Real Estate Withholding Issues Addressed

www.caltax.comM ay 1, 2015Real estate withholding, continued from page 50regulatory changes necessary torevise forms to process withholdingon grantor trusts efficiently.MyFTBIn the next major upgrade of theFTB’s system, the FTB will reflect thereal estate withholding for personalincome tax in the taxpayer’s MyFTBAccount. This change is scheduled forSeptember 2015.What to do this yearThe FTB is making progress towardresolving these issues. To be honest,even when the changes discussed hereare implemented, there will alwaysbe problems with mismatch due tohuman error. However, despite theadditional time involved in processingtrouble returns, we believe there willbe improvement. We recommend thatwhen you have a client with real estatewithholding, you:!! Advise the client that the refundmay be delayed because the returnmay need to be manually reviewedif the withholding credits can’t beapplied;!! Tell your client to send you any FTBnotices received immediately so youcan get the issue resolved;!! Keepcopies of the escrowstatement and Forms 592 and/or593;!! If you notice an error in taxpayername and ID number on Form593 or a difference betweenwithholding on the escrowstatement and Form 593, haveyour client contact the FTB’sWithholding Services andCompliance Section at:(888) 792-4900LLC fee computation, continued from page 49"" Interest, dividends, gross rents,2015 LLC annual fee amountsTotal IncomeAnnual FeeBelow 250,000 0 250,000 or more, but less than 500,000 900 500,000 or more, but less than 1,000,000 2,500 1,000,000 or more, but less than 5,000,000 6,000 5,000,000 or more 11,790reasonable cause exception for thispenalty.Total incomeThe fee is based on “totalCalifornia-source income,” which isessentially gross income under IRC§61 from all California sources beforeany apportionment or allocation pluscost of goods sold.5If the LLC’s income is solely fromCalifornia customers, the fee is fairlyeasy to calculate. However, it getsmore complicated when the LLC hascustomers in other states or receivesincome from other passthroughentities.First, let’s address some of theissues that arise in determining what’sincluded in total income. Obviously,income from sales, lease, or rental ofproperty is included, as is income fromservices performed. But “total income”also includes:!! Gross income from passthroughentities (other than income fromanother LLC that is subject to thefee, see “Tiered LLCs” on page52 of this issue), including thedistributive share of:"" Gross ordinary income from thepassthrough entities as well asthe LLC’s distributive share ofCOGS; andand other distributive items ofincome; 6!! Capital gains (not losses) and IRC§1231 gains (not losses). UnderIRC §61(a)(3), the gains and lossesare never netted;!! Income from the passive holding ofintangible property;!! Income from occasional or isolatedsales; and!! Expense reimbursements.EXAMPLE 5-1: An LLC providesproject management services forconstruction jobs. To keep theproject moving along, the LLC paysvendors on behalf of the client andis then subsequently reimbursed bythe client. According to the FTB,the LLC is required to include thevendor payment reimbursementsin total income for purposes ofcalculating the fee.Income attributable to CaliforniasourcesLLCs with total income fromCalifornia simply use their totalSee LLC fee computation, page 52This publication is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional advice and assumes noliability whatsoever in connection with its use. Since tax laws are constantly changing and are subject to differing interpretations, we urge you to do additionalresearch before acting on the information contained in this publication.SPIDELL’S CALIFORNIA TAXLETTER (ISSN No. 0194-8237) is published on the first day of each month by Spidell Publishing, Inc. , 1134 North Gilbert Street,Anaheim, California 92801-1401. Telephone: (714) 776-7850. Fax: (714) 776-9906. Website: www.caltax.com. E-mail: subscriptions@spidell.com. The subscription priceis 189 for 12 months. Periodicals Postage Paid at Anaheim, CA. 2014, Spidell Publishing, Inc . POSTMASTER: Please send address changes to Spidell’s CaliforniaTaxletter, P. O. Box 61044, Anaheim, California 92803-6144. Federal law prohibits unauthorized reproduction of Spidell’s California Taxletter . All reproduction mustbe approved in writing by Spidell Publishing, Inc. Publisher Emeritus: Robert Spidell. Publisher: Lynn Freer. Editor: Renée Rodda. California Editor: Sandy Weiner, J.D.Senior Editor: Tim Hilger. Contributing Editor: Kathryn Zdan. Contributing Editor: Diane Fuller. Managing Editor: Austin Lewis. Layout: Ana Cervantes.- 51 -

