I’m in zombie mode — it’s midnight and the last of the work is done (for a short time). I’ll be out the rest of today (Tuesday). Tax Day is over.
One place where it’s sort of not over is California. The Franchise Tax Board had major computer issues with their website on Monday. The FTB announced that anyone who pays their tax on April 16th via the FTB’s webpay system (for individuals or for businesses) on April 16th will be considered to have made the payments on April 15th.
A repeat follows, but it’s one again getting a lot of play due to business conditions in California. While I’m focusing on California and Nevada, the principle applies to any pair of states.
Nevada is doing everything it can to draw businesses from California. Frankly, California is doing a lot to draw businesses away from the Bronze Golden State. But you need to beware if you’re going to incorporate in Nevada.
If the corporation operates in California it will need to file a California tax return. Period. It doesn’t matter if the corporation is a California corporation, a Delaware corporation, or a Nevada corporation.
Now, if you’re planning on moving to Nevada incorporating in the Silver State can be a very good idea. But thinking you’re going to avoid California taxes just because you’re a Nevada corporation is, well, bozo.
Two pieces of news out of California regarding the Qualified Small Business Stock situation. For those who aren’t aware, a court last year ruled that California couldn’t discriminate against out-of-state Qualified Small Business Stock (QSB). The Franchise Tax Board interpreted that ruling to mean that for any open tax year, the state would challenge the QSB deductions for anyone who took it. For 2012 on, the California deduction was eliminated, so this is an issue impacting entrepreneurs for tax years 2008 through 2011.
The FTB announced today that they will begin sending Notices of Proposed Assessment (NPAs) in early April. The FTB has also established a simplified procedure to protest the NPAs and it’s clearly noted in their FAQ web page on this issue.
(As much as I think the FTB’s implementation of the Cutter decision is wrong, I want to give the FTB kudos to them for an easily understood webpage and instructions on this issue. I also want to thank them, especially Susan Maples (the FTB’s Tax Practitioner Liaison), for reaching out to the tax professional community in communicating the issues.)
Meanwhile, the tech community remains extremely displeased with the FTB’s actions. Brian Overstreet, the man who began sounding the alarm, has set up a new website on this issue. There’s a very anti-California article on Forbes.com that highlights this issue. Legal action is almost a certainty; many of these entrepreneurs have the deep pockets necessary to fight the FTB.
Let’s say you have a business entity, Widgets, Inc. It’s a Nevada corporation; the corporation is located in Las Vegas. The business has no operations in California but it is a corporation with one owner who resides in California. However, the owner is not involved with day-to-day business; a manager in Las Vegas runs the business. The only officer of the corporation is a Nevadan, too. Does the corporation owe California taxes?
The Franchise Tax Board has said yes for years. Any business entity which is owned by a Californian is subject to California taxation. Earlier this month a court in Los Angeles said no.
As reported in Forbes, the facts weren’t in dispute, and mirror what I wrote above. Since all the evidence showed the company was in Nevada, run by Nevadans, Nevada was the commercial domicile of the company, not California. The company won.
Now, let’s get to the dark side of the case. The article in Forbes doesn’t mention the years in dispute. Unfortunately, the actual ruling does not appear to be available on the Internet. But I did find a predecessor ruling from the Board of Equalization that’s available. Let’s go through the hoops that Daniel V (the corporation in question) went through. From reading the BOE decision, I found that the years in dispute were 1997 and 1998.
Sometime after 1997 and 1998, the Franchise Tax Board sent notices to the company. The company then fought the notices through the FTB’s appeal process. (The dates on this aren’t available.) After losing at the FTB, the company paid some (probably most) of the taxes and penalties, and filed an appeal to the Board of Equalization. (The Board of Equalization hears appeals from the FTB.) The company lost in May 2008, paid the remaining taxes, penalties, and interest, and asked for a rehearing (that’s what I linked to above). That rehearing happened later (probably in late 2008), and the company lost again (the decision was likely not rendered until 2011). The entity then sued in Superior Court (March of 2011). The case was heard in November 2012. The company won…for now. I fully expect the FTB to appeal the decision (though there are reasons not to).
Consider also the FTB’s mentality. This case did go through the FTB appeals process, and the company lost. As far as the FTB is concerned, any business that can be loosely tied to California owes California taxes…period. The facts of this case definitely make one wonder about how the company lost at both the FTB and BOE. But I digress….
I expect an appeal because the FTB’s litigation strategy has been to appeal almost every case, whether they’re in the right or the wrong (see Gilbert Hyatt). Part of this is the FTB’s litigation strategy: To exhaust individuals thinking of suing the agency. It takes a lot of time and money to sue the FTB.
One reason not to appeal is because this case only stands as precedent for the one company involved. If the FTB appeals and loses, then this case is binding upon the FTB (to all businesses with a similar set of facts).
Finally, consider how long this case has festered. It’s been ten years (at least) and it’s likely still not done. It does take a lot of money to fight the FTB.
California budget officials couldn’t figure out where the extra $5 billion in tax revenue came from in January. As this Los Angeles Times article asks, was this an accounting anomaly? Governor Jerry Brown’s administration now believes it was a timing issue.
