In this episode of the SALTovation Podcast, Meredith Smith and Stacey Roberts explore the latest changes in California’s state and local tax landscape, focusing on recent conformity updates and the finalized market-based sourcing regulations. Joined by Michael Cataldo, they examine what these changes mean for taxpayers and the challenges of navigating apportionment nexus and compliance in today’s dynamic economic environment.

Cataldo shares his insights on pivotal income tax cases shaping California’s business climate and breaks down the complexities companies face in understanding business versus non-business income, especially in significant transactions like the sale of a business or its assets. 

Key Takeaways:

• California updated state and local tax rules, including market-based sourcing.
• Changes affect apportionment nexus and compliance for businesses.
• Distinguishing business vs. non-business income is vital in major transactions.
• Recent tax cases are shaping California’s business landscape.
• Staying informed is essential for local and multistate taxpayers.

Connect

Subscribe on your favorite podcast app here.

Follow us on LinkedIn and YouTube.

Talk To A Tax Advocate Today:

https://taxops.com/contact/

Mentioned in this episode:

SALT Contact

SALT Contact

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.

In part one of our conversation with Michael Cataldo, we dig into what's happening in California right now.

Conformity changes the long awaited final market based sourcing regulations and what those rules mean for taxpayers, navigating apportionment nexus and compliance in a modern economy. Michael also shares early insights into key income tax cases shaping the landscape for businesses operating or simply selling into California.

Let's jump in.

Hello everyone and welcome back to the Saltivation podcast.

We have friend of the firm, our California guy, Michael Cataldo with us again and we are so grateful to have him here and in our back pocket for all things California.

So, so we just thought we would kind of check in with him and he could give us kind of an update on what's going on in the state and some maybe cases that he loves, hates, loves to hate check in and yeah, just give us what's going on in his home state. So Michael, thank you again for being here on this Saltivation podcast. It's great to have you back.

Thank you for inviting me back. Always enjoy chit chatting about the latest and greatest in salt issues in California in particular.

Well, your state is usually very busy and at the forefront of what other states look to also do. So.

Yeah, yes, yes, this is true. It's been like that for quite a while. Yeah, for good, for better or worse. I guess. Sort of an outline of what I'm thinking about.

As we chit chat here today. So California has passed a conformity bill.

So it is now conforming to the Internal Revenue Code pre OBB so that that OBBB is not incorporated into the conformity. So there's my big takeaway. There's just an immense amount of things that are and are not followed. Conformity is a bit of a misnomer actually.

But this is kind of par for the course in California. Nothing's changed for decades as far as you know.

It would be great if you could just punch in your federal number and boom, that's the same as California. But it's never been like that. I don't expect it ever will be.

So there's going to be a continuation of non conformity in the base of, of taxes, the other.

Yeah, like the tease is oh, it'll be so much easier to prepare my return. But I mean those who've done this long enough realize that's fool's gold really. It's still, you got.

The return processing software has got to be updated. It will be updated. But you, you know, as the return preparer you got to know what the rul. Our software doesn't always get it right.

You gotta check it, make sure it's doing the right thing and but that's sort of par for the course in, in California. So no, it's not going to make your life easier really.

And maybe we'll get another conformity bill in five years that'll update where we're at now but will not reflect where the IRC is at that point. That's kind of how the, the pattern seems to be going in California.

The other sort of hot topic, if you will, in California income tax is the finalization of the market based sourcing regulations.

The big takeaway is that it's final really and not what's in it because there's been a years long process of developing these regulations and changing what was prior regulations. So not a, not a lot of surprises there because we kind of knew what was happening. They've made some simplifications for some people.

If you have less than 250 transactions in a service industry, you get a special rule. Really it's do you fit in these special rules to use billing address to source your sales of other than tangible personal property?

That makes it easier. I'm not even sure if it's better for you or not.

Versus the sort of more ambiguous waterfall approach where you go to the contracts, the books and records, then you do a reasonable approximation and you do that before you can just go to billing address. So there's a lot of details in there, a lot of examples and not always completely consistent.

Theoretically there's still an immense amount of ambiguity and the volume of the words and the regulation and the number of pages doesn't really make it less ambiguous.

It's just a completely difficult, difficult task for FTD and all the other states to try and Come up with regulations that reflect the modern economy based on statutory language of where the benefit of the service is received. It's like thanks for all the guidance Legislature, not a lot.

So FTD and other states, they are essentially acting like the legislature and coming up with these rules and they will be very significant for those who don't sell tpp. This is really driving everything for you in California.