Spidell’sCalifornia Taxletter LLC fee computation, continued from page 51income for purposes of determiningthe amount of the fee. However, forLLCs with income from both insideand outside California, total incomeattributable to California includes:!! Sales of tangible personal propertydelivered to a California purchaserunder the general sales factordestination rules;!! Income from services to the extentthe customer receives the benefit ofthe service in California (note thecost of performance standard is nolonger applied);!! Income from intangibles if theintangibles are used in California.If the income is from a passiveinterest in an intangible, theincome is California income ifthe investment is managed inCalifornia;Tiered LLCsIn a tiered structure, a parent LLC owns one or more subsidiary, or lower-tiered, LLCs. However, for purposes ofcalculating the LLC fee, allocations or attributions of income to one LLC from another LLC is excluded from total incomeif that income has already been subject to the LLC fee.7EXAMPLE 5-2: LLC 1, LLC 2, and LLC 3 are all California LLCs with 100% of their income from Californiasources.LLC 1 has a 100% ownership interest in LLC 2. LLC 2 has a 100% ownership interest in LLC 3.For the 2014 tax year, the LLCs have the following California-source income:!! LLC 1 has 2 million;!! LLC 2 has 500,000; and!! LLC 3 has 300,000.The LLC fee for these entities would be determined as follows:EntityTotal IncomeLLC FeeLLC 1 1.2 million ( 2 million – ( 500,000 300,000)) 6,000LLC 2 200,000 ( 500,000 – 300,000) 0 (Because total income is under 250,000)LLC 3 300,000 900Note: All three LLCs are still required to pay the 800 annual tax.8EXAMPLE 5-3: ABC, LLC is a California LLC that develops educational software for California schools. It also has a50% ownership interest in Big Ideas, LLC, an educational curriculum developer located in New York City. In addition,ABC, LLC is a passive investor in Big Investors, LLC, which is located and managed out of Nevada.The table below shows the revenues earned by the various entities, distributions made to ABC, and how they areclassified for purposes of computing ABC’s LLC fee.Total revenues earned Revenues fromAmount included in Amount included in ABC,by entityCalifornia customers ABC, LLC’s “TotalLLC’s “Total IncomeIncome”Attributable to California”ABC, LLC 5.5 million softwaresales 4 million 5.5 million totalsales 4 millionBig Ideas, LLC 3 million curriculumsales 2 million 1.5 millionpassthroughdistribution to ABC 0 0 50,000passthroughdistribution to ABC 0Big Investors, LLC 1 million investmentincomeAs the table above shows, ABC would only include the 4 million of its sales to its California customers. It would notinclude the 1.5 million received from Big Ideas, LLC because the income received from Big Ideas, LLC was subject tothe LLC fee. Nor would it include the 50,000 from its income from Big Investors, LLC because the income was froma passive investment that was managed in Nevada.ABC’s LLC fee would be 6,000 based on its 4 million of total income attributable to California sources.- 52 -See LLC fee computation, page 53

www.caltax.comM ay 1, 2015LLC fee computation, continued from page 52!! Income from the sale, lease, rental,or licensing of real property locatedin California; and!! Sales from the rental, lease, orlicensing of intangible property tothe extent the property is located inCalifornia.Simplified assignment methodFor those LLCs with a sales factornumerator of less than 5 million,the LLC may use the sales factornumerator and, using the assignmentrules discussed, subtract anypassthrough income from other LLCssubject to the LLC fee, and then addthe following income attributable toCalifornia:!! Nonbusiness income; and!! Gross receipts excluded fromthe sales factor numerator underapportionment regulations dealingwith specific industries.LLCs that have at least 5 million intheir California sales factor numeratorpay the 11,790 fee applied to LLCswith total income of 5 million ormore, the LLC fee top bracket.9123456789R&TC §§17942(d)(1), 24271R&TC §§17941(d); 17942R&TC §17942(d)(2)R&TC §17942(d)R&TC §17942(b)18 Cal. Code Regs. §17942R&TC §17942(b)(1)(A)R&TC §17941; FTB Tax News (June 2013)18 Cal. Code Regs. §17942(f)Repair regulations: conformity to partial asset dispositionsThe FTB clarifies corporate taxtreatment.By Sandy Weiner, J.D.California EditorAs part of the new tangible propertyrepair regulations, taxpayersmay elect to recognize gain orloss on the retirement, replacement,or other disposition of a partial asset(such as a roof on a building), ratherthan leaving a “stranded basis” on thebooks, as was previously required.1 Ininstances involving casualty losses, gaindeferrals, transfer in a step‑in‑the‑shoestransaction, and sales of a portion of anasset, the partial disposition treatment isrequired.California’s depreciation deductionfor individuals, estates and trusts,partnerships, and S corporationsgenerally follows federal law, so thesetaxpayers may follow the new federaltreatment of partial asset dispositions.2C corporationsIn contrast to the classificationof capital expenditures, California’scorporate income tax (CIT) treatmentof depreciation does not conformto federal law. 3 California doesnot conform to MACRS and neverconformed to ACRS. So followingstandard California conformityanalysis, many practitioners assumedthat California would not conform tothe partial asset disposition treatmentfor corporations.However, the FTB has stated that theywill follow the partial asset dispositionEXAMPLE 5-4: Premium Properties, Inc. (PPI) owns commercial rentalproperty, including a small apartment building in San Francisco. In 2014, itreplaced six of the 10 HVAC units in the building at a cost of 500,000 andwill make a partial asset disposition election under Treas. Regs. §1.168(i)‑(8)on the federal return. If PPI does not make the partial asset dispositionelection, it would be required to continue to depreciate the HVAC units thatwere replaced as well as the replacement HVAC units.The original cost of the six HVAC units that were replaced was 120,000( 20,000 each), with a salvage value of 500 each. PPI has had the propertyfor 10 years.For federal purposes, PPI has been using the straight-line method and isrequired to depreciate the units over a 27.5-year period. To date, PPI hasdepreciated 43,455, leaving a basis of 76,545.For California purposes, PPI uses the 200% declining balance method over a40-year period. To date, PPI has depreciated 47,994, leaving a basis of 72,006.PPI elects to make a partial asset disposition by making the followingadjustments on the federal and state returns:Disposed PropertyReplacement PropertyFederalClaim loss of 76,545Depreciate new units purchasedfor 500,000 over a 27.5-yearperiod using the straight-linemid‑month conversionCaliforniaClaim loss of 72,006Depreciate new units over a40-year period using the 200%declining balance methodrules for corporate taxpayers, becausethe rules do not conflict with the CIT. ButCalifornia will not fully conform becausetaxpayers must still use California assetclasses and useful lives for purposes ofdetermining the depreciation amount,so the actual depreciation deductionwill likely be different.4if a casualty loss, gain deferral,step‑in‑the‑shoes transaction, or sale ofa portion of an asset is claimed on theCalifornia return for the partial asset, apartial asset disposition is required.12Separate electionsA separate California election isallowed for all taxpayers.5 However,- 53 -345Treas. Regs. §1.168(i)-8R&TC §§17201, 17250R&TC §24349FTB Tax News (March 2015)R&TC §§17024.5(e), 23051.5(e)

