What’s Happening

Rarely has a potential change in tax law affecting so few taxpayers attracted as much attention as California’s 2026 Billionaire Tax Act. By definition, the proposed legislation, which takes the form of a ballot initiative subject to a popular vote, only applies to the rarified demographic of taxpayers with a net worth of a billion dollars or more, who are residents of California in a single tax year. That number is around two hundred and fifty individuals, at most, out of a state population approaching 40 million.

But of course, this proposed tax change reflects deeper political and economic conflicts at a national level, and marks a possible turning point in the Silicon Valley tech ecosystem.

This article doesn’t focus on the politics or tax policies of the BTA, but rather how California residency rules might affect the small number of high net worth individuals who may attempt to plan around it. If the measure gets a majority vote in November, the BTA has a retroactive “tax obligation date” of January 1, 2026, just a few short months after it was proposed. That means any billionaire who was a California resident on that date is subject to the tax (if it passes). But a much larger number of Silicon Valley founders and key employees find themselves in the same boat for different reasons under California’s general residency rules: the prospect of large income tax savings by changing residency at the last minute before an impending acquisition or IPO is finalized. The BTA may only affect a few individuals, but it represents a major issue of residency tax planning writ large: how do you change residency with an imminent taxable event about to touch down? It isn’t easy, though it can be done, with proper planning and the understanding of the details for changing residency by a specific date.

But first some background on how we got here.

Background

Like the redistricting proposition passed by California in 2025, the BTA was set in motion by policy disagreements between the major political parties in Washington DC. In the case of the BTA, it was the result of the 2025 federal tax bill that substantially cut funding for Medicaid as well as programs for education and food support. For California, a state with 15 million people dependent on Medi-Cal and other programs facing reduced federal funding, the federal tax changes raised the specter of a $30 billion budget deficit in the coming years. Even for a state whose annual budget exceeds $300 billion (which is larger than that of most countries), this potential shortfall was daunting. Some analysts conclude that the deficit may be structural, but there is no doubt the recent knives-out policy changes in Washington are the primary cause for the Act appearing at this particular moment.

In addition, the sheer magnitude of the BTA distinguishes it from most tax increases. While only applicable to a handful of taxpayers, by imposing a 5% tax on the net worth of billionaires, the Act is projected to raise $100 billion in revenue over 5 years, with much of that revenue derived from a single sector, the tech industry (about half of California’s billionaires are associated with Silicon Valley). If the projections are accurate, that would be about $20 billion a year, or about 7 percent of California’s annual budget, not taking into consideration the cost of the program. While proposed taxes on the assets of high net worth taxpayers have been kicking around the California legislature for several years, they never got traction until the deep federal cuts of 2025.

But even then, it was clear that a wealth tax wouldn’t make it through California’s often byzantine legislative process, which requires a two-thirds majority to enact tax increases. Governor Newsom has staunchly opposed wealth taxes in the past and publicly opposes the BTA. Democrats have a supermajority in the state legislature and can pass any tax legislation they want, but all the state senate districts in Silicon Valley are held by Democrats who either oppose the Act or have remained silent on the issue. As a result, the BTA came into being as a state-wide ballot measure sponsored by a major healthcare union, rather than going through the more predictable and visible legislative process. Almost without warning, it seems well on its way to obtaining the sufficient number of signatures to qualify for the ballot in 2026 (the deadline is in June 2026). If it does get on the ballot, as a citizen’s initiative, it only needs a simple majority to become law.

This sudden appearance on the tax radar scope has implications for the residency issues raised by the Act, in particular its retroactive application. And that is the real focus of this article, since the same fundamental rules affect anyone planning to change residency from California, even if the BTA itself only touches the thin upper stratosphere of taxpayers.

Where Things Stand

The BTA is expected to appear on California’s general election ballot in November 2026. That is, the midterms. This is significant since a midterm election will likely result in higher voter turnout than an off-year, primary, or special election. Presumably, it will raise the chances of the Act passing. It should be noted, however, that California voters have a long history of using the initiative process to actually reduce taxes, rather than raise them, the most famous example being Proposition 13. It isn’t a foregone conclusion that the BTA will be approved. It isn’t a foregone conclusion that it will even qualify for the ballot. On the other hand, initial polling data shows overwhelming support.

California and national media have been quick to report that a number of prominent figures in the tech and financial industries (the two are intimately related in California) have indicated that they are considering moving from California and re-domesticating their companies in lower income tax states. The prospect of an exodus of capital from Silicon Valley, affecting the entire tech ecosystem, has become inevitably linked to discussions of the BTA.

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The retroactivity provision was included for obvious reasons: if the Act didn’t affect taxpayers until it passed in November 2026, the incentive for billionaires to leave the state would have been overwhelming

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This may or may not happen in the long run. However, our contacts with officials at the Franchise Tax Board, California’s tax enforcement agency with respect to residency audits, indicate they aren’t worried in the short run, as applied to the BTA. The reasons involve the timing for changing residency and the difficulty of doing so on short notice. The caveat to this relates to the possible invalidity of the BTA’s retroactive provisions, discuss later in this article.

It’s on this issue that the BTA and the ordinary rules of residency planning converge.

Retroactivity And The Timing Of A Residency Change

If it does pass, the Act contains retroactive language purporting to impose a one-time tax on any “applicable individual” who is a resident of California as of January 1, 2026, even though the initiative can’t go into effect until the election at the end of the year. (As a reminder, the only applicable individuals must have assets with a fair market value of a billion dollars, minus debt and other exclusions, as of the valuation date provided in the Act, which by the way is also partially determined retroactively and proactively, involving a look-back for transferred assets and a present valuation of future interests). The retroactivity provision was included for obvious reasons: if the Act didn’t affect taxpayers until it passed in November 2026, the incentive for billionaires to leave the state would have been overwhelming, and they would have had plenty of time to do so. In fact, the original language of the Act had a retroactive effect date of January 2025, but that was abandoned as an overreach. It’s one thing for a state to impose a tax retroactively from the beginning of the tax year. It’s quite another to apply it to a prior tax year.

“Applicable individual” means, for the 2026 tax year, any individual who is a resident of California “within the meaning of Sections Rev. & Tax Code sec. 17014 and 17015.5.” These sections (along with their regulations) broadly define who is a resident for tax purposes and who is not. To determine whether a taxpayer is a resident or not under the code, California uses the “closest connection test.” The test deploys a body of rules, some intuitive, many not, involving comparing all the contacts taxpayers have with California vs. their home state, and weighing them, in totality. The contacts are often called the Bragg factors, after the leading case in his area, Appeal of Bragg (2003-SBE-002). They involve physical presence, living accommodations, official and non-official representations of residency, social and family contacts, location of professionals, assets, work. A discussion of the test is here.

But applying the Bragg factors by rote won’t insure a taxpayer is a nonresident. In fact, it can likely lead to the opposite result, particularly if a change of residency is at issue (as opposed to a nonresident who is establishing contacts with California, such as a second home or business interests). That’s because not all contacts weigh the same for residency purposes. The weightiest contacts in general, the ones that determine the vast majority of residency adjudication are (a) physical presence (time spent in California vs. the home state during the tax year), and (b) living accommodations (homes in California vs. a primary residence claimed in the taxpayer’s home state). But that too can be a trap for the unwary. The other categories involving what most people might consider trivial details can have a disproportionate impact on showing intent to change residency, which is always the starting point of residency planning involving a move from California.

To successfully claim nonresident status, a California resident has to first change residency, and that involves an entire body of secondary rules. Some overlap with the closest connection test. Some don’t. And the change of residency has to be completed before the taxable event.

For founders of startups and other taxpayers moving from California in anticipation of exiting their companies or otherwise recognizing gains from a liquidity event, that date is the date of the receipt of income. If the taxpayer takes all the actions necessary to change residency before the income receipt (which is usually the closing of escrow on a merger and acquisition or IPO), California can’t impose an income tax on it, unless it is California-source income (but that’s a different subject). The BTA isn’t an income tax; it’s a net worth tax. The timing doesn’t involve receipts of income. Under its retroactivity provisions, if the applicable individual was a resident on January 1, 2026, the tax is imposed, regardless of the timing of any receipts of taxable income. A subsequent change of residency won’t circumvent the tax (though as discussed later, it might do so if the retroactivity language is deemed invalid and it also might affect allocation of the tax among the states).

Changing Residency From California

California taxpayers (and their attorneys) who only focus on the closest connection text and the associated Bragg factors often overlook the first step in exiting California: demonstrating intent to change residency. This almost always requires occupying an abode in the taxpayer’s new home state with the intent to live in that state permanently or indefinitely. In a residency audit, the FTB doesn’t ask taxpayers what they intended (they would all say they intended to change residency). Rather it derives intent from conduct, applying an array of mostly nonintuitive rules that have arisen over decades as the result of regulations, case law, Chief Counsel rulings, and audit practices. Nobody was at the wheel in making these rules. To put this another way, residency status isn’t a subjective matter; it isn’t what taxpayers believe about where they reside, even if those beliefs are well founded. Rather, it is the result of a mechanical application of rules, which more often than not are nonintuitive, if not obscure.

More to the point, complying with those rules is often difficult to accomplish in a short period of time, particularly for taxpayers with long-standing and complex contacts with California. The FTB knows this and has an incentive to audit taxpayers who move shortly before a taxable event. Under the BTA, that date was January 1, 2026, assuming the retroactive provisions withstand judicial scrutiny. Thus, on its face, the ship has sailed for changing residency with respect to the Act, unless the change was made prior to the beginning of the year. But again, a possible escape hatch exists, discussed later.

Occupying, Not Just Buying or Renting

The first element of changing residency is rather obvious, but a surprising number of taxpayers don’t take it to heart. It’s not enough to own or lease an abode in the new jurisdiction. It has to be occupied. A taxpayer can buy the Palace at Versailles, but unless he goes there physically, turns the poignée de porte, and enters the premises with the intent to live in that jurisdiction going forward, he hasn’t moved there and his California residency status remains intact.

Moreover, the new dwelling has to be the sort of abode you can actually move into. Generally, a hotel or Airbnb won’t suffice since they are by definition temporary or transitory, and don’t lend themselves to moving the personal items that constitute the center of a taxpayer’s life, which goes to intent (our next topic).

A leased or rented apartment or home will do as a stopgap measure before buying or building a new home in the jurisdiction, but this raises the “interim home” problem, discussed here. If significant furniture and furnishing can’t be moved into the rental (because its already furnished or simply lacks the space to accommodate a move-in of items important for showing intent to live in the new jurisdiction permanently), then the FTB may dismiss the move-in as mere pretext. A subsequent move into a newly purchased or built home may suffice, but if timing is an issue, it may be too late.

Moreover, even if the rented property is amenable to a move-in of personal effects, it raises other problems. A rented property never compares favorably to property owned in California for personal use. To bring up Versailles again, a taxpayer who rented the palace and transported his belongings there, but still owns even an ordinary home in California as his former residence, he would likely lose in the living accommodations category. Owning residential real property has indicia of intent to live permanently in a jurisdiction that usually outweighs rentals of any magnitude.

Finally, a short-term lease is suspicious. It may defeat the claim of a move-in because it lacks the indications of permanency or indefiniteness, even if the taxpayer ultimately moves into a home they purchase. That, at least, is what the FTB usually argues in an audit involving a move-in date dispute.

All these problems are exacerbated when the move involves short notice to meet a deadline. Which again, for the BTA was the beginning of this year.

Center of Life and Intent to Change Residency

Occupying a home in the new jurisdiction is necessary, but not sufficient. In addition to physical presence, a taxpayer changing residency has to move his “center of life” to the new jurisdiction. Here it gets complicated or at least unclear. “Center of life” is a term of art in residency law. It isn’t clearly delineated in judicial opinions. However, what case law we have identifies items of sentimental value, such as family heirlooms, family photo albums, gifts, as indicative of moving the center of a taxpayer’s life. In addition, auditors usually focus on tangible personal property of monetary value, like jewelry and expensive artwork, as well as personal items such as electronic equipment, important papers, musical instruments, sports gear, a taxpayer’s best clothing, favorite lounge chair, best china, and so forth.

In short, these are the kinds of items people keep in their primary residence, not in a second home. They aren’t systematically listed anywhere in the law per se. The only way to get a full sense of what the FTB expects to see moved to the new abode is by having worked on numerous residency audits where the timing of the move is an issue. And giving the FTB what they expect in a residency audit is the best way to prevail in one.

What taxpayers absolutely must avoid is keeping these center of life items in their former California primary home (assuming they retain one, which for our clientele is usually the plan). In that case, the FTB auditor might conclude that the taxpayer’s new out-of-state home is just a vacation home, not a primary residence, at least until those items are in fact moved there. This is a common mistake of taxpayers (and their attorneys) attempting to change residency on short notice.

Note that center of life items don’t coincide directly with the Bragg factors. Most Bragg factors are “lagging indicators.” They need to get done as soon as possible as part of a change of residency, but most can’t be carried out by the move date itself. For instance, obtaining a driver’s license in the target state is a typical Bragg factor necessary to change residency. It’s in the official representations category. But taxpayers generally can’t obtain a new driver’s license without first moving into a permanent residence in the state. Every jurisdiction requires an application for the license to include a declaration providing a local street address identified as the taxpayer’s primary residence. But that means that the driver’s license won’t be issued until weeks after the move date (during the COVID pandemic it was often months). Bragg factors usually demonstrate intent to move, but only after the fact.

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If the taxpayers planned ahead and established a second home in a low income tax state, that also would make a last-minute move more feasible. That’s true for any taxpayer contemplating an exit, billionaires and non-billionaires alike

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Note further that details, often ones that seem trivial, matter in changing residency. For example, keeping a safe deposit box in a California bank after a move can undermine a claimed move date. Why? Because almost by definition safe deposit boxes store items that are valuable, either monetarily or for sentimental reasons, and those are exactly the sort of center of life items that need to be moved to the new home state in a residency change. Keeping personal property in storage in California after the move date can have a similar unfavorable effect.

