Business owners operating in California and other states can face several layers of state income taxation. California may tax the business entity, its owners, or both, depending on residency, business activities, entity classification, and the source of the income.
These issues become particularly important when a business owner moves between California and another state, operates through partnerships or S corporations, receives income from several jurisdictions, or sells an ownership interest in a business.
A significant 2026 California tax decision also changes the analysis of certain partnership interest sales by nonresident owners. The California Office of Tax Appeals rejected the Franchise Tax Board's position that ordinary income attributable to partnership hot assets under Section 751(a) is automatically sourced to California.
The starting point for these issues is to distinguish residency, nexus, income sourcing, and the nature of the transaction. Each is a separate question that should be considered as part of broader proactive tax planning.
October 2026 Legal Development
In Appeals of J. Burch, J. Carden and K. Carden, 2026-OTA-527P, the California Office of Tax Appeals declined to follow FTB Legal Ruling 2022-02.
The OTA concluded that Section 751(a) changes the character of gain from a partnership interest sale but does not, by itself, convert the transaction into a sale of the partnership's underlying receivables or inventory.
The opinion is currently designated Pending Precedential. It is an important development for nonresident partners, but the result still depends on the transaction structure, the source of the income, and whether other California business income rules apply.
Three Questions Determine California Multistate Taxation
Where Does the Owner Live?
California generally taxes residents on taxable income from all sources, including income earned outside California.
Nonresidents generally are taxed only on income derived from California sources.
Where Is the Business Operating?
A business can establish California filing and tax obligations through physical activity, employees, property, sales, or other connections with California.
A business does not necessarily need a California office to create a California tax obligation.
Where Is the Income Sourced?
California applies different sourcing rules depending on whether income comes from services, tangible property, intangible property, business operations, or the disposition of an ownership interest.
The correct tax result often depends on separating these three questions rather than assuming the business formation state or the owner's current residence controls every item of income.
California Residents Are Taxed on Income From All States
Under Revenue and Taxation Code Section 17041, California residents generally are subject to California personal income tax on taxable income from all sources.
For an individual who owns an interest in a partnership, LLC taxed as a partnership, or S corporation, this generally includes the owner's distributive or pro rata share of taxable income even when the business operates outside California.
Example:
A California resident owns 40% of a partnership operating in California, Texas, and Arizona.
The owner generally includes the entire distributive share of taxable partnership income on the California return.
If another state imposes qualifying income tax on income also taxed by California, an other state tax credit may be available under Revenue and Taxation Code Section 18001.
The credit calculation requires a separate analysis of sourcing and the applicable state credit limitations. California does not automatically allow a credit for every tax payment made to another jurisdiction.
Nonresident Business Owners Can Still Owe California Tax
A business owner who lives in Texas, Nevada, Florida, or another state may still have California taxable income.
Revenue and Taxation Code Section 17951 generally limits California taxation of nonresident individuals to income derived from California sources.
A nonresident partner or S corporation shareholder can therefore receive a California Schedule K-1 reporting California source income even though the owner does not live in California.
The source of the income depends on the applicable California rules. Business income from a partnership is not necessarily sourced the same way as gain from the owner's separate sale of a partnership interest.
This distinction is particularly important when an owner changes residency before a business sale.
For the broader residency framework, see California Residency and Nonresident Tax Rules.
Doing Business in California Creates Separate Tax Obligations
Revenue and Taxation Code Section 23101 provides a broad definition of doing business in California.
A taxpayer can be doing business by actively engaging in a transaction for financial gain within the state.
California also applies statutory economic nexus tests based on sales, property, and payroll.
Those tests generally consider whether California sales, property, or payroll exceed the lesser of an annually indexed dollar threshold or 25% of the corresponding total amount.
The applicable thresholds change annually.
The calculation can also include an owner's distributive or pro rata share of sales, property, and payroll from partnerships and S corporations.
Importantly, the economic nexus thresholds are not universal safe harbors.
A business with California activity below the applicable thresholds may still be doing business if its actual activities satisfy the general statutory definition.
Physical Presence Is Not Required for Every California Tax Obligation
Businesses can establish California tax obligations through several types of activities.
- Employees performing services in California
- Inventory stored in California
- Real or tangible property located in California
- Sales exceeding California economic nexus thresholds
- Business representatives operating in California
- Ownership interests in other entities conducting California business
- Services provided to customers receiving the benefit in California
A business operating primarily outside California can therefore have California filing obligations even when its owners and management never maintain a permanent California office.
