Tax News
Big Business

Business Income Where Are We Today – Part 3

In our October 2013 edition of Tax News, we looked at nonresidents with apportioning business, trade, or profession income with a focus on several law changes summarized in our September 2013 edition of Tax News. In this article, we will focus on partnerships.

What has not changed?

In California, a partnership must file a tax return on California Form 565, Partnership Return of Income, if the partnership is doing business in California or has income from sources within California.[2] California R&TC Section 18633(a)(1) states, “Every partnership,…, shall make a return for that tax year, stating specifically the items of gross income and the deductions allowed by Part 10 (commencing with Section 17001).[3] ” This subdivision goes on to require the tax return to contain specific information related to the persons (partners) who would be entitled to a share in the partnership items whether the partners are residents or nonresidents.

Although a limited liability company (LLC) may be classified as a partnership, for California tax purposes, an LLC will generally file a California Form 568, Limited Liability Company Return of Income. An out-of-state LLC that is not doing business in California[4], has not registered with the Secretary of State, and is filing only to comply with the R&TC Section 18633 requirement to file and report income from sources within California or to file an election on behalf of a California resident may file using the California Form 565.

Similar to the federal law at IRC Section 6698, California law at R&TC Section 19172 imposes a partnership late filing penalty for the late filing of pass-through business entities tax returns (California Forms 565 and 568)[5] or if the tax returns are filed without required information. These penalties are imposed even if all taxes have been paid or (as is the case with a general partnership) no taxes are imposed.

What changed?

California has retained its former definition of doing business in California, but established bright line economic nexus standards to determine if taxpayers are doing business in this state. (R&TC Section 23101) For taxable years beginning on or after January 1, 2011, a partnership is doing business in California if it actively engages in a transaction in California for the purpose of financial profit[6] or if it is organized or commercially domiciled in California. A partnership may also be considered doing business in California if it has California sourced sales, payroll, or property even if the partnership did not actively engage in a transaction in California. The partnership is considered doing business (even if not actively engaging in a transaction in California or organized or commercially domiciled here) when the amount of California sourced sales, payroll or property exceeds the lesser of 25 percent of the partnership’s total (sales, payroll, or property) for the year or one of the threshold amounts (sales, property or payroll), as indexed each year.[7] For taxable years beginning on or after January 1, 2013, the threshold amounts are $518,162, $51,816, and $51,816, respectively.[8] Any pro rata or distributive share of California sourced sales, payroll, or property passed-through from other partnerships or “S” corporations must be included when determining if the 25 percent test or the threshold amounts have been exceeded.[9]

California law generally requires a partnership to determine its gross income per Part 10 of the R&TC. However, California Regulation Sections 17951 through 17954 require an apportioning trade or business to source such business income in accordance with the provisions of the corporate apportionment rules (Sections 25120 to 25139).[10]

For taxable years beginning on or after January 1, 2013, R&TC Section 25128.7 requires:

“all business income of an apportioning trade or business, other than an apportioning trade or business described in subdivision (b) of Section 25128, shall be apportioned to this state by multiplying the business income by the sales factor.”

This means “an apportioning trade or business,” regardless of the form of ownership, (e.g., sole proprietorship, partnership, limited liability company, or corporation), that carries on business within and out of California under Regulation Sections 17951 through 17954, or the provisions of Section 25128.7 is required to apportion the nonresident’s business income using the single sales factor. These businesses must also assign sales of other than tangible personal property under the new market-based rules.[11] Receipts from services are assigned to California to the extent that the customer of the taxpayer received the benefit of the service in California. Receipts from sale of intangibles and income from tangible and real property are now sourced to California to the extent that the property is used or located in California. The partnership will still need to determine the partnership's California property and payroll factors as the partners will need this information for purposes of determining their “doing business” status in California.

