When did California's historical personal-service time-spread method apply instead of the ordinary cost-of-performance rule?

Plain-English summary

Legal Ruling 2005-1 drew a line between labor-driven personal services and services in which capital was a material income-producing factor under California's then-existing sales-factor rules.

When capital was not material, the special personal-service rule used a time-spread method. Employee time spent performing the service in each state was compared with total employee time everywhere.

When capital was material, the special rule did not apply. The receipt followed the ordinary cost-of-performance rule and went to the state with the greater performance costs, considering both labor and capital costs.

The test for a personal service

FTB concluded that a "personal service" for this regulation was any service in which capital was not a material income-producing factor. The term was not limited to doctors, lawyers, other professionals, or specialized one-person work.

But the term also did not include every service performed by people. FTB reasoned that if every service were personal, the regulation's ordinary cost-of-performance rule for services using tangible or intangible property would have no work to do.

The practical question was therefore whether the service primarily depended on employee labor or materially depended on capital such as equipment or other property.

Situation 1: Computer-system consulting

Corporation A designed computer networks for a customer with regional offices in states X, Y, and Z. Its employees customized the networks, specified hardware and software, supervised configuration and testing, and provided maintenance and upgrades. A supplied no hardware, equipment, repair parts, or other material.

FTB held that this was a personal service because capital was not a material income-producing factor. The time-spread method applied.

Every employee's time in each state was a separate income-producing activity for the sales-factor calculation. That included the project manager's time at headquarters in state C and during travel to the customer's regional offices.

Situation 2: Heavy-equipment earth moving

Corporation B prepared an earth-moving bid in state R and performed the construction in state S. Employees spent 25% of their time in R and 75% in S. Labor cost $800,000, while B rented $5 million of heavy equipment entirely for the contract in S.

FTB held that capital was a material income-producing factor, so the personal-service time-spread rule did not apply. The ordinary greater-cost-of-performance method considered both personnel and equipment costs.

Because the greater costs occurred in state S, the entire receipt was assigned to state S.

Time-spread versus cost of performance

Time-spread method

For qualifying personal services, the numerator reflected the ratio of employee time spent performing the service in the state to total time spent everywhere. Each employee's location and time mattered.

Ordinary cost-of-performance method

For a service materially aided by capital, employee time alone did not control. The analysis included the other performance costs, such as the $5 million of equipment rental in the construction example, and assigned the receipt to the state with the greater total cost.

What this means for you

Consulting and professional-service businesses

Under the historical rule, a service performed with little or no material property use could qualify for employee-time sourcing even if it was not a traditionally licensed profession.

Construction and equipment-intensive businesses

A service did not become a personal service merely because employees performed work. Material equipment or other capital could require the ordinary cost-of-performance analysis.

Tax departments reviewing old periods

Document both employee time and capital costs. The same multistate service contract could be sourced differently depending on whether capital materially produced the income.

Common questions

Q: Were personal services limited to law, medicine, accounting, or similar professions?

A: No. FTB said the concept was broader and included any service where capital was not a material income-producing factor.

Q: Did every service count as a personal service?

A: No. Services materially using tangible or intangible property remained subject to the general rule.

Q: Did the consulting project manager's time count?

A: Yes. The ruling included time at headquarters and time traveling to oversee the regional projects.

Q: Why was the earth-moving contract not a personal service?

A: The $5 million heavy-equipment rental was a material income-producing factor, far exceeding the $800,000 employee cost.

Q: Where was the earth-moving receipt assigned?

A: State S, where the work and dedicated equipment costs occurred and where the greater costs of performance were located.

Q: Does this ruling state today's California sourcing method?

A: No. It interprets the 2005 version of the cited law and regulation; current sourcing rules must be checked independently.