For an example involving inventory stored through an online marketplace, see California Nexus and Amazon FBA Inventory.
Passive Ownership Requires a Different Nexus Analysis
Ownership of an interest in a California business does not automatically establish that every passive owner is separately doing business in California.
In Swart Enterprises, Inc. v. Franchise Tax Board, the California Court of Appeal considered whether an out of state corporation holding a 0.2% passive interest in a manager managed LLC was doing business in California.
The court concluded that the passive ownership interest, under the circumstances presented, did not establish that the corporation was doing business in California.
The precedential OTA decisions in Appeal of Jali, LLC and Appeal of MJK Real Estate Fund II, LLC further address the distinction between passive ownership and participation in an entity's business activities.
These decisions do not create a blanket exemption for passive investors.
Management rights, ownership structure, the entity's activities, and California's separate economic nexus tests can still affect the outcome.
California Business Income May Be Apportioned Across States
A business operating both inside and outside California generally must determine how much of its business income is attributable to California.
For most apportioning businesses, Revenue and Taxation Code Section 25128.7 uses a single sales factor.
Certain industries and businesses subject to Section 25128 have different apportionment requirements.
The question is often not simply where the business performs its work. The sourcing of receipts can be more important.
Services Generally Follow Market Sourcing Rules
Revenue and Taxation Code Section 25136 and California Regulation Section 25136-2 provide rules for assigning sales other than sales of tangible personal property.
Revenue from services generally is assigned to California to the extent the customer receives the benefit of the service in California.
A business owner could perform services entirely outside California while generating receipts that are assigned to California under the applicable market sourcing rules.
FTB Legal Ruling 2022-01 provides additional guidance regarding the location where business customers receive the benefit of services.
Tangible Property Uses Different Sourcing Rules
Sales of tangible personal property generally follow destination and other applicable assignment rules under Revenue and Taxation Code Section 25135.
Businesses selling products and services therefore must distinguish the nature of their receipts when calculating California sales factors.
Public Law 86-272 Provides Limited Protection
Federal Public Law 86-272 can restrict a state's ability to impose a net income tax on certain interstate sellers of tangible personal property.
The protection generally applies when the taxpayer's in state activities are limited to protected solicitation of orders for tangible personal property, the orders are approved outside the state, and the goods are shipped from outside the state.
It does not provide a general exemption from California nexus rules.
Activities involving services, certain internet functions, inventory, and other business operations can fall outside the statute's protection.
The precedential 2026 OTA decision in Appeal of Ken's Foods, Inc. addresses the application of Public Law 86-272 to California business activities.
The protection depends on the actual activities conducted rather than simply whether the business describes itself as an interstate seller.
Partnership Income and the Sale of a Partnership Interest Are Different
One of the most important California multistate tax distinctions involves the difference between ordinary partnership operating income and gain from selling an ownership interest.
When a partnership conducts business in California, a nonresident partner's distributive share of California business income generally remains taxable by California.
Regulation Section 17951-4(d) provides rules for determining the California source portion of income flowing through partnerships conducting a unitary business inside and outside the state.
However, the separate sale of a partnership interest can involve different sourcing rules.
A partnership interest generally is intangible personal property.
Revenue and Taxation Code Section 17952 generally provides that income from intangible personal property is not California source income for a nonresident unless the property has acquired a California business situs or another applicable rule changes the result.
The treatment becomes more complicated when the partnership holds unrealized receivables, inventory, or other assets subject to Section 751.
Section 751 Can Create Ordinary Income When a Partnership Interest Is Sold
Internal Revenue Code Section 741 generally treats gain or loss from the sale of a partnership interest as gain or loss from the sale of a capital asset.
Section 751(a) provides an exception for amounts attributable to certain partnership assets.
These assets commonly are called hot assets and include unrealized receivables and inventory items as defined by Sections 751(c) and 751(d).
Certain depreciation recapture items can also fall within the statutory definition of unrealized receivables.
The purpose of Section 751(a) is to prevent a partner from converting what economically represents ordinary income into capital gain merely by selling the partnership interest instead of having the partnership sell its underlying assets.
For federal tax purposes, the amount attributable to Section 751(a) property is generally characterized as ordinary income.