Cost and Inconvenience

One of the fundamental principles of changing residency is that it almost always requires cost and inconvenience. The above examples demonstrate that.

For example, a taxpayer moving on short notice may have to enter a long-term lease if an interim home is part of the plan, even if the larger plan involves moving into a permanent home shortly after the move. It always requires moving center of life items to the new abode, even if there is no real practical purpose to that for taxpayers who can sustain two or more homes filled with expensive furniture and furnishings (which is exactly the type of taxpayer affected by the Act). It’s just a rule that has to be followed, even if it doesn’t make sense. And usually, the most onerous requirement is the limitation of time a former resident can spend in California. If a taxpayer moves to another state, and immediately returns to California, spending equivalent time or more time there than in their new home state for the balance of the year, it is almost foreordained that a residency audit will have an unfavorable outcome.

The Burden of Proof Problem

Even assuming a taxpayer does everything correctly in changing residency on a specific date before a taxable event, even assuming they endure the inevitable cost and inconvenience, it doesn’t help if the taxpayer can’t prove it. A residency adjudication is not like a criminal trial, where the prosecution has to prove its case, and the defendant can take the Fifth. Virtually every residency case opinion begins its analysis section with the words: “FTB’s determinations of residency are presumptively correct, and the taxpayer bears the burden of showing error in those determinations.” That means that the burden of proof is almost always on the taxpayer in a California audit to prove change of residency and when that took place.

In particular, taxpayers not only have to identify and transport the items that are central to their life, and account for their whereabouts, but they have to document the move. It’s important to inventory the items and memorialize for their transport to the new home state. This can take various forms: taking photographs, using a moving company, keeping invoices, retaining insurance policies for valuable items. And they have to keep track of their days in California and their home state (the comparison is between those two jurisdictions – time elsewhere doesn’t help taxpayers establish nonresidency). The statute of limitation on a residency audit is four years from the date of the filing of a California tax return. Usually, the pertinent return is a 540NR part-year return for the year in which a change of residency occurs, which is filed in the next tax year. The FTB rarely audits a former resident upon the filing of the 540NR part-year return. It usually waits at least another year to see what pattern is forming. And it can wait up to four years. The point is, years may pass before the taxpayer is audited. Without written documentation, a taxpayer is likely to forget many of the details of their move by then, as well as where they spent their time.

More than a few residency audits involving millions of dollars in taxes, interest, and penalties run aground because taxpayers (and their attorneys) fail to retain a “residency file” documenting the change of residency and subsequent compliance with the rules. There’s nothing the FTB auditors look forward to more than a disorganized taxpayer who can’t provide detailed documentation to support their claim of nonresidency because they didn’t keep supporting evidence.

The FTB Holding the Cards

Circling back, all this helps explain why the FTB doesn’t seem concerned about a pre-2026 exodus of billionaires. Assuming the retroactivity provisions are deemed valid, the window of opportunity for the individuals affected by the law was so narrow, and general knowledge of how to change residency (even among tax lawyers) so limited, that the FTB expects to taxpayers who opted to change residency to have made the common mistake of focusing on the Bragg factors, and not the intent factors. Where that happened, the result would likely be an unfavorable outcome for the taxpayer, which is commonplace in the more prevalent situation of founders and key employees exiting under an imminent deadline involving a liquidity event. Different circumstances, same problem. FTB auditors have seen this all before.

Of course, for the billionaires who did plan properly, if any, the FTB will face a difficult challenge. An auditor can’t prevail in a residency audit if center of life items were identified, transported, and memorialized in a context demonstrating intent to change residency on a date before January 1, 2026, and the lagging Bragg factors all support that conclusion.

Severability

Finally, there is an additional possible escape hatch for those who didn’t move before the January date, or tried to but failed to meet the intent requirement.

The BTA has a severability clause. It states that if any provision of the Act is deemed invalid by a court, the other provisions remain in effect. In particular, the Act requires that if a court finds the retroactive provisions unconstitutional, then the court must “preserve the imposition of the tax authorized, including by reforming dates or period specified, using the most limited adjustments possible to cure any constitutional or other legal defect.”

The purpose here is clear. The drafters of the Act knew that using a retroactive date would raise constitutional challenges. If those challenges are successful, the default date under the severability clause would likely be the date of the Act’s passage. Applicable individuals who are still residents on that date will owe the tax.

But note that this gives the taxpayers who didn’t move by the beginning of the year a second, if contingent, bite of the apple. Assuming those taxpayers move after January 1, but before the Act’s ratification in November, and assuming challenges to the retroactive application of the Act prevail, then a well-executed change of residency plan during the interim time period could survive a residency audit. And this time, it doesn’t involve moving on short notice, but doing so with many months to accomplish the move before the date the tax is imposed. It also provides a possible grace period for those who did attempt to move before the deadline, but didn’t get it right, for the reasons discussed in this article.

If the taxpayers planned ahead and established a second home in a low income tax state, that also would make a last-minute move more feasible. That’s true for any taxpayer contemplating an exit, billionaires and non-billionaires alike. See Manes Law’s article on pre-exit residency planning for startup founders and key employees.

That’s exactly the scenario the FTB does not want to face.

Of course, there’s a risk. If the Act’s retroactive date of application does survive judicial scrutiny, the change of residency, which is no simple matter as discussed above, would be for nothing, at least with respect to the 5% tax imposed on net worth. It would, however, protect non-California-source income received by the nonresident after the move date going forward.

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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, crypto-asset traders and investors, and taxpayers 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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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.

The post California’s Billionaire Tax Act: The Challenge of Changing Residency On Short Notice, For Billionaires and Non-Billionaires Alike appeared first on California Residency Tax Planning.

What’s Happening?

The digital economy has allowed increasing numbers of nonresidents to work remotely for California firms without becoming California residents, and even without paying California income taxes, in some cases. At the same time, more and more nonresidents find themselves being offered lucrative temporary employment in California. This is particularly true for software developers or other information technology and e-commerce specialists who are in high demand by California’s thriving internet firms to complete a particular project. But it’s also true for medical professionals, management strategists, actors, professional athletes, artists, corporate trainers, even part-time teachers in a specialty field. Top executives tasked with setting up a new branch for their business in the state may also find themselves in this situation.

What all these professionals have in common is project work. The employment in California is temporary in that it involves completing a particular project or term of service. It isn’t permanent or open-ended. Of course, temporary is a relative term. Some projects may only last a few months; others may require more than a year to complete. The issue confronting nonresidents working temporarily in California is whether they will be taxed only on their California-source income or become a resident in the eyes of California’s tax enforcement authority, the Franchise Tax Board, with the result that all their taxable income from any source may be subject to California taxation. To control that, nonresidents working in California should have a plan.

Why It Matters?

At first blush, it might not seem to matter much whether a nonresident working on a temporary basis in California is deemed a resident or not. The W-2 wages (for employees) or 1099 payments (for independent contractors) received while working on a project in California are usually taxable by California regardless of residency status. Where W-2 salary is involved, it’s all but inescapable because the work is performed in California, and California imposes an income tax on compensation for work discharged while physically present in the state. In the case of 1099 income, if the work is in California, that usually means the customer is also located in the state (the FTB uses “where the benefit is received” for sourcing independent contractor revenue). Accordingly, if all the income the worker receives during that tax year comes from the project, it won’t usually make any difference what his residency status is. See this article on the sourcing of W-2 compensation vs. independent contractor payments under California law.

However, if the taxpayer has other sources of income, it can make a big difference. California only taxes nonresidents on income sourced to California. But it imposes an income tax on residents with respect to all their income, from whatever source.  And the top rate is 13.3% (14.4% if the income is W-2 sourced to California).

People who work in IT and e-commerce often work on various projects at the same time, or they have an ownership interest in separate businesses which can produce significant non-California income. Or they may simply have investments in their home state or elsewhere which generate dividends or other distributive share of profits. If they are nonresidents working temporarily in California, the FTB cannot tax any portion of their income sourced to other states. But if they are residents, that income is subject to California income taxes.

Furthermore, the residency status of a worker in California who is married may have a profound impact on the worker’s nonresident spouse, particularly if the nonresident spouse lives in a community property state. In that case, if the worker is deemed a California resident, half of the nonresident spouse’s community income may be subject to California income taxes. This issue is discussed in detail in this article.

Finally, once a person is deemed a legal resident of California, it takes some doing to change residency to another state. It doesn’t automatically end when the employment in California does. So, the tax consequences of being deemed a resident can linger.

For these reasons, it makes sense for nonresidents with a temporary job in California to take steps to avoid becoming a resident for tax purposes, even if all their income for that tax year will be sourced to California in any case. For that, they need a plan.

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Generally, the employment agreement should be drafted to make clear you are a nonresident and you plan to return to your home state upon completion of the project or termination of the contract

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The Non-Rule Rule

On its face, the rule governing working in California is simple. If a nonresident moves to California for a temporary or transitory purpose, then he does not become a legal resident. Such a temporary purpose includes employment in California that is other than permanent or indefinite. But what constitutes temporary work in California? How long is it allowed to last? How is the temporary nature determined?

The regulations and case law offer some guidelines in answering these questions, but the real answer is, it depends on all the facts and circumstances under California’s “closest connection” test. California has few bright-line rules on residency status, and none of these applies to in-state temporary work. The FTB looks at all the contacts a taxpayer has with California vs. the contacts in the taxpayer’s home state, to determine legal residency. That includes employment or other work in California, which is usually accompanied by the establishment of other connections: vehicles, gyms, accounts, and most importantly, living accommodations. For a further discuss of the closest connection test, see this article.

Beware the Nine-Month Presumption

That doesn’t mean nonresidents are left totally adrift when it comes to determining what constitutes a temporary or transitory visit. Case law strongly suggests anything under six months will suffice for temporary work, if the taxpayer maintains their long-term contacts with their home state, and if the work agreements at issue are properly drafted with residency issues in mind. Anything over nine months runs afoul of the nine-month presumption. That presumption states that an individual who spends, in the aggregate, more than nine months of any taxable year in California is presumed to be a California resident. The presumption is rebuttable, but no case exists in which the taxpayer was able to rebut the presumption.

One FTB Chief Counsel Legal Ruling stated that the nine-month presumption could be rebutted if the taxpayer was in California for a single purpose, while keeping all their main contacts with their home state, and only stayed as long as necessary to accomplish that purpose before returning to their home state. An FTB Legal Ruling isn’t a court decision, but rather a published interpretation of California income tax laws by the FTB. It doesn’t have force of law, but has persuasive value in a court case, similar to an IRS Revenue Ruling. This particular case involved a nonresident student attending college in California. But the equities would also seem to apply to temporary work in California.

That said, why risk it unless absolutely necessary? It’s prudent to give the nine-month presumption wide berth if at all possible.

Other Items in the Nonresident’s Control

There are a number of other basic considerations beside time that nonresidents working in California can plan for to control their residency status. Some are relatively easy to manage. Others may take some planning and expense. Two of the most important considerations are the employment contract (or independent contractor agreement) and living accommodations.

The Employment/Independent Contractor Agreement

Nonresidents working temporarily in California should have a written employment agreement with their employer (sometimes the agreement is for an independent contractor, but the principles are similar). If there is no written contract, the FTB may presume the employment is permanent or indefinite, and that can confer residency status. The burden will then be on the taxpayer to prove the job wasn’t intended to be permanent, which may be a difficult task several years after the work ended when an audit might start. Accordingly, the contract itself should spell out the “term” of the employment – that is, when it will begin and end. That can be expressed as a definite period of time, or the accomplishment of a task, which is often the case when the job involves an IT project. The agreement should not have a renewal clause. In a perfect world, the term shouldn’t exceed nine months, due to the nine-month presumption problem. But even if it is for more than nine months, the nonresident should make arrangements for keeping his actual physical presence in the state under that period, if possible, using time off to make trips out of California.

The contract should also set forth the “duty days” required for the project. For a discussion of “duty days” see the above link for “Nonresidents Working Remotely For California Businesses.” Even if the contract is full-time and lasts the entire year, this can be important if, as is often the case, the project requires you to work both in and outside of California. The W-2 salary related to the work while in another state is not taxable by California, if you maintain your nonresident status (note that the same isn’t the case for 1099 income).

If the contract involves high wages and includes sophisticated financial and intellectual property relationships, such as noncompete or nondisclosure clauses (as is often the case with IT contracts), then the payments should be allocated between wages and the other items, if possible. While the wages are completely taxable by California to the extent they are earned while working in state, the other items may not be. Noncompete agreements, for instance, involve a complex allocation of payments between California and other states if they reach outside of California.

Generally, the employment agreement should be drafted to make clear you are a nonresident and you plan to return to your home state upon completion of the project or termination of the contract. This should include tax provisions specifying that the company’s reporting requirements, including withholding, will treat the taxpayer as a nonresident.

Living Accommodations

Even with a properly drafted employment contract, nonresidents can still find themselves facing an FTB residency audit if their choice of living accommodations is not well thought-out.

In a perfect world, the nonresident temporary worker will not give up his residence in his home state. That may be easier said than done if the project is going to last for more than a few months. And that’s especially true if the taxpayer only rents in his home state, which is common among younger employees. Maintaining two households may be financially prohibitive. But if it’s not, it should be pursued. There are costs and inconveniences in maintaining nonresidency status while having significant contacts with California. This may be one of them.

But even if you have to give up your home-state residence, that doesn’t automatically make you a resident of California as long as it is clear your stay here is temporary. The way to signal that is to avoid a long-term lease for your California accommodations. In a perfect world, you should stay in a hotel, but again, that might not be practical if the contract lasts for more than a few months. In that case, a short-term or month-to-month rental should be used.  Some firms, especially in the IT industry, offer short-term living accommodations for temporary workers. If they do, take the offer.

Plan Your Contacts

Along with the living accommodations comes a whole host of contacts you need to plan for: what vehicle to use, where to tell your employer to send your tax documents such as W-2s, where to store your furniture and furnishings if you give up your home-state accommodations, where to vote, what bank to use, how your social media reports your new job. These should be dealt with systematically and not left to chance. Remember, the FTB looks at all the facts and circumstances, all the contacts you have with California vs. your home state to determine residency status, not just one thing or another.