The same is true for a partner’s distributive share. Whether the trade or business is the partnership’s business (if not unitary with the trade or business of its partner), or the partnership interest when combined with the partner’s trade or business (if the partnership’s activities are unitary with the activities of its partner, notwithstanding ownership requirements), the business income of the trade or business would be apportioned using the single-sales factor under the provisions of Section 25128.7 unless the trade or business meets one of the exceptions of Section 25128(b) (taxpayers that derive more than 50 percent of their gross business receipts from a qualified business activity – agricultural, extractive, savings and loan, and banking or financial business).

This change can also have an effect on guaranteed payments. California Regulation Section 17951-4(d) requires guaranteed payments to be treated as part of the partner’s distributive share of partnership income and will be sourced to California in the same manner as business income. When the guaranteed payments are made to a partner who renders professional services to a partnership engaged in the practice of a profession (as described at Regulation Section 17951-4(h)), the guaranteed payments must be treated as part of the partner's distributive share of partnership income and sourced in the same manner as the distributive share of business income under Regulation Section 17951-4(g). Regulation Section 17951-4(g) also requires that a partnership engaged in the practice of a profession rendering professional services[12] to a partnership to include 60 percent of the distributive share of partnership income of each partner rendering professional services to the partnership in its payroll factor.

Example: The A-B-C company is a partnership performing accounting services within and without California. There are three partners, A, B, and C. Partners A and B are general partners and render professional services to the partnership. Partner C is a limited partner and is not active in the partnership business. Partner A is a resident of California, and Partners B and C are either nonresidents or non-California business entities.[13] For purposes of this example, each partner’s principal location is in his or her respective state of residence, and $64,500 of the partnership’s $150,000 sales were for services provided to California clients. The partner’s distributive shares of profit or loss are: A 50 percent, B 30 percent, and C 20 percent. In addition, Partner B receives a guaranteed payment of $10,000. Partnership profits after the deduction for the guaranteed payment is $50,000 for the year.

The partnership’s apportionment percentage for this state will now be based on the partnership’s sales factor. Since this is a partnership performing accounting services, sales will be assigned to the state where the benefit of the services was received. The California source income from the partnership is determined as follows:

 

  Everywhere California Percent

Sales

150,000

64,500

43%

Apportionment percentage (Sales factor)
The partnership’s California business income ($50,000 x 43%)

 

 

43%
$21,500

Partner A
As a resident, Partner A is taxed on that partner’s entire distributive share of A-B-C’s income, irrespective of the source of the income:
A’s share of partnership business income ($50,000 x 50%)

 

 




$25,000

As nonresidents, Partner B and C are taxed on their distributive share of partnership income from sources within California, determined as follows:
Partner B
Partner B’s share of Partnership business income from sources within California ($21,500 x 30%)
Partner B’s guaranteed payment ($10,000 x 43%)
Partner B’s Income from California sources

 

 





$6,450
4,300
$10,750

Partner C
Partner C’s share of Partnership business income from California sources ($21,500 x 20%)

 

 



$4,300

Since Partners B and C have California sourced income, both will have a requirement to file. What form and the amount of taxes each will be required to pay will depend on the type of taxpayer or taxable entity the Partner is and whether or not the Partner is considered to be doing business in California. As explained in our September 2013 edition of Tax News, there are different rules that need to be considered based on the type of taxable entity.

Based on the facts in this example, Partner B as a general partner would be considered to be doing business based on the activity of the partnership in California.

The partnership will also need to provide each partner their distributive share of the property, payroll, and sales on Table 2 of the California Schedule K-1. This information is provided to the partners for two reasons:

  1. For partners that are business entities, to determine if they meet the threshold amount of property, payroll and sales for doing business in California. [14]
  2. For unitary trade or business, to correctly compute the California sales factor. All trades or business with income from sources within and outside California must compute their income in accordance with the provisions of the corporate apportionment rules.

