In this episode of the SALTovation Podcast, Meredith Smith and Stacey Roberts continue their conversation with Michael Cataldo on the complex world of California tax litigation. They discuss pivotal topics such as distinguishing between business and non-business income, the impact of the throwout rule, and the intricacies of alternative apportionment. 

Their conversation reveals how even a minor entry on a tax return can trigger significant consequences, from audits to penalties, and the importance of carefully reviewing tax software defaults, as relying solely on automated systems can lead to costly errors. 

Key Takeaways:

• Early identification of potential tax issues can prevent audits and penalties.
• Differentiating between business and non-business income is critical in California tax filings.
• Understanding the throwout rule and alternative apportionment strategies can impact tax outcomes.
• Reliance on tax software defaults without careful review can lead to costly errors.

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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 two of our discussion with Michael Cataldo, we dig deeper into California's most active litigation areas, from non business versus business income to the throw out rule, alternative apportionment, unitary questions, and how major sales of businesses trigger complex sourcing and constitutional arguments. Michael also breaks down current cases to watch and why early issue spotting is critical for taxpayers.

This is a few years ago when I saw this, but I was reviewing a tax return and the default in the tax prep software is when it saw gain was to automatically put it on the non business income line on the schedule R for apportionment purposes. And I was like, yeah, you can't put anything there. Like, and it was just the way that the software.

And this was, you know, again, this was years ago, but. Right. They're just like gain means non business income in California. I was like, yeah, we, we got to move that, that's bad.

And it was like, just like a programming error. And if you don't review that.

Right.

We had kind of talked about in the very beginning with the one big beautiful bill, conformity and getting the softwares up to date. Like softwares. You can't always rely on them. Right?

Yeah.

And it could have been an automatic audit red flag. Now, fortunately, this was like, I don't know, like $5,000. It meant nothing.

Right.

But it was still something.

Right?

Well, yeah, And I think interest sometimes gets thrown into that too. Like, oh, well, you're like, okay, what kind of interest? What is it? You know, so it doesn't. But it doesn't default to non business income. No, no, no.

It's really up to the taxpayer to argue that it's non business income.

Yeah.

Like if I were designing software with something in mind of let's like get it done correctly with as little trouble as possible, I would default everything business income.

And then look at it, especially when you have a big transaction and then say, well, you know what, we need to override the software to business income. I think if you default to business income, you're going to get audited, you're going to get assessed. There can be penalties.

I mean, you may have a good position, it depends. But if it's you sold the plant that you use in your business, it might be a little trickier. But there still may be some ways to even contest that.

And that's the other area that I see all the time that results in audit adjustments on the sale of the business or a line of business is the sales factor component to that. And where it arises is the taxpayers.

They include the receipts from the sale, the big sale sale of the business, they include it in the sales factor denominator which will dilute your ultimate apportionment percentage. But there's a regulation in California, it's regulation 25, 137C. One big A. And this is the throw out rule.

Substantial and occasional sales are excluded from sales factor. And their basic rule is if it changes the sales factor by 5% or more the sales factor denominator, then it's substantial.

Now it's also got to be out of the usual course of business. Most of the time when you have a sale that substance, it probably is, maybe not always, but they, and then you, you exclude it.

So I had a client who sold the plant. They sold basically a line of business which included a lot of plant property and equipment.

And they included all the receipts in the sales factor denominator, none of them in the numerator because they were pretty much out of state. California was a market state for that. And they had no other. Property or anything else in California.

And so they have a local accounting firm, non California local accounting firm, you know, mid size. If you pay attention to accounting firms, you might have heard of them, but they're not like giants.

And it was already at audit they were going to adjust to eliminate, take out the. The reduce the denominator of the sales factor to take out the receipts from the sale.

And then I get contacted and they're asking about alternative apportionment. What can we do for alternative apportionment? I ended up talking with them. They hire me. And this is where.

It'S a good place to illustrate like how important being able to raise things at the right time and in audit is now here. It was a, it was still an audit and you hadn't paid yet. But I, so I looked at it and they. There was two things they had.

They did have two actually separate entities. And there was another entity that they filed on a standalone. They didn't file combined. They had this other entity which was clearly unitary.

