The Issue
E-commerce, advanced telecommunications, and the new prevalence of remote work have combined to give many married couples more flexibility in their working and living arrangements than in the past. One of these options, rare until recently, is for spouses to assert they live in different states for tax purposes. An increasing number of marriages have the mobility to allow one spouse to reside in California, while the other elects to establish or maintain legal residency elsewhere. This is especially true for high-income couples, where supporting two households is economically feasible, one spouse wants to enjoy the benefits of living in California (often with the couple’s children), and the tax benefits of the other spouse having nonresident status are significant.
That said, it is no simple matter to establish or maintain nonresidency status while married to a spouse who is a California resident. There are traps for the unwary.
To Each His Own Residency
Many taxpayers are surprised to learn California even allows separate residency status for spouses. But in fact, there is no such thing as “marital” residency. Residency status always belongs to an individual, whether married or not. Of course, a spouse’s residency status can have a substantial influence on the other spouse in a residency audit. It’s typical for married couples to live together, and the Franchise Tax Board, California’s tax enforcement agency, has a bias for the typical when it comes to residency determinations. But even leaving that aside, married couple tend to spend time together, and if a substantial amount of that time is spent in California, where one spouse resides, the other spouse can begin to look very much like a resident.
In the past, this situation was so uncommon it hardly made a blip on the FTB’s radar scope. It might involve a scenario where a husband took a long-term job out-of-state or overseas. Older cases are populated with merchant marines and oil-field workers in Saudi Arabia; more recent ones prominently feature professional athletes and corporate managers assigned to overseas offices. That’s changed. Separate-residency marriages are now more about a lifestyle choice involving a global economy and the scenario of remote work that can allow some people to live and work anywhere.
Planning for Separate Residency
Up until recently, separate-residency tax cases for married couples almost always ruled against the taxpayer. This was often because the spouse asserting nonresidency did little or no planning. They took a job out-of-state, moved into a new place (often more akin to a bachelor pad than a true household), and hoped they weren’t audited. They did little or nothing to sever their contacts with California to make it clear their residency had changed, even if their spouse remained a California resident. In fact, most of the cases of separate residency favoring the taxpayer worked only because the nonresident spouses argued they were separating and their marriage was essentially over, rather than that they were intending to continue a marriage between a California and non-California spouse.
For separate residency to survive audit scrutiny (and it is more likely to get audited in high-income situations because the FTB will in many cases be aware of the couple’s global income from the resident spouse’s California tax return), you have to plan meticulously in two areas of residency law. First, it usually has to be unambiguous that the nonresident spouse is not a California domiciliary (a different legal concept than residency). Second, the nonresident spouse has to make sure visits to the California spouse are “temporary or transitory.” Put another way, while the California dwelling is the primary home of the resident spouse, it has to be treated as a vacation/second home by the nonresident partner. That can take take some doing. But first, let’s parse some of these terms.
Domicile Vs. Residency
Generally, the rule is, if you are domiciled in California and you leave for “temporary or transitory” purposes, you remain a California resident, subject to California taxes on all your taxable income. Conversely, if you are not a California domiciliary and you come to California for a temporary or transitory purpose (say, to visit your California-based family), you don’t become a resident and aren’t taxed as one.
So what is domicile? Unlike residence, domicile is defined for tax purposes as your permanent home, the place where you have your most settled and permanent connections, not merely for a limited purpose, such as going to college or working, but as a “fixed abode” (the term often found in case law). It is the place where, whenever you are absent, you intend to return. So, you can be a domiciliary of California even while your residence is elsewhere. The two are often the same, but not necessarily so.
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California uses domicile status to determine if community property law applies to the couple’s income. It uses residency status to determine who gets taxed
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Domicile can make all the difference in a separate-residency marriage. If a California couple decides one of them will take up residency in another state or country, the non-California spouse usually has to be scrupulous about changing domicile first. That’s because the FTB doesn’t ask you what state you intend as your fixed abode; it looks at your actual conduct. And where a taxpayer’s family resides is a weighty factor both in determining residency and domicile, especially if the taxpayer is spending significant time in California. If there is any ambiguity, the FTB will conclude the non-California spouse remains a California domiciliary and is only living out-of-state “temporarily.” If this sounds something like a vicious tax circle, it probably is.
Domicile can play another important role in separate residency if the marriage involves community income. That’s usually the case where the couple both live in California, and one is changing residency (and they don’t have a prenup or a marital property agreement transmuting community income into separate income). The general rule is: California uses domicile status to determine if community property law applies to the couple’s income. It uses residency status to determine who gets taxed. This is discussed in more detail below.
The law identifying what facts and circumstances support domicile status, as opposed to residency, is thin, and frankly confused. To establish or change domicile almost always requires purchasing or renting a dwelling and moving into it. But that’s also true of residency. And in fact, it’s quite possible to maintain domicile in a state where a nonresident doesn’t have an abode, so long as there are other indicia demonstrating the nonresident’s intent to return. The regulations and cases often mention ministerial items as evidence of domicile: voting, filing state tax returns, obtaining a driver’s license, jury duty. These contacts by themselves aren’t enough to support residency status, since they can obviously be self-serving (and again California doesn’t tax based on domicile, but residency). Suffice it to say, that in the context of separate residency, the couple usually has to maintain two complete households, one in California and one in the nonresident’s home state, for the nonresident to successfully assert nondomiciliary status.
