California Residency Tax Planning
The 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.
This date has important implications for the taxation of liquidity events involving capital gains not sourced to California (usually this means entity sales, exercise of stock options, M&As, and IPOs). If the nonresident recognizes taxable capital gain from the liquidity event before they move to CA, the gain generally isn’t subject to CA income taxes. If the move date is before the acquisition, then California imposes income taxes on the gain.
The taxpayers in Housman faced this very issue.
The Facts
The taxpayers were a married Australian couple who founded a successful SaaS company in the land down under. In an attempt to expand the company’s US market share, the husband incorporated a management company in Delaware to be a consultant to the Australian company. The ultimate goal was to sell the entity. Both husband and wife quit their jobs with the Australian company and moved to San Francisco under a temporary work visa to run the management company. Among other contacts with California, the couple rented an apartment in San Francisco under a one-year lease, rented out their Australian home (also under a one-year lease), opened accounts with a California bank, and established an office for their management company.
During the pendency of the one-year lease, the tech giant Adobe approached the couple to purchase their interest in the Australian company, which ultimately sold for $22 million. To receive the funds from the Adobe sale, the taxpayers used their California bank account.
Significantly, for the year before the acquisition, the taxpayers filed a California Form 540NR part-year return. This is the return nonresidents file when they establish California residency during the tax year. They filed resident returns (Form 540) for the year of the sale and for several years thereafter. They would claim on appeal that this was a mistake made on advice of counsel, and they should have filed nonresident returns prior to and in the year of the sale.
In the years after the sale, the taxpayers bought a large expensive house in California, obtained driver’s licenses, had three children, and invested in California real estate. They moved back to Australia about five years later.
The Issue
There was a somewhat complex tax basis issue in the case, which doesn’t concern us here (though the taxpayers did prevail on this issue and received a refund of over $4 million). The residency issue, however, was straight-forward: were the taxpayers residents of California when they recognized the income from the acquisition of their company by Adobe? The taxpayers’ position wasn’t exactly clear. But the claim seemed to be that at the time of the acquisition, they were in California for temporary business purposes (the expansion and sale of their company), and that they only became California residents after the liquidity event, having changed their plans, though it’s possible they were claiming they never became residents at all. This lack of clarity was one of the problems in the case. The FTB argued the taxpayers were California residents under the closest connection test when the income receipt occurred.
The Office of Tax Appeals ruled for the FTB with respect to the taxpayers’ residency.
Mistake Upon Mistake
While it’s possible the taxpayers only intended to spend a year or so in California for short-term business purposes, or that they changed their minds and decided to become California residents only after the liquidity event, the taxpayers’ case appeared doomed from the start. As the court opinion and the hearing transcript shows, they made almost every mistake imaginable to undermine their claim of nonresident status. Let’s review the arguments in the case, since they illuminate what taxpayers in their position should not do.
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The rule is that if an individual is visiting California to perform a transaction or sign a contract or fulfill a relatively well-defined short-term project, it is considered temporary or transitory
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Business Purpose
The taxpayer’s major claim was that they were in California for a short-term business purpose. In support, they cited the limited nature of their leases (in California and Australia), and their purported goal of establishing a satellite office for their Australia company while acting as consultants through their Delaware company. The concept, according to the taxpayers, was they would establish the office, sell the company (or get it ready for sale), and return to Australia, within 12 to 18 months.
The rule, which takes the form of a regulation, is that if an individual is visiting California to perform a transaction or sign a contract or fulfill a relatively well-defined short-term project, it is considered temporary or transitory. However, if an individual is visiting California for business purposes that will take a long or indefinite time to complete, or if the individual is employed in a permanent or indefinite position, they are not in California for temporary or transitory reasons. The regulations don’t provide guidance on what constitutes “short-term” or “long-term,” but case law suggests anything over nine months is problematic, and audit practice indicates that nine-month periods back-to-back over a number of tax years is all but dispositive that the purpose is not temporary or transitory.
