In Appeal of A. Markowski, the Office of Tax Appeals (OTA) considered A. Markowski's appeal of the Franchise Tax Board's (FTB) denial of his refund claim for the 2017 tax year. The key issues in this appeal were whether Markowski was provided proper notice of tax due, whether the FTB was required to obtain and review Markowski’s tax return before issuing its proposed assessment, and whether Markowski received taxable income from a California source in the 2017 tax year.

Background

For the 2017 tax year, Markowski wrote computer codes for Derivative Technology, LLC, which was registered with the California Secretary of State and located in San Mateo, California. Derivative Technology issued Forms 1099-MISC to Markowski, reporting $37,857 of non-employee compensation for the 2017 tax year. Markowski reported this income on his federal tax return but did not file a California return. The FTB issued a Request for Tax Return for the 2017 tax year because it received information showing that Markowski received income from Derivative Technology. When Markowski did not respond, the FTB issued a Notice of Proposed Assessment (NPA) for the 2017 tax year. Markowski did not protest, and the NPA became final. Subsequently, the FTB levied $1,470.31 from Markowski’s bank account. Markowski then filed a claim for refund, which the FTB denied, leading to this appeal.

OTA Analysis

The OTA ultimately held that Markowski was provided proper notice of income tax due, the FTB was not required to obtain and review Markowski’s tax return before issuing its proposed assessment, and Markowski received taxable income from a California source in the 2017 tax year.

Whether income was California source. California Revenue and Taxation Code (R&TC) sections 17041(b) and 17951(a) impose a tax on the taxable income of every nonresident to the extent it is derived from sources within California. R&TC section 17954 states that taxable income of nonresidents from sources within and without California shall be allocated and apportioned under rules and regulations prescribed by the FTB. California Code of Regulations, title 18, section 17951-4 provides income sourcing provisions applicable to a nonresident’s business, trade, or profession. If a nonresident’s business, trade, or profession is a sole proprietorship that carries on a unitary business, trade, or profession within and without California, its business income is apportioned to California under the statutory apportionment provisions of the Uniform Division of Income for Tax Purposes Act (UDITPA), as codified in R&TC sections 25120 through 25139. The requirements for application of Regulation section 17951-4(c) are as follows: (1) the taxpayer must be a nonresident; (2) the taxpayer must be conducting business as a sole proprietorship; (3) the taxpayer must be carrying on a unitary business, trade, or profession; and (4) the taxpayer’s unitary business, trade, or profession must be conducted within and without California. There was no dispute that Markowski was a California nonresident during the 2017 tax year.
- Sole Proprietorship. The OTA found that Markowski was conducting business as a sole proprietorship. A sole proprietorship is defined as a business in which one person owns all the assets, owes all the liabilities, and operates in his or her personal capacity. Derivative Technology issued the Form 1099-MISC for the 2017 tax year reporting that Markowski received nonemployee compensation, and Markowski self-reported this income on Schedule C of his 2017 federal income tax return. Markowski argued that he was an employee according to Dynamex Operations West, Inc. v. Superior Court [(2018) 4 Cal.5th 903]. However, the OTA found that Markowski did not provide credible evidence to establish that he was an employee. The OTA also found that the FTB is not the hiring entity in this case and cannot be placed in the same position as a hiring entity.
- Unitary Business. The OTA found that the evidence shows that Derivative Technology hired Markowski to write computer codes in his capacity as an owner of a sole proprietorship. Markowski, thus, conducted a one-service business, which only he controlled and managed. As far as the OTA could tell from the record, the business was one interrelated and interdependent business employing and consuming the same resources. Therefore, the third requirement has been met.
- Business Within and Without California. The final requirement is that Markowski must have been conducting business within and without California. The record shows that Markowski received income from Derivative Technology, an LLC located in California, for services rendered as a sole proprietor. Although Markowski argued that he did not conduct his business within California because he was never physically present in this state during 2017, the statute does not require a physical presence in California for the state to impose an income tax. Consequently, because Markowski performed services in Connecticut and derived California source income, as discussed next, from a company located in California, the OTA concluded that Markowski was carrying on his business within and without California.
- Source of Income. The amount of such business income derived from sources within California shall be determined in accordance with the provisions of the apportionment rules of UDITPA, contained in R&TC sections 25120 to 25139, and the regulations thereunder.