This would be determined as follows:

 

Everywhere

California

Percent

Property

$200,000

$70,000

35%

Sales

150,000

64,500

43%

Payroll: Employees

Partners:
A   $50,000 x 50% x 60%
B [($50,000 x 30%) + 10,000] x 60%
Total Payroll

56,000


15,000
15,000
$86,000

21,000


15,000
0
$36,000






41.86%

Partner C
Sales ($150,000 x 20%)($64,500 x 20%)
Property ($200,000 x 20%)($70,000 x 20%)
Payroll ($86,000 x 20%)($36,000 x 20%)


$30,000
$40,000
$17,200


$12,900
$14,000
$7,200


43%
35%
41.86%

Nonresident Withholding

Revenue and Taxation Code Section 18662 requires a withholding agent,[15] in this case ABC, to withhold tax on distributions of California source income paid to a nonresident. The partnership must withhold 7 percent on the distributions of California source income made to its nonresident partners B and C for distributions exceeding $1,500 for the calendar year[16] unless a certified Form 590, Withholding Exemption Certificate was received from these partners. The partnership may also request a waiver of the withholding requirement using Form 588, Nonresident Withholding Waiver Request.

Partners B and C (if individuals taxpayers) typically file California Form 540NR or elect to file a group nonresident tax return. See FTB Publication1067, Guidelines for Filing a Group Form 540NR, where the business entity would file a group nonresident tax return for their qualified nonresident pass-through entity owners.[17] If Partners B or C are business entities they will need to file the required business entity form depending on what type of business entity they are and pay depending on their doing business determinations. For example if Partners B and C are corporations, since Partner B is doing business Partner B will be required to file the Form 100 and would be subject to Franchise Tax. Partner C (if C has no other business factors) would be considered to be doing business based on the 25 percent test and would be required to file the Form 100 and would also be subject to the Franchise Tax. However, if Partner C has other business factors that would reduce Partner C’s California sales, property, and payroll factors below 25 percent, Partner C would still be required to file the California Form 100 and pay taxes based on California’s Income Tax (Chapter 3) on its California sourced income.

We stepped-up withholding provisions enforcement, and offer an ongoing Withholding Voluntary Compliance Program (WVCP). For more information on withholding, go to ftb.ca.gov and search for withholding.

[2]See regulation 17951-2.
[3] This refers to the partnership income not the partner income. A corporate partner’s distributive share of partnership gross income is determined in accordance with Part 10, see R&TC Section 24271.
[4] Don’t forget that an LLC that is a member or partner in another business entity may be considered to be doing business.
[5] Similar laws impose penalties on late-filed S corporation returns (see IRC 6699 and R&TC 19172.5).
[6] Be careful because when it comes to partnerships the activities of the partners can affect this determination.
[7] When considering sales for factor purposes be sure to include sales by the taxpayer’s agent.
[8] For taxable years beginning on or after 1/1/2011 and before1/1/2012, the amounts are $500,000, $50,000, and $50,000, respectively. For taxable years beginning on or after January 1, 2012 and before January 1, 2013, the amounts are $509,500, $50,950, and $50,950, respectively.
[9] R&TC Section 23101(b)
[10] This regulation also requires a partner’s distributive share of partnership income derived from sources within California (with some modifications) also be determined using corporate apportionment rules.
[11] R&TC Section 25136.1 (new law) provides special sales factor rules for certain cable system operations, but even those taxpayers must use the new market rules.
[12] See California Regulation Sections 17951-4().
[13] For purposes of this example, a non-California business entity means any business entity that is not incorporated, organized, or formed, and existing, under the laws of California, or qualified through the Office of the Secretary of State to transact intrastate business.
[14] Partners may also be considered doing business in California if they are general partners of a partnership doing business in California, or if they are organized, commercially domiciled or actively engaging in any transaction for the financial or pecuniary gain in California.
[15] A withholding agent is any person or entity having the control, receipt, custody, disposal, or payment of California source income. We also refer to withholding agents as “payers.”
[16] Special rules apply to allocations of California source income to foreign partners and members (payees).
[17] If the withholding credit was not allocated to the nonresident group return, you will need to use Schedule 1067A, Nonresident Group Return Schedule, to allow us to move withholding credits to the group. It will take us six to eight weeks to move the withholding credits and make them available to be claimed on the group return.

 

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