The remaining gain or loss generally retains the treatment provided under Section 741.
The California dispute concerned whether this federal characterization rule also changes the state sourcing of the income.
FTB Legal Ruling 2022-02 Took a Broader Sourcing Position
On July 14, 2022, the Franchise Tax Board issued Legal Ruling 2022-02.
The ruling concluded that when a nonresident sells a partnership interest, the portion attributable to Section 751(a) property should be treated as though the partnership had sold the underlying assets immediately before the partner sold the interest.
Under the FTB's interpretation, the resulting ordinary income could be sourced to California under the partnership business income rules, including Regulation Section 17951-4.
For a partnership conducting business in several states, this approach could cause some of the Section 751(a) gain to be apportioned to California even though the selling partner was a nonresident.
The FTB's position was based on treating the ordinary income component as a deemed partnership asset sale followed by a distribution or allocation to the selling partner.
The California Office of Tax Appeals rejected that interpretation in its 2026 decision involving the Burch and Carden taxpayers.
The 2026 Burch and Carden Decision Rejects the FTB's Section 751 Sourcing Theory
In Appeals of J. Burch, J. Carden and K. Carden, 2026-OTA-527P, the California Office of Tax Appeals considered the California sourcing of gains from sales of partnership interests held through a tiered investment structure.
The taxpayers were California nonresidents.
They owned interests in JCB Investments, LLC, which was classified as a partnership. JCB held an ownership interest in Tory Burch LLC, another partnership that operated a business both inside and outside California.
During 2012 and 2013, JCB sold portions of its partnership interest in Tory Burch.
The gains included amounts characterized as capital gains under Section 741 and ordinary income under Section 751(a).
The taxpayers treated the gains as income from intangible partnership interests that was not sourced to California.
FTB disagreed with respect to the Section 751(a) amounts.
Relying on Legal Ruling 2022-02, FTB treated the hot asset component as if Tory Burch had sold the underlying assets, creating California source business income.
The OTA rejected that position.
What the OTA decided:
Section 751(a) changes the character of the gain attributable to unrealized receivables and inventory. It does not, by itself, cause the partnership to be treated as having sold those assets.
The actual transaction remains a sale of a partnership interest.
Accordingly, the OTA concluded that the gain at issue, including its Section 751(a) component, was subject to the California sourcing rules under Revenue and Taxation Code Section 17952.
The OTA reversed FTB's adjustments in full.
The decision is particularly relevant for nonresident owners considering the sale of partnership interests in businesses with California operations.
The Rawat Federal Appeals Court Decision Was Central to the OTA's Analysis
The OTA relied heavily on Rawat v. Commissioner, 108 F.4th 891 (D.C. Cir. 2024).
In Rawat, the United States Court of Appeals for the District of Columbia Circuit considered whether Section 751(a) changed the federal sourcing of income from a partnership interest sale.
The court concluded that Section 751(a) changes the character of the gain but does not transform the sale into a disposition of the partnership's underlying inventory.
The OTA found the reasoning persuasive when applying California's nonresident sourcing statutes.
The distinction matters because California's rules for business income flowing through a partnership differ from the rules governing the sale of an intangible ownership interest.
The federal Rawat decision does not independently determine California income tax obligations. The significance of the Burch and Carden opinion is that the OTA applied the relevant reasoning to California law.
The Decision Does Not Exempt Every Partnership Sale From California Tax
The Burch and Carden opinion should not be interpreted as providing a universal California tax exemption for nonresident partners.
The OTA distinguished its earlier precedential decision in Appeal of Smith, 2023-OTA-069P, and the California Court of Appeal decision in The 2009 Metropoulos Family Trust v. Franchise Tax Board, 79 Cal.App.5th 245 (2022).
Those cases involved income generated by an entity that was treated as part of the relevant unitary business and whose income was subject to California business income sourcing and apportionment rules.
In Burch and Carden, FTB did not establish its position by arguing that the holding partnership and the operating partnership were unitary or that the sale generated apportionable business income at the holding partnership level.
Instead, FTB relied on the separate theory that Section 751(a) itself created a deemed sale of the underlying assets.
The OTA rejected that specific interpretation.
California tax may still apply when:
- The seller remains a California resident when the transaction occurs.
- The partnership interest has acquired a California business situs.
- The transaction is an asset sale by the operating partnership rather than a separate sale of an ownership interest.