I mean very clearly, but they didn't include it. And that entity did nothing in California and had a ton of, of sales. The other thing is that company didn't. They were.

They sold tangible personal property. They had a guy who telecommuted from California, but otherwise they were protected under PL86,272 no one thought of this either.

So you have two issues that are better than your alternative apportionment issues already because alternative apportionment is a high standard, it's difficult to meet. So look for other ones like this one. We ended up, not only we got rid of the assessment and we got a refund.

Like, hey, it should have been combined reporting. That pretty much eliminates the assessment.

And we had to claim the refund and we had to do it within a certain period of time or otherwise you waive it. It's like, yeah, and all the money we actually paid anyway, none of that's owed. And we got that refund too.

This one, I had to go through the audit arguing this. They all know protest, go through it back and forth, may they. They agreed with the combined reporting.

They said, okay, the assessment's out, but we're going to deny the claim for refund. Then we have to go to the ota, we file our brief, and they're like, you're right, and they dropped it.

So you have to like push through and keep pushing through. A lot of it's luck of the draw with who, who you're going to get.

But the point of all this is when you're thinking alternative apportionment, make sure to think about some other stuff. Also doesn't mean you don't think about alternative portion. You certainly do. But like with the sale of a plant and getting the.

It's, it's a high standard. To clear and convincing, you have to show that the standard formula does not fairly reflect income and by clear and convincing evidence.

And you have to have an alternative which you have to show by clear and convincing evidence is, is reasonable. So the apportionment formula is allowed to not be exact. They have a lot of the states have a lot of leeway in coming up with them.

And you've got to show like, so substantial distortion, not just a little bit here, a little bit there. It's good. You got to show like quantitatively that it's significant because again, it's not a perfect science. It's got to be kind of close.

Well, and there's a lot of states that have that throw out rule. And so, you know, and you know, you, you made the remark earlier about, you know, when some taxpayers go through these sales.

Practitioners are just trying to get returns out the door.

And you're not always thinking about, oh, there was this unusual sale, and then it's all this extra work that goes into trying to determine then what if any of the gain or proceeds has to go into the apportionment factors for all these states. And all the rules are different in all the states.

I mean, there's plenty of states that have the throw out rule, but then there's a lot of states that say, hmm, no, if you've got goodwill, we want a piece of that, et cetera. So that's like a whole other project.

And then if you're trying to argue alternative apportionment, it's not like you can just file that on an originally filed return. You have to get approval from the states for that. And that takes more time.

Yeah, absolutely. I had a client who wanted to do alternative apportionment, but like you said, you can't do it on an original return. So they.

What they did is they filed the original return under the regular, and then they filed an amended return. That way you don't get penalized, because you'll get penalized if you just decide on your own how to do it. That's one workaround.

But, you know, people aren't always thinking of that.

The thing that, like, blows me away when I'm looking at these cases where there's this, you know, massive, you know, millions and millions of dollar gain, and I'm like, well, what's the sales factor? And it's like, we had 150,000 of California sales. Then, you know, the 500,000 of total sales, it's like, wow, you didn't have very many sales.

This piddly amount is going to dictate how we apportion this massive gain. So, I mean, it's like something's off here. Something is not connecting. Right. And now you look at California's Schedule R and they don't.

I wish they required you to report payroll and property factors. I know you don't, but. It'S like, what are the. Then you got to ask, like, what are your payroll and property?

Because, you know, if there's huge amounts of property and payroll, none of it's in California. Very little. And you have this sort of higher percentage of sales in California. What. Let's see if there's some sort of argument that can be.

Can be made to get something different, that it's a more fair reflection. It seems like this Italy amount of sales doesn't necessarily dictate a fair reflection of maybe a big game, like what was sold.

We bought your whole business. Okay, well, let's look at the business. What are you buying?

Are you buying the present value of the sales that we make to California based on this and that's it. Because then I think the sales factor makes sense. But a lot of times you're not buying just the established markets, like what's your ip?

You got some amazing R D that you've done there. We're going to pay a ton for it. And you didn't do any of it in California. It's not relating whatsoever to any of your sales.

It's still R D. You haven't done anything with it yet. And that's the driver of the ultimate sale. Now it's like, here's this huge amount. Why does California get any of this?