The taxpayers were unable to meet their burden of proof that their purpose in establishing the California office met the regulatory requirements. The court noted specifically that the consulting agreement between their management company and their Australian company did not specify when it would expire. It was an indefinite agreement as to term, with the default being to continue until one of the parties terminated it. Moreover, the purpose of the agreement was open-ended on its face. It was to assist the Australian company’s goal of expanding its US presence to build up sales to the point that the entity could find a buyer. The court noted that the purpose was so broad, there was no way to determine by the contract’s wording how long it would take to achieve its goals. In short, there was no time-limited project defined in the agreement.
During the hearing, the administrative judge cogently asked the taxpayer why their stay in California extended past their anticipated time of 12 to 18 months. The taxpayers’ answer was that one thing led to another, and after the sale closed, and after their post-acquisition employment with Adobe ended, they had several children and “didn’t need to go back.” It was probably not the best response.
It didn’t help that the taxpayers admitted that the sale to Adobe came as a surprise. The expectation was the company wouldn’t be marketable until sales increased. The unanticipated bid by Adobe only supported the FTB’s contention that there were no time restraints on the work the taxpayers were obligated to perform for the Australian company. If Adobe hadn’t appeared as a buyer, so argued the FTB, the taxpayers presumably would have continued to work in California looking for offers into the indefinite future.
After the acquisition, the taxpayers became employees of Adobe, and remained in California for five more years. That course of action obviously didn’t support the claim that the taxpayers’ purpose in being in California was a relatively short-term business task.
Nine-Month Presumption
Surprisingly, neither the FTB’s hearing arguments, nor the court opinion, specifically mentioned the nine-month presumption. The presumption is statutory and states that an individual who spends more than nine months in aggregate in California during a taxable year is presumed to be a resident. The presumption is rebuttable by “satisfactory evidence.” But as a practical matter, it is almost impossible to overcome. There is only one old reported case in which a taxpayer spent more than nine-months in California and rebutted the presumption (and it would likely be decided differently today). But while not mentioned directly by the court or FTB, the presumption is in the background. Much of the taxpayers’ arguments involved a claim that their original intent was to spend 12 to 18 months in California. On its face, this would have led to the presumption of residency status. Thus, from the start, taxpayers had the burden of overcoming the presumption of residency. According to the court, they didn’t meet their burden, because there was no evidence of a short-term, time-limited project related to the business.
Cognitive Dissonance
The taxpayers also made inconsistent claims, the cardinal sin of a residency adjudication. One of their defenses was that they intended to move to London before the sale to open an office there. They offered a contemporary video of the husband addressing those plans. But as the court pointed out, the husband also submitted a declaration in the case stating that the London office idea was scrapped once Adobe opened serious discussions to purchase the company. The problem was, those discussions took place before the taxpayers made a trip to London purportedly to determine if they were going to move there. The result was cognitive dissonance.
Moreover, in response to the administrative judge’s questions, the taxpayers indicated that having a child around this time “changed their plans” to move to London. But this wasn’t the reason originally given in the declaration.
Note that bringing up a change of plans due to unanticipated events (like a pregnancy) could be a valid defense. But it goes to a different argument. In that case, the argument is not that the taxpayers never became residents, but that they became residents after the Adobe acquisition (and hence didn’t owe taxes to California on the capital gains). The taxpayers’ attorneys made this point in closing arguments. The idea was that the taxpayers originally intended to stay in California for only a limited time, but their plans morphed. However, there is no consistent narrative. If one bite of the apple is that the taxpayers never intended to become residents, that’s one argument. But if the second bite of the apple is they changed their minds and became resident after the year at issue, a contradiction has been introduced. Presumably, taxpayers know their own intent, and should be able to explain it clearly to the FTB.
In any case, the taxpayer never did move to London. A plan to change residency isn’t a change of residency status. Taxpayers actually have to occupy an abode in their new home jurisdiction with the intent to move there permanently or indefinitely. There was no dispute that the taxpayers spent five years straight in California.
Homes and Physical Presence
The test for California residency (the so-called closest connection test) involves listing all of a taxpayer’s contacts with California and their home jurisdiction, and then weighing them, in totality. Those contacts fall into certain categories. In short, it’s a ledger. The ledger concept is discussed here. But while there are various categories important to determining residency status, as a practical matter, almost all residency audits are decided by two factors: comparing homes and physical presence. The facts in the Housman case were unfavorable to the taxpayers in both of these crucial categories.
