Articles Posted in California State Tax Issues

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How to Take Paul Newman’s “The Sting” Out of Your Taxes

paul_newman0final.jpgWith the rise of the internet, cloud and smart phone economy, more and more people have the option of living in one state while working in another – remotely. The possibilities for reducing state income taxes through this scenario haven’t been lost on savvy hi-tech employees and business owners in California. By simply moving across state borders and working for a California business (or even running it) through the internet, 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 taxing authorities either. Because of that “remote workers” need to be careful and understand the tax rules for nonresidents working for California firms.

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 income with a source in California. And for tax purposes, the source of income from services is the location where the services are performed. This is true even if you are a nonresident, even if the contract with the employer is made out-of-state, and even if the wages are paid outside of California.

You can imagine how important the source rule is for California’s taxing authority, the Franchise Tax Board, when it comes to actors and athletes. When LeBron James travels to California to play the Clips at Staples Center, California gets a cut of his pay for that night.

But what if the employee is a nonresident who doesn’t have to set foot in California to perform his services? Then the source rule works for the nonresident. Remember, the source of the services is the location where the work is actually performed. A nonresident programmer who monitors and upgrades satellite dish software for his 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.

At the employer end, while California companies have to withhold state payroll taxes for resident employees wherever they perform their services, and for nonresident employees for services in-state, not so for nonresident employees who perform services outside of California. This is true, by the way, even if the employee is a nonresident corporate director (or an LLC manager or general partner) and is paid for his work directing the company – as long as he only participates remotely (though don’t confuse this with profit distributions to nonresident owners, which follow different rules I will address in a separate article).

So far so good. 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 LeBron James 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 famous 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. Experience suggests that most nonresident remote employees at some time or other will have to travel to California to perform some services on site.

Note also that it’s easy for LeBron James 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 our programmer or other nonresident workers who perform services from their living room computers. Therefore, scrupulous record keeping and detailed employment contracts are a necessity.

So here are the caveats for nonresidents working remotely:

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 or Texas, it’s important they follow residency rules and genuinely change their legal residency. If they don’t make the necessary changes to reduce or eliminate their California contacts, they may find themselves in a nasty residency tax audit.

Second, make sure to have a written employment contract that spells out the services to be performed out of state and in state, if any. In this way you are in control of the “duty days” allocation, not the FTB.

Finally, if any work is required on site (and it almost always will be at some point) keep good records of your work both in and out of state. This will allow you to make the most of the “duty days” formula allocation.

The information in these articles is not, nor is it intended to be, legal advice. In addition, the articles interpret California law and should not be construed to apply to any other state or jurisdiction.

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…To evaluate this, the distinction between Rule #1 (California income taxes incurred due to residency), as opposed to Rule #2 (California income taxes incurred due to sourcing) is extremely important. Taxpayers are more or less in control of their residency; they can pull up stakes and move. However, the source of income is not as easily controlled. In many cases, the operations that bring in the income rely on California’s market, which is often the market the owner knows and understands. There is no point in moving out of state to avoid the application of Rule #1, if Rule #2 is still going to apply. The tax is the tax is the tax.

But let’s look at the nuts and bolts. It’s not unusual for a business owner to have a corporation and several related tax pass-through entities, such as limited liability companies or limited partnerships, which produce income by providing goods or services here in California. The corporation often provides the LLCs with administrative services, and charges accordingly. Generally, the owner will hold the corporate stock in a family trust. In case like this, creative relocation can have worthwhile tax benefits. Here’s how.

First, remember Rule #1. Since the point of most business enterprises is to get money into the pockets of the owner, if the owner remains a California resident, relocating the corporation won’t help a bit by itself. Assuming all the income from operations passes through the entities (including the trust) to the owner, it will be taxed by California because of Rule #1. All of a resident’s income is taxable by California. So in situations like this, if a strategic relocation is in the cards, step one is for the owner to change residency to a lower tax or non-income tax state. Obviously that’s a big step. It means major change. But if reducing state income taxes is the goal, it’s the sine qua non.

Second, remember Rule #2: moving out-of-state won’t change anything if the source of the income derives from California. The premise here is that the owner’s market is in California, so he can’t move the operations. Paying California income taxes on that is the price we pay for benefiting from the Golden State’s large market. That said, what doesn’t have to be performed here is the administrative services: the management, accounting, etc., that the corporation carries out for LLCs. The source of income from personal services is the location where the services are performed, and not where the nonresident lives, the location where the contract for services is entered into, or the place of payment. Cal. Code Reg §18662-5. Therefore, if the services aren’t performed in-state, it’s not California source.