- The gain constitutes apportionable business income under an otherwise applicable unitary business analysis.
- A federal deemed asset sale election or another applicable provision changes the legal characterization of the transaction.
- Another California statute or regulation specifically requires California sourcing.
The structure of the transaction and the activities of the selling entity therefore remain critical.
Example: A Texas Resident Sells an Interest in a California Partnership
Assume:
- An individual is a bona fide Texas resident.
- The individual holds a partnership interest as an investment.
- The partnership conducts significant business in California.
- The partnership holds inventory and other Section 751(a) property.
- The individual sells the partnership interest to an unrelated buyer.
Under FTB Legal Ruling 2022-02, the FTB would generally have sought to source at least the Section 751(a) component of the gain to California based on the partnership's underlying business activities.
The Burch and Carden decision rejects the proposition that Section 751(a), standing alone, changes the transaction into a deemed asset sale for California sourcing purposes.
If the interest remains nonbusiness intangible property without a California business situs, the gain may be excluded from California source income under Section 17952.
However, the analysis changes if the seller participates in a unitary business, the interest has acquired a business situs, or the transaction is structured as a sale of the business's assets rather than an interest in the partnership.
The federal Section 751(a) ordinary income characterization remains applicable even when the corresponding income is not California source income.
Federal income tax and California sourcing therefore must be calculated separately.
Completed Partnership Sales May Warrant Review
The Burch and Carden opinion may also be relevant to nonresident taxpayers whose prior California returns included Section 751(a) income under FTB's earlier sourcing theory.
A review should first determine whether the transaction matches the legal and factual circumstances addressed by the OTA.
The taxpayer should also identify whether the California reporting position was based on an actual partnership asset sale, an ownership interest sale, or another transaction structure.
If the tax treatment may have been unfavorable, the applicable California claim for refund requirements and statutes of limitations must be considered.
Revenue and Taxation Code Section 19306 generally provides California refund limitation periods, with specific rules depending on filing and payment dates.
The OTA decision does not automatically reopen closed tax years or extend a refund limitation period.
Any amended return or refund claim should be supported by the transaction documents, applicable California sourcing analysis, and current status of the decision.
California S Corporations Have Separate Entity Level Tax
California differs from federal S corporation treatment by generally imposing an income or franchise tax at the S corporation level.
The general California S corporation tax rate is 1.5% of California taxable net income. The rate for qualifying financial S corporations is 3.5%.
Minimum franchise tax requirements can also apply.
At the shareholder level, a California resident generally includes the full pro rata share of taxable S corporation income, while a nonresident generally reports the portion sourced to California.
A business sale can therefore create different results depending on whether the shareholder sells stock or the S corporation sells its assets.
The Burch and Carden decision concerns partnership interests and should not be automatically applied to S corporation transactions governed by different statutory provisions or the principles addressed in Metropoulos.
California Nonresident Withholding Is Not the Final Tax Calculation
California generally requires withholding on certain payments and distributions of California source income to nonresident owners under Revenue and Taxation Code Section 18662.
Withholding is generally a prepayment of the owner's California tax.
The amount withheld does not conclusively establish the amount of income ultimately taxable by California.
A taxpayer can therefore have withholding even when the final California tax calculation produces a smaller liability or a refund.
Depending on the facts, reduced withholding, a waiver, or a group nonresident return may be available under the applicable rules.
The California PTE Elective Tax Remains an Important Planning Tool
California's pass through entity elective tax allows certain partnerships and S corporations to elect to pay California income tax at the entity level.
For taxable years beginning in 2026 through 2030, the elective tax generally equals 9.3% of qualified net income attributable to consenting qualified taxpayers.
The federal planning benefit arises because IRS Notice 2020-75 generally permits qualifying state income taxes imposed on and paid by the entity to be deducted in computing federal taxable income.
California Senate Bill 132 extended the PTE elective tax and modified certain election and credit rules beginning in 2026.
For taxable years beginning in 2026 through 2030, a qualifying entity generally must make a payment by June 15 equal to the greater of:
- $1,000, or
- 50% of the PTE elective tax paid for the previous taxable year.
Beginning in 2026, failure to pay the required amount by June 15 no longer automatically prevents the entity from making the election.
However, the owner's PTE tax credit is reduced by 12.5% of the owner's share of the required June payment that was not timely paid.