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California’s residency system is not set up to be convenient or inexpensive for nonresidents. Just the opposite. Cost and inconvenience are built into the system
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The taxpayers spent more time in California than Australia. A lot more time. And over multiple years. The hearing transcript states that in the year of the acquisition, the taxpayers spent about 340 days in California, and only 30 days out of state. None of the time outside of California was spent in Australia in that year. In other years, they spent only about 45 days in Australia annually. In short, they could not prevail in the category of physical presence. They always spent significantly more time in California than Australia.
Meantime, while they kept their home in Australia, they leased it to a tenant. The taxpayers didn’t use that home on their trips back to Australia, but rather stayed with their parents. They in fact never occupied the Australia property again, but continued to rent it out. They did purchase a home in Australia in 2012, several years after the Adobe transaction, but that was after already purchasing a home in San Francisco. The court didn’t mention this, but it would have been apparent from the tax returns and other papers filed in the case: the San Francisco property was purchased by the taxpayers for $1.7 million and sold by them for $2.5 million after moving back to Australia. It was about 2,500 square feet. In contrast, the Australia property was apparently much smaller. But more to the point it was leased out and couldn’t be, and in fact wasn’t, occupied by the taxpayers after the move to San Francisco.
To summarize, the taxpayers owned a large, expensive home in California, while they didn’t have an operational home in Australia at all, but only income property, while spending almost all of their time in California with only limited trips to their claimed home jurisdiction. Under the closest connection test, that’s a recipe for California residency in most cases.
Inconvenience and Cost
In closing arguments, the taxpayers’ attorney argued that it was understandable that the taxpayer didn’t spend much time in Australia, a country halfway round the world. The argument was to draw a contrast between nonresidents from another state as opposed to those from another country. To quote:
“Was he going to go back and forth between Australia and California, a 14-hour flight, you know, versus — if they were — if we’re talking California versus Nevada, you know, when you’re looking at the days here and days out?”
This was a futile argument, and you can all but hear the judges sigh. California’s closest connection test compares a taxpayer’s California contacts with those of their home jurisdiction. It doesn’t matter that the home jurisdiction is a hemisphere away, and that it would be costly and inconvenient to spend enough time there to maintain nonresident status. California’s residency system is not set up to be convenient or inexpensive for nonresidents. Just the opposite. Cost and inconvenience are built into the system. Residents pay California income taxes; nonresidents avoid that burden but are expected to endure other costs and inconvenience if they establish significant contacts in the state. The concept is, nonresidents can’t live like residents and not pay income taxes. Usually, that means nonresidents have to spend less time in the state, with comparatively inferior living accommodations, than they might prefer. Any argument for nonresidency directed at California’s taxing authorities based on the excuse of cost or inconvenience is fated to fall on deaf ears.
Representations of Residency
But perhaps the most devastating blow to the taxpayers’ case was the fact that they actually filed their state tax returns in California as residents. Not only that, their US federal returns also used their California address, not an Australian address, and reflected US residency status starting in the year before the sale. The company’s returns also stated that it had no nonresident partners, an admission the taxpayers were residents. All these filings were made under penalty of perjury.
The administrative judge pointedly asked the taxpayers at the hearing if they ever amended their state or federal returns to correct their status. The taxpayers admitted they didn’t and attributed the failure to the bad advice of their tax professionals. The taxpayers added that they were confused about the difference between federal and state residency law. They thought California followed the federal 183-day rule (it doesn’t). The court opinion focuses on this inconsistency and the fact that the taxpayers only asserted they filed the wrong tax returns in arguments protesting the audit.
This brings up another unfavorable complexity. The audit involved other issues irrelevant to residency. And in fact, the taxpayers didn’t even claim nonresident status in the audit. They first raised the issue when they challenged the audit outcome. But the taxpayers made representations during the audit unfavorable to their appeal. They characterized their San Francisco address as their “primary residence” and identified their travels outside of California as trips taken while residing in the US. All this was noted at the hearing.
The concept here is important: if you say you’re a resident of California (especially under solemn circumstances, such as signing a tax return under penalty of perjury), generally neither the FTB nor the appellate court will let you successfully deny it later. That’s why representations of residency are so critical to residency planning. They are treated as admissions.