What Is Temporary Or Transitory?
“Temporary or transitory” is itself a legal term of art, and not necessarily intuitive. What the FTB deems short-term or non-permanent is not necessarily what lay people think. A job overseas under a multi-year contract is potentially temporary if it appears you will return to California after the term runs (in one case, the contract was for seven years and the FTB still found it to be temporary). And one factor the FTB particularly focuses on is where the taxpayer’s spouse and minor children live. If they live in California, we return to the vicious circle.
Changing Residency
These difficulties don’t mean mean couples can’t successfully assert separate residency. But separate residency usually requires that they be systematic about planning for the nonresident spouse to obtain domicile status outside of California. The obvious connections have already been mentioned. But it also requires ordering the deeper, less obvious contacts, such as itemizing the personal effects expected to be kept in a principal residence (the “center of your life” analysis that is different for each person), and making sure those items are kept in the out-of-state residence, not in California. The FTB takes the two complete household scenario seriously when it comes to matrimonial status that crosses state lines.
Once domicile is established out-of-state, changing residency while having a spouse living in California becomes, if not easy, at least more feasible. Short of leaving California lock, stock and barrel, changing residency always takes systematic planning, inconvenience, and cost. But that’s especially true if you are moving from California and your spouse is remaining; and even more so if minor children are involved. Your visits to your California spouse’s home must look like temporary visits, not the other way round. This inevitably means the nonresident spouse has to limit time spent in California. And assuming the couple wants to spend significant time together (which isn’t always a good assumption), the corollary to that is, the resident spouse has to endure the inconvenience and cost of traveling to the nonresident spouse’s home state. Or they can meet on neutral ground, in some third state. But what a nonresident spouse can’t do is spend significant time in California living with the other spouse. Case law suggests three months is the limit, but in fact, as in all residency determinations, it all depends on what contacts the nonresident spouse retains in California, what contacts are established in the new home state. Residency status always involves a comparison, like a ledger. But the point to keep in mind is, being married to a California resident living in California puts enormous weight on the California side, right from the start. The test for residency is discussed in more detail here.
Of course, if the couple lives out-of-state and the plan is for one of them to move to California, then the domicile rules may actually work in favor of separate residency. In that scenario, it is presumed the nonresident spouse’s domicile remains out-of-state, unless some action is taken to acquire California domicile (again, voting, licenses, jury duty, buying a bigger and better home). Case law states that the burden of proof is on the proponent of a domicile change, who must “clearly show” evidence to that effect (the phrase is unclear about whether it involves the usual preponderance of evidence standard or the higher “clear and convincing” standard). Obviously, those types of contacts should be avoided at all cost. But with domicile status in another state securely in place, the emphasis can be put on avoiding an unfavorable residency determination by making sure the visits to California have the temporary or transitory profile as defined by law.
Vacation Home Creep
Assuming a married couple successfully establishes separate legal residency status, they face various challenges in preserving that situation. One of them is what might be called “vacation home creep.” “Creep” here doesn’t mean you’re acting like one; it refers to the fact that the nonresident spouse has to be careful to treat visits to a California spouse’s home like he is on “vacation,” a “temporary or transitory” visit. If it looks like the nonresident has moved into the California home and is living there with the resident spouse, then for tax purposes that’s exactly what the FTB will conclude. This same problem often occurs with vacation homes.
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Even if a married couple achieves separate residency status, it doesn’t mean the nonresident is free from California income taxes, despite earning all income out of state
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Seasonal nonresidents (sometimes called snowbirds) often enjoy their California vacation homes so much, they begin to spend more and more time there and fill them up with items associated with the center of their lives (family heirlooms, art, best clothing, important files, etc.); until one day the vacation home looks more like their principal residence than a break from everyday life. It’s all the more likely to happen where the “vacation home” is the place where your spouse and children live. For this reason, nonresident spouses have to be vigilant in keeping the center of their lives in their non-California abode and to avoid the incremental “migration” of their important personal items to their spouses’ residence.
The Community-Property Trap
Another trap for the unwary – and it’s a big one – is how California treats community property for tax purposes, mentioned above. Even if a married couple achieves separate residency status, it doesn’t mean the nonresident is free from California income taxes, despite earning all income out of state. Here’s why.
Married California couples usually file joint state returns (it’s generally required if they file joint federal returns, and most do). In that typical situation, they don’t even need to think about community income as it has no special tax consequences. But if they file separate returns, half of each spouse’s community property must be reported on each return. The reason is obvious, but not something most married California couples need to worry about except in the case of a divorce or death: under California law, community income is allocated to each spouse equally. Accordingly, if one spouse makes $1,000,000 and the other makes $100,000 (assuming the income is all community and not separate), each will report $550,000 on a separate return (50% of the total $1,100,000 of community income), and pay taxes accordingly.
