Nonresident Tax/Audits Issues

Moving Overseas from California: A Residency Minefield for Expats

Published on: May 20, 2019 | by Chris Manes

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.

Increased Volume of 4600 Notices Sent in 2019, Explained

Published on: May 1, 2019 | by Chris Manes

Our office has experienced a significant increase in the number of taxpayers reporting they have received 4600 Notices “Request for Tax Return” sent by the Franchise Tax Board (California’s tax enforcement agency). The likely explanation is discussed below.

What’s Happening?

This July, our office saw a spike of 100% from the prior year in contacts from taxpayers seeking guidance after receiving a 4600 Notice from the FTB. There is a particular increase in nonresidents who have businesses out of state with no direct contacts with California. The notice relates to whether they are “doing business in California” as a result of sales to California customers. The upsurge could simply be more potential clients are choosing to contact our firm, but the more likely explanation is an actual increase in the volume of 4600 Notices sent, especially those relating to doing business in California.

What Is a 4600 Notice?

The FTB sends a 4600 Notice when it has reason to believe the recipient, usually a nonresident, was required to file a California tax return in a prior year, but didn’t. The notice is sent automatically when the FTB receives information to indicate that the non-reporting taxpayer earned or was distributed California-source income or may reside in California. The notice requires recipients to either prepare and file a California tax return or explain why they aren’t required to. If the FTB accepts the explanation, the matter ends there. If the FTB doesn’t, then a full audit follows. Continue reading

The Part-Time Resident Tax Trap

Published on: January 28, 2019 | by Manes Law

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

Internet-Based Companies and “Doing Business in California”: Be Careful What Your Website Says About You

Published on: November 19, 2018 | by Chris Manes

The Issue

With more and more companies forgoing brick and mortar by operating their business through the internet, tax authorities find it increasingly difficult to determine which enterprises are subject to state income taxes and which aren’t. Typically, California has taken an aggressive stance. In 2011, it passed a new law that defined “doing business” in California beyond being physically present by having offices or operations. Instead California sought to define what constituted an “economic nexus” to the state, using factors such as sales, payroll, and inventory. In 2013, comprehensive regulations went into effect casting a broad net over the activities of out-of-state corporations and pass-through entities (LLCs, partnerships, S corporations) as doing business in California. Judicial decisions interpreting those rules are just starting to trickle in. The picture that is emerging indicates that non-California internet businesses need to be wary or they may find themselves subject to California taxation.

Why Does It Matter Whether Your Company Is “Doing Business” in California Or Not?

First, why does it matter if California determines an internet company is “doing business” in California? It may matter a great deal. The determination that an out-of-state entity is doing business in California is one of the ways California can impose income taxes on that business, even if they have no physical presence in California (the other is based on the entity earning California-source income). In some cases, there may be a tax liability even if the company made zero income from California sales. Continue reading

California Residency Audits: Three Year-End Tasks to Reduce the Risk for Nonresidents

Published on: November 11, 2018 | by Chris Manes

Hundreds of thousands of nonresidents have vacation homes, investments, business operations, and other substantial contacts in California. Many fear those contacts will trigger a residency tax audit – California’s system for determining which taxpayers are legal residents and hence liable for California’s state income tax. The concern is warranted, if often exaggerated by internet myths about the Franchise Tax Board, California’s tax enforcement agency, peeping through your keyhole. California is in fact notably aggressive among the states in claiming out-of-state taxpayers as residents. With the highest state income tax in the nation, California cares about residency status much more so than do low or zero income tax states. Because it matters, the FTB wants the facts, ma’am. A residency audit is California’s unpleasant way of getting them.

Fortunately, however, once you understand how California’s residency audit system works, you can plan to reduce your risk. Let’s discuss three end-of-year actions nonresidents can take to avoid the most common scenarios that lead to a residency audit.

What Is A Residency Audit?

First, it helps to know what a residency audit actually is and how they are triggered. Continue reading

The Franchise Tax Board Modifies Ruling: After Unfavorable “Doing Business in California” Case

Published on: October 23, 2018 | by Chris Manes

The Franchise Tax Board, California’s taxing authority, has consistently taken an aggressive stance in claiming out-of-state businesses have income tax reporting requirements for “doing business in California.” The FTB reached a limit in Swart Enterprises, Inc. v. Franchise Tax Board, Cal. Ct. App. (5th App. Dist.), 7 Cal. App. 5th 497 (2017). In that case, a California appeals court ruled against the FTB’s claim that a foreign corporation with a passive .02% ownership in a California LLC was doing business in California. As a result, the FTB was forced to modify its ruling on doing business in California by members of multi-member limited liability companies.