Thus step two involves creating a new entity in a lower tax or non-tax state (or the owner can perform those services upon changing residency) to provide the administrative services. In that situation, neither Rule #1 nor Rule #2 applies to the fees charged by the corporation. The services are not rendered in California, so they are not California source. Neither the entity nor the owner are residents, so their global income isn’t subject to California taxation.

Now, there are complexities with this, as with any tax situation.

The rule about location of performance is strict. If even some of the work is performed in California (say by the owner coming to California to inspect the business), the payment, or a portion thereof, will be deemed California source under special allocations rules. Cal. Code Regs.18 18662-2. Indeed, if the entity is performing other services in-state, or otherwise doing business in California, all the income from the services may be taxable by California. In the Matter of the Appeal of William-Sonoma, Inc., and Subsidiaries (June, 26, 2012). Therefore, to avoid the application of Rule #2, it is very important to “wall-off” any nonresident entity or person from doing any business in California.

Furthermore, new (and somewhat complex) rules went into effect in 2011 regarding what constitutes “doing business in California” for entities. Partnerships and LLCs are considered doing business in this state if they have general partners or members in this state. Likewise, partners and members are considered doing business in this state if the partnership or LLC is doing business in this state. Further, if a partnership or LLC has employees working in California, it might result in the entity being deemed doing businesses in California, even if most of its operations have nothing to do with California. The point is, depending on how the owner’s entities are interrelated, one or all of them might be deemed “doing business in California” for taxation purposes. Therefore, relocators need to carefully scrutinize those relationships to insure none of them can be used to impute “doing business in California” to the nonresident entity.

It’s also noteworthy that any equity distributions from the California entities to the out-of-state entity or the owner (and presumably they will be significant) derives from operations in this state. California applies a source-based concept of taxation for full-year nonresident partners. Appeal of Lore Pick, 85-SBE-066; (June 25, 1985), Appeal of George D. Bittner, 85-SBE-111 (October 9, 1985), Appeal of Estate of Marion Markus, 86-SBE-097 (May 6, 1986); FTB Legal Ruling 2003-1. Essentially, California requires owners of pass-through entities to treat items of income, deduction and credits earned by such entities as if the items were earned by the owners at that time.

Similarly, nonresident shareholders are taxed on the portion of their distributive shares of an S corporation’s income or loss, which are derived from sources within the state. Valentino v. Franchise Tax Board (1993) 25 Cal.Rptr. 282; Rev. & Tax. Cd, §17951. This is a bright-line rule that can’t be avoided. (Dividend income from C-corps is treated differently and generally is sourced not to operations but to where the recipient resides, but that’s another story).

So, in my scenario, while you may be able to free service contracts from California taxation, the same isn’t true for the profits of the companies engaged in operations.

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It’s no secret that California has a high state income tax rate. In fact the Golden State competes with New Jersey and New York for the highest rate in the nation. Nonetheless, despite somewhat overblown media reports, most Californians aren’t in a position to tear their businesses up by the roots and transplant them to low or zero income tax havens like Nevada and Florida. Often those businesses have to operate in California, since that’s where the market for the product or service is, and typically for small businesses, the owner has to be present here in state for the enterprise to grow.

But that’s not always the case, especially when a taxpayer owns numerous entities and some of the income derives from service contracts (usually for management work) among the entities or between the entities and the owner. In that case, some strategic use of out-of-state entities can result in large tax savings that might make the major step of relocation worthwhile.

But before we can address the benefits and pitfalls of relocation, we need to first give an overview of California’s income tax system relating to residency. California taxes residents with respect to their “global” income. This means that for a California resident, income from whatever source – whether in-state or out-of-state – is subject to California taxation. There may be credits for payment to other states, and there may be other mitigations of the taxes due. But leaving that aside, California residents generally must pay significant state income taxes on all the income they make, from whatever source. Let’s call this Rule #1: taxation of all income based on the California residency of the taxpayer.

In contrast, nonresidents only have to pay California income taxes to the extent that the income is “California source.” If a nonresident has no California source income, the taxpayer isn’t liable for any California income tax. California source income means income derived from a business or real property with a situs in California, or from work performed here. That income is subject to taxation by California, even if the taxpayer is not a resident. Let’s call this Rule #2: taxation based on the source of the income being situated within California.

