California-source income

California’s 4600 Notice “Request For Tax Return” – The Definitive Guide for Nonresidents

Published on: July 20, 2021 | by Chris Manes

The Issue

Nonresidents who own vacation homes, business interests, financial accounts, or have other significant contacts in California can receive a notice from the Franchise Tax Board, California’s tax enforcement agency, demanding they file a tax return or explain why they aren’t required to. The official notice number is 4600 (you can find the designation on the lower left bottom of the Notice). Hence the name, “4600 Notice.” It’s also called a “Request for Tax Return,” since the verbiage has appeared in bold on the Notice since about 2017. If a nonresident owns a second home or uses some other address in California, the Notice is often mailed there (which can be a problem if it’s an unoccupied vacation home without mail forwarding, since the deadline for responding may be missed before the recipient even knows the Notice has arrived). But it can also be sent to their out-of-state address. Nonresidents who receive the Notice are often perplexed and concerned about why they received the Notice, and how they are supposed to respond. This article clarifies what the Notice is about, the risk it poses, and the options nonresidents have for responding. Continue reading

Did You Really Think California Wouldn’t Tax NFTs? Non-Fungible Tokens and California-Source Income

Published on: March 13, 2021 | by Chris Manes

Hot as a Recalled MacBook Battery

The non-fungible token market has become as hot as a recalled MacBook lithium battery (if that’s possible). You’ve probably seen the figures: digital artist Beeple sold an NFT for a remarkable $69 million; a LeBron James non-fungible dunk clip lasting ten seconds went for $200,000; Jack Dorsey’s first tweet was auctioned for $2.9 million (though shortly after the sale, the tweet’s value plummeted 99% at a subsequent auction).

Various funds and exchanges now tally NFT transactions in the hundreds of millions of dollars.

The lucky beneficiaries of the market have surely taken into consideration federal taxes. But if they are nonresidents of California, they may not be thinking of how California might treat NFTs for tax purposes. Specifically, depending on the location of the buyer and the status of the seller, the income from NFT sales might be sourced to California, making it subject to California income tax. Oddly, in that case, due to favorable federal capital gains treatment of NFTs, it’s even possible that the California income tax might be higher than the federal tax. To add further complexity, NFTs are almost exclusively sold in exchange for cryptocurrency, adding cryptocurrency tax issues on top of the transaction.

What is an NFT?

People are used to non-fungible assets in the analog world: Action Comics #1 (the first Superman comic book), a stretch of beachfront real estate, the Mona Lisa. You might be able to copy these assets one way or another, but only the original has value. A snapshot of the Mona Lisa or a video of a beach house isn’t worth much. Hence, the non-fungible designation.

In contrast, media on the internet has always been susceptible to unlimited reproduction (whether in violation of copyright or not) without much loss in value. A copy of a YouTube video of Milli Vanilli has pretty much the same value, or lack thereof, as the original. Then came blockchain. The same public-ledger technology that authenticates bitcoin transactions can be used to validate the original digital file of a work of online art, or the NBA’s official slam-dunk competition clips, or Jack’s first, fateful tweet. Blockchain transformed digital media that could be infinitely reproduced with no significant diminishment of value, into a class of assets, like comic books or baseball cards, that could never be copied without a total loss of value. You can still copy an online version of an NFT as a screenshot or other facsimile. But the result is equivalent to a photo of the Mona Lisa. Continue reading

Stranded in California: Coronavirus Lockdown and Nonresident Status

Published on: June 17, 2020 | by Chris Manes

The Issue

Can COVID-19 orders make you a resident? Since the COVID-19 emergency struck, tens of thousands of nonresidents have found themselves marooned in California due to coronavirus travel restrictions. The typical situation involves a seasonal visitor forced to remain in a vacation home longer than intended. But it runs the gamut, involving temporary visits to California prolonged by stay-at-home orders, or by the increased risk of contracting the coronavirus posed by traveling back home, particularly where the only feasible method of transportation is via commercial airline. Some nonresidents have even been formally quarantined due to a family member becoming infected. Unable to return home as planned, many nonresidents find they have already spent the majority of the year in state.