What Happens Next?

While working in California you will ordinarily be subject to the withholding and payroll taxes facing any resident employed in California. You’ll file a nonresident California tax return in April of the next year (a Form 540NR), or October if you file for an extension. If all goes well, the FTB will accept your nonresident status, and you won’t hear from them again. If, however, they send you a notice asking for documents or information about your claim of nonresidency (i.e., an audit), at that point you should seek tax counsel. Since there is a four-year statute of limitations on filed California tax returns, you should keep records of your work in California in a “residency file,” in case of an audit, for at least four years from the date of the filing.

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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, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services 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.

The post Nonresidents Working Temporarily in California appeared first on California Residency Tax Planning.

 A recent poll of adult California residents shows the vast majority are satisfied with the state, but about 40% are considering leaving. Only 18% of those say they are considering a move “very seriously.”

The major reason given for a possible move is economic: over 60% say living expenses are motivating their planning.

The post Are 40% of Californians on the Verge of Leaving the State? Not Really, But a New Poll Tells a Tale of Discontent appeared first on California Residency Tax Planning.

The Issue

After years of wrangling with the issue, California has just enacted legislation to eliminate a state income tax savings strategy some California residents have pursued by establishing a non-grantor gift trust (ING). These trusts are often called WINGs, DINGs, and NINGS, a reference to the three states that first marketed them: Wyoming, Delaware, and Nevada. INGs can offer significant federal estate planning advantages. But they also allow residents of states with high income-tax rates, like California, to avoid paying state taxes on undistributed non-California-source income. The income can then grow free of state income taxes in the trust and be distributed later to the taxpayer (presumably after moving to a state with lower income taxes), or to their beneficiaries. But the new legislation has nullified the state tax benefits for California residents, leaving taxpayers who pursued the ING strategy in the lurch.

Background

INGs were designed by estate planning attorneys to protect assets and potentially reduce federal estate taxes. This means that they are primarily used by high-income and high-net-worth taxpayers. The benefit of the estate tax is derived from two characteristics of INGs (which can also play into the state residency tax planning). First, an ING is an irrevocable trust, and hence a separate taxpayer from the grantor (the person who established the trust). And second, the assets transferred to an ING by the grantor are deemed an “incomplete gift” by the IRS, because they remain under the grantor’s ultimate control. As a result, the value of the assets is not counted against the grantor’s lifetime gift tax exclusion ($12.92 million as of 2023). This can provide a substantial estate tax benefit for high-net-worth individuals. It means they can transfer more value to their beneficiaries free of the federal estate tax (though the current income is subject to federal taxation at compressed federal trust rates).

So much for the federal tax advantages. But INGs also proved to be an effective way for grantors in states with high income taxes to reduce their state tax burden. Due to a number of IRS private letter rulings stating that undistributed income from an ING is not included in a grantor’s gross earnings, and the fact that California generally conforms to federal tax treatment of trusts, California residents who set up INGs in states that didn’t tax these trusts did not have to report the income on their California tax return. This contrasts to a typical living revocable trust, whose income is included in the grantor’s gross income, whether distributed or not. If the income wasn’t California-sourced (for example, because it derived from the sale of intangible assets, such as appreciated stock), then the ING did not have to pay California income taxes as long as the trust followed the formalities that made it a non-California trust. Accordingly, INGs were marketed to California residents as a way of shielding non-California-source income from the state’s high tax rates without requiring them to change residency.

The idea was that the grantor with an ING could ultimately move to a state with lower tax rates at the taxpayer’s leisure, presumably upon retirement, and then receive the income accumulated in the trust free of California income taxes. California grantors got to have their cake and eat it too, as long as they ate the cake later.

How INGs Work

As an example, a California resident creates an ING in Wyoming (a WING!) and funds it with valuable, appreciating stock. After waiting a reasonable period of time (to avoid IRS scrutiny as an abusive tax shelter), the trust sells the stock. The result would be that neither the resident nor the trust is liable for state income taxes. Wyoming has no state income taxes, so it taxes neither the trust nor the grantor. California can’t tax the trust because it’s a separate taxpayer with no situs in California and the income is not sourced to California. California can’t tax the resident because the income wasn’t distributed, and hence, isn’t included in the resident’s gross income. Ultimately, the goal would be for the taxpayer to move from California (perhaps to retire), at which time the WING could distribute the income free from California income taxes, because upon receipt the taxpayer is no longer a California resident, nor is the income sourced to California. The taxpayer also has the alternative of distributing the income, at any time, to the trust’s beneficiaries, presumably children. The tax consequences of that depend on where the beneficiaries live. Finally, the income could remain in the ING until the grantor’s death, at which time it would be subject to federal estate tax rules (but again, free from California taxes since California doesn’t have an estate tax).

INGs’ Impact on California Tax Policy

As you can see, INGs are rather complicated to administer. And they are expensive to establish. They only make sense for taxpayers with high net worth and high income. Accordingly, only a small number of taxpayers nationwide have ever used INGs to shield their income from state taxation. The number estimated for California is negligible: about 1,500. That said, it’s also estimated that the actual undistributed income in complex trusts in the ING states in recent years is anything but small. It could be as high as $6 billion. While only a portion of those trusts are INGs, even a small portion of $6 billion is significant – a fact not lost on tax agencies from high-income states, including California.

New York responded aggressively in 2014, “decoupling” the federal estate tax benefits (which the states do not control) from the state income tax treatment. The New York anti-ING legislation required grantors to include ING income receipts in their individual gross income for state income tax purposes. This nullified any state tax benefit of INGs for New York residents. The Franchise Tax Board, California’s tax enforcement agency, took note and called for the California legislature to follow suit, estimating that a proposed anti-ING law would result in an extra $20 million, more or less, in state revenues annually. The result was the new Section 17082 of California’s Revenue and Tax Code.

The Details

Section 17082 is similar to New York’s anti-ING law. Residents with INGs are required to include the taxable income of the trusts in the gross income reported in their individual California tax return, regardless of where the ING is located. It disregards the ING as a separate taxpayer, and instead treats it as a typical revocable trust, with trust income attributed to the grantor, whether it is distributed or not. Grantors who are residents of California pay income taxes on all their taxable income from whatever source. With a stroke of the governor’s pen, the ING strategy to reduce California residents’ income taxes vanished.

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California residents who relied on INGs to avoid paying income taxes on non-California-source income in 2023 are left high and dry

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Unlike the New York statute, however, the California law is retroactive to January 1, 2023. New York allowed taxpayers to decant or liquidate the ING during a six-month grace period after passage, in order to allow ING grantors time to adjust their asset and tax planning. Section 17082 has no such indulgence. There is no requirement that INGs be wound down under the new law, but the state tax protections of INGs are eliminated even for six months in 2023 before the law was enacted.

What This Means (and Doesn’t Mean) For California Residents with INGs.

California residents who relied on INGs to avoid paying income taxes on non-California-source income in 2023 are left high and dry. Any income receipts in 2023 – even those received before the law went into effect – will be includable in the taxpayer’s gross income for California income tax purposes. Changing residency from California at this point won’t affect the adverse tax treatment of the income receipts already on the books. It’s dollars under the bridge.

As to planning now that the law has been passed, this issue could be a particularly acute problem for residents who anticipate their INGs will experience a large liquidity event in 2023. If a receipt of large amounts of taxable capital gain occurs this year, and the taxpayer is a resident at the time of receipt, the gains will be included in the resident’s California gross income. The taxpayer needs to hit the reset button on that. The non-residency related issues for continuing the trust or liquidating it should be discussed with estate counsel and wealth advisers. As to the California income tax issue, the default strategy remains what it always has been: taxpayers can only eliminate California income taxes on non-California-source income by changing residency before the receipt of income occurs. That might require considerable, swift readjustment in their tax planning.

That doesn’t mean INGs still don’t have federal estate tax benefits. They do. If that was the main purpose of a taxpayer’s use of an ING, and changing California residency is not an option, then there may be no reason to decant or otherwise liquidate the trust. That should be discussed with estate counsel and wealth advisers. However, if state tax savings was the primary motivation, then the taxpayer has to seek another strategy, which basically comes down to changing residency.

Also, tangentially, for residents who leave California but retain a second home in California, having the property in an ING may have benefits in a residency audit if status is the issue. INGs are irrevocable trusts and remain separate taxpayers for federal purposes. If audited for residency, it’s always better not to own property in California. But be aware that the amount of control ING grantors retain over trust assets weakens this argument. There are better ways to use irrevocable trusts in residency planning. Again, a frank discussion with estate counsel and wealth managers is in order to evaluate the overall usefulness of the ING. But for California residency purposes, there is no substitute for planning to change residency status.

To summarize the bad news for California taxpayers who established INGs for residency tax purposes, it’s all for naught going forward.

Conclusion: Back to Basics

INGs have always been a complex, expensive, and uncertain way to reduce California income tax. They always had a big target on their backs. And now the target’s been hit. For California residents who established an ING to avoid California income taxes on their non-California-source income, 2023 is likely to be an annus horribilis. Any taxable ING income receipts in the year to date, even those before the passage of the new law, won’t escape California income taxes. As for the balance of the year, the only recourse this group of taxpayers may have at this point is a hasty change of residency, if the goal is to shield non-California-source ING income anticipated by the end of the year. Delaying the receipts, if possible, may buy some time (talk to your wealth and tax professionals about that). But ultimately there remains only one sure way to protect the income from California taxes: changing residency.

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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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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.

The post The Nonresident ING Fling Dinged: California Closes the Incomplete Gift Tax Trust “Loophole” appeared first on California Residency Tax Planning.

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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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.

The post Moving to California After a Liquidity Event: A New FTB Case Highlights All the Mistakes Nonresidents Can Make appeared first on California Residency Tax Planning.

The Issue

​If you’re in the habit of reviewing California residency cases (and only a tax attorney specializing in the field or a masochist would be), you will occasionally come upon a reference to the Franchise Tax Board’s “Integrated Nonfiler Compliance” system, sometimes called the INC program. The court opinion will mention that the audit was initiated under INC and move on from there. This article discusses how this somewhat secretive program works, and how it affects a nonresident’s risk of a California residency audit. Understanding INC is central to residency planning, particularly for former residents who no longer file tax returns in the state.

Good News, Bad News

The good news is that nonresidents are often in control of the actions required to minimize that risk. The bad news is it usually takes a concerted, systematic effort to avoid the INC system. A single mistake can earn you a residency audit.

Which Nonresidents Does INC Target?

The INC system only targets a certain subset of nonresidents. Specifically, as the somewhat sinister name indicates, it focuses on nonfilers. For nonresidents who in fact file a nonresident California tax return (Form 540NR), the FTB doesn’t need INC to decide whether to audit for residency or not. That’s because a 540NR delivers most of the relevant information to the FTB on a silver platter. The 540NR requires a nonresident to disclose the number of days spent in California during the tax year, ownership of California residential property (directly or indirectly through an entity or trust), and perhaps most importantly the nonresident’s global income. That’s usually more than enough material for the FTB to decide whether to pursue a residency audit, or at least to provide grounds for investigating the taxpayer further by reviewing available databases (including Google and Zillow) before deciding to go forward.

For nonfilers, the FTB doesn’t have any of that information. The purpose of the INC system is to provide some preliminary facts about nonresidents who don’t file a nonresident return in order to ascertain whether it makes sense to initiate a more formal information-gathering procedure. Usually that procedure is a 4600 Notice “request for tax return,” rather than a full residency audit. But a 4600 Notice is often the prelude to the more grueling full audit. For the details about what a 4600 Notice entails, see this article: California’s 4600 Notice “Request For Tax Return” – The Definitive Guide for Nonresidents.

In any case, if you are a nonresident who files a 540NR, you don’t have to worry too much about the INC program, but for all the wrong reasons: the FTB already has you on their radar scope. It should be noted, however, that averting the situations that fuel the INC process is a good idea in general in case you are in fact audited. In contrast, if you are a nonresident who doesn’t file a California tax return, then it’s important to know how INC works in order to prevent getting caught in its net.

The INC system is designed to identify nonfilers of any sort, nonresidents and residents alike. But this article focuses only on nonresidents, and as a factual matter the bulk of the notices generated by the INC system go to out-of-staters.

How The INC System Works

For the most part, when it comes to residency audits, the FTB is like reef coral – it sits and waits for unfavorable information about a taxpayer’s residency status to float by Sacramento. This happens with remarkable regularity, and is usually due to common mistakes made by nonresidents. However, the INC system is one area where the FTB takes the initiative in collecting residency-related information to investigate an individual’s residency status. Here’s how it works.

In the normal course of its operations, the FTB receives more than 500 million documents each year from federal and state tax agencies, financial institutions, municipalities, and other sources. The FTB inputs the information into the INC system, which runs a comparison with FTB records to determine whether a tax return has been filed by individuals who appear (using the system’s particular algorithms) to have reportable California-source income or otherwise may have filing requirements. The nonfilers on that list are then sent a 4600 Notice or other applicable demand for more information about their residency status.

The algorithms aren’t particularly discerning. Almost all the noticed nonresidents are able to resolve the matter in their favor, because in fact they can show they are nonresidents and don’t have a requirement to file a return. But it takes time and trouble to respond adequately. And a small percentage may wind up in a residency audit (or face a notice of proposed assessment if they fail to timely respond to the notice and default, which often happens with nonresidents with seasonally unoccupied second homes in California, where the notice may lay unanswered for months). But that’s neither here nor there for the FTB. The point of the system is to automatically notice taxpayers who may be worth investigating, and whose response provides the information the FTB needs to make a decision about whether the situation merits a residency audit.

By the way, while the vast majority of nonresidents who get caught in the INC system ultimately don’t have to file a nonresident return and are let off the hook, some in fact do owe California income taxes and may have to file a return as a result of California-source income. The reason may be as simple as spending lengthy vacations at a second home in California while working remotely for an out-of-state company for W-2 compensation. See the article: Working While Vacationing: The Perils of California Source Rules for Nonresidents. Or they may have angel investments in California that start generating profit after a long startup period, reflected in a K-1. Or they may rent out their second home when they aren’t using it. For most people, the amount of taxes may be minor. But for high-income nonresidents with significant California contacts, it’s all the more reason to discuss this matter with their CPA before receiving a notice from the FTB and facing the prospect of penalties and interest.

