California Residency Tax Planning
Is Bigfoot a California Resident?
Manes Law discussed its top five internet myths about California tax residency rules in a previous article. Here are five more. Again, they’re in no particular order, but the commentary should provide some indication about how important they are and why.
Myth #1: Leave California, Sell Your Business, And You’re Home Free
Many of our clients are founders exiting startups, either through an IPO or purchase by another company. Or they are long-term business owners in traditional industries who plan to sell their California-based company after retiring out of state. The widespread internet meme insists these scenarios always result in zero California income tax on the gain, even though the sale is of a California business.
The basic concept is correct: if a nonresident sells his interest in a California business (that is, corporate shares, limited liability company memberships, partnership interests), the traditional rule is California can’t tax the gain. But not so fast. Numerous factors play a role in determining whether a business sale by a nonresident will escape California’s tax system.
The first is, the transaction must in fact be the sale of a business interest, not the sale of business assets. For good tax reasons, purchasers often prefer to buy assets, not business interests, if the value in the company is in the assets, not the brand. And in some industries, an asset sale is the standard for a business purchase. But take note: if the assets are situated in California, an asset sale by a nonresident results in California-source income, taxable by California regardless of the residency status of the seller. Generally, only interest sales are eligible for tax-free treatment by California when the owner is a nonresident.
Second, even if it is an interest sale, timing is important. A seller’s residency status counts when an enforceable purchase and sale agreement goes into effect, not when escrow closes or when subsequent instalments are paid. For example, a resident who enters into an agreement to sell his stock in a California corporation, and then moves out of state so that escrow closes after he has become a nonresident, doesn’t get the benefit of the rule. The gain is taxable by California even though payment is made after the seller establishes nonresidency. Note that most letters of intent are not enforceable purchase agreements, so there are still planning opportunities after a potential buyer begins due diligence but before the final contract is signed.
Third, the purchase and sale agreement or IPO plan may generate California-source income by its own terms, taxable by California regardless of the seller’s residency. This is the case if a portion of the purchase price is allocated to a noncompete clause, or if severance pay is built into the transaction, or if the agreement requires the seller/founder to work for the new owner for a period of time in California after the acquisition.
Finally, it comes as a surprise to many CPAs and tax attorneys that as of early 2017, California claims to have the authority to tax business interest sales by nonresidents if the underlying assets of the company are located in California, or if the business has sales in California, under certain circumstances. This was the result of regulations adopted by the FTB in 2017. The regulations appear to contradict 70 years of settle law regarding interest sales, not to mention California’s own statutory system for taxing such sales. But there it is. Not enough time has passed since the issuance of the regulations to test their validity in court; and it isn’t even clear that the FTB is enforcing them. Still, nonresident sellers and founders undertaking an M&A or other exit need to be aware of the new regulations, and plan around them if possible, even if ultimately they may be ruled invalid.
Myth #2: Working In California = Residency
Sometimes the internet wears rose-colored glasses about California residency planning. And sometimes it’s just the opposite: the advice completely misses the opportunities for reducing California taxes by nonresidents through careful planning. This latter category includes the canard that if you work in California, you can’t avoid California residency status.
Working in California, either as an employee or an independent contractor, is obviously a substantial contact that often indicates residency. But it doesn’t make you a resident by itself. Rather, the issue is always whether the work is permanent or temporary. And that usually turns on the terms of the contract and the conduct of the nonresident while working in California.
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It’s fanciful to think that simply changing residency will produce tax nirvana
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If the agreement (which should be in writing) is for a fixed, limited period, and if the nonresident endures the inconvenience and cost of planning to limit other contacts with California, it is quite feasible to work in California for a significant amount of time and remain a nonresident. Under the right circumstances, the Franchise Tax Board, California’s tax enforcement agency, will concede that time spent working in California is temporary. For instance, many of our clients are nonresident professional entertainers or athletes, or highly compensated executives, who come to California to work on a defined project for a specific duration, such as setting up a new branch of an out-of-state company, or performing in a run of a stage production. Some are programmers sent by their companies to work on a software project that may take months to complete. The key to their residency status is the written contract, which needs to spell out terms that indicate temporary status. And then the nonresident must manage his presence here in compliance with what the FTB deems as a temporary stay.