Spidell’sCalifornia Taxletter Taxpayers who fail to update address generally face consequencesDon’t assume the IRS and FTB willpick up changes from the USPSdatabase.By Diane FullerContributing EditorTaxing agencies can only do somuch to track down taxpayerswho move. The two cases belowdemonstrate that the effort made bytaxpayers to make their addressesknown factors heavily in the outcomeof their cases.Taxpayer didn’t update address —lossA taxpayer was held liable for 100,000 in unpaid taxes, penalties,and interest where deficiency noticesfrom the IRS were sent to the taxpayer’slast-known address, even though theIRS had been informed by the PostalService that mail to that address wasnot deliverable.1In this case, taxpayer ChristopherGyorgy’s primary complaint wasthat he never received any deficiencynotices for tax years 2001 through2003, for which he acknowledgedhe did not file returns. However, theIRS had sent a series of notices to thetaxpayer as follows:!! March 2004: a deficiency noticefor tax year 2001, sent to the mostrecent address in the IRS’s databasecorresponding to his most recent taxreturn from tax year 2000;!! November 2004: Form 2797,Referral Report of PotentialCriminal Fraud Cases, sent to asecond address based on formssubmitted by third parties; however,this information obtained fromthird parties was not considered“clear and concise notification” ofGyorgy’s address change, and inany case, there was no responsefrom the taxpayer;!! December 2006: a deficiencynotice for tax year 2003, sent tothe original address on the 2000return, which was returned to theIRS as undeliverable and marked“unable to forward;” andCalifornia conformityCalifornia conforms to the federal change of address notification.For California purposes, use Form FTB 3533, Change of Address, tochange a home or business mailing address. You may also use federalForm 8822. This address change will be used for future correspondence.Generally, complete one Form FTB 3533 for each taxpayer who filed aseparate return.If you have a POA, attach a copy of your Form FTB 3520, Power ofAttorney, and write “copy” at the top of Form FTB 3520.For a list of state agencies that will likely need a change of addresssubmitted, see the chart “Who to contact to report a change of address” onpage 55 of this issue of Spidell’s California Taxletter .!! July 2007: a deficiency notice fortax year 2002, sent to the originaladdress, which was again returnedas undeliverable.In 2009, a federal tax lien was filedagainst Gyorgy’s real property.Gyorgy claimed that the IRS hadabused their discretion when they usedhis last-known address from tax year2000 for the deficiency notices for taxyears 2002 and 2003, even with fullknowledge that they were marked asundeliverable.Jacqueline McKechnie was aCanadian citizen who reportedlyleft the U.S. for Canada in February1993, and subsequently lived inGermany for two years. Accordingto the taxpayer, by the time the FTBissued an NPA in July 1997 for the1993 tax year, her mail forwardingservice had expired, so she neverreceived any communication fromthe FTB. She stated that she wasconfident that her federal and stateobligations were fulfilled, so she had“If the IRS was supposed to use another address, itwas Gyorgy’s responsibility to contact the IRS andinform them of any change.”However, Gyorgy was unable toprovide any documentation to supporthis contention that he had updatedhis address at any time. The courtdetermined that no amount of duediligence on the part of the IRS wouldhave uncovered a new address forthe taxpayer because Gyorgy neversubmitted one. If the IRS was supposedto use another address, it was Gyorgy’sresponsibility to contact the IRS andinform them of any change.Taxpayer prevails over FTBIn another case with a morefavorable outcome for the taxpayer,a California nonresident was able toprove that she had moved to Canadaand then to Germany where theforwarding service had expired by thetime the FTB mailed their Notice ofProposed Assessment (NPA).2- 54 -no need to contact the FTB and hadalways paid her taxes on time. Shewas unaware of any deficiency untilMarch 2012, at which time she paidthe FTB’s assessment of 4,764, andthen filed a claim for refund of interestand penalties.The FTB contended that by the timethey issued the NPA, they becameaware that the taxpayer no longerlived in Canada and used “reasonablediligence” in finding the Germanyaddress, which was the last-knownaddress at the time the FTB mailed theNPA.In this case, the Board determinedthe FTB had abused its discretion indenying the taxpayer’s request forabatement of interest, assessed fromthe date of the initial NPA in July1997. Although regulations providethat, except for fraudulent or falseSee Address changes, page 55

