kind of like, okay, come to California, have your, your board meetings here and if your company is based in New York, well, you can hang out here, earn all your income while you're in California as a non resident and you're not going to pay any tax in California even though you're here. But then the reverse is also true. You're in New York, you're on a board, you're a non employee board member.

But if you're the company that you're working for or providing the service for is headquartered in California, they're going to say that's California source income. Even if you never step foot in California, that's, that's where they're heading with that.

One of the things is, and in salt, it always seems, especially when you're talking about business, non business income, where do you allocate it? It's to the commercial domicile. And it seems, it's always just assumed that that's like an easy answer.

And it's becoming less and less easy as time goes on. Especially with here we are on this call here we're all in different places.

Technology has made it such that so it can be more of an issue as to where the headquarters is.

Meredith: 00:16:35

I mean we have a lot of clients that have just like, we don't have an office, we don't like everyone is remote. The only thing we have is a PO box somewhere that gets literally auto forwarded to our controller's house.

So it's not this person's home address that we're putting on a tax return, it's your domicile, where your PO box is. Even though there's no officer there, there's no management happening.

Stacey: 00:17:02

Right. Where are the books and records?

Meredith: 00:17:05

The Internet.

Stacey: 00:17:06

Correct.

Michael: 00:17:07

The cloud.

Stacey: 00:17:08

In the cloud. In the cloud.

Yeah, I mean I've had that, I've, I've had those questions like the accounting team is spread out, you know, they're remote and books are in the cloud. What's the commercial domicile?

Michael: 00:17:21

Yeah, it's difficult.

Stacey: 00:17:22

Great question. It's a great question.

Michael: 00:17:25

And I think the States and California would love to just eliminate that as a, a thing in the allocation apportionment world. We don't like business income at all for one. And even if it is and we can't get away from it, let's use this business situs rule.

This Metropolis case kind of alluded to that in their concurring opinion. Which is not the law actually because they decided the case based on a different rationale.

But it's just kind of indicative of where it seems to be going. And like you say, hey, it's non business income. All right, we're going to win.

And then they come back and go, okay, but we're going to say that you're commercially domiciled here then now we get all that. Where are the, where are the officers who are running the company? That's like the main thing. But like it could be dispersed all over the place.

Meredith: 00:18:23

Yeah, we also have a. I mean it's a little different because this group of kind of entities does have a color or Colorado, California manufacturing facility.

But realistically all of their officers are in the UK like their cfo, their CEO. Realistically they have one kind of managing director. You know, so it's not chaos in an office, but the board, everyone sits in the uk.

Michael: 00:18:51

Yeah. You can have a commercial domicile there. Why not?

Meredith: 00:18:54

Doesn't have to be in the US So under source. I mean again they're this entity within a large scale structure is you know, incorporated in California.

So but you could have completely unrelated board of directors. Not even in the US So now it's nowhere.

Michael: 00:19:13

Right, Right. Or it's. It's not in California. Not. Not here. Right.

Meredith: 00:19:21

And so what. And this might also kind of speak to budget, you know, Governor Newsom doing stuff. But California kind of suspended some NOLs.

done before. We talked about: 2008

Why do you think California always goes there to kind of that NOL suspension And you know, do you have any sort of thoughts on that and just kind of some of those suspension of items, you know that some states do, some states don't. I think Pennsylvania's realistically got a permanent 60% cap on any NOL utilization. Connecticut's got some suspension.

when California did in about: 2008

Michael: 00:20:21

They've been using this NOL suspension for quarter century now as part of their budgeting process. It's always when the budget looks dire. This latest version actually gives them an opportunity to reverse it.

If the rent, if the money is in, if things go better, but the prior ones did not. It's just easier. I mean it's difficult to get a tax increase even though this is a tax increase. I think, I think it is, but it's easier for them to.

And they've done it so many times.

I think the problem is that people investing in California are going to be like, okay, there's a good chance we're not going to be able to use our NOL at some point because California is, it's a cyclical. There's wow, we are way above budget. One, one minute and then oh my gosh, we are in catastrophic is California's.

The revenue California generates from its income tax is like almost all of it is from the 1 percenters and almost all of that is from basically the stock market. So stocks go up. You could look at track NASDAQ and track California's budget.

There might be a little lag, but there's huge reliance on that and that's why there's so much volatility. So then in the lower times, and it's like, hey, we need to pay all of these bills we have every year, no matter.

So we turn off the NOL faucet, we can get a little bit more money in. And then the theory is you'll get those extra years later, it's suspended, but you're not going to lose a carryover year.

Stacey: 00:22:00

So it's like an easy kind of low hanging fruit for them.

Michael: 00:22:03

Yeah, yeah. A way to raise taxes without raising taxes.