For instance, an employment contract for under a year (and even more than a year in the right circumstances), will be deemed temporary if it has a fixed stated term (without renewals), specifies the nature of the project and how it will be completed, and avoids references to an indefinite duration. In addition, the nonresident must take pains to limit or avoid all the typical contacts that lead to residency: things like voter registration, driver’s licenses, permanent abodes, vehicle registration, and financial accounts. It also helps to limit time in-state, and that can be accomplished by making frequent trips back to a home state, even if that’s inconvenient and costly. And by the way if some of the work can be carried out remotely, it may also reduce the income subject to California tax, regardless of residency status. See, Nonresidents Working Remotely For California Businesses.
That said, at some point even a fixed term is too long to be reasonably interpreted as temporary. An agreement to work in California for over a year is usually pushing it, and any period over 18 months is usually deemed permanent on its face. Moreover, the nine-month presumption acts as a limit for how much time a nonresident can spend in California in aggregate during a particular tax year. If the nonresident spends more than nine months, a presumption of residency arises. The presumption is rebuttable, but there are no cases where it has been successfully (except an old college attendance case, which would probably be decided differently today). The concept is, taxpayers who spend more than nine months in California receive virtually all the benefits of living here full-time, and hence must take the burden of being taxed as a resident. That said, a nonresident with a contract longer than nine-month term can dodge the bullet by taking every possible opportunity to leave the state during the year so that in aggregate, the amount of time in-state is nine months or less. This means fleeing the state on holidays, vacation time, even some weekends. The cost and inconvenience is large. But such is the nature of nonresidency planning.
The better plan is to contract for less than a nine-month term.
Finally, the nonresident must realize that the income earned while working in California will likely be taxed by California regardless of residency status. That’s because worked performed while present in California (as an employee) or worked performed for a California company (as an independent contractor) is California-source income by definition. But for nonresidents with significant non-California-source income, it can make a big tax difference if they are deemed residents or are able to maintain their nonresidency status while working full-time in-state.
In short, there are planning opportunities here that the internet messengers of residency doom overlook.
Myth #3: The FTB Is Watching You
Related to this pessimism is the fiction the FTB is watching you. There are websites and forums – even some attorneys – that suggest nonresidents not make smartphone calls while in California, because the tax authorities are monitoring them to trap unwary visitors. Or they imply the FTB sends spies to see when they are in their vacation homes. This myth is usually accompanied by mentioning a few high profile cases (such as the infamous quarter-century-long litigation involving Gilbert Hyatt, the inventor of the single-chip microprocessor), where the FTB takes what appears to be an unreasonably aggressive stance against nonresidents. But rest assured, the FTB is not watching you. It has neither the resources nor the inclination to take measures to monitor every nonresident who has a vacation home or business interest in California. Rather, the FTB takes the easy route. When it comes to residency audits, it’s like a sea anemone: it usually just sits back and waits for tax and financial documents to come to Sacramento, often the result of common mistakes, as happens when nonresidents use a California vacation home address for receiving information returns (W-2s, K-1s, 1098s, 1099s, etc.), because it may be more convenient.
Indeed, while the FTB often aggressively pursues residency cases once an audit is underway, it is much less strict in initiating such audits than many other states. New York, for example, seems to have a policy to audit virtually every upper bracket taxpayer who leaves the state. California’s residency audit system doesn’t function that way.
A fuller discussion of how residency audits are triggered is discussed here. The point is, planning to avoid a residency audit doesn’t involve stealth; it requires knowing the circumstances of how residency audits are triggered and the types of profiles the FTB is likely to audit once something comes to the attention of an examiner. Generally speaking, the FTB has no idea who is physically present in California and who isn’t. But if it audits at taxpayer for residency, at that point, it will certainly find out.