The rules relating to who is a resident and who isn’t get very complex and fact specific. I won’t get into them here. See Christopher Manes’ A GUIDE TO SUCCESSFUL (TAX-FREE) SNOWBIRDING and THE PART-TIME RESIDENT TAX TRAP, on the Sanger & Manes website. Suffice it to say that if a taxpayer follows the necessary steps, he can change residency to a lower tax state. The issue is, when is such a major relocation worthwhile? We’ll review question that in Part II.

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So we’re on to Part 2 on this topic. Here, we’re talking about a US citizen who owns a California home (maybe in Palm Springs), but lives in Illinois.

Presumptions Generally

Let’s review the FTB’s presumptions on time spent in California. If you spend more than 9 months (in a calendar year) in California- you are presumed to be a California resident that year (but you can rebut it by going to the checklist). You can find this presumption in Cal Rev. & Tax Code §17016. There is also a lesser presumption (found in regulations as opposed to the Cal Rev and Tax Code) which provides if you are present in California less than 6 months a year, you are presumed to not be a California resident. This “lesser” presumption is found at 18 Cal. Code of Regs. §17014(b). I consdier it a lesser presumption since it comes from the Cal tax regs and not the Code (unlike the 9 month presumption). There is no presumption if you are present in California between 6 months and 9 months. But in all events, you still must go back and review the checklist.

Make Sure to RE-Review the Checklist

We must re-review the checklist of items the FTB looks at from Part 1 of this topic (e.g., location of your spouse/RDP and children; location of your principal residence; where your vehicles are registered; where you maintain your professional licenses, etc.). The FTB may still deem the American from another state (Illinois) a California resident if they have enough checks in the wrong category, even though that person does not spend more than 6 months a year in California.

What Does it Mean For the American From Another State to Be Deemed a Resident of California?

It’s significant. It means that California will tax the individual up to 9.3% of the income they earn anywhere in the world.

What Taxes Must the American Who Is Not Deemed a Resident of California Still Pay to California?

Here were talking about owing tax to California solely on California source income. So what are we talking about here?

Gain From the Sale of California Real Property- A big one. You sell your California vacation house, you owe tax in California. Count on 9.3% of the gain on the property (i.e, buy for $300,000, sell for $500,000, its 9.3% x $200,000= $18,600 in tax to the state of California). You’re still going to owe tax to the IRS on top of this. By the way, upon the sale of your house, the buyer must withhold from you (the out of state seller, or the in state seller for that matter) either: 3.3% of gross sales price ($500,000 x 3.3%= $16,500); or 9.3% of the gain ($18,600), and send it in directly to the FTB. You, as the seller, can choose the withholding amount (you should choose the lower amount).

We’ll talk about the tax on other sources of California income in Part 3 of the series.

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We next start a detailed series on the consequences of, and how to avoid, being deemed a California state resident for state income tax purposes. We will track this discussion on our Canadian Snowbird blog.

General Rules on California State Taxes

Let’s start with some general principles of California state taxation:

Residents of California– are taxed on ALL income, including income from sources outside California. A California resident is any individual who meets any of the following:
• Present in California for other than a temporary or transitory purpose.
• Domiciled in California, but outside California for a temporary or transitory purpose.

Domicile means the place where you voluntarily establish yourself and family, not merely for a special or limited purpose, but with a present intention of making it your true, fixed, permanent home and principal establishment. It is the place where, whenever you are absent, you intend to return.

Nonresidents of California– are taxed only on income from California sources. A nonresident is any individual who is not a resident.

Part-year residents of California– are taxed on all income received while a resident and only on income from California sources while a nonresident. A part-year resident is any individual who is a California resident for part of the year and a nonresident for part of the year.

California Has a High State Income Tax

Individuals from other states and other countries will want to avoid being deemed a California State Tax Resident. Why? Because California state taxes are not low. For 2102, the highest rate of tax (for individuals earning over $98,000 approximately) is 9.3%. That’s in addition to the federal income taxes (with a high rate of 35%). So this is a high state income tax, no question.

How Does the FTB (the California Franchise Tax Board) Determine Whether an Individual is a California Tax Resident?

