Articles Posted in California State Tax Issues

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INGs struck down in California

The Issue

After years of wrangling with the issue, California has just enacted legislation to eliminate a state income tax savings strategy some California residents have pursued by establishing a non-grantor gift trust (ING). These trusts are often called WINGs, DINGs, and NINGS, a reference to the three states that first marketed them: Wyoming, Delaware, and Nevada. INGs can offer significant federal estate planning advantages. But they also allow residents of states with high income-tax rates, like California, to avoid paying state taxes on undistributed non-California-source income. The income can then grow free of state income taxes in the trust and be distributed later to the taxpayer (presumably after moving to a state with lower income taxes), or to their beneficiaries. But the new legislation has nullified the state tax benefits for California residents, leaving taxpayers who pursued the ING strategy in the lurch. Continue reading

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moving to california tax consequencesThe Case

A recent case from California’s Office of Tax Appeals brings some clarity to how strictly  California dates a change of residency for income tax purposes when a nonresident claims to have moved to California shortly after a liquidity event. The case, Appeal of Housman, OTA Case No. 18010200 (November 2022), in some ways is the flipside of Appeal of J. Bracamonte, a case involving a resident who claimed to move to another state shortly after a stock sale. Bracamonte is discussed in detail in this article. Both cases went badly for the taxpayers, and for many of the same reasons: failure to plan, failure to keep residency related records, establishing or retaining superior living accommodations in California, spending more time in the state than in their home jurisdiction during the year at issue.

Overview: The Importance of Timing

As discussed in the Bracamonte article, changing residency from California is binary: it happens on a specific date. Indeed, the date has to be reported on Schedule CA of the 540NR “part-year” return, which exiting taxpayers, with few exceptions, have to file for the year they move. The converse is also true for nonresidents moving to California. Schedule CA of the part-year return requires those taxpayers to disclose the date they become California residents. Continue reading

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California flag surveillanceThe Issue

​If you’re in the habit of reviewing California residency cases (and only a tax attorney specializing in the field or a masochist would be), you will occasionally come upon a reference to the Franchise Tax Board’s “Integrated Nonfiler Compliance” system, sometimes called the INC program. The court opinion will mention that the audit was initiated under INC and move on from there. This article discusses how this somewhat secretive program works, and how it affects a nonresident’s risk of a California residency audit. Understanding INC is central to residency planning, particularly for former residents who no longer file tax returns in the state.

Good News, Bad News

The good news is that nonresidents are often in control of the actions required to minimize that risk. The bad news is it usually takes a concerted, systematic effort to avoid the INC system. A single mistake can earn you a residency audit.

Which Nonresidents Does INC Target?

The INC system only targets a certain subset of nonresidents. Specifically, as the somewhat sinister name indicates, it focuses on nonfilers. For nonresidents who in fact file a nonresident California tax return (Form 540NR), the FTB doesn’t need INC to decide whether to audit for residency or not. That’s because a 540NR delivers most of the relevant information to the FTB on a silver platter. The 540NR requires a nonresident to disclose the number of days spent in California during the tax year, ownership of California residential property (directly or indirectly through an entity or trust), and perhaps most importantly the nonresident’s global income. That’s usually more than enough material for the FTB to decide whether to pursue a residency audit, or at least to provide grounds for investigating the taxpayer further by reviewing available databases (including Google and Zillow) before deciding to go forward. Continue reading

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california taxation of capital gains

The Case

A new case from California’s Office of Tax Appeals brings some clarity to how strictly California dates a change of residency for income tax purposes when a resident moves out of state shortly before a liquidity event. The case, Appeal of J. Bracamonte, OTA, Case No. 18010932 (May 2021), emphasized the importance of how much time a resident spends in California after the purported move. Bracamonte also sheds light on the “interim home” problem, which occurs when a resident moves into an out-of-state rental pending purchase of a permanent home in their new home state, while retaining ownership of their former primary residence in California. Finally, the ruling – probably inadvertently – seems to provide guidance on the date for determining when a taxpayer’s residency status is relevant to a liquidity event (the date of the closing, the date of the income receipt, or the date when an enforceable agreement is in effect). The case can be found here.

Background: How Does California Date a Change of Residency?

Changing residency from California is binary: it happens on a specific date. How do we know that? The Franchise Tax Board, California’s tax enforcement agency, requires that a resident leaving California identify the specific date of the residency change on Schedule CA of the Form 540NR “Part-Year” return, which exiting taxpayers, with few exceptions, have to file for the year they move. The exact question on the schedule is: “I became a California nonresident (enter new state of residence and date (mm/dd/yyyy) of move).” By the way, nonresidents moving to California also have to complete Schedule CA, conversely disclosing the date they become residents.

