California Court Sides with Taxpayer, Allows Three-Factor Apportionment

On February 26, 2026, a California Superior Court concluded that a multistate company that raises, harvests, and packages pork products is an agricultural business required to use a three-factor formula that includes property, payroll, and sales under California Rev. & Tax. Code (R&TC) § 25128. The court rejected the California Franchise Tax Board’s (FTB’s) position and ruled that even if the company was not an agricultural business, alternative apportionment was appropriate because the standard single-sales factor formula did not fairly represent the company’s business activity in the state.¹

What is particularly salient about this decision is the judge’s comments related to the single-sales factor formula. The examination of the alternative apportionment provision allows for an examination of the taxpayer’s property and payroll, not just sales.

Under R&TC § 25128, an agricultural business is one that “derives more than 50 percent of its ‘gross business receipts’ from conducting” an “agricultural business activity” and that such businesses are required to use a three-factor apportionment formula. Agricultural business activities include “activities relating to any stock,” and “activities relating to…harvesting any agricultural…commodity,” including raising, feeding, and caring for or managing animals on a farm. The taxpayer not only engaged in these activities but established at trial that more than 60% of its receipts were attributable to such activities. Thus, the taxpayer was required to utilize the three-factor apportionment formula.

Relying on Regs. § 25128-2, the FTB concluded that the taxpayer is not an agricultural business and applied a product-based approach. The FTB looked only to whether the final product sold had undergone any processing, and if so, none of the taxpayer’s activities generated receipts from agricultural activities. However, R&TC § 25128 does not use the term “product” or “processing.” Further, the court noted there is no indication in the statute that the nature of the product matters, stating that there is no statutory authority “to disregard a taxpayer’s activities leading up to a final sale.” Thus, the court opined that the regulation’s product-based approach, which disregards the taxpayer’s production and harvesting activities, conflicts with R&TC § 25128. The court further concluded that the regulation is inconsistent with the statute’s purpose of preventing businesses from being penalized when they have no choice regarding the location of their manufacturing activities, as was the case for this taxpayer.

Even if the court had determined that the taxpayer was not an agricultural business, the court ruled that the taxpayer was entitled to depart from the mandatory single-sales factor formula using the R&TC § 25137 alternative apportionment rules. These rules allow taxpayers to petition for separate accounting, exclusion, or inclusion of one or more factors or another method that provides for equitable allocation and apportionment. The court concluded that using the single-sales apportionment formula did not fairly represent the taxpayer’s business activity in the state because it disregards all of the taxpayer’s substantial activities (hog production, harvesting, and processing), which occur almost entirely outside the state. The court rejected the FTB’s attempt to limit business activity to the sales factor items only, noting that, except for one small plant in California, all of the taxpayer’s employees and property were located outside of the state. The court pointed out that only 1.02% of the taxpayer’s activities occurred in the state, application of a single-sales factor yielded an apportionment percentage of over 6.6%, and that this difference of more than 600% “justifies the application of an alternative apportionment formula.” The three-factor apportionment formula was deemed a reasonable alternative.

The court noted that in 1966 California adopted and codified the Uniform Division of Income for Tax Purposes Act (UDITPA), which was drafted by the Uniform Law Commission in 1957. The apportionment formula contained in UDITPA is an equally weighted three-factor apportionment formula consisting of payroll, property, and sales, meant to “apportion…that income among states [which] is necessary to avoid tax duplication or other inequity.” The Gillette Co. v. Franchise Tax Bd. (2015) 62 Cal.4^th 468, 473.

The court opined that the changes to the three-factor apportionment formula in 1993 (to a double-weighted sales factor) and in 2012 (to a single-sales factor) were made “to incentivize businesses to locate their operations in California.” The court noted that the U.S. Supreme Court and California Supreme Court have stated that the three-factor formula “has become something of a benchmark against which other apportionment formulas are judged.”

Finally, in reviewing the FTB’s argument that the taxpayer failed to exhaust its administrative remedies, the court rejected the FTB’s argument that the taxpayer was required to introduce evidence used at trial—including witness testimony and expert reports—during the audit of the taxpayer. To this, the court stated that this “would turn every audit into a full-blown trial,” which is “inconsistent with FTB’s practice” and “is inconsistent with well-established law.” Second, the FTB argued that the taxpayer was required to raise the activity-based approach during the administrative process, and the FTB was deprived of fully considering the merits of the taxpayer’s refund claim. The court rejected this as well, stating that the taxpayer raised the issue, but even if it hadn’t, it would not have made a difference because the FTB auditor followed Regs. § 25128-2.

Ryan’s Take and Action Steps

While the decision, on its face, is particularly important to agricultural businesses, especially where the FTB applied the end-product analysis as outlined in the regulation, it is equally important for any taxpayer that believes the single-sales factor formula does not fairly represent its in-state business activity.

Application of alternative apportionment, the court explained, allows for the examination of not only sales but also property and payroll. Thus, taxpayers seeking to challenge the single-sales factor should carefully examine all of the activities of their business, as well as the court’s reasoning, to determine whether an apportionment challenge is viable. Businesses that conduct significant income-generating activities outside the state especially should examine whether the single-sales factor fairly represents business activity in California and under the dicta of this case, in other states as well.

For assistance regarding fair apportionment in any state, contact our Ryan tax professionals today.

¹ Smithfield Packaged Meats Corp. v. Franchise Tax Board (February 26, 2026) Cal. Superior Ct., No. 21STCV39637, Proposed Statement of Decision No. 21STCV39637.

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