Apportioning Income for a Multistate S Corporation with California Operations
Pacific Coast Design, Inc. (PCD) is an S corporation incorporated in Delaware with its headquarters in Oregon. PCD provides architectural services. In 2023, PCD had total gross receipts of $5,000,000. Of that, $1,500,000 came from California customers, but the services were performed in Oregon. PCD also has a California office with one employee who performs administrative support and occasional client meetings; the office costs $200,000 annually. PCD's payroll is $2,000,000, of which $150,000 is paid to the California employee. PCD's property everywhere is $1,000,000, including the California office valued at $250,000. PCD elected S status for federal purposes and files a California S corporation return (Form 100S). PCD has a California net income of $800,000 after adjustments. PCD's shareholders are all individuals, two of whom are California residents. PCD has not filed a California return for 2023, claiming that it has no California-source income because services are performed in Oregon.
1. Determine whether PCD is subject to California tax and, if so, calculate its California apportionment percentage using the current apportionment formula.
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PCD is subject to California tax if it is doing business in California. Under R&TC §23101, doing business includes actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. PCD maintains a California office, employs a California employee, and earns $1,500,000 from California customers. These activities are regular, continuous, and substantial, so PCD is doing business in California and must file a California return. As an S corporation, PCD is subject to the 1.5% California franchise tax on its net income (or the $800 minimum tax, whichever is greater). California uses a single sales factor apportionment formula for most taxpayers, including S corporations. The sales factor is a fraction: California sales divided by total sales. California sales are sales where the customer receives the benefit of the service. For services, the benefit is received where the service is performed? Actually, under California's market-based sourcing rules (R&TC §25136), sales from services are in California to the extent the purchaser of the service received the benefit of the service in California. The benefit of architectural services is generally received where the building or project is located. Here, PCD's California customers are likely receiving the benefit in California, even though services are performed in Oregon. So the $1,500,000 from California customers is included in the California sales factor numerator. Total sales are $5,000,000. The sales factor is 30% ($1,500,000 / $5,000,000). California net income is $800,000, so California apportioned income is $240,000. The California franchise tax is 1.5% of $240,000, or $3,600, but PCD must pay the greater of that or the $800 minimum tax. Since $3,600 > $800, PCD owes $3,600. However, PCD may also be subject to the 1.5% tax on the apportioned income, and the shareholders include their share of California-source income on their California returns. PCD's argument that it has no California-source income is incorrect because the sales factor includes sales to California customers based on market sourcing, not where services are performed.
2. How should the two California resident shareholders report PCD's income on their California personal income tax returns, and what credit may be available for taxes paid to other states?
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PCD is an S corporation, so it is generally not subject to California income tax at the entity level (except the 1.5% franchise tax). Instead, income, deductions, and credits flow through to shareholders. California resident shareholders are taxed on all income, regardless of source. Therefore, the two California resident shareholders must include their proportionate share of PCD's total net income ($800,000) on their California returns, not just the California-apportioned income. They will receive a Schedule K-1 (100S) from PCD showing their share of ordinary income and California adjustments. Because PCD is doing business in California, it must file Form 100S and report the California apportioned income, but the shareholders' California taxable income includes 100% of their share of PCD's income. The shareholders may be eligible for a credit for taxes paid to other states. If PCD pays income tax to Oregon or another state, the shareholders may claim a credit on their California returns for their share of tax paid to the other state on income that is also taxed by California. The credit is limited to the California tax on the income sourced to the other state. The shareholders should obtain information from PCD about taxes paid to other states. Additionally, the shareholders may need to make estimated tax payments. The two California resident shareholders cannot exclude PCD's income even if it is apportioned outside California; they must report all income and then claim the other state tax credit. The nonresident shareholders would only report California-source income (the apportioned amount). PCD's failure to file a California return may result in penalties and interest, and the shareholders may be liable for taxes on their shares.