If it even brushes against California, the state government wants to tax it…
Income earned from CA-based clients by Out-of-State Residents
One of my clients is a lawyer but he moved to Las Vegas to try standup comedy. He didn’t set foot in California for two years. But he kept his law clients, all of whom were located in California, and earned income from them while living in Vegas. Both his accountant and another tax attorney told him he absolutely did not need to file a California tax return for the years he lived in Vegas. California’s Franchise Tax Board (“FTB”) had a different take. Sure, he’s not a resident, but he needs to file a return to report his California-related income. He’s “doing business in California,” even if he’s physically elsewhere.
Out-of-State Firms with California-based “Managers” or Investors
Another client is an investor in Beverly Hills. She holds a 10 percent non-managing interest in a Montana LLC with a hotel in Billings. In other words, she’s merely an investor in the hotel. California required the LLC register with the state, pay the $800 annual franchise fee, and file a tax return in California, because it’s “doing business in California.” I pointed out to the FTB that relevant statutes say that an LLC does business in California if a manager is in the state. The FTB replied that it considers any member of an LLC a “manager.”
These FTB positions probably violate the U.S. Constitution. And they do violate minimum-contacts tests that have arisen to determine a state’s jurisdiction over a person who does not live there (a state cannot exert jurisdiction over a person unless there are “minimum contacts” between the person and the state). But the cost of proving this is prohibitive.
My lawyer/comic client will pay $20,000 in income tax if he agrees to settle the case. If he wants to litigate it to an answer, that will mean appealing to the FTB (where a loss is a foregone conclusion), then the Office of Tax Appeals, then a Superior Court, all of which are likely to say “sure, you have minimum contacts with California,” because that position brings more money to the state. Having lost at all these levels, then he will need to file suit in a federal district court alleging a violation of the Constitution. The litigation could easily cost more than $100,000.
In the case of the Montana LLC, there may be some relief for non-California taxpayers. The state of Arizona has sued California in the Supreme Court, asking it to find California’s overreach to be unconstitutional. At the moment, the parties are arguing over whether Arizona can actually start the lawsuit by filing a complaint with the court. The dispute will probably take several years to iron out. Follow it here.
California’s tax system in these two cases is unjust. Unfortunately, it is unlikely to change, because fighting and winning will almost always be far more expensive to the individual taxpayer than giving up and paying an illegitimate tax. Read more about dynamic here.
FTB Exploitation of Taxpayers Unwilling to Wage Costly Legal Challenges
The FTB uses a tactic that suggests it deliberately exploits most taxpayers’ inability to fight the FTB’s decisions. My lawyer/comedic client has offered to settle his case by filing CA returns for the two years he lived in Nevada, in exchange for the FTB waiving late-filing penalties. My client clearly qualifies for “reasonable cause” relief, because his accountant and attorney told him he didn’t need to file a CA return. But the FTB won’t settle in this manner. They say he can file the tax returns, and then request another bureaucratic evaluation of whether the penalty exception applies. I expect the FTB to immediately say it doesn’t, starting another fight which will cost more than the penalties themselves. By refusing to consider both the tax liability and the penalty, the FTB is ensuring that it will receive the tax and the penalty because it will cost my client more to fight it than it would to just pay an illegitimate tax. WRONG!!!
August 15, 2019