If you're multi state it will drive whether you have nexus or not because you have to apply these rules to figure out if you have Spanish efficient sales trigger factor presence nexus which is getting close to 800,000 a year now it's inflation adjusted.

Not only will they dictate whether you have a filing obligation, it'll also be the rules to determine how much of your income is going to be apportioned to California and ultimately taxed. So yeah, it's critical for the service industry and those that are not selling tpp. This is kind of a.

All the rules for you for the most part, once you get that tax base down, the apportionment is. A huge factor.

So question for you, do you feel like those regulations, I mean I think personally when I read them, I think that they were trying to anticipate every possible example that could be out there. Do you feel that they like really missed the mark on some industries or examples or anything like that?

I mean you mentioned that there's still ambiguity. I guess I just, I struggle with how are taxpayers supposed to apply these rules.

So I guess to answer the first question, they did not even remotely come close to getting every possible scenario. I think they understood that they would never be able to do Feels like sort of a, hey, someone brought this issue up.

We should put it in the regulation. Put it in an example.

Someone brought this one up and you know, it's like these are interesting issues like how do we source receipts from R and D activities. It's not completely clear what the statute says, so they've got to come up with, with some theories and you know, they struggled with it.

Do we do a look through to the customer's customer or do we just only focus on the customer? They've sort of vacillated back and forth through rulings on which way to go.

They are now favoring, although it's not 100% but there's a lot of look through provisions in the regulations where the taxpayers are now going to be challenged. As far as information goes, do they even have the information?

Hopefully FTB audits this with a mind towards is this information even accessible to you. Because if it's not, then what else do you have? All you have is your customer's info. You go with that.

But then can you reasonably approximate the customer's customer? I mean, that's sort of in the eye of the beholder. Can you guess? I mean, is guessing good enough? Where do you get your information?

So, same old challenges, but now with regulations that are final, my prediction is, you know, these regs are going to rival the IRC 482 regs at some point. Because with the direction they're going, all it can do is grow and just get bigger and bigger and bigger.

It's almost like, hey, let's just skip regulations and have a ruling process. Send in your scenario. We'll give you a ruling. It's not. That is not how it is. But it kind of feels like that.

So with that, I was thinking about also giving a bit of an update on California litigation in the income tax realm. What's going on in the courts. And noticeably, these cases you'll see have similar themes.

And it's really the sale of a business or a significant sale of a line of business and all the assets of a business. This is where there's a lot of litigation.

I get a lot of work in this area and there's a lot of different rules, a lot of gray areas, really important to know the facts and circumstances of the taxpayer. And this will be a.

It'll reveal why as I go through some of these cases and then sort of talk about some of the cases that I've handled or I'm handling right now that raise these issues of like, how do I apportion a huge gain on a substantial sale? And these issues are not just California. Every state's going to have issues with doing that.

So I'm not going to get into a lot of detail about all these cases. I'm going to mention some just sort of off the cuff. If it's something that you want more of.

Anyone who's listening to this, feel free to contact me, or you can just check out the litigation roster on FTB's website. They list all the cases. So there's this one. It's a pending class, certifications, Ball Media. And also Wynn Realty, R W E I N Realty.

And these cases are challenging the doing business standard in California as not constitutional. So it's kind of saying, hey, you know, factor presence is not constitutional. We'll see where that goes.

And a lot of it is, you've got these small taxpayers. You know, you owe the $800 every year because you hit these thresholds.

So it's not like necessarily like, hey, physical presence is back even if they win.

You got to look sort of to the specific taxpayers in these cases, and a lot of them are, again, the minimum taxpayers saying, this is not constitutional. I have nominal connection to the state of California. And it's interesting because can you as a state.

Get around constitutional constraints with your market sourcing rules? Like, if a market sourcing rule ultimately says this is California source income and you have to pay tax on it, is that just the end of the game?

Hey, that's the rule.

Or you look at the rule and your specific circumstances and say, even though this rule would source income to California, it does so in an unconstitutional way. The latter is. Is actually correct. So anyways, that's Ball Media and Wind Realty.

It's been going on for a while and well, I expect be going on for a bit longer. I think they might be in settlement discussions now, actually. But anyways, those issues are there about doing business.

So, Michael, with those two, are they. What's the, what are they doing. Where they're saying they don't have. Have. They're not doing business. Right.

Is it just that they haven't met like the 800,000 adjusted for inflation, you know, the sales threshold? They don't have property or payroll.

You know, there's, there's a variety of them they don't have. I think most of them are that they've hit that threshold. That's the argument they're saying that you.