It bears mentioning that changing residency is a legal concept, and most taxpayers don’t know the rules or how to apply them to a calendar. This means there is no easy answer to when a residency change occurs. In fact, it can be totally counterintuitive. When the FTB asks an ambiguous question, it’s usually intentional. The FTB hopes the taxpayer will make a mistake that might be advantageous to the tax authority. Serendipitously, the taxpayers in Bracamonte did just that, originally putting a move-date on their 540NR that made no sense factually, something they were grilled about during trial, presumably eroding their credibility in the eyes of the court. Continue reading

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The Issue

With the rise of ecommerce, advanced telecommunications, and the new prevalence of remote work due to the COVID pandemic, more and more people are choosing the option of living in one state while working for an employer in another, sometimes without ever setting foot at the employer’s place of business. The possibilities for reducing state income taxes through this scenario haven’t been lost on founders, hi-tech C-suite, and other key employees in California. By moving across state borders and working for a California business (or even running it) through Zoom and other telecommunications, they become nonresidents, potentially free of California’s high income tax rates, while still being able to participate in California’s thriving economy.

Of course, this situation isn’t lost on California’s tax enforcement agencies either. Because remote work can attract audit scrutiny, nonresidents working for California firms need to be careful and understand the tax rules governing remote work, especially when it comes to highly compensated former residents.

California Tax Rules For Remote Employees: The Basics

Generally, if you work in California, whether you’re a resident or not, you have to pay income taxes on the wages you earn for those services. That’s due to the “source rule”: California taxes all taxable income with a source in California regardless of the taxpayer’s residency. In other words, nonresidents pay California income taxes on taxable California-source income. With respect to employees, the source of income from services compensated by W-2 wages is the location where the services are performed, not the location of the employer. This is true even if you are a nonresident, even if you don’t work out of a California branch or office, and even if the wages are paid to you outside of California and booked as payments to a nonresident worker. Continue reading

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calcouple4blog1

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. Continue reading

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Manes Law graphic six-month presumption

The Six-Month Mythos

You don’t have to be a tax lawyer to know that the way to avoid becoming a resident of California is to spend less than six months in the state during any calendar year. Right? Well, not exactly. The “six-month presumption,” as it’s called, which is mentioned in one form or another in almost every Google search result of California residency rules, isn’t all that it’s cracked up to be. That’s not to say the amount of time spent in California doesn’t play an important role in determining legal residency. Just the opposite. It’s critical. But the real rule is more complex and has to be understood in the context of how California determines residency. It isn’t by counting days. In fact, relying on the six-month figure as a magical way to avoid California residency can get a taxpayer into serious tax trouble.

What Is The Six-Month Presumption?

The six-month presumption is established by regulation. You would think it would say something simple like: if you spend no more than six months in California during any calendar year, you’re not a resident. That’s the popular online version. And frankly it’s the version many auditors for the Franchise Tax Board (California’s tax enforcement agency) seem to have in the back of their minds. But that’s not the legal rule.

Rather, the rule has various qualifiers: if a taxpayer spends an aggregate of six months or less in California during the tax year, and is domiciled in another state, and has a permanent abode in the domicile state, and does nothing while in California other than what a tourist, visitor, or guest would do, then there is a rebuttable presumption of nonresidency. What would a tourist, visitor or guest do? According to the regulation, nothing much more than owning a vacation home (or presumably renting one), having a local bank account for local personal expenses, and belonging to a “social club” (read “a country club”).

These qualifiers call for some parsing. Continue reading

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Californians moving overseas

The Issue: Even Casablanca Isn’t Far Enough Away to Avoid A California Residency Audit

The global economy has enabled growing numbers of California residents to find employment overseas, often in Pacific Rim or European countries. Many of these jobs are in financial services or high-tech industries and can be very lucrative. The temptation is to pack up and leave without thinking about the California tax consequences. But that can be a costly mistake. California has special rules for changing residency to another country. If they aren’t scrupulously followed, expatriates can find themselves facing a large California tax bill along with the cheerful balloons at their welcome home party.

Changing Residency To Another State vs. Another Country

Changing legal residency from California to another state has fairly straightforward rules, if you’re willing to seriously pull up stakes. If you keep a vacation home, or a business, or work remotely, then it gets more complicated. But the concept is clear enough: to change your legal residency from California to another state you have to (a) intend to change your residency (that is, intend to leave for other than temporary or transitory purposes) and (b) physically move to the new state (you can’t just think about moving).