In those scenarios, it’s reasonable for out-of-state visitors to ask (as many contacting my office have) whether they will be deemed California residents due to the extra time spent in coronavirus lockdown. And the corollary question to that is, will the Franchise Tax Board, California’s tax enforcement agency, find out about the extended sojourn, and if it does, how will that affect the likelihood of being audited?

The Short Answer

The short answer is, remaining in California longer than planned for reasons not within your control is, in most cases, a temporary or transitory purpose. Therefore, unexpected delays in leaving California, beyond the power of the nonresident to mitigate, don’t usually confer residency status. The coronavirus pandemic is just such as case.

However, as usual with residency rules, it’s never that simple. Context may determine whether getting locked down in California jeopardizes nonresidency status. The good news is, the year is only half over, and that means even the worst-case scenarios can be managed in the remaining months of 2020. For nonresidents still stranded in California by the coronavirus emergency, what they do next may make all the difference.

And now the long answer. Continue reading

Where Is Bitcoin? Cryptocurrency and California’s Income Sourcing Rules

Published on: September 28, 2019 | by Chris Manes

Where is Bitcoin?

This may sound like a question on a Philosophy 101 midterm exam. But in fact, it’s a real-world tax issue, with potential huge tax consequences for nonresident traders, investors, and users of cryptocurrency, at least to the extent they have financial connections with California, through an exchange or via cryptolending. This is all the more true with the recent IRS announcement that it is scrutinizing thousands of cryptocurrency investors to determine if they have properly reported taxable income relating to crypto. Where the IRS finds taxes due from cryptocurrency transactions, the Franchise Tax Board, California’s main tax enforcement agency, is sure to follow.

Why It Matters

California taxes residents on all their taxable income, from whatever source. In contrast, California taxes nonresident only on income sourced to California. Some income is easy to source. Rents from California real estate? It’s California source: California taxes that income even if the owner lives on the moon. Wages from working in California or selling a product in state? Same result, regardless of the taxpayer’s nonresident status.

Those examples are clear. But what happens if the source involves the trade or investment of an intangible asset? Then things get complicated, if not murky. What are the tax consequences of selling founders stock you own in a California startup for a $10 million gain and you now live full-time in Texas? If the proceeds aren’t sourced to California, you owe zero state taxes. If the proceeds are California-source, you might owe over $1.3 million. The same considerations arise with vesting stock options, sales of software, goodwill, trademarks, royalties. And the answer under California sourcing rules when it comes to intangibles is always: “it depends.”

Cryptocurrency falls into the intangible category. And because crypto is a relatively new class of assets, the rules that apply to California taxation remain out of focus. Continue reading

Study of Total Tax Burden by State: Some Expected and Not-So-Expected Results

Published on: June 30, 2019 | by Chris Manes

A recent study comparing the states by income tax, sales tax, property tax, average overall tax burden and average effective income tax rates, including dollar for dollar and by percentage, produced expected results about California’s high tax burden, but also some surprising insights. It wasn’t unexpected that California failed to appear in the lowest 10 states for any tax category. What was surprising for some, however, is that California didn’t appear in the top 10 states for any category except average overall tax burden, and sales taxes. In fact, this confirmed what residency tax planners should know as a matter of course: changing residency from California doesn’t equal tax nirvana for every taxpayer. The details matter. How much tax savings a residency change can produce, if any, or if indeed leaving California will result in a higher overall tax burden (to a taxpayer’s consternation), depends on numerous factors, including the destination state.

The study, carried out by HireAHelper, an online booking agency geared to people looking for moving services, used Bureau of Labor Statistics figures. It conforms to similar studies over the last decade or so.

