By Erin Zhang

A trade or business with income inside and outside of California must understand California rules for apportionment and allocation of income to calculate California taxable income . Business income is subject to apportionment and nonbusiness income is subject to allocation .

Business Income & Apportionment Per R & TC Sec . 25120 , business income is that “ arising from transactions and activity in the regular course of the taxpayer ’ s trade or business and includes income from tangible and intangible property if the acquisition , management and disposition of the property constitute integral parts of the taxpayer ’ s regular trade or business operations .”

Nonbusiness income is everything other than business income : rental income , patent and copyright , etc . Usually , nonbusiness income is allocated to the states that it is produced or earned ( interest income ).

The first step is determining which portions of a taxpayer ’ s entire income is business or nonbusiness . The taxpayer can be a single corporation or a group of affiliated corporations conducting business in a unitary nature . Generally , business income is apportioned to different states by a formula that varies among states . For taxable years beginning on or after Jan . 1 , 2013 , all business other than those deriving more than 50 percent of their gross receipts from agriculture , extractive business , savings and loans or banks and financial activities must apportion income to California multiplying business income by the sales factor ( i . e . single sales factor apportionment formula ).

When looking at gross receipts of a unitary group with two or more entities filing a combined report , 50 percent is determined at the groupwide level . Sales among the group members are excluded from gross receipts in this test .

Per R & TC Sec . 25136 , if the taxpayer is receiving income from sale of service or intangible property , the gross receipts from the sales must be determined as : a ) Sales of service : Assigned using the market-based sourcing rule to California in which the services or benefits of the services are received or delivered , or where the customer or marketplace is located . b ) Sales of intangible property : Assigned to California to the extent that the intangible property is used in California . c ) Sales from the sale , lease , rental or licensing of real property : Assigned to California if the real property is located in California . d ) Sales from lease , rental or licensing of tangible property : Assigned to California if the tangible property is located in California . For sales of tangible property , California adopts the Finnigan rule : Sales to some states that lack sufficient connection to create nexus are included in California ’ s sales when calculating the apportionment percentage .

Income from a Partnership or LLC When there is income from a partnership or LLC tax as a partnership , if an apportioning trade or business conducted by a partner is unitary with the apportioning trade or business of the partnership or LLC , the partner ’ s distributable share of business income of the partnership is generally treated as business income of the partner . And the partner must add to its tax return its share of the partnership or LLC ’ s sales gross receipts from business activities in and out of California .

If the apportioning trade or business conducted by a partner is not unitary with the apportioning trade or business of the partnership or LLC , the partnership or LLC apportions its business income separately on schedule R , R-1 , R-2 , R-3 and R-4 .

The first step is determining which portion of the taxpayer ’ s income and its distributive share of the partnership items constitutes business and nonbusiness income , under R & TC Sec . 25120 . Even if the partnership ’ s business and the taxpayer ’ s business are not unitary , the taxpayer ’ s share of the partnership ’ s trade or business shall be treated as another trade or business of the taxpayer .

Example : Corporation A has 20 percent ownership in Partnership S and both of their principal business activities are real estate investing . S reported a Sec . 1231 gain from real estate , and other deductions on schedule K-1 ( Form 565 ) to A .

The revenue reported by S , where the gain originated , relates to the management and sale of property . The relationship of the assets sold to partnership activity would be the main driver in determining the character of the gain . As the processing of buying and selling real property is considered business activity within the scope of “ real estate investing ,” the gain from sale of real property is deemed to be business income . When flow to A , the gain retains its character as business income .

Further , A , as a limited partner , isn ’ t involved in S ’ s operations or decision making , so S is not unitary with A . Income on Schedule K-1 is treated as separate business and apportioned to California using its distributive share of sales .

Erin Zhang is senior tax manager at Hood & Strong LLP . You can reach her at ezhang @ hoodstrong . com .

10 CALIFORNIA CPA JULY 2024 www . calcpa . org