In a recent case decided by the California Office of Tax Appeals (“OTA”), a three-judge administrative law panel interpreted the state’s income apportionment and sourcing rules in a manner that would require many out-of-state service providers to file an annual income tax return and pay taxes in California, even if the services are provided and the service provider is domiciled in another state. Although the case was decided in May of 2019, the OTA had until mid-September 2019 to determine whether the decision would have precedential effect. In deciding that it would, the OTA has effectively put taxpayers and practitioners on notice that the California tax net has expanded to reach those who are both not residents and those who do not actually provide services while physically in California.
Blair Bindley, a script writer who worked exclusively and was domiciled in Arizona during 2015, was in the business of developing works for television and film producers on a contract basis. During the tax period at issue, Bindley was commissioned by Mindbender Enterprises, LLC (“Mindbender”), as well as Lakeshow Films, LLC (“Lakeshow”) to produce scripts on a “work-for-hire” basis, meaning that the rights to the works created would belong to Mindbender and Lakeshow, respectively. Both Mindbender and Lakeshow were and are California companies.
During the California Franchise Tax Board’s (“FTB”) automated review process, where documents received by employers and/or other payors are matched with tax returns from employees and service providers, the FTB determined that Bindley did not file a tax return for 2015, despite having received $25,000 from Mindbender and $15,000 from Lakeshow. The FTB sent a letter to Brindley requesting he either (1) file a California tax return for 2015 or (2) explain why he was not required to file such return.
After correspondence from Bindley to the FTB asserting that he was not obligated to file a California tax return because he did not have California source income, the FTB sent Bindley a Notice of Proposed Assessment (“NPA”). After a timely protest of the NPA, protest proceedings, and the upholding of the assessment by the FTB, an appeal was lodged with the OTA.
In ruling in favor of the FTB’s proposed assessment, Administrative Law Judge Patrick Kusiak wrote for the concurring panel. Judge Kusiak organized the OTA’s analysis into three parts consistent with determining whether a nonresident is subject to California’s income apportionment rules:
- Whether the taxpayer was carrying on a business within California, outside California, or both within and outside California,
- The type of entity conducting the business at issue, and
- Whether or not the business was “unitary” in nature.
The OTA panel determined that Bindley was engaged in business both within and outside of California. The court relied on the fact that although he was domiciled and performed all of the work related to drafting, editing, and delivering the scripts in Arizona, payments received for work that Bindley performed.
The second prong of the court’s analysis was not at issue. Bindley was engaged in a sole proprietorship and was not an employee of another organization.
The third prong required the court to determine whether Bindley’s business was “unitary” in nature. Although California’s tax code does not provide a definition of a unitary business, Regulations provide guidance as to what is not a unitary business. When “the part [of the business] within the state is so separate and distinct from and unconnected to the part without the state such that the respective businesses are not part of a unitary business.” The OTA panel reasoned that because the scriptwriting services being performed in Arizona could not be disconnected from the payments made to Bindley from clients in California and therefore, Bindley’s business activities were unitary in nature. Because all three prongs were met, the court went on to analyze the application of California’s market-based sourcing rules.
California’s market-based sourcing rules source income based on where the benefit of the particular service is enjoyed or received. The court determined that the FTB has reasonably concluded that benefit of Bindley’s work product was located within California because Mindbender and Lakeshow were California companies.
What does the OTA’s decision in Bindley mean for other out-of-state service providers?
Because Bindley has precedential effect, it can be cited as authority by the state in its effort to broaden its tax reach. Those who provide services to customers within California from out of state, may find themselves in the crosshairs of California tax authorities even if they do not live or perform services while physically within California.
Of even greater concern, Bindley supports the notion that a sole proprietor may be required to file a tax return and be subject to tax in California even if they have never been to California or marketed directly into California. Likewise, many out-of-state business owners may not be aware of their obligation to file a return or pay tax in California as if they are domiciled and perform business completely outside of the state, they likely are not being advised by a California tax professional.
The reach of this case, could potentially be argued, applies to services provided entirely outside of the U.S. to California service recipients / payors wherein the foreign service provider could arguably have a California filing requirement even where they might not have a federal filing requirement.
