4600 Tax NoticeOur office has experienced a significant increase in the number of taxpayers reporting they have received 4600 Notices “Request for Tax Return” sent by the Franchise Tax Board (California’s tax enforcement agency). The likely explanation is discussed below.

What’s Happening?

This July, our office saw a spike of 100% from the prior year in contacts from taxpayers seeking guidance after receiving a 4600 Notice from the FTB. There is a particular increase in nonresidents who have businesses out of state with no direct contacts with California. The notice relates to whether they are “doing business in California” as a result of sales to California customers. The upsurge could simply be more potential clients are choosing to contact our firm, but the more likely explanation is an actual increase in the volume of 4600 Notices sent, especially those relating to doing business in California.

What Is a 4600 Notice?

The FTB sends a 4600 Notice when it has reason to believe the recipient, usually a nonresident, was required to file a California tax return in a prior year, but didn’t. The notice is sent automatically when the FTB receives information to indicate that the non-reporting taxpayer earned or was distributed California-source income or may reside in California. The notice requires recipients to either prepare and file a California tax return or explain why they aren’t required to. If the FTB accepts the explanation, the matter ends there. If the FTB doesn’t, then a full audit follows.  Continue reading

 

California Tax Traps for Nonresidents

Sunny Taxxy California

Most of the world knows the Palm Springs area for its picturesque golf courses, celebrity homes and halcyon weather. Among the taxing authorities in Sacramento, however, the words “Palm Springs” conjure up less carefree images. Spurred by the state’s appetite for tax revenues, the Franchise Tax Board, California’s main tax enforcement agency, has tapped into a new revenue source: taxing seasonal visitors to popular vacation spots in California, where residents often have second home. Palm Springs is one such area. But so is Santa Barbara, Sonoma County, San Diego.

Seasonal Visitors As Tax Targets

This is how it works. California taxes residents based on their worldwide income, from whatever source, no matter how far-flung. In contrast, California taxes nonresidents only on their income derived from California sources. For instance, these might include a limited partnership operating in California or rent from an investment property. Since California has the highest income tax rate in the country, visitors who suddenly find themselves defined as “residents” may face a large and unexpected tax liability.

Obviously, the FTB  would like to claim everybody who sets foot on California soil as a resident and subject their income to California tax. That’s their job, after all. As many seasonal visitors have discovered, the FTB’s policies sometimes seem not to fall too far short of that mark.

A special division of the FTB has for years systematically targeted seasonal “part-time” residents for audit (I use the term “part-time” loosely, since we are talking about nonresidents who spend part of the year here, not part-time legal residents per se; but the term has stuck). Though other vacation spots experience their share of audits, historically the most common casualties are affluent “snowbirds” who own vacation homes in the Palm Springs area as an escape from the winter blasts of the Midwest or northern states. In fact, many of the major cases in residency taxation are eerily similar: they usually involve Midwesterners who own winter vacation homes in Palm Springs and environs. If the FTB finds significant taxable income coupled with meaningful contacts with California (such as a vacation home, business interests or long visits to the state), it can lead to the launch of a full-blown residency audit. Continue reading

 

Temporary Work in CaliforniaWhat’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 (see my article Nonresidents Working Remotely for California Businesses ). 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.

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. It isn’t 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. To control that, nonresidents working in California should have a plan.

Why It Matters?

At first blush, it might not seem to matter whether a nonresident working on a temporary basis in California is deemed a resident or not. The wages or 1099 (independent contractor) income received while working in California is usually taxable by California regardless of residency status. That’s inescapable because the work is performed in California in the case of W-2 salary. In the case of 1099 income, if the work is in California, that usually means the customer is 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.

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% (14.3% if the income is W-2 sourced to California). Continue reading

 

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The Issue

With more and more companies forgoing brick and mortar by operating their business through the internet, tax authorities find it increasingly difficult to determine which enterprises are subject to state income taxes and which aren’t. Typically, California has taken an aggressive stance. In 2011, it passed a new law that defined “doing business” in California beyond being physically present by having offices or operations. Instead California sought to define what constituted an “economic nexus” to the state, using factors such as sales, payroll, and inventory. In 2013, comprehensive regulations went into effect casting a broad net over the activities of out-of-state corporations and pass-through entities (LLCs, partnerships, S corporations) as doing business in California. Judicial decisions interpreting those rules are just starting to trickle in. The picture that is emerging indicates that non-California internet businesses need to be wary or they may find themselves subject to California taxation.

Why Does It Matter Whether Your Company Is “Doing Business” in California Or Not?

First, why does it matter if California determines an internet company is “doing business” in California? It may matter a great deal. The determination that an out-of-state entity is doing business in California is one of the ways California can impose income taxes on that business, even if they have no physical presence in California (the other is based on the entity earning California-source income). In some cases, there may be a tax liability even if the company made zero income from California sales. Continue reading

be69b4ce-157d-4f45-b50f-6b7133f1608dHundreds of thousands of nonresidents have vacation homes, investments, business operations, and other substantial contacts in California. Many fear those contacts will trigger a residency tax audit – California’s system for determining which taxpayers are legal residents and hence liable for California’s state income tax. The concern is warranted, if often exaggerated by internet myths about the Franchise Tax Board, California’s tax enforcement agency, peeping through your keyhole. California is in fact notably aggressive among the states in claiming out-of-state taxpayers as residents. With the highest state income tax in the nation, California cares about residency status much more so than do low or zero income tax states. Because it matters, the FTB wants the facts, ma’am. A residency audit is California’s unpleasant way of getting them.