Just can't do that.

Yeah, like that's not just a blanket constitutional thing you can do in all cases.

So is that like a due process?

Yeah, due process. Commerce clause as well. So there will be facts that matter. There's also.

Folks who own partnership interests and the partnerships operate in California. So those, those issues are out there.

And like when you're in audit and the state is saying, we want to get a lot of money from you and we're going to do, we're going to figure out a way. Here's how we've done it. Like, you've got to like, raise every issue you can. Like, it's like, I don't know.

That doesn't, you know, it seems to be extreme constitutional. It's not due process. That's like a big, that's a big statement and sometimes people just shy away from it. Just raise it.

If you can put together a cogent argument, raise all of them. Don't, don't Wait, so anyways, yeah, so.

I know these are income tax cases, but are they looking at Wayfair at all? Right. Where that ability, kind of, that factor presence was ruled.

Okay, under the Supreme Court where they're like, well, yes, the tax types are different, but if you're making an argument or the Constitution, the Constitution is the same 100%.

The state is going to look at Wayfair and say, means we can just come up with a number. 100,000, right. Here's this number. But I don't think that really is the full story because you have to ask yourself, how do you arrive at that number?

Can you just arbitrarily come up with a number that's based on anything you want and that's fine with due process? I don't think so. Now, I'm not saying the states do, but you need to look at the rule that, the sourcing rule.

How do you get this hundred thousand number and is that enough? And another thing is, and I've said it before a million times, this $100,000, it's not magic. I don't think there is.

You can't just say, hey, Wayfair said 100,000 is fine in all cases. A hundred thousand was fine for a multi billion dollar company. So there are companies that are not multi billion dollar companies.

There are companies that are not using extensive technology to tap into the markets of the state like Wayfair was with their virtual showrooms. There are companies who are doing absolutely none of that. So Wayfair is distinguishable. But no doubt the states will be looking to Wayfair.

And I mean, the key to me, Wayfair really just says, you can't rely on Quell's physical presence rule. Okay, there's still other rules. You know, we don't just, we don't need to have this sort of arbitrary. Are you physically there or not?

That's not the case. So there's another case. It's actually a series of cases. And this all stems from an Office of Tax Appeals decision in Microsoft. So this was.

A little about a year and a half ago or so the Office of Tax Appeals was faced with this question. So Microsoft had a massive dividend from foreign sources, like many others, just sort of, hey, the TCJA set up a system to bring all this money back.

So hey, you pay tax on it now, bring it back. That's for federal. But hey, California's here and they're not. Doesn't really change anything from California's perspective.

You paid a dividend, you received A dividend, and that dividend is taxable. Now Microsoft was a waters edge taxpayer, so as a waters edge taxpayer you get a 75% dividend DRD.

So they did that and there's no dispute that they were entitled to a 75% DRD.

The issue in the case was for sales factor purposes, whether you include all of the dividends in the sales factor denominator, all of them, 100%, which is what Microsoft was arguing or what FTB argued is you only include the amount that is includable in the tax base. So therefore you only include the 25 million. 25%, sorry, not billion. It would be closer to a billion.

So the OTA and FTB cited its own legal ruling saying doing this and whatnot.

But the OTA sided with Microsoft and they said, yeah, gross receipts means gross receipts and there's nothing limiting it to income that is included in the, in the tax base. So these go in decision in favor of Microsoft gavel down. Within a month, the legislature enacted legislation to reverse the OTA's decision.

And this is an OTA that is now. Five years old. So it's a new, it's a new. Well, it's older than that now. Now it's seven. But time's going by too fast. Still relatively new.

Still relatively new and trying to get its footing in California. And it, you know, people would say it favors state and these things. You know, the state doesn't have the burden like taxpayers do.

So it's difficult to win at ota. But they, they will refute what the state says sometimes. And they did so here just happened to be in a massive dollar case.

So it's kind of disappointing to see them have their legs taken out from under them by the legislature. But that's what the legislature did.

They basically just reversed it and said STB's right, if it's not included in the tax base, it's never included in the sales factor. So now there's a statute that says that this legislation also said this is reflective of current law. This is the, this is the big thing.

This is reflective of current law. So it's always been this way. So. So the attack, the, this was not gonna, gonna stand. And lawsuits have been filed challenging this legislation.

And the big thing is not that they gutted OTA's decision. They can do that. Courts make decisions and legislatures react and reverse it. That's. But it's the retroactivity.