This usually doesn’t matter much if both spouses are California residents. But what if one spouse leaves California and sets up domicile and residency in another (lower-tax) state with the specific purpose of reducing state income taxes? Will the nonresident spouse still have to file tax returns reporting his or her share of the community property? Remember, California uses domicile status to determine community property rights, and it uses residency status to determine who is taxed. The rule is, if both spouses are domiciliaries of a community property jurisdiction (either another state or another country), then California’s community property rights apply. That means half of any community income belongs to the each spouse.
So, to answer the question, if a nonresident spouse moves to a community property jurisdiction, changing both residency and domicile status, the nonresident spouse has to report 50% of his California spouse’s community income on a California nonresident return (Form 540NR), assuming the income of the resident spouse is California-source income, which it usually is. And, more to the point for residency tax planning, the California spouse must report 50% of the nonresident spouse’s community income on a California resident return (Form 540). To use the figures above, this means that if the nonresident makes $1,000,000 (and is domiciled in a community property jurisdiction), the resident spouse reports $500,000 of that on a Form 540, plus $50,000 of income (50% of the community income earned in California). The nonresident spouse has to file a Form 540NR reporting $50,000 of his spouse’s income (50% of the community income earned in California), because even as a nonresident he has to report and pay taxes on California-source income.
As you can see, this rule can wreak havoc on any tax savings anticipated in moving to a lower income tax state. The tax benefits with respect to community income are at the very least cut in half. To add insult to injury, all the zero-income-tax states nearest to California are community property jurisdictions: Nevada, Texas, Washington. The equitable distribution/separate property states with zero personal income taxes are far afield – Florida, Wyoming, South Dakota, Tennessee, New Hampshire, Alaska (which is actually an opt-in/opt-out community property state). Being that far away from a spouse living in California often makes the separate-residency marriage somewhat problematic when it comes to logistics. But it can be worthwhile for those willing to endure the inconvenience and cost of far-flung matrimony. There are special rules to determine whether a couple with separate residency are allowed to file separate returns at all (it usually requires them to file separately at the federal level) and what the nonresident’s income threshold for reporting in California is. If the nonresident state is under non-community property rules, an entirely different tax analysis applies. Accordingly, careful tax planning involving the destination state (or country) is required before any decision is made to assert separate residency.
Note that this problem can arise even when one spouse effectively changes residency to a non-community property state, if the spouse remains a California domiciliary. California is of course a community property state, and it’s quite possible for spouses to have separate residency but both have California domicile. If so, the above community property rules apply.
But, also note that this problem arises only if the couple’s income is actually community, regardless of whether the nonresident spouse is domiciled in a community property state or not. By default, the income will be community if both spouses are domiciled in community-property jurisdictions. However, if they have a valid prenuptial agreement characterizing their income as separate, the problem vanishes. And even if they don’t have a prenup, it’s not necessarily too late. The couple can enter into a marital property agreement with the same result. With a prenup or postnup in place, the nonresident spouse can live and work in a community property state free from most California tax entanglements.
That said, postnups are notoriously hard to negotiate if there is a large disparity in the spouses’ earnings. The spouse with lower income has to relinquish substantial rights in the marital income to make this level of residency tax planning work. Typically, creative family law lawyering is required to protect that spouse’s financial interest by some other means, such as an irrevocable trust or asset swaps, and that usually means significant planning expenses.
On the bright side, there are planning opportunities here for knowledgeable taxpayers who understand the domicile rules in cases where the spouse who wants to move to California starts with out-of-state domicile status. In that scenario, with careful planning, the spouse may be able to maintain a non-California domicile even after changing legal residency to California. With that profile, the California spouse’s income may avoid being characterized as community, even if the other spouse lives in a community property state and even if there is no prenuptial agreement opting out of the community property system. The California spouse will still have to report any taxable income on a Form 540, but this arrangement may obviate the requirement that the out-of-state spouse report half of that income as California-source on a nonresident return, thus avoiding the situation where the FTB is aware of the global income of a highly compensated non-California spouse, incentivizing an examiner to audit. Needless to say, significant thought needs to go into residency tax planning at this level.
The Working-In-California Trap
Finally, spending significant time in California, even on “vacation,” always comes with the risk of generating California-source income just by working while physically present in-state. It’s almost inevitable in a modern economy that people work while vacationing. If the nonresident spouse isn’t retired, and if he isn’t careful, working remotely while visiting his California spouse could create a tax obligation without him knowing it and that may open the door to a residency audit. See, Working While Vacationing: The Perils of California Source Rules for Nonresidents.
To summarize, married couples have the right to opt for separate residency status. This can lead to large tax savings if carried out in compliance with California residency tax laws. But the road to separate residency is a minefield. To get the full tax benefits and to keep them requires careful planning, not just driving to a bachelor pad across the state border.
Updated 1/3/21
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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.
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