FTB Walks Back Prior Ruling

Specifically, the FTB has modified California FTB Legal Ruling No. 2014-01, 07/22/2014, which sets forth the FTB’s analysis on a number of “doing business” scenarios involving members of multiple-member LLCs that are classified as partnerships for tax purposes. The ruling had asserted that the distinction between “manager-managed” and “member-managed” LLCs, made no difference in determining whether a member of the LLC was doing business in California. The reasoning in Swart Enterprises made that assertion untenable. As a result, the FTB has removed the language and replaced it with the innocuous phrase: “a narrow exception may apply in limited circumstances.” Continue reading

“Request for Tax Return” Time for Nonresidents: How Not to Make that Mistake Again

Published on: April 28, 2018 | by Chris Manes

With Tax Day having come and gone, the Franchise Tax Board, California’s tax authority, is now busy sending out its annual 4600 Notices, also known as “Request for Tax Return” letters. Almost all 4600 Notices are sent to nonresidents, mostly those who own a vacation home or have a business interest in California, and have made one of several common mistakes. For a full discussion of what a 4600 Notice is, see “They’re Back: FTB 4600 Notices Coming Soon to You.”

If you receive a 4600 Notice, the first order of business is to timely and effectively respond. Whether that means filing a nonresident tax return (a Form 540NR) or providing a proper legal explanation for why you don’t have to, depends on the circumstances. Second, assuming the notice gets resolved favorably, the next task is preventing the same problem from recurring in future years.

Automatic vs “Reviewed” Triggers

4600 Notices don’t just happen. They are triggered. The trigger is usually one of several common, avoidable mistakes by nonresidents.

In my practice, the typical 4600 Notice involves a nonresident who owns a vacation home in California with a mortgage. Out of convenience or just as an oversight, the nonresident tells the mortgage lender to send the Form 1098 Mortgage Interest Statement to the vacation home. Form 1098 is the “information return” mortgage lenders generate to report loan interest. They send one copy to the FTB and another to the borrower. If the “Payer/Borrower” address on the 1098 is in California, and the borrower doesn’t file a state tax return, the FTB will automatically send a 4600 Notice. Continue reading

They’re Back! – FTB 4600 Notices Coming Soon to You

Published on: May 17, 2017 | by Chris Manes

It’s that time of year again. The time when the Franchise Tax Board sends out its 4600 Notices, “Request for Tax Return,” the bane of snowbirds and other part-time residents of California, especially those with vacation homes. And a potential trap for the unwary.

What Is A 4600 Notice?

A 4600 Notice is sent by the FTB because it believes the recipient, usually a nonresident, was required to file a California tax return, but didn’t. The notice usually goes out a month or two after the April 15 tax filing deadline, but it can show up any time after that, even years later. There is no statute of limitations. As a practical matter, however, the FTB generally sends the notice within a short period after the tax filing deadline or not at all. That’s because, as explained below, the notice is usually triggered by information provided by third parties (such as banks, mortgage lenders, employers) in the same tax year at issue.

The notice requires you to file a return, or explain why you are exempt. It’s usually directed at nonresidents, who for various reasons discussed below, have the misfortune of popping up on the FTB’s radar scope.

Why Did You Get A 4600 Notice?

When I say the FTB believes a nonresident was supposed to file a California tax return, I’m speaking metaphorically. 4600 Notices are mostly sent out through an automated system. No thinking is involved. The typical scenario goes like this. You’re a nonresident who doesn’t file a California tax return because you don’t live in California and didn’t have any California source income. But you do have a mortgage on your vacation home, or a small local bank account that bears interest, or you work remotely for a California firm which for convenience sake uses your local address for correspondence. As a result, the bank, lender or employer sends a Form 1099-INT (bank interest) or Form 1098 (mortgage interest) or a Form W-2 (wage income) to Sacramento with your name and local address on it. Come April 15^th, FTB computers cross-reference these “information returns” with filed tax returns. When nothing comes up, a 4600 Notice issues. Continue reading