R&TC section 25128.7 states that for taxable years beginning on or after January 1, 2013, all business income of an apportioning trade or business shall be apportioned to this state by multiplying the business income by the sales factor. The sales factor is a fraction, where the numerator is the taxpayer’s total sales in California during the tax year and the denominator is the taxpayer’s total sales everywhere during the tax year.

To determine what amount to include in the numerator of the sales factor, R&TC section 25136 governs the assignment of receipts from sales other than sales of tangible personal property, such as receipts from services. Sales from services are assigned to this state to the extent the customer of the taxpayer receives the benefit of the service in this state. California Code of Regulations, title 18, section 25136-2(c) states that “Service’ means a commodity consisting of activities engaged in by a person for another person for consideration.

The OTA found that Markowski’s activities met the definition of “service” because he wrote computer codes for Derivative Technology for consideration. The OTA found that Markowski was in a regular trade or business of offering his services to the public.

California Code of Regulations, title 18, section 25136-2(c)(2) provides the following cascading rules to determine receipt of the benefit of services: (A) The location of the benefit of the services shall be presumed to be received in California to the extent the contract between the taxpayer and the taxpayer’s customer or the taxpayer’s books and records kept in the normal course of business, notwithstanding the billing address of the customer, indicate the benefit of the services is in California. (B) If neither the contract nor the taxpayer’s books and records provide the location where the benefit of the service is received, or the presumption in subparagraph (A) is overcome, then the location where the benefit is received shall be reasonably approximated. (C) If the location where the benefit of the service is received cannot be determined under subparagraph (A) or reasonably approximated under subparagraph (B), then the location where the benefit of the service is received shall be presumed to be in this state if the location from which the taxpayer’s customer placed the order for the service is in this state. (D) If the location where the benefit of the service is received cannot be determined pursuant to subparagraphs (A), (B), or (C), then the benefit of the service shall be in this state if the taxpayer’s customer’s billing address is in this state. The OTA was unable to apply the first cascading rule under subparagraph (A) because the record does not contain the contract between Markowski and Derivative Technology nor Markowski’s book and records. Under subparagraph (B), the OTA reasonably approximated the location where Derivative Technology received the benefit of Markowski’s services. “Reasonably approximated” means, in relevant part, “considering all sources of information other than the terms of the contract and the taxpayer’s books and records kept in the normal course of business, the location of the market for the benefit of the services is determined in a manner that is consistent with the activities of [Derivative Technology] to the extent such information is available to [Markowski]”. Public records from the California Secretary of State show that Derivative Technology is registered and located in California. Moreover, Derivative Technology listed a California address on the Form 1099-MISC that it issued to Markowski in the 2017 tax year. Thus, Derivative Technology received the benefit of Markowski’s services within California. Accordingly, the entire $37,858 Markowski received from Derivative Technology in 2017 is sourced to California.

Markowski argued that the market-based sourcing rules under Regulation section 25136-2 is unconstitutional because it sources income to California from Markowski who has worked from Connecticut and who has never been in California. Regulation section 25136-2 is based on a statute, R&TC section 25136(a)(1), which provides that sales from services are in this state to the extent the purchaser of the service received the benefit of the services in this state. The OTA noted it does not have jurisdiction to determine whether a California statute is invalid or unenforceable under the United States or California Constitutions, unless a federal or California appellate court has already made such a determination.

Therefore, the OTA sustained FTB's assessment.

Prepared with assistance from NotebookLM.