How the Franchise Tax Board, California’s tax enforcement agency, determines intent and what constitutes “moving” is another matter. The FTB doesn’t ask taxpayers what they intended; rather, it derives intent from their conduct. For that, the FTB uses the “facts and circumstances/closest connection” test, which compares all of the taxpayer’s California contacts with all of the taxpayer’s contacts in their new home state, and weighs them, in totality. But not every contact weighs the same, and since there are few bright-line rules, an audit can sometimes seem like a Kafka novel in its excruciating focus on seemingly casual details used to punish the unwary. A more detailed discussion of the closest connection test is here. That said, if you follow the regulations and case law, avoid common mistakes, and endure the cost and inconvenience built into establishing and maintaining nonresidency status for taxpayers with significant California contacts, you can have some degree of certainty about establishing yourself as a nonresident in another state.

Continue reading

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The Issue

Nonresident individuals and out-of-state companies often make loans to California-based borrowers. It’s not unusual for those promissory notes to be secured with California real estate. The scenarios take many forms. A person may inherit the note from a parent, or they may feel obliged to make a loan to a child purchasing their first home. Or the note may be on the books of an out-of-state company as a result of the sale of assets or a subsidiary to a California buyer. Clients in these circumstances often ask me whether the interest from the note is California-source income. The short answer is, generally no. The long answer is, it depends.

Why It Matters

It obviously makes a financial difference if loan interest is California-source income. Nonresidents are taxed by California on income sourced to this state. If the interest on such loans are California-source income, the nonresident must file a nonresident return and pay California income taxes. An analogous situation applies to out-of-state companies that hold such notes. If the interest is revenue sourced to California, the lender is “doing business in California” and owes California taxes on that revenue. But even if the amount of tax is minor, there may be a larger downside. For nonresidents, a California income tax reporting requirement means that the Franchise Tax Board, California’s tax enforcement agency, will know everything about the taxpayer’s global income. That’s because the nonresident must attach a federal return, Form 1040, to the nonresident state return, Form 540NR. It’s not the end of the world, and it by no means guarantees a residency audit, but if the person’s global income is particularly high, and if there are indications of other significant contacts with California, then it could increase the chances of the FTB initiating a residency audit, something that promises unique unpleasantries for nonresidents. See, California Residency Audits: Three Year-End Tasks to Reduce the Risk for Nonresidents.

For business entities, having California-source income raises similar complications. An out-of-state company doing business in California has to register as a foreign entity and file all appropriate entity tax returns, regardless of how de minimis its California taxable income is. And, if the entity is a pass-through, the reportable California-source income may also require the principals to file nonresident returns. A double whammy. Continue reading

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California Tax Traps for Nonresidents

Sunny Taxxy California

Most of the world knows the Palm Springs area for its picturesque golf courses, celebrity homes and halcyon weather. Among the taxing authorities in Sacramento, however, the words “Palm Springs” conjure up less carefree images. Spurred by the state’s appetite for tax revenues, the Franchise Tax Board, California’s main tax enforcement agency, has tapped into a new revenue source: taxing seasonal visitors to popular vacation spots in California, where residents often have second home. Palm Springs is one such area. But so is Santa Barbara, Sonoma County, San Diego.

Seasonal Visitors As Tax Targets

This is how it works. California taxes residents based on their worldwide income, from whatever source, no matter how far-flung. In contrast, California taxes nonresidents only on their income derived from California sources. For instance, these might include a limited partnership operating in California or rent from an investment property. Since California has the highest income tax rate in the country, visitors who suddenly find themselves defined as “residents” may face a large and unexpected tax liability.

Obviously, the FTB  would like to claim everybody who sets foot on California soil as a resident and subject their income to California tax. That’s their job, after all. As many seasonal visitors have discovered, the FTB’s policies sometimes seem not to fall too far short of that mark.

A special division of the FTB has for years systematically targeted seasonal “part-time” residents for audit (I use the term “part-time” loosely, since we are talking about nonresidents who spend part of the year here, not part-time legal residents per se; but the term has stuck). Though other vacation spots experience their share of audits, historically the most common casualties are affluent “snowbirds” who own vacation homes in the Palm Springs area as an escape from the winter blasts of the Midwest or northern states. In fact, many of the major cases in residency taxation are eerily similar: they usually involve Midwesterners who own winter vacation homes in Palm Springs and environs. If the FTB finds significant taxable income coupled with meaningful contacts with California (such as a vacation home, business interests or long visits to the state), it can lead to the launch of a full-blown residency audit. Continue reading

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