Fortunately, however, once you understand how California’s residency audit system works, you can plan to reduce your risk. Let’s discuss three end-of-year actions nonresidents can take to avoid the most common scenarios that lead to a residency audit.

What Is A Residency Audit?

First, it helps to know what a residency audit actually is and how they are triggered. Continue reading

bloginuseDBIC-1The Franchise Tax Board, California’s taxing authority, has consistently taken an aggressive stance in claiming out-of-state businesses have income tax reporting requirements for “doing business in California.”  The FTB reached a limit in Swart Enterprises, Inc. v. Franchise Tax Board, Cal. Ct. App. (5th App. Dist.), 7 Cal. App. 5th 497 (2017).  In that case, a California appeals court ruled against the FTB’s claim that a foreign corporation with a passive .02% ownership in a California LLC was doing business in California.  As a result, the FTB was forced to modify its ruling on doing business in California by members of multi-member limited liability companies.

FTB Walks Back Prior Ruling

Specifically, the FTB has modified California FTB Legal Ruling No. 2014-01, 07/22/2014, which sets forth the FTB’s analysis on a number of “doing business” scenarios involving members of multiple-member LLCs that are classified as partnerships for tax purposes.  The ruling had asserted that the distinction between “manager-managed” and “member-managed” LLCs, made no difference in determining whether a member of the LLC was doing business in California.  The reasoning in Swart Enterprises made that assertion untenable.  As a result, the FTB has removed the language and replaced it with the innocuous phrase: “a narrow exception may apply in limited circumstances.” Continue reading

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It’s no secret that California has a high state income tax rate. In fact, it has been the undisputed income tax champion for the past decade or so (the middle brackets are more compressed, and some states even have higher middle bracket rates). 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, Texas and Washington State. Often those businesses have to operate in California, since that’s where the market for the product or service is, or there is valuable cachet in having a California location such as Silicon Valley or Orange County. And often for small businesses and startups, the owner has to be present in-state for the enterprise to operate and 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. Moreover, as e-commerce continues to grow in market share, a physical presence in California becomes less and less necessary for many businesses, and relocation may result in tax savings for sales to non-California customers. Some companies may have started in California, but as they’ve prospered, they can operate from any state. In cases like these, some strategic use of out-of-state entities can result in large enough tax savings to make the major step of relocation worthwhile. But details matter.

The Rules Of California Residency Taxation

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 individual residency and business domicile. Changing residency is not a panacea for every tax problem. It only works in certain situations. And to determine where it works requires understanding the basic rules of how California taxes individual residents, nonresidents and businesses. Continue reading

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

When Changing Residency Isn’t Enough

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

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

moz1With Tax Day having come and gone, the Franchise Tax Board, California’s tax authority, is now busy sending out its annual 4600 Notices, also known as “Request for Tax Return” letters.  Almost all 4600 Notices are sent to nonresidents, mostly those who own a vacation home or have a business interest in California, and have made one of several common mistakes.  For a full discussion of what a 4600 Notice is, see “They’re Back: FTB 4600 Notices Coming Soon to You.”

If you receive a 4600 Notice, the first order of business is to timely and effectively respond.  Whether that means filing a nonresident tax return (a Form 540NR) or providing a proper legal explanation for why you don’t have to, depends on the circumstances.  Second, assuming the notice gets resolved favorably, the next task is preventing the same problem from recurring in future years.

Automatic vs “Reviewed” Triggers

4600 Notices don’t just happen.  They are triggered.  The trigger is usually one of several common, avoidable mistakes by nonresidents.

In my practice, the typical 4600 Notice involves a nonresident who owns a vacation home in California with a mortgage.  Out of convenience or just as an oversight, the nonresident tells the mortgage lender to send the Form 1098 Mortgage Interest Statement to the vacation home.  Form 1098 is the “information return” mortgage lenders generate to report loan interest.  They send one copy to the FTB and another to the borrower.  If the “Payer/Borrower” address on the 1098 is in California, and the borrower doesn’t file a state tax return, the FTB will automatically send a 4600 Notice. Continue reading

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The fortunes currently being made in Bitcoin and other cryptocurrency investments and trading offer unique opportunities for tax planning that other appreciated assets often do not. This article discusses one of those aspects: the importance of residency planning in reducing cryptocurrency tax liability at the state level.

What Makes Cryptocurrency Conducive To Residency Tax Planning?

Bitcoin and other cryptocurrencies are unique assets in many ways. But for residency tax planning purposes, these three factors make all the difference.

First, much of the taxable gain in appreciated cryptocurrency investment remains unrealized – that is to say, the investors have yet to sell or exchange their initial investment. This is due to the volatile nature of cryptocurrency values, but it’s also a result of the second factor.

Second, unlike traditional investments, the Bitcoin phenomenon has been driven by young disruptive investors, not the usual Wall Street sages with briefcases stuffed with earnings-to-value reports. Many of my clients made relatively small investments, either directly or through mining, in their early twenties, and now, as they enter their thirties, they find themselves sitting on millions or even tens of millions of untaxed appreciated cryptocurrency. Because younger people tend to be mobile, they can move anywhere before cashing out. Which brings us to the third factor. Continue reading

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