Even if, I mean there are arguments to, to be made. Again, facts and circumstances matter a lot. You got to look at the transaction, what's being bought, what, why are they buying it?

So who is buying it?

Yeah, who's buying it and for what use they're gonna use.

Yeah. And I mean I've done some of this work flow through entities.

You know, you alluded to that earlier where it's, you know, the flow through entities use similar apportionment rules. And I've had sales of businesses where maybe it's a S corp and the S corp shareholder, like main shareholder is a California resident.

So then you gotta figure out how much estimated payments they have to make based on the sale of the business and the credit for taxes paid to other jurisdictions. It's a mess. It is a big project and it can be a lot. It can be very material for these companies and for these.

Ultimately, if it's a flow through entity, the ultimate owners.

Absolutely. And you know, most of the ones I see are that it's the flow through entity.

You know, if you have like the really big corpse and they're affiliated groups and they're massive. They've got people who are kind of looking into this.

It's the smaller ones that are using S corpse and you know, start the business in the garage just tinkering around with some friends. You stumble upon some something incredibly valuable.

You develop it a little bit and then some big player comes in and says we want that and we buy it. And all of a sudden your little garage business suddenly turned you into a billion dollar gain.

And like, wow, how are we going to pay the taxes on this? Where, where do we have to pay the taxes? What was our market for? And then you say, okay, I'm a, you know, the escort in California, the S Corp.

It's flow through, just like federal, but there's a 1.5% tax on the S corp level. And then through case law, California says that if it's business income at the S Corp level, it's California source income to the shareholders.

It's the Metropolis case. So you know there was a good two decade period where there was this fight the individuals had with the state that this is income from intangible.

It's sourced my state of residency. And that fight went on but Metropolis ended it.

Yeah, your character has established the business in which you're deriving the income from.

Yep, yep, exactly. And they, they look to the federal rules for that and say this is how the federal rules treat it. So you're treated as if you earned it.

So you could, you could have like intangibles like I don't know, investment interest income that an S corp had for some reason that flows through to you then because that actual to the S corp maybe it's non business income. It depends. If it was purely an event like hey we have extra money, we have nothing to do with it, we're going to set it aside.

Maybe that's non business income. But for most, for the issues that there's a lot of money at stake, it's not that. So yeah, the S Corp setup is very common.

And then there's this question. Because I mean a lot of people have tried to plan around this Metropolis case like how do we get these huge gains and not pay tax in California?

I'm here to tell you I don't think there is the one way to do it. But you can set up in a way to make it less. If you're planning and you're structuring or to give yourself arguments, maybe they won't carry the day.

But maybe. And maybe they will. There are some things that are not totally certain in the law, like. Holding companies.

FTB is taking the position that holding companies are unitary with their subsidiaries.

The State Board of Equalization, which is the predecessor to the OTA had an opinion where they talked about it and they said there's no special unitary rule, unitary business income. It's a due process. It's derived from the United States Supreme Court precedent dictating what a state can and cannot tax.

So how do you get around this? Like, hey, I'm a holding company and maybe I don't meet any of the unitary standards.

FTB argued that there should be a special unitary rule for holding companies. And the State Board of Equalization said, no, there is no special rule. It's constitutional thing. We can't change the Constitution.

But don't get too excited. Like that would be a nice one.

Just, hey, let's just set up this, set up another corp and have it sell the business so it's not its own business, but the State Board of Equalization. They said, okay, well when you have a holding company, then every single thing that holding company does, even if it's very little, is magnified.

So maybe they guarantee a loan but do nothing else. That's magnified. That's going to be enough to create a unitary business. But they left open because they said specifically there's no special tests.

So the regular tests of Unity still is applicable. So theoretically, if you have a holding company that's done nothing at all, then I don't know how you have a unitary business.

But the question is practically, can you have a holding company do nothing at all? And then if it does one thing, that thing is probably going to be deemed enough to be. Unitary under this sort of, yeah, it's magnified.

I don't know what. The courts haven't really got into that. So that's another thing where maybe you hadn't thought about it and now your claim for refund period's over.