The Results

The study showed that California’s average total effective state and local income tax burden (income taxes, sales taxes and property taxes) is – no surprise – in the top ten, in a dollar for dollar comparison. Only New York, Illinois, Oregon, Connecticut, New Jersey, Massachusetts and Minnesota exceeded California in this category. However, as a percentage, using median income, California is squarely in the middle of the states at 8.9%, tied with South Carolina, of all places. California is also not in the top ten states for effective income taxes, using a method of applying the average effective rate to the median income and expressed in dollars (that is, what median income taxpayers actually pay in dollars versus what they would pay based on marginal rates – but query whether that’s a helpful metric). As might be expected, California appears in the top 10 states with the highest sales tax rates.

Needless to say, the traditional zero income tax states of Nevada, Texas, Washington State, Wyoming, Florida, South Dakota and Alaska came out smelling like a rose in overall tax burden, and also in almost every other category. Continue reading

Five (More) Internet Myths About California Residency Rules

Published on: June 24, 2019 | by Chris Manes

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. Continue reading

Secured Promissory Notes and California-Source Income, Explained

Published on: May 11, 2019 | by Chris Manes

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

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

Leaving California, But Coming Back to Work: Income Tax Traps After Changing Residency

Published on: June 12, 2018 | by Chris Manes

It’s no trick to leave California to avoid its high income taxes – if that’s all you want to do. You can sell all your California assets, including your home, terminate all business contacts, never spend any time in the state after your move, close all your financial accounts, sever all your professional and social connections. And so forth. Taxpayers who leave California lock, stock, and barrel don’t really have to worry about residency issues (despite scary stories on the internet). But in fact, most people who change their legal residency from California have something else in mind. They also want to or have to retain contacts with the state. That might mean a vacation home or income properties; it might be managing a California business remotely, with operations in the state; it might involve working while in California, from meeting potential clients or investors to working at a branch of an employer for designated periods. The last situation, which is fairly common, requires planning, since changing residency may not be enough to avoid California income taxes if your work for an out-of-state or in-state employer brings you back to California.

When Changing Residency Isn’t Enough

A typical situation involves a business owner who changes legal residency and moves the business out of state. But it can also involve an executive who moves out of state, but still has to make business trips to California, because that’s where the company’s client base or operations are located. Well and good. Unless a taxpayer changes legal residency, everything else is moot from a tax perspective. But the fact is California is an economic powerhouse. Few businesses, especially those in high-tech and financial services, can succeed without participating in the California market. And that often means meeting with and cultivating potential clients or investors in Los Angeles or Silicon Valley, where the capital, expertise and demand resides, or spending time working at a California branch of the company.

If that’s the case, it’s important to understand the differences between personal residency versus doing business in California versus working while physically present in California. These are three separate tax circumstances, which require different approaches to manage. Continue reading

California and Nonresident Whistleblower Awards: No Good Deed Goes Untaxed – Or Does It?

Published on: January 27, 2018 | by Chris Manes

Whistleblower awards are big business. In 2016 alone, the IRS paid over $60 million to whistleblowers. The SEC awarded a similar amount. A patchwork of other whistleblower laws involving 57 federal statutes and 44 states, including California, also result in tens of millions in annual payouts. Not all whistleblower laws involve awards, but rather damages for retaliation. For instance, Penn State was ordered to pay coach Michael McQueary $12 million after firing him for reporting the notorious Jerry Sandusky to college officials. Though the amounts vary widely year to year, the trend is more tips filed, more whistleblower cases, bigger awards.

Whistleblower cases usually take a long time, with many obstacles along the way that can derail final payment. The average is three years. It’s a long wait, but it does provide an opportunity for tax planning for those who don’t want to be taxed by California for an award that can run from hundreds of thousands to tens of millions of dollars (my practice has involved tax planning for clients who received awards along most of this spectrum).

How Are Whistleblower Awards Taxed?

At the federal level, the taxation of whistleblower awards has been highly litigated and subject to Congressional tinkering. But the ultimate result is the proceeds of the award are taxed as ordinary income. How to calculate the amount of the “proceeds,” and whether a deduction for attorney’s fees (which are usually a large percentage of the award) is allowed, depends on the particular federal statute that applies. Continue reading