For some time now, California has been the worst state in the country when it comes to exploiting the most tangential of connections to claim tax liability. Recently, the state reasserted its claim to this dubious distinction by attempting to claim the right to tax the sale of partnership interests by nonresidents.
The pace at which taxpayers, both business and individual, have continued to flee the state for greener pastures has only accelerated in recent years. The most recent tax migration data, looking at the difference between tax years 2018 and 2019, finds that California lost over 117,000 taxpaying households and just under $18 billion in adjusted gross income from its tax rolls.
One would think California would learn that the way to keep taxpayers from running for the hills would be to create a fairer and more competitive tax code. Unfortunately, the state has instead responded to this trend by ramping up its efforts to catch up out-of-state taxpayers in its tax web.
One of the latest guidances from the state’s Franchise Tax Board (FTB) overturns commonly accepted rules about who has the right to tax the sale of partnership interests. Traditionally, the sale of these interests is a taxable gain for the seller’s state of residence, but not for other states, even if the partnership in question holds assets in another state.
Consider the sale of stock shares. The corporation that the share represents an interest in may have assets all around the country, but the seller does not need to pay capital gains tax to each state that the corporation holds assets in or derives income from. Instead, they pay capital gains tax to their resident state, and the federal government.
That’s usually how it works for partnership interests as well, but the FTB is seeking to change that. The FTB’s guidance applies rules under Section 751 or the Internal Revenue Code, intended only to apply to federal taxes, to state taxation of Section 751 assets, giving itself the right to tax a portion of nonresidents’ partnership sales as business income.
Alone, that’s a slightly wonky tax ruling. However, the recent history of FTB actions shows that it is representative of a trend.
Most notably, the FTB took the lead this year in applying a somewhat goofy interpretation of federal Public Law 86-272, which protects out-of-state businesses from income tax obligations in states in which their only activity is the sale of tangible goods.
The FTB became the first state, since followed by aggressive tax enforcement protégé New York, to claim it could ignore those protections so long as the business in question maintained a website with a number of common functions. These included a “virtual chat” customer service feature, the use of digital “cookies,” and enabling job applications through the website, among others. Taken together, this laundry list threatens to rope in just about any business selling into California and operating a modern website.
Another example is the FTB’s application of its “doing business” tax to nonresident passive investors in LLCs that have ownership shares in California businesses, almost by definition not “doing business.” To enforce this, the FTB engages in extrajudicial seizures of out-of-state taxpayers’ assets from banks with California branches, often causing the unfortunate involuntary “taxpayers” significant bank fees for these seizures.
These are just a few examples of how aggressive the FTB has become, as a more comprehensive list could not possibly fit in a single column. Nevertheless, the trend is quite clear: taxpayers of all stripes expose themselves to even the most limited of connections to the state of California at their own peril.
And while these aggressive state actions are profitable in the short term, they do lasting damage to the economy at large, as well as principles of tax fairness. If California can’t learn that its tax jurisdiction ends where its borders do, either the courts or Congress must teach them.