www.caltax.comM ay 1, 2015Address changes, continued from page 54returns, every notice of proposeddeficiency assessment must bemailed within four years of the datea taxpayer files his or her return,3 thetaxpayer was able to prove that theforwarding service had expired by thetime the NPA was sent.Last-known addressIn 2001, regulations establishedthat a taxpayer’s last-known address“is the address that appears on thetaxpayer’s most recently filed andproperly processed federal tax return,unless the Internal Revenue Service(IRS) is given clear and concisenotification of a different address.”4The same regulation further statesthat “change of address informationthat a taxpayer provides to a thirdparty, such as a payor or anothergovernment agency, is not clear andconcise notification”5 in determininga last‑known address. However, theIRS will update taxpayer addressesby referring to data maintained in theU.S. Postal Service’s National Changeof Address database.12345Gyorgy v. Comm. (February 27, 2015) U.S.Court of Appeals, Seventh Circuit, Docket No.13-3363Appeal of Jacqueline McKechnie (September10, 2013) Cal. St. Bd. of Equal., Case No.683821R&TC §18416Treas. Regs. §301.6212-2Id.Who to Contact to Report a Change of AddressAgencyFormWebsiteIndividualBOEBOE-345-SP, Notice ofBusiness Changewww.boe.ca.gov/permits licenses.htm#changeaddressCountyAssessorContact county for formwww.boe.ca.gov/proptaxes/assessors.htm DMVForm DMV 14, Notice ofChange of /welcome EDDForm DE 24, Change ofAddresshttps://eddservices.edd.ca.gov/ ezre/iAppsShared/EZRegHome Page.aspxFTBForm FTB 3533, Changeof l IRSForm 8822, Change Changes PostOfficePS Form 3575, Changeof Addresshttps://moversguide.usps.com Secretaryof StateForm SI-200 for CAcorporation or otherforms listed by inessentities/forms/ Form SOS/NP 34 tm SocialSecurityAdmin.Use my Social Securityaccount online or contactlocal office to updateaddress by uestionID 3704 VeteransAffairsVA Form 20-572,Request for Change ail/a id/3045 - 55 -Business

Spidell’sCalifornia Taxletter You can now ask FTB legal staff questions directlyThe FTB has released some statisticson the types of questions they haveanswered.By Renée Rodda, J.D.EditorThe FTB’s new Ask a LegalExpert program allows you tosubmit “basic legal questions”directly to a specific Legal DivisionBureau. At a recent FTB presentationon compliance and legal outreach,the FTB shared some information onthe questions they have received,and the responses that have beenprovided.While the program is designed toanswer only basic questions, it seemsthat quite a few taxpayers have gottenanswers to their questions. FromOctober 2014 through February2015, the legal experts received154 questions, 94 of which receivedsubstantive answers.We did not receive informationon what specifically was asked, orwhat answers were provided, butwe can tell you what subject matterea

LLCs must use Form FTB 3536, Estimated Fee for LLCs, to remit the estimated fee. Estimating the fee The estimated fee is required to be at least 100% of the current taxable year fee. 4 If the taxpayer’s payment is late or less than the amount owed, the FTB will asses