Many businesses increased dividend payouts and other income into last year because of federal (and California) tax hikes. Many individuals (at the urging of tax accountants like me) make their fourth quarter estimated tax payment at the end of December rather than in mid-January to lower their tax bill; state income tax paid is deductible on federal income tax. The same is true for corporations (state income tax they pay is deductible on federal income tax).
While I do believe that some of the income isn’t timing related–Californians didn’t have time to make changes to their spending habits due to the late (in the year) passage of California’s tax hike–most likely much of it is just tax revenue coming in early. And there’s still the $500 million judgment in the Gilbert Hyatt case; that decision by the Nevada Supreme Court could come at any time.
Mortgage debt forgiveness was part of the “Fiscal Cliff” bill that passed Congress on January 1st. If you sell your primary residence in a short sale (or your home is foreclosed), the cancelled debt (up to $400,000) is generally not subject to federal taxation. California had a similar provision (but only up to $250,000); however, that provision expired on December 31, 2012.
Lawmakers in California are considering extending the legislation into 2013. The measure has bipartisan support, so it’s likely this (or something similar) will be signed into law. I would expect, though, that the dollar limit for the California measure would be less than the federal measure.
I used to live in California’s central valley. It’s prime agricultural land, with citrus, almonds, pistachios, stone fruits, grapes, and practically anything else that you can eat. The cities there aren’t big (Fresno is the largest), and poverty and unemployment are rampant.
The central valley is also where California will begin construction of a high speed rail network. The idea is to build the first stage from Madera (population 61,416) to Bakersfield (population 347,483). It will pass through my old hometown of Visalia (population 124,442) and Fresno (population 509,039). To date, California has raised $6 billion of the current cost estimate of $68 billion.
Most rapid transit needs subsidies; clearly, a rail line from Madera to Bakersfield is going to be a money-loser. Meanwhile, California has been raising taxes, driving businesses out of the Bronze Golden State. The state has yet to purchase any property that will be needed for the route (though approval was granted earlier this month to begin that process). Given that the land is of good use for agriculture, expect court battles to develop over what a fair price is.
Meanwhile, where is the other $62 billion going to come from? Given the recent uproar in Congress with the fiscal cliff and the upcoming uproar over the debt ceiling, I doubt any proposals for high speed rail will make it through. There’s also the basic problem that you can fly from Los Angeles to San Francisco in an hour; high speed rail will take just as long (or longer)…so there is no speed advantage. At least it’s no longer my state tax dollars going for this project.
Phil Mickelson has overcome a chronic illness (psoriatic arthritis) and continues to be one of the best golfers in the world. However, Mr. Mickelson golf game may be felled by something that his home state of California and the US government have implemented: taxes.
From the Golf Blog (from Sports Illustrated), Mr. Mickelson is quoted as saying,
There are going to be some drastic changes for me because I happen to be in that zone that has been targeted both federally and by the state and, you know, it doesn’t work for me right now…so I’m going to have to make some changes…
If you add up all the federal and you look at t he disability and the unemployment and the Social Security and the state, my tax rate’s 62, 63 percent. So I’ve got to make some decisions on what I’m going to do.
Ouch: A 62% marginal tax rate is quite high. His income tax rate is likely a bit less; Joe Kristan calculates it at 52%. Whether it’s 52% or 62%, it’s a lot, and when you earn $61 million a year before taxes, you don’t want to see your pay reduced by over half.
Mr. Mickelson could move to Nevada or Florida, and his tax rate would drop by about 8%; still high, but not astronomically high. I suspect Mr. Mickelson is torn between living in one of the most beautiful areas of the world (he resides in suburban San Diego) versus keeping more of his hard-earned income.
Now let’s consider entrepreneurs who call Silicon Valley home. They’ve been building up businesses, and let’s assume they see an opportunity to go “public” (issue stock on a stock market) and cash in. Let’s look at what would happen if they are in California versus Texas (or Nevada):
1. In California, they’ll face the highest state income tax in the country (13.3%) versus no income tax in Texas.
2. In California, capital gains are taxed as ordinary income for state taxes. There is no tax in Texas. (Many states with state income taxes have preferential capital gains treatments, too…but not California.)
3. In California, there is no Qualified Small Business Stock exemption. Not an issue in Texas; there’s no state income tax.
4. California has one of the worst business climates in the country (especially with regulations). Texas is among the best in the country.
So assume you are the president of HighTechCo, a Silicon Valley start-up. You can go public in California, or you can move your business to Texas. If you end up in Texas, you will make more money off your initial public offering (IPO), you will end up in a better regulatory climate, and you can hire employees at generally lower wages than in the Bay Area. Sure, the weather isn’t as good as California, but there are no earthquakes either. I suspect a lot of business owners will elect to use moving vans prior to their IPOs.
As Alan Greenspan said, “Whatever you tax you get less of.” California is going to find out that their tax increases will not be the long-term savior of their budgets. The only solution is cutting expenditures. Business owners can move, and many individuals (such as Mr. Mickelson) and businesses (such as the hypothetical HighTechCo) are going to choose that route.
As expected, the California Supreme Court has accepted Gillette vs. Franchise Tax Board. While no date has been announced for the arguments, I’d expect the case to be heard this Spring or Summer, with a decision sometime before year-end.
The Gillette case is very important to multi-state entities that file in California.