Stacey: 00:22:07

Right.

Michael: 00:22:07

And then you know, it's, it applies to corps and individuals, but optically it looks like you're getting the businesses and not the little guy.

Meredith: 00:22:17

Mm.

Michael: 00:22:18

So yeah, I had a case once in one of these NOL suspension deals where the, the client actually.

So during the year, one of the years NOL suspended, but also at, during that same year they actually incurred an NOL FTB's argument and they have a legal ruling that says this is if you didn't, if you weren't able to utilize the nol, then you don't get an extra year. And the statute doesn't say that. The one back in the years I was dealing with doesn't say that, but FTB's legal ruling does.

That legal ruling is iffy questionable in my view anyway of its applicability.

o get the extra year. This is: 2008

They tinker with it a little bit. But that's kind of my experience with the NOL suspensions. Well.

Meredith: 00:23:28

Cause California didn't adopt or what's California's carry forward period? Is it still limited to 20 years but not capped at 80?

Michael: 00:23:39

Not capped at.

Meredith: 00:23:40

They didn't adopt TCJA. No. 80% but unlimited.

Michael: 00:23:45

They did not.

Meredith: 00:23:46

So you are still having an opportunity for an NOL to. To expire where other states kind of adopted the forever carry forward.

Michael: 00:23:55

Yes. And then each. I mean California's NOLs like Gee, over the last 25 years it is.

You could write a book on it as far as like what are the carryover years? I mean sometimes it's 5, sometimes it's 10. It's changed so much. So you gotta kind of look at each year's rule and your NOL schedules could be insane.

What your carryovers are.

Stacey: 00:24:21

Need a flowchart.

Michael: 00:24:23

Yeah.

Meredith: 00:24:23

Yeah. That's the accountant free the decision tree.

Stacey: 00:24:27

Yeah.

Meredith: 00:24:30

I'm sure Illinois could draw you up a, you know, a flowchart for your.

Stacey: 00:24:35

That flowchart doesn't make any sense to me either. So.

Meredith: 00:24:38

No.

Michael: 00:24:39

Which.

Stacey: 00:24:39

It's going to the wayside I think now anyway. So it's okay.

Meredith: 00:24:44

And then kind of as we wrap anything kind of on the horizon that you're keeping your eye out that we.

That you think California is going to pick on that we haven't really talked on or this is kind of like a big, you know, they're going to start taxing software. Right. Like that's. That's the newest, greatest, hottest, latest. Or that's not true. I'm not saying that.

But just something that there's something that you're keeping the eye out that I'm. All of a sudden I'm quite maybe edit that out.

Michael: 00:25:15

California, big state, big tax state. Right. But they are unlike the east coast, they're unwilling to tax technology. Really.

Meredith: 00:25:25

Yeah.

Michael: 00:25:27

California, you can understand why.

Meredith: 00:25:30

Right.

Michael: 00:25:30

We want to keep these people here.

Stacey: 00:25:32

Yep.

Michael: 00:25:33

The big boys have. Have some say in it. So like SAS and things like that. I haven't seen much California doing that. At some point it gets desperate. Maybe. Maybe they do.

So there's one area it's. I wouldn't say it's new but emerging and I think a lot of people aren't aware of it. It's. It goes back to Udipta and Independent contractors.

And there was this case, Binley. I don't know if you're familiar with Binley. It surprised a lot. Okay, well then I got even better case after that one.

Stacey: 00:26:11

All right, let's do it.

Michael: 00:26:13

All right, so Binley was a screenwriter and he was in Arizona, just lived in Arizona. Screenwriter. And he sold his scripts to someone in California, never filed a California return. He was a sole proprietor.

So the screenwriter issued a: 1099

nding some other sources. But: 1099

And this went up to the Office of Tax Appeals. It is a precedential decision. And they said, okay, Mr.

Binley, you owe California tax because market based sourcing, your customer received the benefit of your service in California, your service being writing transcripts. So there was a case before which was non precedential, this appeal of Larson. And in the appeal of Larson, the OTA decided the opposite of this.

They decided there was no unitary business going on in California because Larson was a non out of state person. He didn't come into California at all for no services in California. And FTB made the argument about market based sourcing.

They got the: 1099

People were happy until Bingley came out.

And then people were kind of surprised, a little bit shocked, like, hey, you're conducting a unitary business in California because you have a customer who's receiving the benefit of the service in California. So now I want to talk about this other case and it's. They use Bimley for, for the basis of it appeal of Luber L O O B E R.