You're fighting about alternative apportionment, but you didn't raise that issue. That's why it's good to get people involved early. When there's big dollars at stake. You can come up with these things.

Maybe they win, maybe they don't. It's not. There's no court case yet. So there is an SBE case and there's some risk, hazards of litigation on both sides for that, for that issue.

One, Michael, I keep going back to right, you talked about the Microsoft case where in your denominator you had 100% of activity when only you're right, you had a discrepancy between your apportionment representation in your tax base. Right? But then on the flip side, you have and this. And the state was like, no, no, no, like it has to be the same, right?

So you have to include 25% in your denominator because you have 25% your tax base. But what about, you know, when we were talking about distortion on the other side on, you know, kind of that occasional sales stuff. Like what?

Why do they get to have their cake and eat it too, other than their estate? And they can do whatever they want.

Well, they don't if you raise things in proper time. Because alternative apportionment, despite its sort of difficulty in improving, it's available.

And it's available whether you want to contest the standard formula. Maybe you want to contest throwout reg. And hey, that throwout rag as applied creates distortion. You can certainly do that. So it's, it's, it's.

They're not always getting everything they want unless you lit them. You, you gotta, you gotta raise these things. And there's a case.

And it's interesting because it's the, the throwout reg is, is being challenged at all. As, as a regulation being applied. So a little bit of background. So California has its standard apportionment formula.

Every state that has an income tax, they have their standard apportionment formula. California is a single sales factor. Now there's regulations under.

So this, the throw out rule was actually being challenged at the State Board of Equalization years ago.

There was actually a case before this case which said, no, you have to prove distortion even if you're going to use these regulations.

That got changed is this SV case called Fluor F L U O R. It's like in the 90s, I think, which said, hey, if it's a 25, 137, regulations are the standard formula and to deviate from them you have to. Prove distortion. Not you don't have to prove distortion to apply them. Now taxpayers are challenging this.

There's this case Winfield W Y N N E F I E L D. I think it just filed an appeal because they lost at the trial court. Not even on the merits of the issue I'm describing, but because guess what? They didn't pay. You have to pay first.

But they're challenging the application of the regulation. They're saying hey, the statute says single sales factor. That's what the statute says.

And then the other statute says you can deviate from this statute if you have to prove all this stuff and you can't just by regulation change that statutory. So that's the argument FTB saying, you know, this four case controls and if we have a regulation then that is part of the standard formula.

So it's really a burden issue. So then you can say, hey, this thorough rule, I sold my plant or whatever.

Now we're putting it in because the general rule says you include all gross receipts. So we're including all gross receipts in the sales factor. We're going to have none in the numerator and a bunch in the denominator.

Ftb, if you want us to throw that out, you need to have established by clear and convincing evidence that it's distortive and a reasonable replacement. I'm sure they would try that, but that's their secondary argument. So that argument's going on also in a case called Worthington Oil and Gas.

So those are two cases that are really, it's all, all these different issues stem from a big sale, sale of business, sale of a line of business, maybe sale of an incredibly valuable asset. Two other cases I'm going to mention real quick just because it's sort of related is Janus Capital case.

This is before even market based sourcing generally was, was applied. But they came up with this reg, which is not surprisingly somewhat favorable to in state California residents, less favorable to out of state ones.

So Janus Capital is challenging that reg under the same sort of argument that hey, the burden here is the standard formulas. You don't apply this regulation, we're going to apply the standard formula. And FTB doesn't want to do that.

They have the burden to establish applying something else. FTB is saying this is a regulation under floor, it is the general rule. So it's a burden shifting kind of argument. That's Janus Capital.

And then there is Smithfield. This is the last case that I have to talk about. This one's pretty interesting since we are talking about alternative apportionment.

Smithfield is all about alternative apportionment. And so Smithfield, like I go to the grocery store and I'LL admit it, I enjoy bacon and Smithfield. I buy bacon and Smithfield is there.

I didn't realize the extent of the, of the efforts Smithfield's required to make to, to make this delicious bacon that's nice in a nice package for me just to throw in the microwave and I'm eating bacon. So they have a one argument is there's a special. So California has a single sales factor.

And I say that generally, but there are certain industries which actually use it for three factor formula, agricultural being one of them. Smithfield's arguing that they're agricultural because they raise their own pigs, and that is agricultural.