The election should therefore be evaluated based on the owner's federal and California tax position, available credits, cash flow, and payment deadlines.
For additional detail, see California PTE Tax: Missed June 15 Payment and Credit Reduction.
Other State Tax Credits Require a Separate Sourcing Analysis
When a California resident pays qualifying income tax to another state on income also taxed by California, an other state tax credit may be available under Revenue and Taxation Code Section 18001.
The credit is not automatically equal to the full amount of tax paid to the other state.
The calculation can depend on how California sources the income, the residence of the taxpayer, the type of tax paid, and statutory credit limitations.
When two states apply different sourcing rules, it is possible for the taxpayer to encounter income taxed by both jurisdictions without receiving an equivalent credit for every dollar of tax paid.
The appropriate multistate projection should calculate the resident state tax, nonresident state tax, and available credits together.
Changing Residency Before a Business Sale Requires Advance Planning
A business owner moving from California to Texas, Nevada, or another state may change the scope of future California taxation.
However, moving does not automatically eliminate California tax on income earned through California business activities.
The analysis involves at least two distinct questions.
- Was the individual a California resident when the income was recognized?
- If the individual was a nonresident, was the income nevertheless sourced to California?
The answer can vary depending on whether the transaction involves operating income, a distribution, an asset sale, a stock sale, or a partnership interest sale.
The Burch and Carden decision is important because it addresses one of those distinctions, but it does not eliminate the need to establish a genuine change of residence.
A taxpayer should document the relocation and determine the character and source of the expected gain before the transaction closes.
Federal and California Taxable Income Can Differ
California generally begins with federal taxable income concepts but does not conform to every federal tax provision.
Senate Bill 711 updated California's general Internal Revenue Code conformity date to January 1, 2025, for taxable years beginning on or after January 1, 2025.
California subsequently enacted Senate Bill 1435 in September 2026 to address technical conformity and related statutory matters.
Significant federal and California differences can remain in areas such as depreciation, Section 179, business deductions, and other tax provisions.
Separate California basis, depreciation, and carryover calculations may therefore be required.
For additional discussion, see California Federal Tax Conformity and OBBBA Differences.
California Estimated Taxes Should Be Coordinated With Entity Payments
Business owners operating in several states can have multiple payment obligations during the same year.
Depending on the circumstances, these may include:
- California entity level income or franchise taxes
- California PTE elective tax payments
- California personal estimated income tax payments
- Nonresident withholding
- Other state estimated income taxes
- Other state entity level taxes
These obligations should not be calculated independently without accounting for credits and payments already made.
PTE tax credits, withholding, prior year overpayments, and other state tax credits can affect the amount of additional estimated tax required.
Coordinating these amounts helps avoid unnecessary overpayments while reducing the likelihood of underpayment penalties.
Questions Business Owners Should Review Before a Major Transaction
A multistate tax review should address the facts before a significant business transaction occurs.
- Where is the owner legally resident and domiciled?
- Does the entity conduct business in California under Section 23101?
- Is the income business income or nonbusiness income?
- What sourcing and apportionment rules apply?
- Is the business structured as a partnership, LLC, S corporation, or C corporation?
- Will the transaction involve an asset sale or an ownership interest sale?
- Does a partnership interest sale include Section 751(a) ordinary income?
- Does the partnership interest have a California business situs?
- Are the relevant businesses or entities part of a unitary business?
- What federal and California gain, basis, and recapture calculations are required?
- Are California withholding or estimated payments required?
- Would a California PTE elective tax election be beneficial?
- Are other state income tax credits available?
- Could an existing California reporting position be affected by the Burch and Carden decision?
Final Takeaway
California multistate tax planning requires more than determining where the owner lives or where the business was formed.
Residency, nexus, income sourcing, apportionment, entity classification, and transaction structure can each affect the amount of income California is permitted to tax.
The 2026 Burch and Carden decision provides an important development for nonresident partners selling partnership interests involving Section 751(a) hot assets.
The OTA rejected FTB's position that the federal hot asset characterization rule automatically converts the transaction into a deemed sale of the partnership's underlying assets for California sourcing purposes.
However, the decision does not exempt every partnership interest sale from California taxation. Unitary business relationships, business situs, actual asset sales, and other sourcing provisions can produce different results.
For business owners planning a move, sale, or restructuring, the federal and California consequences should be evaluated before the transaction closes.
