by David Allen Duner, CPA

The purpose of this article is to analyze the complicated California non-resident state tax withholding rules for loan servicing agents and mortgage fund managers who have control, receipt, custody, disposal or payment of items of income from lending activities. This article does not address California Securities law, for which your organization must comply with when you have non-residents of California as investors in trust deeds or investors in mortgage funds.1 The purpose of this article is to aid your organization on when you need to withhold California taxes, what records you should maintain to determine residency of your investors, timing of tax payments, and quarterly and annual tax compliance forms to be filed with the State of California Franchise Tax Board.

Determining whether the income is sourced to California; therefore subject to California tax for non-residents is complex, especially for mortgage funds and individual trust deed investors. The confusion/complexity comes because the income generated is reported as interest income on either a 1099-INT or K-1 tax form. Normally when a taxpayer sees interest income on those reporting documents the presumption is the taxpayer will source the income and pay tax only to their state of residency. California sources income to California if: (1) income is from real or tangible personal property located in California; (2) income is from a business, trade or profession carried on in California; (3) compensation for personal services within California; and (4) income from stocks, bonds, notes, bank deposits and other intangible personal property having a business or taxable situs in California. Specifically, Cal Rev & Code § 17952 states that “income of non-residents from stocks, bonds, notes or other intangible personal property is not income from sources within this State unless the property has acquired a business situs in this state…”2. This happens when funds become an asset associated with a business situs in California.

The complexity comes from the “business situs” portion of this code section and begs the question when does interest income change from investment income (taxed to the state of residency) to interest income from intangible personal property with business situs in California. Unfortunately, finding authority directly on point for trust deed investors or mortgage fund investors is elusive. A definition of Business Situs can be found in the California apportionment regulations for Financial Institutions. While the audience of this article is those who avoid being considered a financial institution under the laws of California, we rely on this definition as the lending activities are similar for our clients. By definition “Business Situs” shall be the place at which intangible personal property is employed as capital; or the place where the property is located if possession and control of the property is localized in connection with the taxpayer’s trade or business so that substantial use or value is attached to the property3.” Furthermore, reviewing apportionment regulations for taxation of banks or financial institutions holds that income from mortgage activity is included in the sales factor numerator based on where the property is located that is securing the mortgage. Therefore, it would be held that while a trust deed lender or a mortgage fund generally is not a financial institution, the function of providing mortgage funding would lead the intangible income to have a business situs in California; therefore taxable to a non-resident of California; therefore required to have California tax withheld by an entity operating in California with nexus in California. The conclusion is that if you are a trust deed lender and the property securing the note is located in California – any interest income generated from such investment is sourced to California, or if you are a mortgage fund that operates as a partnership with nexus in California and the asset securing the mortgage is located in California – any income is considered California sourced.

The takeaway from this article is if your organization is operating in California it is important to maintain documents that prove residency of the investors. It is particularly important your organization makes any potential investors aware of your organization’s withholding obligations as part of your overall due diligence on whether your organization accepts the new investor. Your initial questionnaires for new investors should not only include the forms discussed below but should also have language to inform investors of any changes to the information compiled in the questionnaire should be communicated to the loan servicing agent or fund manager when they occur and not at the end of the year. Partnership agreements and loan servicing agreements should include language that addresses what the investor needs to do if they relocate out of California. For example, the loan servicing agent or fund manager should inform investors that withholding of California tax will be taken out of future distributions if an investor relocates out of California or if the investor leaves any investment to an heir who is a non-resident of California if that investor passes on while holding such an investment.