The Takeaway
Could there have been a different result for these taxpayers? The answer is yes, if they had planned for a residency audit from the start, and endured the cost and inconvenience of that planning. The major issues highlighted by the case, and how to handle them are as follows:
- Written Agreement. To spend significant time in California for a business purpose while maintaining nonresident status requires a well-drafted agreement that provides a definition of the project and a limited timeline for accomplishing it. Open-ended agreements with no time limitations undermine the claim that the taxpayer is in the state for a temporary or transitory purpose. It is crucial to taxpayers who have to work in California for any substantial amount of time – actors, professional athletes, executive establishing a company branch. This Manes Law article goes into more detail on this issue.
- Keeping the Ledger Test in Mind. Nonresidents have to keep in mind that the test California uses for residency is essentially a ledger, as described above. Two of the most consequential factors are homes and physical presence. If a nonresident plans to spend significant time in California (essentially losing in the physical presence category right off the bat), it’s critical to prevail in the comparison of homes. That is, you can’t obtain superior living accommodations and spend more time in California than your home state and expect to convince an auditor you are a nonresident. These two category simply carry too much weight. The vast majority of residency audits are determined by these two categories.
- Nine-Month Presumption. If a nonresident has to spend significant time in California it’s important to move heaven and earth to limit that time to nine months or less. This is true even if it involved the cost and inconvenience of traveling out of state whenever possible. Once a taxpayer exceeds the nine-month period, they walk into any adjudication as a presumed resident. And that presumption is almost impossible to rebut. Therefore, foremost in nonresident planning for a project in California is limiting the aggregate time in any tax year to avoid the nine-month presumption.
- Representations of Residency. In addition to the categories of homes and physical presence, one category has special significance in California residency determinations: representations of residency. It is critical to avoid stating you are a resident of California, especially under formal circumstances (like filing tax returns), or where a benefit accrues. The obvious ones are voter registration and driver’s licenses (both involve penalty of perjury attestation). Most nonresidents know about those. But there are others such as home insurance, health insurance, tax exemptions, loan applications, with lesser solemnity but similar impact in a residency audit.
- Consistency. The taxpayers’ narrative in the Housman case was erratic. To prevail in an audit, it is important to plan for a specific goal and stick to it as much as possible. In the real world, circumstances do change, and that may mean a change of plans. But the change should be deliberate and considered, and the reasoning behind the change plans should be memorialized to avoid the ambiguities and contradictions the Houseman taxpayers presented to the court. Note also that the claims the taxpayers made in the audit came back to haunt them in the appeal because their position changed. Consistency in claims and factual assertions throughout legal proceedings is critical for nonresidents to defend their status.
- Intent vs. Purpose. Taxpayers (and their tax counsel) often confuse intent and purpose in the context of residency planning. The opinion noted that even if the taxpayers intended to return to Australia, that didn’t mean the purpose of their stay in California was temporary or transitory. Although nonresident taxpayers may intend to conduct themselves in a manner consistent with nonresidency, if their purpose in being in California is long-term or indefinite, they will likely be deemed residents. The purpose itself has to be well-defined in terms of its goal and timeline. And the place to memorialize that is in a written agreement.
- Records or the Lack Thereof. The relevant facts in the Housman case went back to 2008. The audit occurred in 2012. The appeal was heard in 2022. That’s a 14-year time span. Needless to say, at the hearing, the taxpayers couldn’t remember all the relevant facts and had to plead ignorance to some of the questions by FTB counsel. The problem with that is, the burden is on the taxpayer to demonstrate the FTB’s decision was incorrect. Without records, a number of important facts could not be established in the residency elements of the case. This is a common problem in residency adjudications. It’s what helped to sink the taxpayers in the Bracamonte case. Nonresidents who establish significant contacts with California must have a plan to keep meticulous records of the relevant facts in case of an audit.
As a postscript, it should be noted that because the taxpayers prevailed in the tax basis argument, which had nothing to do with residency, they received a large refund from the FTB and probably suffered little or no financial damage . But that was just a fortunate happenstance, not a planned outcome. Nonresidents who come to California near the time of a large liquidity event should rely on planning, not serendipity.
The Housman case can be found here.
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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, and global citizens who are able to live, work, or retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.
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