It's like, hey, we have a decision by ota. It interprets the law to say this is what it says now. The legislature jumps in. They. And it's. The arguments are, okay, this is separation of powers.

Does the legislature have any role in deciding tax appeals? They don't. Can they go retroactively to forever to change what is. What is the rule? These are the things that are being litigated right now.

So Cal Tax has a case against FTB on this issue. A corporation called Keywit also has one on this issue. And the National Taxpayers Union is another one.

And these are all currently in litigation right now. I'm going to go. We talked earlier about procedures and how important procedures are to. Making your claim effectively in court.

Now, these taxpayers, they were aware of the challenges, but there was at the national taxpayers case, these all got consolidated. Not the Cubit one, but caltechs and national taxpayers. So there's a requirement to litigate in California.

You have to exhaust your administrative remedies, for one. You have to state the grounds in a claim for refund that's timely filed and you had to have paid the tax.

So there was a ruling that said, you're out of here. You can't even litigate this because you haven't paid anything yet. You have to exhaust your administrative remedies.

So these issues of retroactivity that violate due process, they're going retroactive to infinity unless you, Unless you say, hey, the legislature can act as a court and just disregard a court's interpretation, which I don't. I don't think they can. So they were not able to do that. So this issue is going to be there for a while.

There's going to eventually be a taxpayer, you know, there's. Microsoft is going to have to pay.

They may be doing something now, but there are going to be taxpayers who have to pay on this, and that'll get them into court. Who knows how long that will take?

Is it the assessed tax or tax act question that they have to pay? Or if I pay my $800 minimum tax, is that sufficient enough to. Be able to say I paid my tax and can litigate?

No, you have to pay all of it, including penalty and interest, like kind.

Of the amount of tax in question.

So, like, you get into situations where maybe you paid some of it and the statute of limitations is running on filing a claim. But you've paid some, but not all. Well, what you have, there's a procedure. It's called an informal claim. You say, I paid some, I haven't paid all.

I don't think it's right. Here are my grounds for why it's not right.

So then that sort of holds in abeyance for statute of limitations purposes, your claim, but it doesn't become formal until you've made full payment. So then maybe like a year later you finally can pay all the interest, for example.

Now once that payment is made, it is a formal refund claim and you can't get into court without having filed the claim for refund with the agency. And that agency either denying the claim or, or ignoring the claim for six months, then it's deemed denied and then you can go to court.

But you do have to pay everything.

But there are procedures to preserve your rights because sometimes you're like, I can't pay all this in a year and that's the only amount of time I have. So there are ways to handle that.

So I want to talk about a case which relates to market based sourcing for service providers who are not corporations. And this is the Garcia Rojas case. Now this. I think this is like the amount at stake is not very much in the firm handling it is a big firm.

So they're I think trying to, you know, they're taking this case because it's important, significant and it's really sucking a lot of small individual individuals that are not residents of California and never even stepped foot in California are being subject to California's income tax. And really the, the case that this is challenging is an Office of Tax Appeals case appeal of Bindley, which you may have heard of.

And the reason, because this never happened until market based sourcing came about.

And there's regulations that are not relating to market based sourcing that are talking about how individuals who are non residents report their income from California sources.

And in that reg existing regulation which has been there for, you know, it's predates market based sourcing says well if you're a sole proprietorship or a partnership or some other pass through entity, you apportion by the DIPTA provisions in the California corporations section of the tax law. So we go to the sourcing rules.

But now later California adopts market based sourcing and as a result this sort of leaks into individuals who are, you know, not W2. It's a big distinction. They are independent contractors. So now you know, there was this case, I can't remember the name of it right now.

It was non precedential, an OTA case. And it involved a tax return preparer in Washington who did tax returns for clients located throughout the country as well as California.

Sorry, I'm blanking on the form that you get when you pay an independent contractor. You guys know this.

It's the NEC. Like non employee compensation.

There's all sorts of them.

Yeah, one of the 10 items.

Yeah, there are. There's maybe there's other numbers to it too, but they get that there's some.

GS and like some Rs. It depends.

Pick a lottery.

Obviously we're not individual income tax preparers. That's very obvious.

So these people have to. That that's how they get found out is basically their clients tell on them.

So she went to the Office of Tax Appeals and basically was like, what are you talking about? I don't, I never stepped foot in California. And the OTA was like, doesn't matter.

Now at the ota, here's another sort of gray area about what kind of issues can you raise at the Office of Tax Appeals?

Like there's a provision in the California Constitution that prohibits administrative bodies, which would include the ota, from declaring a statute unconstitutional. And that's just because of separation of powers. You can't. A court can, but they cannot.