Things to Do Before Making Any Payments to Non-Residents of California – Loan Servicing Agents

California FTB Form 590, Withholding Exemption Certificate, should always be part of the package of documents you request from all new investors. This form provides the best defense for the broker if he or she is audited by the California Franchise Tax Board. This form obligates the investor to check a box that provides a reason why he or she is not subject to California tax withholding. Similar to the IRS form W-9, this form does not need to be updated yearly but absolutely needs to be maintained in your records. The form should be reviewed for completeness (signed, dated) and reviewed for the address used on the form. The street address should not be a post office box, or an “in care of” address. If a change of address occurs or if the investor passes on and leaves his/her investment to an heir, the withholding agent must reevaluate the investor’s residency status4. Withholding is required when the payee is unknown or unidentified, or fails or refuses to provide the payer with the required information.5

If you determine an investor is a non-resident of California it is possible to not withhold on such an investor. The process is burdensome but is easier than the overall process of withholding tax and preparing and filing all of the necessary forms with the Franchise Tax Board. The loan servicing agent, along with help from the recipient will prepare and file California FTB Form 588, Non-Resident Withholding Waiver Request.

This form is a request by the loan servicing agent, on behalf of the recipient, to be notified by the FTB if withholding can be waived. It is requested by the Franchise Tax Board that it be prepared and filed a month before you plan to make any payments to any investor who is a non-resident of California. The form can be filed online if your organization has registered with the Franchise Tax Board. This form will be reviewed and needs to be approved by the Franchise Tax Board otherwise withholding is required. Some reasons why a waiver may be granted are if the recipient has filed California tax returns within the last 2 years and is current on their tax liability, or if the payee is making timely CA estimated tax payments in the current year. You can also attach a specific reason and include substantiation that would justify a waiver from withholding. Withholding waivers are effective for a maximum term of 24 months and will expire on December 31st of the succeeding calendar year granted. Therefore it could be less than two years and will need to be renewed with the Franchise Tax Board.

Things to Do Before Making Any Payments to Non-Residents of California – Mortgage Fund Managers

As part of accepting a new investor in the fund, fund managers require the new investor to complete an investment questionnaire for legal purposes. Normally, these questionnaires will include some tax questions. In addition to the tax questions, the fund manager needs to have the new investor complete California FTB Form 590, Withholding Exemption Certificate. This form provides the best defense for the fund manager if he or she is audited by the California Franchise Tax Board. This form obligates the investor to check a box that provides a reason why he or she is not subject to California tax withholding. Similar to the IRS form W-9, this form does not need to be updated yearly but absolutely needs to be maintained in your records. The form should be reviewed for completeness (signed, dated) and reviewed for the address used on the form. The street address should not be a post office box, or an “in care of” address. If a change of address occurs, the fund manager must reevaluate the payee’s residency status6. Withholding is required when the payee is unknown or unidentified, or fails or refuses to provide the payer with the required information.7

If you determine an investor is a non-resident of California it is possible to not withhold on such an investor. The process is burdensome but is easier than the overall process of withholding tax and preparing and filing all of the necessary forms with the Franchise Tax Board. The fund manager, along with help from the investor will prepare and file California FTB Form 588, Non-Resident Withholding Waiver Request. This form is a request by the fund manager, on behalf of the investor, to be notified by the FTB if withholding can be waived. It is requested by the Franchise Tax Board that it be prepared and filed a month before you plan to make any payments to any investor who is a non-resident of California. The form can be filed online if your organization has registered with the Franchise Tax Board. This form will be reviewed and needs to be approved by the Franchise Tax Board otherwise withholding is required. Some reasons why a waiver may be granted are if the investor has filed California tax returns within the last two years and is current on their tax liability, or if the investor is making timely CA estimated tax payments in the current year. You can also attach a specific reason and include substantiation that would justify a waiver from withholding. Withholding waivers are effective for a maximum term of 24 months and will expire on December 31st of the succeeding calendar year granted. Therefore it could be less than two years and will need to be renewed with the Franchise Tax Board.

Another required piece of compliance is California FTB Form 3832, Limited Liability Company Non-Resident Members’ Consent. This form is used by a mortgage fund that has non-resident California investors and has California sourced income. By signing this form, the non-resident investor is consenting to file a California non-resident personal income tax return if income levels cross statutory thresholds. This form must be attached to the fund’s California tax return. Also, the original signed consent form should be maintained by the fund manager in case of audit by the Franchise Tax Board. If the investor fails or refuses to sign form FTB 3832, the fund is required to pay California tax on the partners’ distributive share of income at the investor’s highest marginal rate. If applicable, this form should be obtained from the investor at the time of the initial capital contribution.