Citations and references

• Cal. Rev. & Tax. Code § 25136
• Cal. Code Regs., tit. 18, §§ 25136(b)(1), 25136(d)(2)(C), and 17951-4(h)
• I.R.C. §§ 448(d)(2)(A) and 911
• Appeal of Woodward, Baldwin & Co., Inc., 63-SBE-072
• Appeal of John Blair & Company, 65-SBE-009
• Appeal of Pacificorp, 2002-SBE-005

Source

• Landing page: California FTB Legal Rulings
• Official PDF: Legal Ruling 2005-1

Original ruling text

STATE OF CALIFORNIA
STEVE WESTLY
FRANCHISE TAX BOARD - LEGAL DEPARTMENT
Chair
PO Box 1720
Rancho Cordova CA 95741-1720
JOHN CHIANG
Telephone (916) 845-3309
Member
FAX (916) 845-3648
TOM CAMPBELL
Member

March 21, 2005

LEGAL RULING 2005-1

SUBJECT: Personal Services for Sales Factor Purposes

ISSUE

What constitutes a "personal service" for purposes of attributing gross receipts to this state using the time-spread method provided by regulation section 25136, subsection (d)(2)(C)?1

FACTS

Situation 1:

Corporation A, a company located in state C that provides computer system consulting services, enters into a consulting contract with Customer. The contract calls for Corporation A to design a computer system at each of Customer's regional offices, located in states X, Y, and Z. The contract calls for Corporation A to design the network, provide specifications for hardware and software requirements for the network, oversee the configuration and testing of the network, and provide maintenance and network modifications and upgrades for two years after initial installation and testing. Under the contract, Corporation A will not supply any hardware, equipment, repair parts, or other material. Because Corporation A's employees will be required to customize the network at each regional office and oversee all phases of installation and testing, individual employees will be assigned to each of Customer's regional offices with a manager assigned responsibility for the entire project. The manager is located at Corporation A's headquarters in state C, but travels to each of Customer's regional offices periodically, in order to oversee the different aspects of the project.

Situation 2:

Corporation B, a heavy equipment construction company located in state D, enters into an earth-moving contract with Customer located in another state. Corporation B prepares the bid for the contract in state R and performs the service in state S.

1
All section references are to the Revenue and Taxation Code, and all references to regulations are to the California Code of Regulations, title 18, unless otherwise specifically noted.

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Corporation B rents heavy equipment in state S. Corporation B's employees spend 25 percent of their time in state R estimating and preparing the bid, and 75 percent of their time performing the construction activities in state S. Employee costs are $800,000 and the equipment rental cost is $5,000,000, entirely dedicated to a single earth-moving contract in state S.

LAW AND ANALYSIS

Receipts from a sale "other than a sale of tangible personal property" are included in the sales factor under the rules set forth in section 25136 and regulations thereunder. Section 25136 assigns receipts from sales of other than tangible personal property to the state where the income-producing activity occurs. If the income-producing activity occurred in more than one state, the sale is assigned to the state in which the greater costs of performance occurred.

Regulation section 25136, subsection (d)(2), provides special rules for determining when receipts from income-producing activities are in this state. Subsection (d)(2)(C) addresses gross receipts from the performance of personal services and provides that the time each employee spends in each state will constitute a separate income- producing activity for purposes of the sales factor. This method, known as the time- spread method, provides for a "ratio which the time spent in performing such services in this state bears to the total time spent in performing such services everywhere."

The factual situations addressed in this ruling raise the question of the extent to which a service is considered a personal service under regulation section 25136, subsection (d)(2)(C). Although the concept of personal services has been used in different contexts in the California income and franchise tax regulations, the term "personal service" is not defined in Part 11 of the Revenue and Taxation Code.

The concept of personal services has been part of California's apportionment of income regulations for over fifty years. Prior to the adoption of the Uniform Division of Income for Tax Purposes Act (UDITPA), former regulation section 25101, subsection (a),2 provided that "[i]n the case of personal service organizations, such as advertising agencies, business management firms, etc., the property factor is generally omitted since it is not a material income producing factor in this type of business." This regulation was discussed in Appeal of Woodward, Baldwin & Co., Inc., 63-SBE-072, May 28, 1963, and Appeal of John Blair & Company, 65-SBE-009, March 4, 1965. 3

2
Cal. Admin. Code, tit. 18, § 25101, sub. (a). Register 58, No. 9 (May 19, 1958).
3
The concept of personal services was addressed in another apportionment context in a Wisconsin case. In Shelley v. Wisconsin Dept. of Revenue (1975) 70 Wis.2d 551
[235 N.W.2d 515], Wisconsin's statute provided that corporation income from personal services performed by the employees was business income that followed the situs of

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In addition, the concept of personal services is found in regulation section 17951-4. This regulation provides rules to compute the payroll factor for nonresident sole proprietors and partners engaged in the practice of a profession, which is defined in subsection (h) as "the practice of law, accounting, medicine, scientific or engineering discipline and the practice of any other profession involving personal services where capital is not a material income-producing factor."