Myth #4: If You Don’t Come To California, You Aren’t Doing Business Here
This myth is a recipe for disaster for nonresidents and out-of-state businesses who have customers in California. The rules for doing business in California can be complicated. But one thing is certain: you don’t have to be physically present in California to be doing business here. Nonresidents who perform services for California customers, even if over the internet or using other forms of telecommunication, have an “economic nexus” with the state under rules that went into effect in 2011. The concept is, if you are making sales in California, the revenues are taxable by California. You don’t have to have offices here, and you don’t have to ever travel to the state. The nexus is economic, not physical.
Now, what constitutes “sales” in California is a term of statutory art. For indirect, unlocalized services, like wealth management, marketing/advertising, insurance sales, and so forth, it can get complex, and the regulations are dense. That said, if you are providing services directly to customers, and the invoice has a California address, expect to have to pay taxes on the revenues. The FTB usually becomes aware of this when a California-domiciled business or individual resident takes an expense deduction based on a Form 1099. But there are other ways for an audit to be triggered. Accordingly, failing to report and pay taxes for income from services provided to California customers based on the premise that the out-of-state enterprise has no in-state offices and no agents or employees here, is playing tax roulette.
Myth #5: Changing Residency = Tax Nirvana
Finally, the internet is rife with the notion that everybody should flee California to reap the abundant benefits of lower taxes. What this myth fails to grasp is that, while California has the highest top income tax rate in the country, at the middle and lower brackets there is often only a small rate difference with other states. For people with average incomes, that difference usually doesn’t result in significant tax savings, if any. In fact, some low income tax states are actually higher at the middle and lower brackets. And that’s just looking at income taxes. Many low income tax states have high property taxes. Some have an estate tax (California eliminated its inheritance tax in 1982, though the tax legislation passed by Congress in 2017 raising the federal estate tax exemption to over $11 million has led to serious proposals to reinstate it). Others have higher sales tax rates. In fact, a recent study comparing the overall tax burden of the states concluded that California doesn’t even rank in the top quintile. In 11th place, it is below the stolid midwestern states of Minnesota, Illinois and Iowa (though obviously well above the zero-tax states of Nevada, Florida, Texas and Washington, which traditionally attract the lion’s share of Californians anxious to change residency).
The fact is, in overall taxes, most middle and low bracket taxpayers aren’t substantially benefited by leaving California, especially when you consider the various costs of changing residency, and especially if attorney in-put is involved.
In contrast, residency tax planning makes sense mostly for highly compensated individuals, or those expecting a large liquidity event, such as a business interest sale, an IPO, cashing in cryptocurrency, or disposition of qualified stock options. Taxpayers who pay high California income taxes because they have high income can often obtain significant tax savings by changing their legal residency to a lower tax state, but that isn’t true of 90% of taxpayers. My rule of thumb, based on several decades of experience preparing California residency tax plans, is that taxpayers with AGI under $250,000 generally don’t reap enough income tax savings from a residency change to justify the cost and inconvenience (this, of course, assumes all that’s at stake is tax savings; if the resident wants to leave California for other reasons, then it makes sense to follow the residency rules to take what tax benefits are available, even if sparing). And the real tax advantages start to materialize above the $500,000 level.
Moreover, the benefits not only depend on rates, but the sources of income a taxpayer has. If a California resident receives all his income from a California-based business, for instance, then changing residency by itself produces no tax advantage: since all the income is sourced to California, California will tax it regardless of residency. This is just as true for high income taxpayers as it is for lower brackets. The taxpayer can relocate his business out-of-state to solve this problem. But to the extent that the business derives revenues from the California market, that income will remain taxable California-source income, even after the relocation.
There are many permutations of the California-source problem and how to work around it. The point is, effective residency tax planning has a variety of moving parts. It’s fanciful to think that simply changing residency will produce tax nirvana, when in fact the tax benefits depend on the move-in state’s overall tax burden, the taxpayer’s AGI, and the sources of income.
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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. We assist a clientele of successful innovators and investors, including founders exiting their startups through a sale or IPO, Bitcoin traders and investors, professional actors and athletes, and global citizens able to live and work anywhere. Learn more at our website: www.calresidencytaxattorney.com.
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No information contained in this post should be construed as legal advice from Justia Inc. or the individual author, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.