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The category that triggers the most FTB inquiries to nonresidents are information tax returns. By far

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Worse still, a few such taxpayers not only have to file California tax returns, but also maintain such extensive contacts with the state that they are in fact legal residents under applicable rules. Those taxpayers need to seek legal counsel in preparing a residency plan to avoid what might be a catastrophe. The test used by California is discussed here.

The INC Database

While the INC system receives hundreds of millions of documents, the categories that count with respect to residency audits are quite limited. They can be reduced to the following: information tax returns with your tax ID and a California address on them (Form W-2s, 1099s, 1098s, K-1s, etc.); active professional/occupation licenses issued by a California board; IRS audit reports for taxpayers with California addresses; business licenses with California addresses.

Let’s discuss each category separately.

The Big One: Information Tax Returns

The category that triggers the most FTB inquiries to nonresidents are information tax returns. By far. A typical situation involves a former resident who retains a second home in California (a former primary residence) after moving out of state, without systematically informing the entities that generate information tax returns of the taxpayer’s residency change. As a result, 1098s from mortgage lenders, 1099s from financial institutions, K-1s from investments, and so forth, continue to be sent to the California address. The nonresident may think nothing of it since they collect all the information tax returns at their second home during tax time anyway, just like they did when living as a California resident.

But the FTB doesn’t look at it that way. The INC system interprets information tax returns with a California address for the taxpayer as an apparent admission that the taxpayer lives in California. If the nonresident doesn’t file a return, a 4600 Notice is automatically sent, untouched by human hands.

In contrast, if the taxpayer did change the home address on the information tax return, then it’s still possible the FTB will inquire into the taxpayer’s filing or residency status, if the information tax return gets to Sacramento. But it isn’t automatic. An FTB examiner has to review the information to see if the situation appears innocuous or not (usually it is). For instance, if a 1098 Mortgage Interest Statement shows an encumbrance on a California home, but the taxpayer’s address is out of state, the examiner usually gets the picture that the taxpayer is a nonresident with a vacation home in California. The number of houses owned in California by nonresidents isn’t well researched, but a decent estimate is 200,000 units (there are about 7.5 million second homes nationally, with about an eighth of that number located in California, with indications that a third of that number involves nonresidents). Given that high figure, there’s little incentive for an examiner to audit a nonresident with a second home in California unless there are other indicia of residency or income-sourcing issues.

The same is true for 1099s from banks and brokerage firms. Every year, the FTB gets thousands of 1099s from financial institutions in California with out-of-state addresses for the taxpayer. That set of facts by itself usually doesn’t warrant further investigation.

IRS Revenue Agents Reports

Another consequential input to the INC system involves information provided by the IRS. Due to strict confidentiality rules, the IRS doesn’t share taxpayer data helter-skelter with the FTB. But it does provide certain details regarding federal tax audits involving taxpayers using a California address on a federal return. The targets are taxpayers who understated their federal income, or failed to file a federal return when required, and got caught, resulting in an unfavorable IRS revenue agent report.

So why would a nonresident use a California address on a federal return? The answer usually is, by mistake or out of misplaced emphasis on convenience. Some former residents leave the US to live overseas and use a relative’s or friend’s house in California as their address to make sure any notices from the IRS reach them in a timely manner. Some taxpayers move out of state but continue to use their former residence (converted to a second home) for tax contact purposes out of sheer habit. Or they mistakenly think that they should use their California address for a prior year return because they were residents in that year, even though the IRS filing occurs after they left California. Whatever the rationale, it’s never a good idea.

Note also that the IRS audit may involve a return going back a number of years. A substantial underpayment, for instance, could be audited up to six years after the filing. It then may come as a complete surprise to the nonresident to get a 4600 Notice out of the blue for a tax year that is a distant memory.

The takeaway is simple: never use a California address on a federal return once you move, even if you were a resident in the tax year at issue. But by “never” I mean, unless your CPA, having reviewed your tax return, says otherwise. All tax return filings are unique.

City/County Business Tax Program

The INC system includes information sharing with cities and counties that impose local business taxes. The way it works is, participating cities send the FTB their business license data. The FTB then matches this information with its records and sends notices to taxpayers with business licenses who didn’t file a tax return. The FTB reciprocates by correlating tax return data to the business license information to identify taxpayers who reported business income but have no city business license. The state legislature even passed a law to encourage this cross-referencing: Rev. & Tax. Code Section 19551.1 et seq.

It sounds slightly Orwellian, but I’ve only seen a few cases of 4600 Notices being issues on this basis. The information usually involves rentals subject to municipal codes, or businesses run out of a second home while the nonresident is in California. Needless to say, nonresidents who rent out property in California or run a business from a second home should consult their CPAs about their California filing requirements. It’s quite likely they have to file nonresident returns.

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This seems to be braggadocio on the FTB’s part, an attempt to make nonresidents feel they are being scrutinized more closely than they actually are

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By the way, as an aside, it’s not the end of the world to have to file a nonresident return. It does, however, usually increase your residency audit risk, especially if you spend significant time in California. Some attorneys advise nonresidents to file a nonresident return even if they don’t have to (that is, a zero-income-tax return), if only to start the clock on the statute of limitations. But that can be a bad idea if the profile projected in the return indicates residency (high income, significant time in California, ownership of a large, expensive home, a large liquidity event  shortly after changing residency, even if in another tax year, and so on). But that’s a separate topic.

Professional (Occupational) Licenses

The FTB purports to use occupational license information to identify nonresident nonfilers. Usually, this would be former residents who retained professional licenses in California after their move. This typically involves difficult-to-obtain licenses which nonresidents are loath to give up: attorney bar memberships, medical licenses, CPA certifications, licenses for real estate brokers, financial advisers, contractors. The INC system purports only to be concerned about active licenses, so the obvious way to defang this problem is to change the license to inactive status, if that’s possible. If not, a nonresident runs the risk of the FTB starting an inquiry based on an active professional license. But frankly, the risk appears to be de minimis. In twenty-five years of practice, I’ve never seen a 4600 Notice or other residency-related procedure initiated due to license information finding its way to the FTB. That’s why I use the word “purports.” This seems to be braggadocio on the FTB’s part, an attempt to make nonresidents feel they are being scrutinized more closely than they actually are.

But if you are audited, active professional licenses do count against you, so some thought has to go into managing them after moving out of state, even if that means giving up a hard-earned certification.

The Takeaway

The INC system has been around for decades. It sweeps up thousands of nonfiler nonresidents every year. But only a small percentage actually wind up having to file a return or endure a full-fledged residency audit. That said, you win 100% of the audits that never happen, and one line of defense for reducing residency audit risk is eliminating contacts used by the INC system to trigger an inquiry. The boogeyman here is usually an information tax return. Nonresidents should be scrupulous in avoiding a California home address on any such return. Further, any of the contacts that set off the INC system, even the uncommon ones, are for the most part the kinds of contacts a nonresident should avoid regardless, INC or no INC. An ounce of prevention is worth a pound of arguments with an FTB auditor.

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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, crypto-asset traders and investors, 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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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.

The post California’s “Integrated Nonfiler Compliance” System: How it Affects Nonresident Taxpayers appeared first on California Residency Tax Planning.

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.

Overview: Good News, Bad News

The good news is in most cases the Notice is a result of a mistake or some misinformation, discussed below at length, which can often be easily explained, resolving the matter. The bad news is, in some cases the Notice may put at risk the recipient’s nonresident status if they haven’t been careful in planning how their contacts with California compare with their home state. This is particularly true for former residents who recently moved from California, retained substantial connections with the state, and may not have disentangled themselves sufficiently from California residency to meet the legal standard. But it also can raise problems for longstanding nonresidents who have been spending more time at their California vacation home than their primary residence. The 4600 Notice is not the start of an official residency audit, but in cases like the ones just mentioned, it can be the prelude to a full audit if a proper, timely response isn’t made.

4600 Notice Risk vs. Audit Risk

There is a vast difference between the magnitude of California’s 4600 Notice program and its residency audit regime. Despite internet myths that California issues residency audits as readily as Netflix issues another crime drama, California is actually somewhat sparing in bringing full residency audits. The restraint is not out of the kindness of the FTB’s heart. It’s a simple matter of resources. California’s residency rules are complex, and a great deal of resources have to be expended to make a residency adjudication, even where the circumstances are relatively simple; not to mention the fact that California has a population of about 40 million highly mobile people. In contrast, the State of New York audits virtually every taxpayer in the top brackets who leaves the state, a task made feasible due to the fact that New York’s residency rules are notably straightforward.

In short, the risk of a nonresident being audited for residency is low, except for those in specific high-risk categories (high income, a residency change shortly before a large liquidity event, marriage to a California spouse, work performed while physically present California for a significant amount of time, etc.). But unlike residency audits, 4600 Notices are issued by the bucketful. In 2019 over 430,000 4600 Notices were sent to nonfilers, according to FTB’s annual report to the legislature. Over half of these led to nonfilers filing a return. Not all of these taxpayers were nonresidents. But a large percentage were. Accordingly, the risk of receiving a 4600 Notice is high and somewhat indiscriminate compared to the risk of being audited for residency. The problem is, as discussed in this article, the 4600 Notice itself can increases the risk of a residency audit.

The Purpose of a 4600 Notice

The official purpose of the Notice is to instruct nonfiler recipients to either file a California tax return for the activity referred to in the Notice or provide an explanation of why they aren’t required to. Hence the “Request for Tax Return.” The Notice should be distinguished from a “Demand for Tax Return,” FTB Form 4684B, which is directed at out-of-state companies ostensibly doing business in California without filing the required returns.

The Notice is accompanied by a “Reply to FTB” questionnaire, which the nonresident must use if claiming a California tax return isn’t required. The questionnaire is potentially problematic. It can cause trouble for recipients who have been lax in establishing or maintaining their nonresident status. The FTB uses the questionnaire to gather financial/tax information: a person’s global income, where they work, what sort of California real estate they own. Needless to say, an entrepreneur or actor making $1 million a year and spending significant time in a Malibu beach house is likely to get more scrutiny from the FTB than a minimum wage worker.

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The FTB isn’t searching out the information. It’s like coral: it just has to wait for taxpayer information to come to it, usually by mistake

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The Deadline

The first page of the Notice will always indicate the due date for responding. It is critical that recipients either reply by the deadline or get an extension. Failure to timely respond can result in the taxpayer losing various administrative rights, and it usually means the FTB will issue a Notice of Proposed Assessment, which is much more difficult and costly to respond to than a 4600 Notice. Therefore, the first thing a recipient should do is calendar the deadline. It’s usually about 30 days from receipt. Most nonresidents receiving the Notice should retain a tax professional to assist in the response, so prompt action is in order.

A 30-day extension to the due date can usually be obtained merely by calling the number on the Notice and requesting it. The FTB’s historic practice has been to grant the first extension no questions asked. A second extension is another matter. That usually requires the assistance of a tax professional to jump through the hoops.

What Triggers a 4600 Notice?

4600 Notices are triggered by different kinds of tax or financial information coming to the attention of the FTB with respect to nonresidents who don’t file a California tax return. For the most part, the FTB isn’t actively searching out the information. It’s more like coral: it just has to wait for taxpayer information to come to it, usually by mistake. And this happens with alarming regularity. In the vast majority of cases, the information involves an official tax document, such as a Form W-2, 1099, 1098, K-1, etc., known by the IRS as an “information tax return.” If the information tax return involves a California-based payor or has a California address for the nonresident (which it never should, but often does), wheels start turning. The concept is, if an information tax return contains either type of data, the FTB has reason to believe that the recipient may be receiving California-source income or may be a resident, which if true, a California tax return would have to be filed. At that point, once the information tax return indicating a filing requirement makes its way to Sacramento, the FTB has to be persuaded otherwise, using the reply questionnaire.

The Integrated Nonfiler Compliance Program

That’s not to say the FTB is entirely passive when it comes to acquiring the information that might lead to the issuance of 4600 Notices. Since 2004, the FTB has had in place the so-called Integrated Nonfiler Compliance Program. The program is essentially a data base of tax and income information, which the FTB can then cross-reference with taxpayers who haven’t filed California returns. The information involves not only the aforementioned information tax returns, but also federal returns using a California address, occupational and professional licensing data, which the FTB culls from the records of California’s licensing boards (such as the State Bar of California, the California Board of Accountancy, the Contractors State License Board, and so forth), and even car leases (at least, the FTB has indicated it reviews vehicle lease data; I have never seen such a case in over 20 years of practice in this field, and I expect it is empty braggadocio on the FTB’s part). If you read appellate cases on residency, the INC program is sometimes mentioned as the procedural trigger of the action, resulting in a 4600 Notice being issued, leading to a notice of proposed assessment, and ultimately an appeal.

Automatic vs. Discretionary Notices

Information tax returns will automatically trigger a 4600 Notice if it has a nonresident’s name, tax ID number, and a California address, such as a vacation home or business address, and the taxpayer didn’t file a nonresident return (the last item applies to the vast majority of nonresidents). The FTB uses an algorithm to cross-reference the two conditions, as part of the INC program. Where both exist for a particular taxpayer, the result is a Notice being sent. In other words, an information tax return with a nonresident’s tax information sent to a California address almost inevitably provokes a 4600 Notice. The vast majority of 4600 Notices are issued under this automated system (over 360,000 in 2019, about 85%). For this reason, it’s critical that nonresidents who do not file California tax returns, never use a California address for any K-1, 1099, W-2, etc. It invites the problem.

To give an example of a common mistake. If the nonresident owns a second home in California, and has a mortgage on it, the mortgage lender will generate an annual Form 1098 Mortgage Interest Statement, reporting the interest from the loan to California tax authorities. If the nonresident uses the address of the California property in the “Payer’s/Borrower’s” section of the form (rather than using their primary out-of-state residence), then as far as the FTB algorithm can tell, there is a person living in a house in California (often a big expensive house, which can often be discerned by the size of the mortgage), but hasn’t filed a tax return.