And then there's a gross receipts number that you use to compare are 50% or more or more than 50% of your gross receipts relating to your agricultural. If so, then you get three factor. If not, then you're in the general rules. So that's one issue.

But the reason I bring it up is the other issue is they're saying even if we can't use the three factor, even if we're not an agricultural business, the single sales factor distorts our income. Now, this does not involve a sale of anything. It's their ordinary business. They're huge business.

They're worldwide, generating all kinds of money selling bacon. So they're arguing for. Property and payroll factors. So single sales isn't cutting it for us. They.

So in California, if you want to do an alternative apportionment, I mean, you can request, you can file it like on a, on a return, but ultimately it gets reviewed by a committee, the alternative apportionment committee. They will look at it. You go back and forth, they decide yes or no, or maybe we'll do this other thing that neither of us came up with.

But that's sort of the process you go through. And then you can appeal that to the Office of Tax Appeals. Smithfield did that.

And in addition to their argument about them being statutorily permitted to use three factor because of being agricultural, they also made their argument about distortion. And the typical arguments you would expect are, look at all this property, look at all this payroll. How could we possibly do any of this without it?

The standard formula, if the single sales factor does apply, completely ignores this. We want. Relief. So they didn't get it, not at the ota.

And now they're in court and they have been for some years, and they're sort of going back and forth right now. They. You have to, you got. You want to hire experts quite a bit in these cases that involve a Ton of money.

When you're talking about distortion and arguing that the standard formula doesn't fairly reflect the business activities, it's helpful to have some evidence, like an economist or something to evaluate your business activities and say, hey, you know what? Here's my report. And there should be this much represented or this much represented.

Sort of your burden is you got to show with evidence that the standard formula doesn't work. So one of the things that's interesting about this case is that the ota, they basically just said that, like, you know, no property, no payroll.

So now in court, they're trying to expand on their basis for doing that. They're like, hey, well, let's look at cost accounting. Let's use that.

Now there's lots of arguments saying unitary theory replaces cost accounting, but they're trying to meet their burden. They're showing facts using cost accounting, but FTB's arguing, and I don't know what the result's going to be.

You didn't raise that in your claim for refund. So even if that is the case, you can't bring it. You're barred anyway.

So just another thing to think about in getting, like, if you feel like this might end up going to litigation or some sort of appeal where the dollars are high, get someone involved early who would actually take the case just to make sure you've got everything buttoned down the best you can.

Yeah. And I think that's a good kind of takeaway for, I mean, just in general. Right. With some of these, you know, more material issues. Right.

Just to get somebody involved early who's a subject matter expert in that.

And then, you know, your point is not lost as far as, you know, if they, if you, if you bring up all, if you put all of those issues out there, then at least those are out on the table and you're not barred from bringing them up later.

Absolutely.

Or trying to.

Yes.

You know, bring them up later.

Yeah. Just less things to fight about.

Like, you know, that's one thing about litigation against the state is they are adept at trying to kick you out on procedural grounds. You look at all these cases, it's like, oh, they lost because they didn't pay. They lost because they didn't exhaust their administrative remedies.

They lost because they didn't raise their grounds. Like the substantive issue. They might have won, but we'll never know. So that is the extent of my.

What I had anyways, as far as a little, little teaser update and what's going on in California.

Well, yeah, and as all those hopefully don't get settled out of court and we actually have, you know, takeaways from them. You know, Stacy and I are not attorneys. Although sometimes it feels like we play one on tv.

Um, we are very grateful for your friendship, your knowledge, your expertise, and so we love having you on the podcast. And I'm sure we will have you back as these things get settled and then more things to come.

There will be more to come, but there's always something. There is always something. It's a pleasure to. To be here with you guys chit chatting about tax stuff. Yeah, well, I always appreciate you guys are.

Whether you're a lawyer or not, you're actually doing legal work. Like the code is a statute and you have to read that, so.

Indeed we do. And we've been doing it for a long time.

Yeah, exactly.

I don't know what you're talking about. Stays. Not me.

I am older than you.

All right, well, that is another episode of Saltivation. Till next time.

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.