It applies the “Closest Connection Test.” This refers to the state with which a person has the closest connection during the taxable year. For the FTB, this literally means counting all the California contacts a person has and comparing that number with the non-California contacts. Of course, some contacts simply weigh more than others.

Factors to consider are as follows:
• Amount of time you spend in California versus amount of time you spend outside California.
• Location of your spouse/RDP and children.
• Location of your principal residence.
• State that issued your driver’s license.
• State where your vehicles are registered.
• State in which you maintain your professional licenses.
• State in which you are registered to vote.
• Location of the banks where you maintain accounts.
• The origination point of your financial transactions.
• Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys.
• Location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member.
• Location of your real property and investments.
• Permanence of your work assignments in California.

So a determination of residency, at first instance, is a balancing test. Again, not all factors are created equally. A job or real estate ownership indicates a closer tie than merely enjoying a country club membership.

There’s a lot more to discuss regarding California income tax, including how nonresidents are subject to tax on their California source income, in our next post….

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As a California property owner, you have the right to appeal the amount of your property taxes. You can use an attorney to represent you in your appeal, or you can do it yourself. Property taxes are assessed (and appealed) on a county-wide basis in California, so for those of us in Riverside, Banning/Beaumont and the Coachella Valley (Palm Springs, Rancho Mirage, Palm Desert, Indian Wells, etc.), our appeals are handled in Riverside County.

Am I really Challenging The Amount of My Taxes?

Actually no, what you are really challenging is the Riverside County Assessor’s enrolled value of your property.

Appeals Generally

First of all, there is a chance (maybe unlikely) you can change your assessed value without even appealing. You can try contacting your Assessor and make the case informally. Absent a glaring mistake or omission by the Assessor, that’s probably not going to work. So you can file an appeal with your local appeals board (for us in the Palm Springs area, this means the Appeals Board of Riverside County). Again, an attorney is not required, but property tax appeals frequently include legal issues, and attorneys are used to the appeals process (they do many of these), so it’s not the worst idea. And by the way, the appeals process (with the Riverside Board) is going to take a while, in fact you can count on months (maybe 6 to 8 months until your hearing).

What Kind of Appeal Do You Want to File?

Decline in Value Appeal– Very common. You believe your property is no longer worth as much as the assessed value. If you are filing a decline in value appeal, you must file your appeal as follows:

If you received your assessment in the mail by August 1- you must file your appeal between July 2 and September 15.

If you did not receive your assessment in the mail by August 1 (you received it later)- you must file your appeal between July 2 and November 30.

Base Year Value Appeals– A little different than a decline in value appeal. Here, what you’re auguring is that there should be a change in your property’s “base year value”, because (for example) a change in ownership of the property occurred, or perhaps there has been a change to the structure of the property (you added a garage). The concept of a base year value, of course, stems from California’s Proposition 13. Under Proposition 13, once a base year value has been established (for example, when you buy a previously owned house, the property has now undergone a change in ownership, and a new base year value is established), the property value (for tax purposes) can only go up a small percentage each year. We’ll speak more of Prop. 13 in detail in later blog posts.

Calamity Reassessment Appeal– A natural disaster has affected the value of your property (so a reassessment is required).

What Kind of Evidence Can You Present?

Obviously, most people will want to show evidence that their property is not worth what the assessor believes. The best evidence will be sales of houses which are comparable to yours (e.g., in your area, of like size, etc.). While the Appeals Board will consider this evidence, the only “comps” which generally count for their purposes are the sales that occurred between January 1 and March 30 of the year in question (sales prior to Jan 1 can be considered as well, but must be adjusted for elapsed time). You may wish to consider getting a formal appraisal (although evidence of three comparable sales of home sales in your area (within one mile radius of your home), of (generally) the same size and condition, will generally suffice.

For more information on the Riverside County Property Tax Assessment Appeals Process, give us a call.

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California residents are subject to California state income tax on all income regardless where earned. Frequent visitors to California who are not deemed California residents are only subject to California state income tax on their California source income. So the stakes are big when determining whether one is a California resident.

Under California law, a person who stays in the state for other than a temporary or transitory purpose is a legal resident, subject to California taxation. Basically, brief vacations or transactions, such as signing a contract or giving a speech, constitute temporary or transitory purposes that do not confer residency. Every other kind of visit can confer such a status, including coming to California for health reasons, extended stays, retirement or employment that requires a long or indefinite period to accomplish.