But the Notice may also be sent when the information tax return appropriately uses an out-of-state address for the nonresident. In that case, however, an examiner needs to review the information to see if it indicates that a tax return is required. It’s discretionary. That decision to send the Notice will turn on whether the information tax return involves a California-based business or financial institution, which might indicate the nonresident is receiving California-source income, or working while in California, or hiring employees in-state and running a business here, and so forth.

It should be noted, however, that the problem is in many cases not caused by the nonresident. The FTB often receives false or garbled information from third parties, and the only tool the FTB has to sort the matter out is a 4600 Notice. They can’t just call taxpayers up and ask.

Finally, not all 4600 Notices are issued due to an information tax return. Other, desultory information can come to the FTB and result in a Notice. For instance, it’s not uncommon for the FTB to receive a copy of the taxpayer’s federal return (Form 1040), and for whatever reason, the nonresident used a California address on it. This can happen when a nonresident moves overseas and uses the address of a relative or friend living in California on their federal return out of convenience, because they don’t have any other local US address. Or the problem can arise for “digital nomads,” who have no fixed address and use a California P.O. Box or other California address for official business. Needless to say, that can be a costly mistake. In cases like that, all the FTB knows is that a taxpayer indicated on their federal return that they live in California, but they didn’t file a California return. Again, the FTB can’t just call the nonresident up and ask for a clarification. It’s only tool is the 4600 Notice.

Don’t Make that Mistake Again

If the 4600 Notice is the result of a mistake, typically a misdirected information tax return, the misstep needs to be identified to properly respond. But not only that, resolving the matter for the year at issue won’t prevent another 4600 Notice in subsequent years if the mistake is repeated. Indeed, it’s not unusual for a nonresident nonfiler to receive a 4600 Notice one year after the next, based on the same underlying error, even though the prior year Notice was resolved in the taxpayer’s favor. Accordingly, the goal should be to identify the trigger to the Notice for the year at issue, and then fix the problem so it doesn’t happen again. As discussed below, every 4600 Notice can potentially lead a taxpayer into a minefield waiting to explode into a full residency audit. So, it behooves nonresidents to avoid making the same mistake again.

Types of 4600 Notices

There are different types of 4600 Notices. The types more or less correspond to the different categories of information tax returns triggering the Notice. Some inquire into investment income from California sources, others involve purported work in California, and so forth. The FTB has a designation for each type, indicated by a letter after the number. For instance, a 4600B usually involves income sourced to CA banks/financial institutions; a 4600C relates to information about operating a business in California; a 4600F usually stems from a federal return with a California address on it; a 4600J is looking for proceeds from a broker or barter exchange; a 4600K, earned income from a 1099 or interest income from a 1098. But there is significant overlap, and the categories aren’t completely rationalized. Moreover, the FTB constantly revises the Notice in all its many variations.

The FTB Explanation

Fortunately, recipients don’t have to rely totally on the FTB’s ambiguous categorization system. The first page of the Notice always has a brief explanation of what triggered the Notice, beginning with verbiage such as: “We believe you need to file a [year] California return. We received information that you . . .” The explanation will refer to the information tax returns at issue, or other documents which piqued the FTB’s interest. That’s usually enough to determine what probably went wrong. This assumes that the documents in fact contain faulty or misleading information (like the wrong address), and the nonresident isn’t required to file a California tax return, but in some cases, a tax return actually is required, and the only mistake was the failure to file one.

Responding to a 4600 Notice.

Responding to a 4600 Notice can be tricky and involves multiple steps. You do not want to scrawl down a response and send it to the FTB, hoping for the best. Nonresidents need to proceed systematically. The steps are discussed below.

Step 1: Determine Whether a Tax Return Is Due

The first thing recipients have to determine is whether they are in fact required to file a California nonresident tax return (Form 540NR). Some nonresidents do indeed receive taxable California-source income which they mistakenly fail to report. It’s best to retain a CPA to determine that. The information tax returns or other documents referred to in the Notice will point the CPA in the right direction as to what possible income sourcing issue exists.

If, after reviewing your books and records, your CPA determines that you do have to file a 540NR, then the appropriate response to the Notice is to do just that before the Notice deadline (and again, you can usually receive a no-questions-asked extension of 30-days in situations where preparing the tax return involve complexities requiring extra time). That will resolve that particular Notice. But, of course, there will likely be penalties and interest assessed for the late filing. Moreover, and more important, the return may provide additional information to the FTB, such as the number of days spent in California during the tax year or a large liquidity event in the year at issue reported on your federal return (which must be attached), and that might encourage an examiner to initiate a full residency audit. And the FTB examiner doesn’t have to agree with how you reported the income, or whether additional taxes are due. But that’s the risk all nonresidents with reportable California income have to take. All the more reason to plan ahead to try to eliminate California-source income, if feasible; and if not, to understand what the risk-enhancing information an examiner will see on your nonresident return, with the goal of managing it to your favor.

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In cases where the taxpayer hasn’t been cautious about their residency status, especially where the taxpayer is in the highest income bracket, responding to the Notice can be a minefield

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Step 2: The (Possible) Informal Approach

Assuming a California tax return is not required, then, subject to your CPA’s counsel, if this is a simple matter of a wrong address on an information tax return or a 1040, you may want to just call the FTB at the number on the Notice and carefully and politely explain the mistake. Sometimes, if there was an obvious error and the FTB agent can verify it by looking at your digital file, the entire matter can be resolved over the phone, particularly if this same type of misinformation caused a 4600 Notice in prior years and was resolved in your favor. If the agent does close on the file based on a telephone call, it’s not because of the FTB’s largesse. The reason a phone call sometimes works to settle a 4600 Notice is that the FTB sees the same types of mistakes over and over again. Rather than going through the formal process to reach what will be the inevitable outcome, the FTB agent may have an incentive to end the matter without using more FTB resources for no purpose.

This is not a formal process. The FTB doesn’t offer it as an option. The FTB agent has no obligation the close the file based on a phone call. Some agents won’t even entertain an explanation over the phone. I am not recommending it. You should discuss the matter with your CPA or other tax professional before going forward to determine if the informal approach makes sense in your particular case. I can only state from experience that it sometimes works in the simplest cases.

Note that if you do avail yourself of the informal method, you have to be extremely careful not to offer any information other than necessary to communicate the simplest explanation possible. You don’t want to get into any details about your residency status besides indicating you are nonresident and a simple, easily understood mistake occurred. Any other information could open up a can of worms and be used against you if the 4600 Notice process goes forward.

Step 3: The Formal Reply

Getting back to the official response: most nonresident recipients of a 4600 Notice don’t have to file a return. Rather, as already indicated, 4600 Notices are overwhelmingly sent as a result of a mistake involving a misdirected or otherwise garbled information tax return. The FTB sends a reply questionnaire along with the Notice to be used to provide the explanation. Usually, a sufficient reply is as simple as pointing out that the nonresident mistakenly used an address of a second home in California rather than their primary residence out of state; or that the nonresident used a California address of a friend or relative, because they were out of the country; or the sale of the property that generated the information tax return was in another state. And so forth. The common mistakes are well-known to the FTB. They happen over and over and over again. So, the examiner is receptive to a plausible excuse for what happened if it falls into the usual categories of gaffes.

The Key Section

The reply can be submitted in hard copy or online. In either case, the key is usually the narrative to be provided in the “Explanation” section, variously labeled Part C or Part 3 in the reply questionnaire. The other parts of the questionnaire involve questions that have to be responded to, but there isn’t much strategy to that. The questions are straightforward (discussed in more detail further on). Since the reply is under penalty of perjury, the answers have to be truthful and to the point.

Where a common mistake has occurred, the focus should be on the narrative explanation. That’s where the nonresident convinces the examiner that there was a mistake of some kind, which may have indicated the recipient was a resident or had filing requirements. The explanation must be drafted to put that misimpression to bed. Part C or Part 3 usually only provides a few lines on the questionnaire. Accordingly, it’s wise to attach an exhibit if the explanation requires more space, and in most cases, it does.

Everything disclosed in the explanation should argue for nonresidency and refer to documentation supporting it in an orderly fashion. The explanation has to be backed up with documentation. Enough documentation should be attached to support the claim, but not so much that other questions are raised. The documentation should be carefully reviewed by a tax professional to insure there are no disclosures in it which are inconsistent with nonresidency.

That shouldn’t be a problem if the nonresident has taken care to maintain nonresidency and understands the test the FTB uses to adjudicate residency status. The test is discussed at length here.

Danger, Will Robinson!

Unfortunately, not all nonresidents do take care. Generally, responding to a 4600 Notice which resulted from a common mistake on an information tax return should be left to a tax professional. A knowledgeable CPA is usually sufficient. But this assumes that the nonresident doesn’t have significant contacts with California and has engaged in informed planning to establish or maintain nonresident status. Where this planning is lacking, then the nonresident may have taken actions inconsistent with nonresidency or apparently inconsistent with it: spending more time in California than their home state; buying a bigger, better second home than their primary residence; making representations of California residency in their loan or insurance documents; moving expensive vehicles or watercraft to California – the types of conduct that can shift the weight of the residency ledger to the Golden State, or at least appear to from the perspective of the FTB.

In cases where the taxpayer hasn’t been cautious about their residency status, especially where the taxpayer is in the highest income bracket, responding to the Notice can be a minefield. The taxpayer has to truthfully disclose information to explain the mistake (the response is under penalty of perjury), but too much information or equivocal facts may result in additional questions being raised in the mind of the FTB examiner. The last thing a taxpayer wants is a tax official with questions. It can lead to a full residency audit.

The FTB is cognizant of this. Depending on which type of 4600 Notice is sent, the reply questionnaire asks questions that are pertinent to whether the recipient had unreported California-source income or had contacts with California that might be inconsistent with nonresidency. The questions may include whether the nonresident worked while physically present in California, what their gross income was, whether they received a K-1 from any company doing business in California, whether they sold or rented any California real estate or other assets, the location of their employer, whether they cosigned a loan for the purchase of California property, whether a third party paid their mortgage on California property, and if they moved from California during the year at issue, what date they moved.

Since these and other questions like them are raised on a 4600 Notice, a nonresident with significant connections with California might want to plan accordingly to be able to answer the questions in a manner that would defang them and truthfully indicate nonresidency status to an examiner reviewing the reply.

Professional Assistance

When the response threatens to enter into areas that put the recipient’s residency status at issue, and where the potential tax liability is large, the taxpayer should retain not only a CPA (you should always do that), but also a tax attorney with experience in responding to 4600 Notices. But even more effective is to have a plan in place beforehand to minimize the risk of a Notice being sent, or if it is sent, will result in ready, truthful answers that strongly support nonresidency.

The FTB’s Next Step

If the mistake is clearly explained in a timely response to the Notice, the matter is usually resolved. The FTB indicates this by sending a “confirmation letter,” stating the explanation is accepted. That closes the matter. At least for the year at issue. If the same mistake is made in subsequent years, another 4600 Notice may arrive in the mail. The FTB doesn’t look to history in deciding whether or not to send a Notice. Each year stands on its own.

In contrast, if the FTB doesn’t accept the explanation, things can go downhill fast. The FTB can demand the nonresident file a tax return, or initiate an audit for residency or for unreported California-source income. A full-blown audit can quickly become expensive and put at risk all the taxable income received by the nonresident during the year at issue. And this may put subsequent or prior years into residency limbo. It pays, therefore, to take the Notice seriously and deal with it with professional assistance.

Manes Law’s 4600 Notice Response Services

Manes Law has a decades-long record of success in assisting 4600 Notice recipients. Please note that Manes Law only accepts 4600 Notice cases where the potential tax liability is over $100,000. We only work on a fixed-fee basis as a consultant to the team handling the response, which should include a CPA. Contact us for information on our fixed-fee amount. Simple 4600 Notices, involving smaller tax liabilities or common mistakes that are easily explained without much risk of exposing the recipient to an unfavorable residency audit, are usually best handled by a knowledgeable CPA or other tax professional billing at an hourly rate.

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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, crypto-asset traders and investors, and global citizens who are able to live, work, and retire where they want. Learn more about our services 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.

The post California’s 4600 Notice “Request For Tax Return” – The Definitive Guide for Nonresidents appeared first on California Residency Tax Planning.

What’s Happening?

There’s a noteworthy residency-related Easter egg in the criminal tax fraud indictment against the Trump Organization and its CFO, Allen Weisselberg. The complaint includes the charge that Weisselberg fraudulently failed to file tax returns as a New York City resident, thus evading the municipality’s income tax on the city’s inhabitants. Monetarily, it’s one of the lesser offenses. It isn’t even mentioned in much of the media coverage. But it shines a spotlight on a question that sometimes arises in California residency tax planning: are there criminal tax fraud risks in asserting nonresidency while retaining or establishing significant contacts with California?

The Short Answer

The short answer is no. You would have to blatantly abuse California’s unique system for determining residency status, or commit outright perjury, to incur criminal tax fraud charges for claiming nonresidency. However, the long answer is, while California residency rules aren’t the same as New York’s, the two systems are enough alike that the Weisselberg case may embolden the FTB to think otherwise.

Background

First, the obvious point: the Weisselberg indictment was brought by the State of New York. Accordingly, no matter how the case is resolved, it can’t have a direct precedential impact on the enforcement of California’s residency rules. California draws on its own robust jurisprudence to adjudicate residency tax issues. It rarely needs to look to the outcomes and opinions from out-of-state courts in that regard.

That said, California and New York both belong to a relatively small class of like-minded high-income-tax states (others in the ranks include Hawaii, New Jersey, Oregon, Minnesota, and Vermont). In addition to the state income tax, the denizens of New York City face a city-level income tax, which can approach 4% in the top bracket. Both California and New York take taxpayers’ residency status seriously because it can have a large impact on tax revenues. In contrast, zero- or low-income-tax states generally have anemic bodies of law addressing residency. It just doesn’t matter much to the treasury of Nevada or Florida or North Dakota whether any particular taxpayer is a legal resident or not.

