California: Nonresident Individual Did Not Have California Source Income

The California Office of Tax Appeals (OTA) recently dismissed an assessment of tax on income earned by an individual that was a Texas resident. The individual performed services for a California LLC as both a W-2 employee and an independent contractor. He received a 2015 Form 1099-MISC for design services performed for the California LLC but did not file a California non-resident income tax return. The output of design services performed in Texas was for a customer of the LLC located in Canada. Specifically, the service helped the Canada customer promote and sell products.

Under California law, income tax is imposed on nonresidents to the extent the nonresident has California source income. If a nonresident’s business, trade or profession is a sole proprietorship that conducts a unitary business with operations within and without California, the nonresident’s income is apportioned to California using the market-based sourcing rules that apply to corporations.  The OTA determined that although the individual was conducting business as a sole proprietorship, he did not have California source income. Under California law, receipts from sales of services are assigned to California to the extent the taxpayer’s customer receives the benefit of the service in California. The market-based sourcing regulation provides cascading rules, which generally focus on the location where a taxpayer’s direct customer receives the benefit of the services. However, the OTA noted that in certain circumstances the benefit of a taxpayer’s service will be received by the taxpayer’s customer’s own customer. The OTA concluded that, in this instance, the facts warranted looking instead to the location of the California LLC’s customer. Applying the cascading rules, the OTA reasonably approximated the location where the benefit was received to be Vancouver, Canada where the LLC’s customer was located and where it received the benefit of the design services that helped it promote and sell products. Please contact Gina Rodriquez at 916-551-3132 with questions on Matter of the Appeal of Christopher J. Wood.