California Shapes Precedent With Tax Board Sourcing Decision

The vast majority of decisions issued by the California Office of Tax Appeals involve small dollars, often with taxpayers waiving the right to an oral hearing. However, that does not mean these “small” decisions have no legal significance, especially where the OTA designates such a decision as precedential.

This is the case in Appeal of R. Sheward, decided on May 25 and released by the OTA on July 6. Sheward involved a tax assessment of $1,798 plus interest, $899 in penalties, and a filing enforcement fee of $93. But the issue in Sheward—how the Franchise Tax Board taxes the California source income from a multistate unitary business conducted as a sole proprietorship—is important.

Sheward was a nonresident of California and a resident of Ohio. During the 2017 tax year, she contracted with the California Horse Racing Board to serve as a horse racing steward. The contract explained the services would be provided in California—which they were. She received a Form 1099 from the state of California for $53,834 and a Form 1099 for income from Minnesota, and reported total gross receipts of $94,301 on her federal income tax return related to her business as a “race track judge.” She did not file a California return, and the FTB issued a notice of proposed assessment for additional tax and penalties/fees based on estimated California source income of $53,834—i.e., the figure from the California 1099. Sheward protested the assessment, lost the protest at the FTB, and appealed to the OTA.

A nonresident of California is still subject to personal income tax on California source income. Where a nonresident earns income from sources within California, the nonresident’s taxable income from sources within and without California is allocated and apportioned under FTB regulations. If the taxpayer is a nonresident, conducts business as a sole proprietorship, conducts a unitary business, and conducts that unitary business within and without California, the FTB’s regulations provide the taxable California source income is determined by applying the statutory apportionment formula found in California’s version of the Uniform Division of Income for Tax Purposes Act, or UDITPA.

In Appeal of Sheward, OTA concluded that all four requirements above were satisfied. Sheward was a resident of Ohio, not California; her business was a sole proprietorship; it was a “unitary” business because the horse racing services she performed in California and Minnesota were similar, constituting a one-service business that she controlled and managed; and she conducted business in California and other states.

The OTA explained the next step is to apply UDIPTA, which apportions business income by a sales factor, the numerator of which is California sales and the denominator of which is all sales, everywhere. Sales from services are sourced by statute to where the benefit of the service is “received,” and the FTB’s regulations provide a hierarchy of cascading rules for making that determination.

Rejecting the FTB’s argument that it had to reasonably approximate the benefit received in California, the OTA found that Sheward’s contract with the California Horse Racing Board reflected the benefit was received in California. However, rather than stopping there as the FTB had done in its estimate, the OTA next computed a California apportionment factor of 57.1% ($53,834 California sales divided by $94,301 total sales). Applying that factor to the total unitary net business income of $51,772 as reported on Sheward’s federal return, the OTA concluded that Sheward had California source income of $29,562—not $53,834 as assessed by the FTB.

The OTA rejected the FTB’s claim that using information from her federal tax return, filed under penalty of perjury, was unreliable. The OTA also rejected the FTB’s claims that the federal information on her Schedule C did not distinguish between business and nonbusiness income. Remarkably, the FTB also claimed that her income from Minnesota Harness Racing Inc., should be sourced to California if the benefit was received in California. The OTA pointed out that horse racing judging services performed in Minnesota did not result in any benefit received to anyone in California.

The legal analysis in Sheward seems straightforward, and the dollars are small, so why is this decision significant? It addresses the FTB’s legal authority to assess tax on unreported income based on an estimate of income and its unwillingness to follow its own regulations. If the FTB’s estimate is “reasonable and rational,” then it is presumed correct, and the burden shifts to the taxpayer to show it is erroneous.

In Sheward, the FTB neatly sidestepped its own regulation, which required apportionment, and instead simply picked up the figure on the California 1099 and used it as an estimate. That estimate resulted in $53,834 of California source income, nearly twice the California source income properly computed by the OTA using the FTB’s own regulation. “FTB was unable to show that it properly applied those provisions here,” stated the OTA. “Men [and women] must turn square corners when they deal with the Government; it is hard to see why the government should not be held to a like standard of rectangular rectitude when dealing with its citizens.” See Title Ins. Co. v. State Bd. of Equalization.

This four-part regulatory analysis is well known after the 2019 precedential decision in Appeal of Bindley, where the OTA sustained the FTB’s proposed assessment on California source income of a nonresident, self-employed screenplay writer who performed all his services outside of California but performed those services for California limited liability companies. More interesting, the OTA noted that the FTB’s claimed reasonable and rational estimate of $53,834 of California source income was actually higher than the total income of $53,299, which Sheward reported from all sources on her federal return.

The FTB’s initial action to make an estimate based on the California 1099 seems to have been reasonable at the time it was made. But as the OTA noted, after the FTB used that estimate to issue the proposed assessment, Sheward then provided the FTB with a copy of her federal return, which included the Schedule C. “The federal return shows that FTB should have applied its own rules,” remarked the OTA.

Those of us who regularly practice before state tax agencies are well aware of the problems of confirmation bias, which is the tendency to process information by interpreting it in a way consistent with one’s existing belief. Once, as here, a decision is made by a tax agency, it tends to hold fast to that belief—even in the face of later received conflicting information. The FTB is legally entitled to claim the legal presumption that its determinations are presumed correct, but the presumption is a rebuttable one. Credit goes here to the OTA, which recognized the presumption of correctness is rebuttable and the correct result is to be determined under rules that apply to the FTB and taxpayers.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Eric J. Coffill is senior counsel in Eversheds Sutherland’s Sacramento office. He has nearly 40 years of experience counseling clients on state and local tax controversy and litigation matters at the administrative, trial, and appellate levels, particularly those involving the California Franchise Tax Board and the California Department of Tax and Fee Administration.

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