Second, criminal tax fraud has effectively been off limits when it comes to residency disputes in most states. That’s particularly true for California. As far as this author can tell, no charges of criminal tax fraud have ever been brought where residency was the central issue. In particular, no nonresident who filed a nonresident return has ever been charged with willful intent to falsely avoid taxation as a resident, even where the arguments for non-California status were dubious. This conclusion is based on the author having focused exclusively on this area of law for over two decades and researched the matter for this article, though it is important to note that Manes Law’s practice does not include criminal tax defense.

The dearth of criminal tax fraud cases involving California residency isn’t difficult to understand. California residency law has few bright-line rules. Rather, in a residency case, the FTB compares all the contacts a taxpayer has with California with all the taxpayer’s home-state contacts, and then it weighs them, in totality. It’s like a ledger. How much weight each item brings to the residency ledger isn’t easily parsed by reviewing applicable law or the facts. To put it another way, generally, no one thing makes you a California resident, and no one thing makes you a nonresident. Instead, the determination is based on the weight of all the contacts combined. Unfortunately, not every contact weighs the same, and the rules to gauge the differences aren’t particularly intuitive and can in fact be outright puzzling. California doesn’t even have a serviceable method to calculate the date a person changes residency, though the state requires every departing taxpayer to identify and disclose just such a date. See Manes Law’s “Liquidity Events, the Interim Home Problem, and Determining the Date for Changing California Residency: A New FTB Case Sheds Some Light.”

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Residency is determined by all the facts and circumstances, not by bright-line rules, a system that doesn’t lend itself to criminal prosecution

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Having to prove criminal intent in a system where so much is left indeterminate has consistently deterred the FTB from bringing criminal fraud charges where disputed residency is central to the outcome. It would be futile in most cases for the FTB to act otherwise.

What Might Criminal Residency Tax Fraud Look Like?

That doesn’t mean California wants taxpayers to think it would never bring such charges. On the contrary, California recently enacted a law establishing an intergovernmental task force, which includes the FTB, to coordinate the investigation and prosecution of criminal tax fraud. As for the FTB, the first item listed on the “Tax Fraud” page of the FTB’s website is: “Claiming to be a resident of another state while residing in California.”

But it’s hard to construe what the FTB intends by this admonition. It’s something of a tautology: the very thing at issue in most residency tax cases is whether the taxpayer was “residing in California,” which is a legal, not a factual, determination, made by applying rules without exact edges. In California, a person can spend more than six months in-state and own a large, expensive home, and still not be a resident, depending on what contacts they have in their declared home state; and it’s quite possible for a taxpayer to never set foot in California during an entire tax year or more, own no home, and still be deemed a resident. Residency is determined by all the facts and circumstances, not by bright-line rules, a system that doesn’t lend itself to criminal prosecution. The only way the FTB’s reference to “residing in California” would make sense in the context of a criminal tax fraud case would involve situations where a taxpayer stayed in California for long uninterrupted periods of time knowing he is a resident (because, say, he has no significant contacts with any other state), but deliberately pretends he isn’t, while taking benefits only available to residents (such as health care insurance, the homeowners’ property tax exemption, or owner-occupied loans or home insurance rates).

Procedurally, this would unfold one of two ways. Either the taxpayer doesn’t file a California tax return at all, or he files a nonresident return.

In the first instance, criminal tax fraud for failure to file a tax return in a year “while residing in California” simply begs the question of whether the taxpayer’s time in California constituted “residing.” Deciding that may not be that difficult once the facts are known; but proving that the taxpayer knew the time spent in California constituted legally residing there is another matter, given the notorious uncertainties in California residency law. Willfully failing to file is a criminal offense under Rev. & Tax. Code section 19706, which is a “wobbler” statute, meaning it can proceed either as a misdemeanor or a felony, depending on how egregious the circumstances are. It would only apply to a putative nonresident in the kinds of circumstances just mentioned: a taxpayer living in California essentially continuously with no out-of-state contacts knowingly making residency representations in order to obtain tax or other benefits, with no other reason for spending that much time here other than wanting to live in California. That just doesn’t happen. It’s so obviously risky, and where significant tax liability is at stake, so blatantly unnecessary, given legitimate ways to plan for nonresidency.

If the taxpayer does file a nonresident return (Form 540NR), a different set of considerations apply. Nonresident taxpayers who report to California have to accurately disclose the number of days spent in California and whether they own a home in-state, directly or indirectly through an entity or trust they control, along with their global income (by attaching their Form 1040). The disclosure is under penalty of perjury. If a taxpayer spent an entire year in California and reported it accurately on a 540NR, while disclosing high income and ownership of a California abode, the FTB would almost inevitably initiate a residency audit based on that information. The issue would be whether or not the taxpayer had a defense for claiming nonresidency under those circumstances. The defense could be anything that would indicate a temporary purpose to the California stay, from having to take care of a sick relative, to getting a temporary job, to being stranded in-state due to the COVID emergency. Of course, the taxpayer might not prevail in the audit. Indeed, any taxpayer who spends in aggregate more than nine months in California during a tax year will almost certainly be deemed a resident as a result of the all-but-unrebuttable nine-month presumption under Rev. & Tax. Code section 17016. But the point is, the case would be a garden-variety residency adjudication, not a criminal fraud proceeding. (Note, I’m leaving aside procedural matters such as the fact that usually a local district attorney would bring a criminal tax fraud proceeding, not the FTB, but you get the picture).

If, in contrast, the taxpayer reported the number of days in California on the 540NR inaccurately, that’s a different matter. Arguably, if the understatement were significant and material to residency status, the FTB could bring a criminal fraud charge under Rev. & Tax. Code section 19705, for filing a false return. But usually, a defense of mistake, excusable negligence or the like is enough to forestall the issue from ever arising. I have been involved in various residency audits where it turned out the taxpayer’s 540NR grossly understated the number of days spent in California, but the inaccuracy, once discovered, didn’t lead to accusations of criminal fraud. It simply impeached the credibility of the taxpayer in the eyes of the auditor (which is bad enough in a residency audit). The reality of the situation is nonlawyers don’t usually appreciate the legal significance of accurately reporting time in California on a 540NR (and that applies not only to taxpayers, but many non-California CPAs). As a practical matter, the FTB takes that into consideration. I am unaware of any reported case involving a nonresident undercounting days on a 540NR leading to a charge of criminal tax fraud.

Note that it’s obviously easy to avoid this problem entirely. If you have to file a nonresident return, keep meticulous track of the days spent in California, and report the correct number. But that’s a subject for another article.”

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The likelihood that a taxpayer would face criminal tax fraud charges in a California residency dispute is vanishingly small

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Differences Between California and New York   

Circling back to the Weisselberg case, the State of New York alleges Weisselberg committed criminal tax fraud by not reporting as a New York City resident for a number of years, thus evading the municipal income tax. The allegation is that Weisselberg lived full-time in a Manhattan apartment and concealed the fact from tax authorities by using a Long Island address for tax purposes. The charge that the Manhattan apartment was also paid for by the Trump Organization without Weisselberg reporting this financial benefit as income has more serious criminal implications, which has eclipsed the residency aspects of the indictment. But this count is criminal tax fraud relating to a residency dispute, which makes it a rarity.

It should be noted that, unlike California, New York has some history of bringing criminal fraud cases in residency matters, though the instances are rare. The difference is likely due to the fact that New York residency rules are more specific than California’s. New York law focuses on time spent in the state, with the basic rule being, if you spend more than an aggregate of 183 days in the state while owning a permanent abode, you’re a resident. Since this is a relatively clear standard, New York has an easier time proving willful intent to evade taxes by people who are aware of how much time they spend in the state and under what circumstances, but conceal or misrepresent the facts to escape reporting as a resident.

Our Thought Bubble

The likelihood that a taxpayer would face criminal tax fraud charges in a California residency dispute is vanishingly small. This is all the more certain in cases where taxpayers actually plan for nonresidency, legitimately using the (admittedly ambiguous) rules for their benefit, while making all required disclosures to the tax authorities. Even the most aggressive FTB investigator wouldn’t get near a fraud charge in that context.

That said, there is no reason to tempt fate. The type of reckless disregard for residency rules hypothesized in this article (and alleged in the Weisselberg case) should obviously be rejected, if not only to avoid risk, but because it’s totally unnecessary. Most nonresidents can keep the ongoing contacts they might want with California, if they plan carefully and accept the reality that maintaining nonresidency accompanied by significant California contacts inevitably requires enduring various costs and inconvenience. It’s built into the system. If it weren’t, nobody would be a resident of California. But any degree of cost and inconvenience is better than an unfavorable residency audit, not to mention a tax fraud prosecution.

Finally, not only is The People of the State of New York v. Weisselberg (and The Trump Organization) a high-profile criminal residency case, for obvious reasons it’s likely to become one of the most publicized criminal tax fraud cases since Leona “only the little people pay taxes” Helmsley went to jail. It’s reasonable to wonder if it will encourage the FTB to consider changing its historic practice of steering clear of criminal fraud cases in residency disputes. The answer is probably not. But if Weisselberg is convicted and sent to prison for lying about his residency to get a tax benefit, you have to imagine the FTB will probably look longingly toward Gotham.

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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, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services 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.

The post Criminal Tax Fraud in California Residency Cases: Will the Trump/Weisselberg Indictment Give the FTB Ideas? appeared first on California Residency Tax Planning.

The Case

A new 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 resident moves out of state shortly before a liquidity event. The case, Appeal of J. Bracamonte, OTA, Case No. 18010932 (May 2021), emphasized the importance of how much time a resident spends in California after the purported move. Bracamonte also sheds light on the “interim home” problem, which occurs when a resident moves into an out-of-state rental pending purchase of a permanent home in their new home state, while retaining ownership of their former primary residence in California. Finally, the ruling – probably inadvertently – seems to provide guidance on the date for determining when a taxpayer’s residency status is relevant to a liquidity event (the date of the closing, the date of the income receipt, or the date when an enforceable agreement is in effect). The case can be found here.

Background: How Does California Date a Change of Residency?

Changing residency from California is binary: it happens on a specific date. How do we know that? The Franchise Tax Board, California’s tax enforcement agency, requires that a resident leaving California identify the specific date of the residency change on Schedule CA of the Form 540NR “Part-Year” return, which exiting taxpayers, with few exceptions, have to file for the year they move. The exact question on the schedule is: “I became a California nonresident (enter new state of residence and date (mm/dd/yyyy) of move).” By the way, nonresidents moving to California also have to complete Schedule CA, conversely disclosing the date they become residents.

It bears mentioning that changing residency is a legal concept, and most taxpayers don’t know the rules or how to apply them to a calendar. This means there is no easy answer to when a residency change occurs. In fact, it can be totally counterintuitive. When the FTB asks an ambiguous question, it’s usually intentional. The FTB hopes the taxpayer will make a mistake that might be advantageous to the tax authority. Serendipitously, the taxpayers in Bracamonte did just that, originally putting a move-date on their 540NR that made no sense factually, something they were grilled about during trial, presumably eroding their credibility in the eyes of the court.

More to the point, since the date of a residency change can have enormous tax consequences, you would expect that California would have clear guidelines for calculating it. Simply put, recognition of gain is subject to California income taxes before the date a California taxpayer changes residency, whereas after that date, the gain is free of California taxation (leaving aside sourcing issues). In a large capital event, millions of dollars of income taxes can ride on what exact day a taxpayer’s residency status changed. That’s exactly the issue faced by the taxpayers in the Bracamonte case.

But in fact, California has provided almost no direction on how to fix the move-date for residency purposes. Only a handful of cases address the issue, all with various degrees of vagueness. The best we can say, stitching together the opinions, is that to change residency from California usually requires a showing of three elements, more or less: (a) the resident occupied an abode in their new jurisdiction; (b) the resident’s intent was to move there permanently or indefinitely; and (c) the resident arranges to have weightier contacts on the home-state side of the ledger than on the California side. Let’s dignify this bundle of factors with the name “the Move-Date Rule.”

This Move-Date Rule is actually a (somewhat incoherent) mash-up of the rules for determining domicile (discussed here) and the facts and circumstances/closest connection test (discussed here). The incoherency arises from the fact that the closest connection test includes a comparison of time spent in each jurisdiction after the move-date, which assumes that the move-date has already been established as a point of reference. But the move-date itself is determined in part by counting the days where the taxpayer spent time afterwards. The vicious logic is evident. In addition, all this is subject to the “two-year rule,” a court-created standard which states that normally, for purposes of determining residency, an absence for two years or less from California is considered only temporary and transitory. This would seem to imply that the move-date can’t even be determined until at least two years have passed after it has been asserted. A Catch-22.

But there is no point in cursing the move-date darkness. The rule, such as it is, leaves the taxpayer in a state of uncertainty as to what constitutes the date of a residency change. The situation, therefore, calls for erring on the side of caution, as the taxpayers in the Bracamonte case learned to their detriment.

The Interim Home Problem

This brings us to the Interim Home problem. It’s not uncommon for taxpayers to move out of state and rent a place for a period of time while they look for a permanent home to purchase, or while having a new home built. The interim home is just that: an abode where a former resident lives during the interim between leaving California and occupying their permanent dwelling in their new home state. The intent is to move permanently to the new tax jurisdiction, even if the interim home accommodations are temporary. The issue arises, can taxpayers claim the date when they occupied an interim home as their move-date on the 540NR, or does the Move-Date Rule require the date only apply to the subsequent move into the permanent home.

Arguing from general principles, there is no reason that moving into an interim dwelling can’t be used as the date for a residency change. This is made obvious in situations where the taxpayer sells a California home and moves into an interim home, pending purchase of a permanent residence. All other contacts being equal, it would contradict the Move-Date Rule for the FTB to argue that such a move didn’t show intent to relocate out-of-state permanently. The taxpayer literally wouldn’t have an abode in California to compete with the out-of-state interim home as a primary residence. But if occupying an interim home is sufficient to demonstrate intent to change residency to a new state in that case, there is no reason on its face that it is inconsistent with a residency change where a California property is retained after the move. It just means that the taxpayer still has to meet the burden of the closest connection test, which requires conduct sufficient to show intent to move to another state, not to a particular address.