How does the Franchise Tax Board determine whether a visit has a temporary or permanent purpose? It applies the “Closest Connection Test.” This refers to the state with which a person has the closest connection during the taxable year. For the FTB, this literally means counting all the California contacts a person has and comparing that number with the non-California contacts. Of course, some contacts simply weigh more than others. A job or real estate ownership indicates a closer tie than merely enjoying a round of golf at a country club or a concert at the McCallum. The weightiest factors for residency are:

• Amount of time you spend in California versus amount of time you spend outside California.
• Location of your spouse/RDP and children.
• Location of your principal residence.
• State that issued your driver’s license.
• State where your vehicles are registered.
• State in which you maintain your professional licenses.
• State in which you are registered to vote.
• Location of the banks where you maintain accounts.
• The origination point of your financial transactions.
• Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys.
Location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member.
• Location of your real property and investments.
• Permanence of your work assignments in California.

This is only a partial list of the factors to consider.

So What is a Frequent California Visitor (aka, a “snow bird”) of California to do?

First, know the rules for keeping your status as a part-time resident. Snow birds have a presumption of nonresidence if they follow certain guidelines. The total amount of time you spend in California during the year has to be less than 6 months. You can own a vacation home (but it should probably be smaller or of less value than your main out-of-state residence). You’re allowed to have a small local bank account to handle your financial needs related to your stay. Your can have a membership in a local country club. Limit your California contacts to these, and you will probably avoid a lengthy audit, form or no form.

Second, lower your local profile. The State of California doesn’t know you’re here unless you or the financial institutions you deal with let them know. For instance, any interest generated on your local bank account gets reported to the State of California as a form 1099. You can fly under the State of California’s radar by opening a non-interest bearing account. It may cost you a few bucks in interest, but it may avoid an expensive residency audit. Given the ease with which you can access funds across state lines nowadays, it may not even be necessary for you to open a local account.

Similarly, a lot of part-time residents like to have local brokerage accounts. It seems free time and sunshine go together with playing the market. The problem arises when stock in a local account issues dividends, which get reported to the State of California. You should consult your broker concerning ways to avoid this. Again, because of the ease of trading stock nowadays, the broker may be able to hold the stock for you in an out-of-state affiliate of his office, or you can forget about brokers and trade online (you didn’t hear that from me). At the very least, have all brokerage statements sent to your out-of state address. The same is true for bills from all local professional services.

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Background: California’s “New Home / First-Time Buyer” tax credits are available for taxpayers who purchased a qualified principal residence on or after May 1, 2010, and before January 1, 2011. Additionally, these tax credits are available for taxpayers who purchase a qualified principal residence on or after December 31, 2010, and before August 1, 2011, pursuant to an enforceable contract executed on or before December 31, 2010. Both credits are limited to the lesser of 5 percent of the purchase price or $10,000 for a qualified principal residence. Taxpayers must apply the total tax credit in equal amounts over 3 successive tax years (maximum of $3,333 per year) beginning with the tax year in which the home is purchased. Note, however, the total amount of allocated tax credit for all taxpayers may not exceed $100 million for the New Home Credit and $100 million for the First-Time Buyer Credit.

New Home Credit: A qualified principal residence, for purposes of the New Home Credit, must:
Be a single family residence, either detached or attached. This can be a single family residence, a condominium, a unit in a cooperative project, a house boat, a manufactured home, or a mobile home. A home constructed by the taxpayer is not eligible since the home has not been “purchased.”
Have never been occupied. Sellers must certify that the home has never been occupied in order for a taxpayer to receive an allocation of the credit.
Be eligible for the California property tax homeowner’s exemption.
Be occupied by the taxpayer as their principal residence for a minimum of 2 years immediately following the purchase.

Update: As of March 24, 2011, the First-Time Buyer Credit was fully allocated. However, the California Franchise Tax Board (FTB) has issued an update on the New Home Credit. As of May 17, 2011, the FTB has numerous reservation requests and applications, but has not yet received sufficient applications to allocate the full $100 million. Claimants should continue using the 2010 forms for homes purchased pursuant to an enforceable contract in 2010, but closing in 2011. Taxpayers who applied for the New Home Credit for a purchase that closed escrow in 2010 and have not yet received a determination from the FTB, may either: get an extension to file their tax returns (to avoid penalties and interest, compute and pay any balance due as if their application will not be approved) or file now, but do not claim the credit (if their application is approved, they may then file an amended return).