Under the California Franchise Tax Board's (FTB) new withholding regulation proposal, California Code of Regulations (CCR) Section 18662-7, law firms may be prospectively required to withhold on a nonresident partner's distributive share of California-source income based on the partner's withholding tax rate. Previously, the State merely required withholding on distributions paid.

The regulation also proposes: (1) a variable withholding rate dependent on whether a law firm partner is an individual, C corporation, S corporation or an upper-tier pass-through entity; and (2) two new forms, FTB Form 592-Q and FTB Form 592-PTE.

Second interested parties meeting

On Friday, September 8, 2017, the California FTB held its second Interested Parties Meeting (IPM) for the proposed addition of CCR Section 18662-7 (Proposed Regulation), specifically addressing issues arising with domestic pass-through entity withholding, including partnerships. Before the second IPM, the FTB posted Proposed Regulation draft language, diagrams to illustrate examples of the Proposed Regulation text and an Explanation and Background for the Proposed Regulation.

The proposed language for CCR Section 18662-7 would require a law firm to withhold tax on a nonresident partner based on the partner's tax rate of withholding multiplied by that partner's distributive share of California-source income. The new proposed method of calculating withholding would supersede the current requirement to withhold primarily on distributions paid.

Moreover, the updated tax rate of withholding, previously held at 7%, depends on whether the law firm partner is an individual, a C corporation, an S corporation or an upper-tier pass-through entity.

Lastly, the proposed regulation provides for two new FTB Forms: (1) FTB Form 592-Q, a payment voucher submitted with each withholding payment made to the FTB on behalf of a nonresident owner; and (2) FTB Form 592-PTE, which is filed annually by a pass-through entity to allocate withholding to its owners. Based upon analysis of the proposed regulation and initial correspondence with the FTB, it appears that law firms will be required to notify partners of withholding payment remittance within 10 days of the later of the withholding payment due date or the date a withholding payment was made, with limited exception.

Note that the FTB summarized each new proposed section of CCR Section 18662-7 and then paused for comments after each section. There were no comments on the first several subsections of the proposed regulation. Following is a summary of the IPM, recently attended by EY State Tax professionals.

Comments on the tax rate of withholding

After the FTB summarized the proposed language for CCR section 18662-7(b)(7) — Tax Rate of Withholding, a commenter asked whether the language "highest marginal tax rate" included the 1% Mental Health Services Tax, if applicable; the FTB affirmed that it did.

Comments on reporting requirements

Several comments were made on the proposed language for CCR Section 18662-7(d) — Reporting Requirements. The FTB clarified that the quarterly payments using the proposed Form 592-Q were to be "lump sum" payments and then taxpayers would perform an annual reconciliation of the withholding payments using the Form 592-PTE.

We currently understand the FTB-proposed due date for both FTB Form 592-B and FTB Form 592-PTE would be January 31.

The FTB will accept written comments regarding the proposed language for CCR Section 18662-7 through October 6, 2017. Although a specific date and time for the next IPM was not given, EY will continue to monitor discussions and will notify law firms as the regulatory process continues.

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