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The lesson here is, never use the term “temporary” while describing your interim home in a residency proceeding

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In the normal course, the Interim Home problem has little consequences if the taxpayer in fact moves into a bigger, better dwelling in their new home state after only a short time during which the income taxes at issue aren’t substantial. At that point, the nonresident status is usually beyond doubt. With no real monetary incentive to challenge the earlier move-date, the FTB rarely does. But the Interim Home problem becomes acute in circumstances where a liquidity event is contemplated. In that case, if the gain is recognized while the taxpayer is still living in the interim home, it gives the FTB an incentive to argue that the move-date didn’t occur, if at all, until the permanent home was occupied. In contrast, if the taxpayer moves into the permanent home before the liquidity event, even just a day before (residency is binary), then that argument is forestalled. This is exactly the problem the taxpayers in Bracamonte faced.

Facts of the Bracamonte Case

The taxpayers were a married couple who lived in and were residents of California through 2007. They owned a valuable aviation services company, which would ultimately sell for over $17 million, the crux of the tax dispute. In early 2008, before contemplating the sale, the Bracamontes decided to move to Nevada. They rented an apartment in Henderson, Nevada, in anticipation of finding and buying a home there, and they undertook the usual formalities for changing residency (relocating financial accounts, noticing professionals of their new address, obtaining Nevada driver’s licenses, registering to vote in Nevada, registering a vehicle there, retaining medical professionals, and so forth).

In May 2008, the Bracamontes were contacted by a prospective buyer of their company. The parties signed papers in June, and the transaction closed on July 18.

Before the closing, but after their purported move to Nevada, the couple spent about 90 days at their large, expensive California home, with less than a month in Nevada, as well as some time at a second vacation home in Arizona. They also kept three vehicles registered in California (something the court remarked was “noteworthy”). The transcript of the oral hearing indicates the taxpayers claimed that the time was spent “wrapping up” their contacts in California.

After the closing, the couple terminated their post office box in California, registered the California vehicles in Arizona, and (finally) bought a home in Nevada, which they occupied in September of that year.

The taxpayers filed a nonresident return for 2008 (a Form 540NR), claiming they changed residency on February 26, 2008, the date they occupied their interim home. The FTB asserted that the couple failed to change their residency before July 18, but conceded the change happened in September, when they moved into their permanent Nevada dwelling. The tax consequences resulting from the differing dates was the basis of the dispute: if the Bracamontes changed residency before the $17 million transaction in July, they owed no income taxes to California on the gain (the basic rule is a nonresident’s’ taxable income is not subject to California income taxes unless it has a source in California, and capital gains from entity sales generally do not). In contrast, if they didn’t change their residency until after the sale closed, then the transaction resulted in over $1.5 million in California income taxes.

The court ruled against the taxpayers. The reasoning was as follows. Because the Bracamontes failed to show by their conduct that they intended to move permanently to Nevada before the closing date and that they had shifted the preponderance of their contacts to Nevada, their time outside of California was deemed temporary or transitory. Two factors played a prominent role in the opinion. The first was that the taxpayers rented a place in Nevada, buying a house only after the transaction closed (“their possession of their apartment was marked with impermanence,” according to the opinion). The second was that after their claimed move-date, they spent more time in California than in Nevada.

The court conceded that the Bracamontes were in the process of moving to Nevada and genuinely took action to find and purchase a permanent home there. But the “interim home” they rented before actually buying the permanent home was insufficient to support a residency change. The taxpayers didn’t help their case at trial by emphasizing the temporary nature of their interim home. From the transcript:

Q: Why did you want to go rent an apartment in Nevada?

A: Oh, well, we needed a temporary place to live. We didn’t know how long it would take to buy a house. So, we thought the best situation for us would be renting an apartment for a while, while we house hunted and found a house.

The lesson here is, never use the term “temporary” while describing your interim home in a residency proceeding. When asked about what personal property they moved into their interim home, Mr. Bracamonte answered all-too honestly: “[W]e only took from San Diego what we needed to as far as bedding, a bed, a nightstand, lamps, chairs, a table. We took linens, you know, towels, some dishes with us. It was just – it was just temporary as far as we were concerned.” Nor did it help that they retained ownership of their large expensive home in California and used it during this period for a significantly longer time than their interim home. They didn’t even hire a moving company, which suggested to the court that the center of their lives remained in their California home.

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There are costs and inconveniences related to becoming a nonresident while retaining significant contacts in California

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The Takeaway

The case offers some guidance for dating a change of residency, along with negotiating the related “interim house” issue, particularly in the context of a large liquidity event happening in the same tax year as the move out of state. The items potentially relevant to residency planning are as follows:

Spending Less Time in California Than Your Home State After the Move-Date

To bring some certainty to a claimed date of residency change, a taxpayer can’t spend more time in California than in their new home state after the residency change during the balance of the year after their move (something that shouldn’t be done in subsequent tax years either). It’s not that taxpayers can’t spend any time in California after a residency change. But any time in California after the move-date counts against you on the residency ledger. A reasonable amount of time, consistent with a temporary purpose (vacation, winding down affairs in California, business trips), is acceptable. But spending more time in California after a residency change during the same tax year vitiates the claimed move-date, as the Bracamonte court concluded. And note that it’s California vs. your new home state, not California vs. the world; a plurality rule, not a majority rule (that is, spending less than six months in California is not a sufficient way to conceive a residency plan). Time spent in other states doesn’t help you in the ledger analysis (see, “The Six-Month Presumption in California Residency Law: Not All It’s Cracked Up To Be”). This is particularly important where a liquidity event is contemplated. The taxpayers in Bracamonte apparently hadn’t anticipated the sale when they moved; it appeared on their radar scope after they occupied their interim home. But to comply with the Move-Date Rule, at the very least they needed to avoid spending more time in California than in Nevada. Of course, many residents leave California in full anticipation of a liquidity event. In that case, if enough is at stake, enduring the inconvenience of not only limiting time in California after the move-date, but not returning at all during the same tax year may be the prudent course of action (it cost the Bracamontes over $1.5 million in taxes for the pleasure of returning so frequently to California after the move).

There are costs and inconveniences related to becoming a nonresident while retaining significant contacts in California. Where the recognition of a large amount of capital gain is planned, spending little or no time after the move-date may be one of them. In the next tax year, the issue of spending more time in California can be revisited.

Moving into an Interim Home: the “Near and Dear” Test

The Bracamonte case didn’t foreclose a move-date related to occupying an interim home. It did make clear, however, the taxpayer has to actually move into the interim home. That means more than just buying pots and pans and a mattress. The concept (from other residency cases) is that the taxpayer has to move items into the interim home that constitute the center of their lives. During trial, while questioning Mrs. Bracamonte, the court called it the possessions that are “near and dear” to a person. The exchange bears repeating:

Q: Now, every family, especially, the mom and daughters and the like, and they always have things that they kind of consider to be – for a lack of a better expression – kind of, like, near and dear to them. It could be a momento. It could be a vase. It could be a number of things. Did you have any of those near and dear types of possessions in Nevada while you were in the apartment?

A:  Not while I was in the apartment, no.

Leaving aside the gratuitous mansplaining by the judge, the case was probably lost at this point.

What constitutes the “near and dear,” the items that are the center of your life, is different for every person. To expand on the court’s list, it might include things like important documents, family heirlooms, valuable artwork, your best china, your favorite lounge chair, whatever. What you don’t want to do is to have those items remain in your California property (as the Bracamontes did), because then, in retrospect, it may look like you never really moved to the interim home as a primary residence. Of course, you are entitled to have a nice vacation home in California with nice things in it, while having a principal residence in a new state. But there should be some indication that the center of your life was moved to your interim home pending the occupancy of your permanent residence to avoid having the interim home look like a vacation home, while the center of your life remains in California, which is what happened to the Bracamontes. While the particulars remain unclear, a resident moving to an interim home out of state should make some effort to move something important from their former California residence. And it needs to be memorialized, so that, if you are audited, you can say with evidentiary support that you “moved into” the interim home. One of the problems with the Bracamonte trial was that the couldn’t remember details such as this. It’s not surprising; the case came to trial 12 years after the events. This is why an effective residency plan involves systematically keeping a contemporaneous file of “residency facts” that may come up in a residency proceeding, such as what near and dear possessions were moved into an interim home.

To repeat the mantra: there are costs and inconveniences involved in effective residency planning. Where an interim home is involved, it may entail renting a large, unfurnished abode, enduring higher moving costs to furnish it with items from the former California residence, and undertaking a second move into the permanent home. The background question is always whether the taxes at stake warrant the burden.

Remember: It’s a Ledger

The taxpayers in Bracamonte had other options. They clearly wanted to keep their former residence as a vacation home (which is also true of almost all of our clients: comprehensive residency planning is usually only necessary for former residents who retain significant contacts in California after their move). But it’s not an either/or situation. The Bracamontes could have prevailed if they had listed their California property, moved into the interim home, and then later, after the liquidity event, purchased or rented a second home in California (preferably with accommodations inferior to their Nevada property, which by then they would have purchased). Or the taxpayers could have rented out the California home, essentially converting it to an asset rather than a second home competing with their interim home for the status of primary residence. Sometime after the liquidity event, when the lease terminated, they could have resumed using the property as a vacation home. Or the taxpayers could have transferred the California property to an irrevocable trust for the benefit of their children (if that made sense for estate planning purposes in any case). To summarize: whatever accommodations you have in your new home state are always evaluated in the context of the accommodations you retain in California. And you are in control of that, though it may mean delaying enjoyment of the property for a while. Again: cost and inconvenience is built into the system for nonresidents.

Our Thought Bubble

The FTB conceded that on the date the Bracamontes purchased the home in Nevada and moved into it (along with the other conduct they engaged in to reduce their California entanglements), they became nonresidents. The court’s opinion didn’t rely on this concession, so it is not part of the ruling. However, it provides insight into the FTB’s thought process in liquidity event situations. Taxpayers leaving California who purchase a home in your new home state which compares favorably with their California property, if any is retained, and occupy it before the recognition of gain in an entity sale, can point to the Bracamonte case if the FTB disputes the move-date. This assumes all the other factors of a residency change are met.

Our Second Thought Bubble

There was a second timing issue in the case, which the court didn’t address directly. Namely, the timing of the transaction itself. In the sale of an entity interest, is the relevant date for inquiring into the seller’s residency status (a) when the escrow closes; (b) when the income is actually received; or (c) when constructive receipt occurs based on the existence of an enforceable agreement. The court accepted the closing date as the date relevant to the taxpayer’s residency status, without comment. This is presumably helpful to residents moving from California pending an entity sale, since it’s often the case that an enforceable agreement comes into effect well before the closing date. Presumably, under Bracamonte, a taxpayer could enter into a purchase and sale agreement (or M&A agreement or an IPO plan), and move out of state before the date of the closing, and claim the gain is not subject to California income taxes. In fact, the case invites taxpayers selling an entity interest to delay the closing for just this purpose. However, this is probably wishful thinking. The court didn’t have to rule on the transaction date issue to reach its conclusion, and might have ruled differently if the matter had been central to the tax dispute. Further, there is other authority that argues California doesn’t use the closing date for application of residency status, but rather the existence of an enforceable agreement. This would seem to make sense to avoid the perverse incentive of delaying closing in order to get out of Dodge. But in a pinch, the case offers a favorable argument.

An historical note: California actually did try to define by statute how to determine the transaction date for residency change purposes. It took the form of Rev. and Tax. Code section 17596. It was a disaster. The statute read:

“When the status of a taxpayer changes from resident to nonresident, or from nonresident to resident, there shall be included in determining income from sources within or without this State, as the case may be, income and deductions accrued prior to the change of status even though not otherwise includible in respect of the period prior to such change, but the taxation or deduction of items accrued prior to the change of status shall not be affected by the change.”

Several cases determined under section 17596 focused haplessly on interpreting the meaning of income “accrued prior to the change of status,” a phraseology that California’s own tax agencies at the time found “obscure,” “troublesome,” and “enigmatic.” It led to contradictory and incoherent rulings, and ultimately, the section and its successor were repealed, leaving the issue in limbo.

Our Third Thought Bubble

During oral arguments, the FTB didn’t focus on the Move-Date Rule per se, but rather the benefits the taxpayers received from California, including legal processes and business ties, and the taxpayer’s confusion in using an earlier move-date in their nonresident return, which conflicted with Nevada voting law. Significantly, the court basically ignored these matters. File this under: parties put on one case; judges see another.

By the way, the transcript of the residency proceeding can be found here. It should be required reading for residents thinking of moving from California to an interim home pending a liquidity event, as a blueprint for how not to plan a residency change when a large amount of capital gain is expected to be recognized shortly after a move-date. Virtually every error that could be made in planning for a residency change in those circumstances, was.

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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, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services 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.

The post Liquidity Events, the Interim Home Problem, and Determining the Date for Changing California Residency: A New FTB Case Sheds Some Light appeared first on California Residency Tax Planning.

The Issue

With the rise of ecommerce, advanced telecommunications, and the new prevalence of remote work due to the COVID pandemic, more and more people are choosing the option of living in one state while working for an employer in another, sometimes without ever setting foot at the employer’s place of business. The possibilities for reducing state income taxes through this scenario haven’t been lost on founders, hi-tech C-suite, and other key employees in California. By moving across state borders and working for a California business (or even running it) through Zoom and other telecommunications, they become nonresidents, potentially free of California’s high income tax rates, while still being able to participate in California’s thriving economy.

Of course, this situation isn’t lost on California’s tax enforcement agencies either. Because remote work can attract audit scrutiny, nonresidents working for California firms need to be careful and understand the tax rules governing remote work, especially when it comes to highly compensated former residents.

