Generally, the income of a business that works outside of California is not necessarily exempt from California tax. California applies market-based sourcing to identify whether revenue is considered California sales to many service providers, freelancers, and consultants, as well as to pass-through business owners.
The question isn’t just, “Where was I when I did the work? Rather, California puts the question: “Where did the customer benefit from the service?” Always go for experts (similar to an attorney for IRS issues) who can handle your case swiftly.
Market-Based Sourcing (MBS)
The sale of services and other intangible property is subject to the same rules of assignment to California as apply to the sale of tangible property. With services, revenue is allocated to California based on the benefit that the purchaser receives in California from the service.
That can lead to potential California-source income for a business that is based in Texas, Nevada, New York, or another state, but serves California customers by providing a benefit to them in California.
Client Location vs Benefit Location
At this point, things start to get complicated.
Suppose a tax consultant is employed by a company in California from Nevada. The consultant performs every task from Nevada, but the California company uses the advice for its California operations. The revenue can be allocated to CA since the customer benefits in CA.
If the same California customer contracts with the consultant to assist his or her business operations in Nevada, however, the revenue might not count as a California sale. California’s Franchise Tax Board particularly notes that the location of the customer isn’t necessarily a deciding factor.
How California Determines the Benefit?
The FTB’s framework looks at four questions in general:
- What is the customer?
- What was your service?
- What did the customer get out of it?
In which place was that benefit obtained?
California has a billing-address presumption for individual customers, while taxpayers could argue for a different benefit location based on the contracts and ordinary business records.
The Reasons Are Important for Your Tax Bill
Market-based sourcing is in addition to California’s apportionment rules. Many apportioning businesses use one-sales factor to apportion a portion of their business income to California.
In the case of a business with $1 million in total sales, and a 30% sales factor allocated to California, the business income apportionable to California might be 30% of the business income. Professionals (like a tax resolution attorney) will make your job much easier.
Not all of the $300,000 may be considered taxable income. Sales factor is calculated based on qualifying business income, as defined by the appropriate apportionment regulations.
Tips for Out-of-state Business Owners
To minimise sourcing errors:
- Keep detailed records identifying customers and where services are used.
- Check contracts for language about the purpose and location of services.
- When the benefits of different services are in different locations, separate the revenue streams.
- Hold on to evidence that demonstrates your sourcing process.
- Review California filing/nexus requirements on an annual basis.
- Seek professional tax advice in the case of major contracts in California or intricate business arrangements.
All income earned by a resident of California does not necessarily count as California-source income. However, working outside of California does not automatically provide you with protection. This can be important even when the location where the customer gets the benefit is significant.
Knowing what constitutes a “market-based” source of income and what is not, and documenting the rationale behind the assignment of income to the appropriate source, can help avoid potentially expensive California tax surprises.