Things to Determine at the Time of Making Payments – Loan Servicing Agents

Loan Servicing Agents are required to withhold tax on payments to California non-residents based on 7% of the California sourced interest income. Withholding tax is not required on any payments considered a return of capital (principal payments). If it is determined that the total payments during the calendar year will be less than $1,500 (gross interest income), then withholding is optional. All taxes withheld by loan servicing agents are considered to be trust fund taxes of the state, therefore can result in the personal liability of the agent. Missing or late payments have significant penalties associated with them, so therefore due care should be exercised when handling these funds like you would for employee tax withholdings.

Things to Determine at the Time of Making Payments – Mortgage Fund Managers

If your mortgage fund has California non-resident investors, you are required to withhold tax based on 7% of the California sourced income actually distributed to the investor. Withholding tax is not required on any payments considered a return of capital. If it is determined that the total payments will be less than $1,500 then withholding is optional. All taxes withheld are considered to be trust fund taxes of the state, therefore can result in the personal liability of the fund manager. Missing payments or late-payments have significant penalties associated with them, so therefore due care should be exercised when handling these funds like you would for employee tax withholdings.

Things to Do After Making Payments – Loan Servicing Agents

Tax withheld from payments to California non-residents needs to be remitted to the Franchise Tax Board. The due dates for paying the withholding tax to the FTB are as follows: for payments during January – March, April, 15th, for payments during April – May, June 15th, for payments during June – August, September 15th, for payments during September – December, January 15th. The quarterly form is FTB 592 and the payment voucher to use for these payments is FTB form 592-V. Be careful of electronic funds rules when submitting payments. At the end of the calendar year you will need to prepare and provide your investor with a 1099-INT. This form will need to be filed with the IRS and with the FTB showing the amount of California tax withheld. You must provide the 1099-INT to the investor by January 31st, and it must be filed with the Franchise Tax Board by March 31st. Furthermore, if you have more than 250 information returns, you are required to electronically file these forms.

Things to Do After Making Payments – Mortgage Fund Managers

Tax withheld from payments to California non-residents needs to be remitted to the Franchise Tax Board. The due dates for the quarterly withholding tax payments are as follows: for payments during January – March, April, 15th, for payments during April – May, June 15th, for payments during June – August, September 15th, for payments during September – December, January 15th. The quarterly form is FTB 592 and the payment voucher to use for these payments is FTB form 592-V. Be careful for electronic funds rules when submitting payments. At the end of the calendar year you will need to file the annual form FTB 592 along with forms 592-B to the Franchise Tax Board by March 15. Also form 592-B must be provided to the investor by January 31.

Summary

These rules are complex and therefore attention should be given when you have investors who are non-residents of California. Facts and circumstances can vary among taxpayers. A tax professional can answer your questions regarding tax compliance and the documents your firm should maintain in order to avoid liability for withholding taxes. If it is determined upon audit that your organization was required to withhold and failed to do so, there are substantial penalties, you are still liable for the tax, and it can be extremely difficult to get the withholding tax back from investors.

Disclaimer

This article is meant for information purposes only. The specific rules related to the above subject are more in depth. Please consult a tax advisor for additional information and specific requirements.

Endnotes

  1. Determining who you can market your services to should be made by legal counsel with knowledge of California Securities Laws.
  2. Cal Rev & Code §17952
  3. Cal Reg. § 25137-4-1(a)(3)
  4. Cal. Code Regs. §18662-4(b)(1)
  5. Cal. Code Regs §18662-1(b)(3)
  6. Cal. Code Regs. §18662-4(b)(1)
  7. Cal. Code Regs §18662-1(b)(3)

David Duner, CPA is the managing partner and founder of David Allen Duner, Certified Public Accountants, Irvine, CA. Our firm has been providing audit and tax services to the mortgage industry for over 30 years. We can be reached at 949-263-0030 or at David@DunerCPA.com