At your service: FTB ruling looks at "personal services," time-spread method.

What constitutes a "personal service" for purposes of attributing gross receipts to California using the time-spread method provided by California Revenue and Taxation Code Sec. 25136(d)(2)(C)?

Receipts from a sale "other than a sale of tangible personal property" are included in the sales factor under the rules set forth in Sec. 25136.

Sec. 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.

Sec. 25136(d)(2) provides special rules for determining when receipts from income-producing activities are in California. Sec. 25136(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."

What is a Personal Service?

The factual situations addressed in this ruling raise the question of the extent to which a service is considered a personal service under Sec. 25136 (d)(2)(C). While the concept of personal services has been used in different contexts in the California income and franchise tax regulations, "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 more than 50 years. Prior to the adoption of the Uniform Division of Income for Tax Purposes Act, former Sec. 25101(a) 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."

Also, the concept of personal services is found in Sec. 17951-4, which provides rules to compute the payroll factor for nonresident sole proprietors and partners engaged in the practice of a profession, defined in Sec. 17951-4(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."

"Personal services" or "personal service income" are used in the Internal Revenue Code. For example, compensation for personal services is listed as part of the definition of earned income in IRC Sec. 911. Former IRC Sec. 1348 imposed a ceiling on the graduated tax rate applicable to personal service income, defined in IRC secs. 911(b) and 401(c)(2)(C).

In general, under former IRC Sec. 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 Sec. 448(d)(2)(A) as its principal activity.

IRC Sec. 448(d)(2)(A) lists the performance of services in "health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting" as taxpayer activities that constitute personal services.

Narrow, Broad Personal Service

Personal services might be construed narrowly, as in the context of a specialized service performed by an 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 listed in Sec. 17951-4(h).

However, examples under Sec. 25136(d)(2)(C) dealing with a traveling road show or opinion surveying, indicate that personal services shouldn't be construed that narrowly.

Personal services might be construed broadly, such that virtually all services are personal services; but Sec. 25136 suggests otherwise.

Sec. 25136(b)(1) reads: "the rendering of personal services or the utilization of tangible and intangible property by the taxpayer in performing a service."

The word "service" in the second clause isn't modified by the word "personal," indicating that there are services that aren't personal services.

The fact that the rule for personal services is characterized as a special rule under Sec. 25136(d)(2)(C) also indicates that "personal service" doesn't include all services.

The focus of the special rule is on "personal" services and not on other type of service, such as a service that may include the use 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 operate. All services would be governed solely by time spent by employees. Thus, the concept of cost of performance as provided by Sec. 25136(b) would be irrelevant with regard to services.

No authorities extend the concept of personal services to those services in which capital is a material income-producing factor. Sec. 25136(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 Sec. 25136(d)(2)(C) includes any service performed where capital isn't a material income-producing factor. Personal services aren't limited to professional services or specialized services performed by one individual.

This information is provided courtesy of the FTB. Read the complete text of Ruling 2005-1 at www.ftb.ca.gov/law/rulings/.