The terms "personal services" or "personal service income" are also used throughout the Internal Revenue Code (IRC). For example, compensation for personal services is listed as part of the definition of earned income in IRC section 911. Former IRC section 13484 imposed a ceiling on the graduated tax rate applicable to personal service income, which was defined by reference to IRC sections 911(b) and 401(c)(2)(C). In general, under former IRC section 1348, a taxpayer was not entitled to the benefits of the maximum graduated tax rate limitation on personal service income if capital was a material income-producing factor with respect to that service. The IRC also defines a personal service corporation as one that has the performance of personal services (as defined in IRC § 448(d)(2)(A)) as its principal activity. IRC section 448(d)(2)(A) lists the performance of services in the fields of "health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting" as activities of the taxpayer that constitute personal services. (See also, Treas. Reg. § 1.441-3(d).)

Personal services might be construed narrowly, as in the context of a specialized service performed by one individual for the personal benefit of another, such as the services of a doctor or a lawyer, or in the context of professional services such as those specifically listed in regulation section 17951-4, subsection (h). However, the examples under regulation section 25136, subsection (d)(2)(C), those dealing with a traveling road show or with opinion surveying, indicate that personal services should not be construed that narrowly.

On the other hand, personal services might be construed broadly, such that virtually all services are personal services. But, regulation section 25136 suggests otherwise. For instance, the language of regulation section 25136, subsection (b)(1), consists of two parts separated by the disjunctive “or” and reads: “the rendering of personal services or the utilization of tangible and intangible property by the taxpayer in performing a

the business. The court held that the phrase "income derived from personal services" meant such income or gains as result from the performance of services or labor without the material aid of capital. 4 Repealed by the Economic Recovery Tax Act of 1981, P.L. 97-34, § 101(c)(1).

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service.” The word “service” in the second clause is not modified by the word “personal,” indicating that there are services that are not personal services.5

The fact that the rule for personal services is characterized as a special rule under regulation section 25136, subsection (d)(2)(C), is also indicative that the term "personal service" does not include all services. The focus of the special rule is on the performance of "personal" services and not on any other type of service, such as the performance of a service that may include the utilization of tangible or intangible personal property. If every service, no matter how capital intensive, were governed by the time-spread mechanism, there would be no circumstance under which the general rule, the cost of performance rule, would ever operate: all services would solely be governed by time spent by employees. Thus, the concept of cost of performance as provided by section 25136, subdivision (b), would be rendered irrelevant with regard to services.

Although the term "personal service" is defined in different contexts, no authorities extend the concept of personal services to those services in which capital is a material income-producing factor. Furthermore, the language of regulation section 25136, subsection (b)(1), is consistent with the above-cited authorities that limit personal services to those services in which capital is not a material income-producing factor.

The personal service rule of regulation section 25136, subsection (d)(2)(C), includes any service performed where capital is not a material income-producing factor. Furthermore, personal services are not limited to professional services or to specialized services performed by one individual.

HOLDING

Situation 1:

The contract between Corporation A and Customer calls for a personal service where capital is not a material income-producing factor. Corporation A will perform the contracted-for services utilizing the labor of its employees with little or no utilization of tangible or intangible property. Accordingly, the time-spread method will be used to determine Corporation A's costs of performance. The time each employee, including the project manager, spends in each state will constitute a separate income-producing activity for purposes of determining the numerator of the sales factor.

5
In the Appeal of Pacificorp, 2002-SBE-005, September 12, 2002, order denying petition for rehearing dated December 19, 2002, the State Board of Equalization acknowledged that regulation section 25136, subsection (b)(1), identifies income- producing activity as encompassing not only personal services, but also services that utilize tangible or intangible property.

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Situation 2:

Because capital is a material income-producing factor in this situation, the special time- spread rule does not apply in this situation. Therefore, considering both personnel costs and heavy equipment costs, the standard cost of performance rule would assign the receipt to the state with the greater cost of performance; in this case, to state S.

CONTACT INFORMATION

The principal author of this ruling is Karen D. Smith of the Franchise Tax Board, Legal Department. For further information regarding this ruling, contact Ms. Smith at the Franchise Tax Board, Legal Department, P. O. Box 1720, Rancho Cordova, CA 95741- 1720.