So the OTA has looked at that and really liberally interpreted it to the point where they're saying, you know, it's a constitutional issue, we can't address it. And then like, well, yeah, you can.

You can say it's unconstitutional as applied without saying that the statute itself is unconstitutional, but they're not really comfortable with doing that.

So there are some limitations on these issues you can raise and, you know, due process might have been a good one for this lady in Washington to have raised, but did not because she was at the ota. So the OTA found in favor of ftb. She owed tax. She was also penalized. She tried to say, I shouldn't have the penalty cot like nope.

We've got this rule, we're putting everyone on notice right now. You're not getting out of penalties if you ignore market based sourcing and just say oh, I didn't know that's not going to cut it.

So this case, the Gar Garcia Rojas case is challenging that for really all of these. There's so many that are small and getting sucked into it. None, none of them.

Or not very many have it have a sufficient amount of tax in dispute to really put a good fight and challenge it, including on constitutional grounds. So this one is doing that now. So this one to keep an eye on. We'll see. We'll see where it goes. There are, let's see.

One, there are three other cases that are sort of like a group of cases that I'd like to talk about. And it involves. Like selling a business or selling a big part of the business, something that is not the normal part of the business.

But it's not an ordinary course of business. It's an unusual transaction. We're selling a line of business or, or we're selling all of our assets to or getting acquired.

So these cases kind of revolve around that.

Well, yeah.

And before you jump in Michael, just because I think sometimes I feel like even other practitioners don't understand that if you're selling even a line of business that that's not necessarily non business income.

Now maybe there's some extenuating circumstances, factual issues out there that there that could be argued but I think that that's kind of where some practitioners first go like oh, they're not, this isn't the in the ordinary course. So therefore we're going to treat this as non business income.

And a lot of the states will they look at that very, very closely and quickly because it's usually something that's reported.

Well, yes, I mean these are like the majority of the cases I handle involve a sale of a line of business or a whole business. It's just there's a lot of money at stake when these things happen.

So all of these sort of intricate salt issues come to the surface and are really more relevant when there's more dollars at stake. But they're absolutely there are.

Because I mean you're talking about, you know, accountants from very small accounting firms up to very big ones that are not in California. Maybe they're not super up to speed on California.

They 40 whatever states and how many clients and how many returns as an out of state stator and you're trying your best to do this and then the clients might be like what are you talking about? There's no way I could owe that much money. So a lot of times you see a non business income position.

California has a and know most of the states have gone to this now, pretty much all of them. The functional test. So even if it's out of the usual course, it's still business income. If what you're selling was used in the business.

The typical example is like a plant, like okay, we're selling the plant that we use to manufacture the wiz widgets that we sell. You'd say hey that's out of our ordinary course. Non business income. Well the state's going to say it's business income under the functional test.

You got to pay tax on it. So that's one of the things that typically.

Like they're pretty laser focused on picking those up on audit and surprising it's still, they are still coming down that way. I mean the law is pretty clear on that.

But there are circumstances where you could could argue and it depends very much on the circumstances whether it is indeed meets the functional test or not or is it non business income. It depends on the scenario. And I've got an example, here's an example of one case that I had with ftb.

So this company, they were in the media business. They had been for quite a while. They were making money off it but they didn't really want to invest the the money they were making into media more.

They sort of saw it as lower margin. So they decided this is all one single corporation, we're going to do some angel investing.

And they took millions of dollars and spread it out amongst hundreds of different potential investments. They were all minority interests in high tech or things had nothing whatsoever to do with their media business at all and no management.

It was just cut a check hope of this this turns well they did have a few that actually hit and so there was a, you know a big income hit there and their position was it's non business income because it had nothing to do with their media business which was the only thing being done in California. But FTB on audit said hey that's you know, that's business income. We're going to tax it.

You get sometimes you get lucky with the protest officer when you challenge the audit and you get one that really is going to look into the issues because this one is a no brainer. I mean we're talking about less than 1% interest to zero control whatsoever.

Completely unrelated to what's going on in California, and ultimately they relented. And you're right, that's non business income, and they went away, which they should have.

So that's sort of an extreme example of where, hey, non business income. It's not always business income. And then, you know, on the spectrum, there's areas where maybe it's a little less surgeon.

This podcast is for educational purposes only and is not intended, nor should it be relied upon as legal, tax, accounting or investment advice. You should consult with a competent professional to discuss specifics of your situation and the applicability of the information presented.