California Source Income Tax Rate Determined On Worldwide Income for Non-California Residents

A recent California State Board of Equalization (BOE) decision illustrates California's broad reach to tax non-residents. Specifically, the California Franchise Tax Board (FTB) was able to successfully argue that additional tax was due from a non-California resident to cancellation of debt income from property also located outside of California.

In the Matter of Appeal of Melissa Stevens, BOE Case No. 603937, an unpublished decision, the BOE found that even though the property was not in California. The additional cancellation of debt income resulted in a higher applicable California income tax rate to the taxpayer who earned California source income as a traveling nurse in California.

In this case, Ms. Stevens timely filed her California income tax returns and paid her California source income. Subsequently, Ms. Stevens was audited by the Internal Revenue Service (IRS) which resulted in additional income based on the cancellation of debt. The IRS adjustment was reported to the FTB's Revenue Agent Report Unit that issued a Notice of Proposed Assessment based on the increase to Ms. Steven's taxable income even though the cancellation of debt income was not California source income.

It is true, California Revenue and Taxation Code (CRTC) Section 17041(b), imposes a tax on the California-source income of all nonresidents of California. The tax rate, however, is determined by taking into account the non-resident taxpayer's worldwide income. Appeal of Louis N. Million, 87-SBE-036, May 7, 1987. This formula does not tax non-California source income, but merely takes into consideration the out-of-state income in determining the tax rate that should apply to California source income. The purpose, the FTB argued, is to apply the graduated tax rates to all persons, not just those who live in California for the full year.

CRTC Section 17041(b)(2) states that the tax rate for a California Non-resident's tax on the total taxable income is calculated as if the taxpayer was a California resident, and then divided by the taxpayer's total taxable income as if the taxpayer was a California resident. The resulting rate is then applied to the non-resident's California taxable income to determine the amount of California tax.

The constitutionality of using out-of-state income to determine in-state tax rates has been upheld by the Courts, holding that taxpayers with equal income were similarly situated and should thus be taxed at the same rate. Therefore, a non-resident earning $10,000 in California and $90,000 outside of California should be taxed at the same rate as a California resident earning $100,000. So, if the rate for the California residents' earning $10,000 and $100,000 is 1% and 5%, respectively, the non-resident's tax rate on the $10,000 of California source income would be 5%, the same as the similarly situated California taxpayer.

Formula:
(tax on total taxable income )/ (total taxable income)=California tax rate
(California tax rate)(Ca taxable income)= prorated tax due.

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