California Residency Tax Planning
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.
The goal for nonresidents and entities with an out-of-state business domicile should be to obviate reporting requirements completely, if possible.
How It Works
Here are the rules. They are deceptively deceptive.
First, let’s discuss entities. If an out-of-state entity is a “financial organization,” then the rule is straightforward. Interest from a loan to a California resident or California-domiciled entity is California-source income, period. Further, if the loan is secured by California real estate, it is California-source income regardless of the residency or situs of the borrower. A financial organization, for this purpose, means a bank or a mortgage lender.
Second, all other corporations or entities don’t have to worry. They are specifically exempted from this rule. Accordingly, companies with an out-of-state situs not in the business of making loans, don’t have to report interest from California-based borrowers to California. To give an example, if a Nevada corporation which produces widgets takes back a note from the sale of old equipment to a California company or its principal, and the note is collateralized with California real estate, the loan interest is not reportable as California income.
Finally, what about individual lenders? As I indicated, nonresidents sometimes inherit notes, often from parents who may have made a loan to the taxpayer’s siblings, nephews, or nieces. Or the nonresident may have made a loan to a child who lives in California. Surprisingly, there is no case law or statute directly on point. Nor do the regulations exempt individuals from the “financial organization” rules. However, we can deduce the answer from general law and by analogy to the entity rules.
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Interest from a note isn’t California-source income as a matter of black-letter law – unless the note has acquired a “business situs” in California
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California Revenue and Tax Code §17952 states that income of nonresidents from stocks, bonds, notes, or other intangible personal property is not income from sources within this state, unless the property has acquired a business situs in California. No mention of the borrower’s residency status. No mention of security. Just “business situs.” We’ll get to that.
It is telling that no FTB case has claimed California-source income results from a note secured by local real estate or entered into by a California-based debtor. Indeed, if an out-of-state (non-financial) corporation can receive incidental loan payments for this category of debt without incurring California income tax, then all the more so should a nonresident individual who is not doing business in California be exempt.
But, But, But
However, it gets complicated. Interest from a note isn’t California-source income as a matter of black-letter law – unless the note has “acquired a business situs” in California. What does that mean?
A business situs is acquired in California if the property is employed as capital in-state. The regulations provide an example: if a nonresident pledges stocks, bonds or other intangible personal property in California as security for the payment of indebtedness, taxes, etc., incurred in connection with a business in the state, then a business situs has been established. This language seems to overlap with promissory note terminology. But don’t get confused. Notes may be secured by other property, but it’s rare to use a promissory note itself as collateral. For an intangible asset to acquire a situs in California, the nonresident lender (not the resident borrower) has to encumber the intangible asset. For the most part, this applies to situations where the nonresident owner of stock pledges shares to cover debt or otherwise uses the stock as capital. That’s not the case with a collateralized note. Although the note may be secured with California real estate, it’s the debtor, not the lender, who encumbered the property (which already has a California situs by definition if it’s California real estate). That’s not the same as a nonresident pledging stock. The nonresident lender didn’t pledge anything. Accordingly, nothing in the regulations indicates that a loan collateralized by California real estate results in loan payments having a business situs in California.
But there’s a further complication. The FTB issued new regulations in late 2016 claiming the authority to tax the sale of stock and other business interests owned by a nonresident based on the location of the underlying entity assets. The regulations even mention – passingly and cryptically – another intangible interest, dividends. Leaving aside the fact that these regulations are totally contrary to half a century of settled case law and seem to contradict the statutes relevant to this very situation, the regulations don’t mention notes. One interpretation of these regulations is that the FTB is keeping its options open to tax the interest from notes secured by California real estate, by analogy. But that’s unlikely. The better interpretation, one potentially cogent to a disputed case, is that the FTB’s failure to include collateralize notes in its new regulations purporting to tax intangible interests is an implied admission that it lacks the authority to do so.
Conclusion
To summarize: except for specially defined out-of-state financial companies, business entities with incidental interest income from notes secured by California real estate or payable from California-based borrowers, have no reporting requirements under straightforward rules. For individuals, there’s less clarity, but the outcome should be the same, except in the unlikely event of a water landing where the note is used as collateral itself, or if the FTB gets strangely aggressive and claims its new regulations apply to notes, even though it didn’t bother to include debt instruments in its regulations when it had the chance.
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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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