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:

• 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.

• Sales of intangible property: Assigned to California to the extent that the intangible property is used in California.

• Sales from the sale, lease, rental or licensing of real property: Assigned to California if the real property is located in California.

• 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.