California Tax Rules For Remote Employees: The Basics

Generally, if you work in California, whether you’re a resident or not, you have to pay income taxes on the wages you earn for those services. That’s due to the “source rule”: California taxes all taxable income with a source in California regardless of the taxpayer’s residency. In other words, nonresidents pay California income taxes on taxable California-source income. With respect to employees, the source of income from services compensated by W-2 wages is the location where the services are performed, not the location of the employer. This is true even if you are a nonresident, even if you don’t work out of a California branch or office, and even if the wages are paid to you outside of California and booked as payments to a nonresident worker.

You can imagine how important this income-sourcing rule is for California’s tax enforcement agency, the Franchise Tax Board, when it comes to highly compensated employees like CEOs, actors, and professional athletes. When James Harden (a nonresident) travels to California to play the Lakers at Staples Center, California gets a cut of his pay for that night in the form of state income taxes. The reason: as an employee of his NBA team, Harden performed his services in California on that particular night. It doesn’t matter which team he plays for or where he resides. The wages from that game are taxable California-source income because he performed his employee services while physically present in California, even though he is a nonresident. He may be entitled to a tax credit under the ”other state tax credit” system that exists among the states to prevent double taxation on the same income. But that’s a different issue (and since California has the highest income tax rates on the top bracket, he still has to pay income taxes to California on the difference between the credit amount and amount of incomes imposed on the California-source income).

But what if the employee is a nonresident who never sets foot in California to perform his services? Then the source rule works in the nonresident’s favor, even if the employer is California based. Remember, for employees, the income sourcing of wages is determined by where the employee’s work is actually performed, not the location of the employer. A nonresident programmer who monitors and upgrades satellite dish software for a Los Angeles-based media company, all while sitting comfortably in front of his computer in his Austin, Texas condo, doesn’t earn California-source income and doesn’t have to pay California income taxes, as long as the work is performed outside of California.

At the employer end, while California companies have to withhold state income taxes for resident employees wherever they perform their services, and generally for nonresident employees for services performed in-state, this is not the case for nonresident employees who perform all their services outside of California.

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Highly compensated managers, executives and key personnel who work remotely may also have significant taxes at stake. So, they too need to make sure duty days and other residency language appears in their employment contracts

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This is true, by the way, even if the employee is a highly compensated corporate officer, an independent director, or a non-principal LLC manager, as long as the taxpayer is a nonresident, and the compensation takes the form of W-2 wages, though there are special rules for sourcing director salary, and it is important not to confuse wages paid to principals in their officer capacity with profit distributions made to them in their ownership capacity (which is addressed in this article).

But Of Course, It’s Never That Simple

Such are the basics for sourcing and reporting personal income taxes with respect to nonresident employees. But, of course, California’s taxation of nonresidents is nothing if not complex. Personal income taxes have to be distinguished from employment (payroll) taxes, which fall under separate rules.

California’s employment taxes involve unemployment insurance, state disability insurance, and employment training taxes. They are applied to employee wages and are usually withheld by the employer. California’s Employment Development Department (EDD) administers these taxes, not the FTB.

The EDD uses a multi-step analysis to determine whether a nonresident’s wages are subject to employment taxes, and whether the worker should be classified as a California employee by the employer (as opposed to an independent contractor).

The first step is to determine whether the nonresident employee performs any services in California. If not, employment taxes do not apply. The analysis is over. If any services are performed while physically present in California, then onto the next step.

The next step is the “localization test.” If most of the services are performed in California, with only incidental services performed elsewhere, the services of an employee are subject to California employment taxes.

If the localization test doesn’t apply in any state (that is, neither California nor the nonresident’s home state), then the EDD moves to the “base of operations test.” Under this test, the employee’s services are still considered subject to California employment taxes if some services are performed in California and the individual’s base of operations is in California. What is a “base of operations”? The EDD defines it as the place of more or less permanent nature from which the employee customarily starts work and returns within the terms of the same contract.

Finally, if neither of the above tests apply in any state, an employee’s services are considered subject to California employment taxes if some services are performed in California and the place from which the employer exercises general direction and control over the employee’s services is in California. This might alternatively be called “the branch test.” If the worker takes directions from a California branch or office, the tax jurisdiction is in force. If the worker takes directions from a branch or office not in California, then the employment taxes don’t apply.

Nonresident employees working for a California business typically avoid California employment taxes under the first and second tests, because most of their work or their base of operations is out of state. However, where the first two tests are inconclusive, they can get caught up in the direction and control test.

As you can see, these tests can be factually challenging and ambiguous. The result is employers often don’t apply them correctly, and nonresidents working remotely for California companies find themselves in a tax dispute with California or their employer.

Employees Versus Independent Contractors: The “Never Set Foot” Rule

Note, this entire analysis assumes the nonresident is an employee, and not an independent contractor (that is, the taxpayer receives W-2 wages versus 1099 payments). For nonresident independent contractors, different rules apply. Specifically, the issue is not where the independent contractor performed the services, but in what state the benefit was received. Accordingly, even if nonresident independent contractors never set foot in California, if they perform services for a California-based customer, they have an economic nexus with the state and are likely doing business in California for income tax purposes. That determination falls under a totally different set of stringent, often complex rules, which typically result in the net revenue from a sale of products or services to a California customer being subject to California income taxes (though there are special exemptions for sales of products, as opposed to services).

This often comes as a shock to nonresident independent contractors who receive an audit notice from the FTB for services performed entirely outside of California, and who thought the “never set foot” defense applies to them. It doesn’t. It only applies to employees. Moreover, the status of the vendor as independent contractor matters not only to nonresident sole proprietors, but any out-of-state business entity with sales to California customers. For more details about the economic nexus rules for independent contractors, see “Internet-Based Companies and ‘Doing Business’ in California: Be Careful What Your Website Says About You.”

The “Duty Days” Issue

Returning to our remote employee, so far so good if he hasn’t set foot in California. But what if a difficult glitch arises requiring the programmer to fly to Los Angeles to fix the system on site? Then everything changes. The source rule kicks in against the employee. In that case, just like Harden playing at Staples Center, or Paul Newman (who was a resident of Connecticut) making a movie in Hollywood, California taxes the income from those in-state services. What the FTB does then is to use an allocation formula based on “duty days” – the days the employee is present in California and working – in proportion to total work days.

The reason I mention Newman, by the way, is that he prevailed in a landmark case against the FTB for his performance in The Sting. Newman was able to show that the duty days formula should be based on what his contract actually required for working in and out of California, rather than the FTB’s own calculation of duty days. Paul L. and Joanne W. Newman v. FTB (1989) 208 Cal. App. 3d 972. That’s why it’s very important to have a written employment contract that clearly states what obligations an employee has to work in California and what constitutes such work. In fact, the union contracts of professional athletes and actors usually meticulously define and limit duty days, because so much potential state income taxes are at stake. Highly compensated managers, executives and key personnel who work remotely may also have significant taxes at stake. So, they too need to make sure duty days and other residency language appears in their employment contracts. And as a practical matter, it’s very rare for any remote worker not to have to make some visits to California to perform work while physically present in the state. The more time spent in state, the more taxes at issue, and the more pressing the need for dealing with duty days in the employment agreement.

Note also that it’s easy for James Harden to prove how many days he worked in California and how many days he worked outside of California. You just have to look up the NBA schedule. It’s not that easy for a programmer or other nonresident workers who perform services from their living room computers, and also make trips to California. Therefore, scrupulous record-keeping and detailed employment contracts are a necessity to prevail in an audit.

The Vesting Equity Compensation Plan Issue

If a vesting equity compensation plan are part of the remote worker’s compensation package, the tax implications of duty days increase astronomically. That’s because the number of duty days may determine what portion of the stock or other equity interest vesting is allocated to work in California, and if the options are non-qualified or their characterization as compensation isn’t limited by a section 83(b) election at the federal level, then they will be taxed as wage income. A portion of that compensation will be prorated to California, as a result of the duty days spent here. Needless to say, if the options are related to a startup that hits the jackpot in an IPO or a merger and acquisition, the value of the options and hence the income tax potentially due to California may be enormous. The taxation of equity compensation plans is inherently complex. The duty days concept adds an extra layer of complexity. Therefore, any remote worker with vesting stock options needs to have their compensation package carefully analyzed and managed for this vulnerability by tax counsel who understands California-sourcing rules. This applies to other forms of vesting compensation, such as restricted stock units, golden handcuffs, nonqualified deferred compensation, and phantom-stock incentive plans.

To add insult to injury, some of these nonqualified plans may not become taxable for many years. This is particularly true of deferred compensation plans. At that point, the taxpayer may no longer be associated with their California employer and many not have access to the employer’s records. If the nonresident didn’t keep track of his work in and outside of California during the vesting period, it may be difficult to convince an auditor not to allocate a maximum amount of income to California (as the FTB tried to do in the Newman case). The burden is on the taxpayer.

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Long-term nonresidents who begin remote employment with a California business don’t usually need extensive planning or input from a tax attorney

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Who Needs Remote Work Planning (And Who Doesn’t)?

For founders and key employees who are currently residents, taking advantage of remote work tax benefits requires that they first change residency. After that, the planning will focus on managing any retained contacts in California and entering into an employment agreement or remote work agreement consistent with nonresidency. A comprehensive, integrated attorney-drafted plan is usually a good idea, particularly where the former resident retains significant connections with California, such as a vacation home, business investments, and hard assets such as expensive vehicles, yachts, and aircraft.

In contrast, long-term nonresidents who begin remote employment with a California business don’t usually need extensive planning or input from a tax attorney. Rather, a knowledgeable CPA is often sufficient to determine their California reporting requirements, if any. The exception occurs where the nonresident remote worker is required to make trips to California to perform some of their employment duties. If the duty days add up to a significant amount of time, and the nonresident employee begins accumulating the kinds of contacts in California which typically accompany lengthy stays (such as renting living accommodations, keeping a vehicle, using a permanent office, etc.), then some additional planning may be in order for highly compensated individuals.

Employer Withholding And The Unintelligible Form DE-4

Note that this doesn’t mean longstanding nonresidents who begin employment with a California company won’t get into reporting disputes with their employer. Even large sophisticated companies like Facebook, Google, and PayPal seem unable to comprehend the W-2 sourcing and withholding rules. They tend to withhold first and ask questions later, often treating nonresident employees as if they were working in California full-time.

Part of the problem is reluctance by California employers to get involved in the overwhelming complexities of residency tax determinations. And part of it is the poorly drafted withholding exemption form provided by the EDD. California doesn’t use an IRS Form W-4 to determine or exempt withholding for California tax purposes. The EDD has its own form, a DE-4 “Employee’s Withholding Allowance Certificate.” The DE-4 is notoriously poorly drafted. Taken at face value it suggests that hardly anyone can avoid California income tax withholding, including nonresident employees who owe no California income taxes because they performed zero work in California. Rather than trying to parse the DE-4, California companies with nonresident workers tend to throw up their hands and withhold, leaving the problem for the nonresident employee to sort out with the FTB. The EDD tests for employment taxes and employee classification, discussed above, hardly help to clarify matters.

There is little purpose to arguing with the employer over this, unless you are a key employee with negotiating power. The EDD has put everybody in a no-win situation as a result of its incoherent withholding exemption form. Nonresident principals who receive W-2 wages can, of course, stop the withholding except where required by law. For principals and key employees, the withholding situation should all be memorialized in an employment contract with remote work and duty-days provisions.

If the California employer does withhold when it shouldn’t, it’s not the end of the world. California-source income is determined by law, not by employers’ withholding practices. What it does mean, however, is that the nonresident worker will have to file a nonresident return (Form 540NR) for the year at issue, and request a refund from the FTB for any income taxes withheld for compensation for work performed outside of California.

The tax professional to assist in filing for the refund is a knowledgeable CPA. A tax attorney is usually overkill, unless extremely large amounts of withheld income taxes are at stake.

In the normal course, filing a 540NR to obtain a refund doesn’t raise much audit risk for longstanding nonresident employees. However, it may do so for employees who are spending significant time in California, particularly if they own a second home here. Those residency-related facts have to be disclosed on Schedule CA of the 540NR, which may pique the interest of an FTB examiner. But again, unless very large amounts of income are at stake, this is something best handled by a CPA.

Summary, Caveats

To summarize, working remotely for a California firm as a nonresident has the potential for significant tax savings. But there are important caveats.

First, the entire favorable tax treatment of working remotely is based on the assumption that the employee is truly a legal nonresident. For employees who move from California to a lower tax state like Nevada, Texas, or Florida, it’s important they follow residency rules and meet the legal standard for changing California residency status. If they don’t make the necessary changes to disentangle themselves from California contacts and manage those they keep (such as working for a California company remotely), they may find themselves in an unpleasant residency tax audit with a large tax liability at stake.

Second, in contrast, long-term nonresidents who start remote work with a California company don’t usually need extensive planning, at least not with a tax attorney. They don’t face significant audit risk, unless they start spending an inordinate amount of time in California, begin accumulating significant California contacts, and receive large compensation packages. Generally, they only need the guidance of a knowledgeable CPA for tax reporting purposes, which may involve multistate returns and a refund request if the employer withheld or otherwise reported improperly.

Third, the favorable tax treatment of remote work depends on employee status. Independent contractors providing services or products to California customers fall under totally different rules involving thresholds for doing business in California.

Fourth, in a perfect world, the nonresident employee should have a written employment agreement or remote work agreement, which spells out the services to be performed out of state and in state, if any. In this way you, not the FTB, are in control of the duty-days allocation. In addition, the employment contract should reflect the employee’s nonresident status, deal with withholding, and handle other residency-related matters such as the office or branch the employee is assigned to, and provide for remote work. Generally, only principals and key employees need to or are in a position to obtain the appropriate language.

Finally, if any work is required on site (and it almost always will be at some point), the employee will need to keep good records of their work both in and out of state. This will allow the nonresident to make the most of the duty-days formula allocation. That allocation is all the more important if the nonresident’s compensation package includes vesting equity compensation. If that’s the case, how duty days are defined or limited may make a tremendous difference in the amount of California taxes owed when the options are exercised or otherwise become taxable.

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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, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services 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.

The post Nonresidents Working Remotely for California Businesses: Taking “The Sting” Out of California Income Taxes appeared first on California Residency Tax Planning.