This will be close to your hearts because this is an out of state accountant. This out of state accountants. Yes, did accounting services. She was in, in the state of Washington. So there's no personal income tax there.

ause that's where you'd get a: 1099

And FTB came knocking on her door and said, you need to pay tax for these years. And they applied Binley. It went to the OTA non presidential decision. But I think a. A tale worth paying attention to.

of market based sourcing and: 1099

I'm going to pull up the, the regulation just so I can read it. Pardon me. I want to be exact. I'm wearing this page out.

Meredith: 00:29:49

We'll send you a tax marks bookmark so that every time you open that page you can see you can think of us.

Michael: 00:29:56

Okay.

the regulation it's, it's the: 179514

Then there's: 179515

What it says they have an example and it is for oh lawyers, accountants and other professionals are supposed to source their income based on where they perform the services. So there's a little conflict here between the two.

Stacey: 00:30:57

Sure.

Michael: 00:30:58

To regulations and the OTA almost. I mean I don't know.

They, they put a footnote that appellate never raised the question of whether this regulation should apply which it seems applies directly on its face. She's an accountant. She did not perform certain. And that's. It didn't raise it. We're not going to help her out and we're not going to waive penalties.

They're really just saying hey, we're very serious about these market based sourcing rules. If you've got clients here that you're serving, we expect that you comply with these rules. You file your returns, you pay your taxes.

One other thing to note about this issue with independent contracts, sole proprietors really especially for the smaller businesses. One way to kind of alleviate this concern is to create an LLC or a corporation because then you get into the factor presence rule.

Meredith: 00:32:01

That was going to be. My question is if you know, do the factor presence rules apply to humans and if not could she have had the. Yeah. Started a business or had.

And had the business be paid?

Michael: 00:32:14

No. So in California as an individual if you have California source income of above it's like it depends on your filing status. Like 30,000.

I mean it depends if you're married, filing jointly or whatever. But it's not, it's not a lot generous. No, it's not a lot. Right. But if you just.

If you perform your services with a limited liability company or a corporation, then you can say, hey, we don't have to file here because we haven't exceeded that. And then you're safe from that for the smaller ones. Once you exceed it, then you're kind of in the same. Same mix.

But there's a bit of surprise especially for. Because she ended up having. What was it, like 300,000 for all of the years. Like she would have been protected if she had it.

Stacey: 00:33:01

So I have a question on this though. Like, because you have to have a unitary business in order for those to apply. So is she unitary with herself? I mean, what.

Where's the unitary business, basically? So what's the argument there?

Michael: 00:33:15

Yeah. If you want to read Binley, you can read it a million times. Good luck finding it. But I think the theory is this. It's because California.

It's because California adopted market based sourcing. The unitary business is. Now includes your market.

Stacey: 00:33:33

Gotcha.

Michael: 00:33:34

I think that's the theory.

Stacey: 00:33:35

Which is.

Michael: 00:33:36

I think that.

Stacey: 00:33:36

Well, which is. Right. Which is. That's where I was kind of what I was wondering what. What is she unitary with the customer?

Michael: 00:33:46

Or.

Stacey: 00:33:46

Or where's her mark? Her market is.

Michael: 00:33:49

Her market is part of her. Part of the confines of the unitary business includes that. Not where you're working. So that's theory.

Stacey: 00:33:58

That is pretty egregious.

Michael: 00:33:59

Yeah, well, I mean this hasn't been challenged in court yet. This is the otr. It is a precedent opinion and that's how it goes. If there's ever a case, then we'll have to see what a court says about it.

That could undo all of that. But until then.

Stacey: 00:34:17

Right, But I think. Yeah, it's a cautionary tale.

Michael: 00:34:20

Right. A cautionary table. A tale peels of louver L O O B E R. It's worth looking up just to, you know, especially.

Stacey: 00:34:29

Yeah, especially for. Well, especially for those accountants that might be listening to this as well.

Michael: 00:34:35

Yeah. Or you know, attorneys, service providers. It's like, hey, read it before you go to bed if you want to.

Meredith: 00:34:41

Have some nightmares or you're having trouble falling asleep.

Michael: 00:34:45

Yes. There's no benefit on the other side of it where it's like, hey, I'm here. But it's like I'm a resident. So worldwide income is taxed.

Stacey: 00:34:53

I don't really. Right, right.

Meredith: 00:34:57

Well, Michael, thank you so much for your time, for your friendship, your advice, your you're kind of being part of our network of friends of the firm. We greatly appreciate your expertise and taking the time to sit with us.

I'm sure maybe after another California legislative session, we'll see what happens. Make you a recurring guest based on geographic so thank you so much for your time. We really appreciate it.

Michael: 00:35:27

Absolutely.

Stacey: 00:35:28

Happy.

Michael: 00:35:29

Happy to do it. Thanks, guys.

Stacey: 00:35:30

All right, thanks.

Meredith: 00:35:32

That's another episode of SALTovation. Till next time.

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