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.

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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.

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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.

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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.

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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:

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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.

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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:

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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.”