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Image for Guidelines for Determining California Residency

Out-of-state visitors who own vacation homes in California or otherwise spend significant time here are often anxious about their residency status. Let’s go over the basics of California residency taxation. They can be confusing, and sometimes brutal.

How Residents And Nonresidents Are Taxed

California residents are subject to California state income tax on all income regardless where earned. It doesn’t matter what or where the source. If a California resident derives income from investments in Saudi Arabia or from pensions accrued while working out-of-state, California will tax that income. The resident may qualify for a credit for paying taxes to other states, but the default rule is, a resident’s global income is subject to California income tax. Period. With a top bracket rate that is currently the highest in the nation, California residency comes with a significant tax impact.

In contrast, nonresidents are only subject to California state income tax on their “California-source” income.  That may be zero or it may be significant. California-source income takes many forms, some obvious, some more subtle. It could be rents derived from California real estate or income from business operations or wages for performing temporary work in-state (obvious). Or it could be a portion of the sales proceeds attributed to a noncompete clause when a founder sells his California business, or the gain from non-statutory stock options vested while the employee worked in California (not obvious). To celebrity name drop, when LeBron James, an Ohio resident, used to play the Lakers at Staples Center for the Cleveland Cavaliers, he paid California taxes on the income he made on game night, which in his case was no small amount. [By the way, now that James signed with the Lakers, he has a different problem: whether he can work for a California employer, train and practice here for a significant part of the year, and still remain a nonresident – the answer is yes, but that’s a different analysis (see, “Nonresidents Working Remotely for California Businesses: How to Take Paul Newman’s ‘The Sting’ Out of Your Taxes“).

So, the stakes can be high when determining whether a taxpayer is a California resident or not.

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graphic for NFT article

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

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

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

What is an NFT?

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

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

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CA residency photoE-commerce, advanced telecommunications, and the new prevalence of remote work have combined to give many married couples more flexibility in their working and living arrangements than in the past. One of these options, rare until recently, is for spouses to assert they live in different states for tax purposes. An increasing number of marriages have the mobility to allow one spouse to reside in California, while the other elects to establish or maintain legal residency elsewhere. This is especially true for high-income couples, where supporting two households is economically feasible, one spouse wants to enjoy the benefits of living in California (often with the couple’s children), and the tax benefits of the other spouse having nonresident status are significant.

That said, it is no simple matter to establish or maintain nonresidency status while married to a spouse who is a California resident. There are traps for the unwary.

To Each His Own Residency

Many taxpayers are surprised to learn California even allows separate residency status for spouses. But in fact, there is no such thing as “marital” residency. Residency status always belongs to an individual, whether married or not. Of course, a spouse’s residency status can have a substantial influence on the other spouse in a residency audit. It’s typical for married couples to live together, and the Franchise Tax Board, California’s tax enforcement agency, has a bias for the typical when it comes to residency determinations. But even leaving that aside, married couple tend to spend time together, and if a substantial amount of that time is spent in California, where one spouse resides, the other spouse can begin to look very much like a resident.

In the past, this situation was so uncommon it hardly made a blip on the FTB’s radar scope. It might involve a scenario where a husband took a long-term job out-of-state or overseas. Older cases are populated with merchant marines and oil-field workers in Saudi Arabia; more recent ones prominently feature professional athletes and corporate managers assigned to overseas offices. That’s changed. Separate-residency marriages are now more about a lifestyle choice involving a global economy and the scenario of remote work that can allow some people to live and work anywhere.

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CA residency and coronavirus

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

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

The Short Answer

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

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

And now the long answer.

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You don’t have to be a tax lawyer to know that the way to avoid becoming a resident of California is to spend less than six months in the state during any calendar year. Right?  Well, not exactly. The “six-month presumption,” as it’s called, which is mentioned in one form or another in almost every Google search result of California residency rules, isn’t all that it’s cracked up to be. That’s not to say the amount of time spent in California doesn’t play an important role in determining legal residency. Just the opposite. It’s critical. But the real rule is more complex and has to be understood in the context of how California determines residency. It isn’t by counting days. In fact, relying on the six-month figure as a somehow magical way to avoid California residency can get a taxpayer in tax trouble.

What Is The Six-Month Presumption?

The six-month presumption is established by regulation. You would think it says something simple like: if you spend no more than six months in California during any calendar year, you’re not a resident. That’s the popular online version. And frankly it’s the version many auditors for the Franchise Tax Board (California’s tax authority) seem to have in mind. But that’s not the legal rule.

Rather, the rule has various qualifiers: if a taxpayer spends an aggregate of six months or less in California during the year, and is domiciled in another state, and has a permanent abode in the domicile state, and does nothing while in California other than what a tourist, visitor, or guest would do, then there is a rebuttable presumption of nonresidency. What would a tourist, visitor or guest do? According to the regulations, nothing much more than owning a vacation home, having a local bank account for local personal expenses, and belonging to a “social club” (read “a country club”).

These qualifiers call for some parsing. Continue reading →

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married-couple-residency-6-copy-1-300x226Two recent court decisions have reemphasized how difficult it can be for a nonresident with a California spouse to avoid California income tax. Difficult, but not impossible.

Why The Cases Are Important

The opinions were issued by California’s Office of Tax Appeals, the state’s new administrative tribunal for determining tax appeals. Though nonprecedential (meaning they cannot be cited in future cases), the decisions are important because they are the first cases involving the issue of married couples with separate residency heard by the OTA since it took over appellate responsibility from the State Board of Equalization in 2018. As such, the cases offer some insight into how to plan for separate residency situations.

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Manes Law Blog imageNobody needs reminding that California is a high income tax state. Most people know there can be tax benefits from changing residency or maintaining nonresidency status where California is involved. With a top bracket rate of 13.3%, California residency at the time of a large capital gains event (such as a startup sale or IPO, for instance), can result in millions of dollars of state income taxes, while across the border in Nevada, the tax would be zero. But details matter. The amount of tax savings, if any, achievable through strategic residency tax planning depends on various moving parts: sources of income, types of compensation, connections people want to or must maintain with California, community property rules (for married couples), the cost and inconvenience of acquiring nonresident status, to name a few. The refrain found everywhere on the internet that huge tax savings beckon every resident to flee the state is simplistic at best. Accordingly, considerable forethought, usually with CPA assistance, is advisable before committing to a residency plan. This article discusses why.

How California Taxes Residents vs. Nonresidents

First the basics.

California residents are subject to California state income tax on all their taxable income regardless of the source. It doesn’t matter if the income comes from the moon, if it is taxable, then California tax system claims jurisdiction. It’s possible a California resident to qualify for a credit for taxes paid in another state for out-of-state income, and some income types are exempt on their face in California (such as social security retirement benefits), but the default rule remains: a resident’s worldwide income is subject to California income tax. Period.

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Bitcoin image for manes law articleWhere is Bitcoin?

This may sound like a question on a Philosophy 101 midterm exam. But in fact, it’s a real-world tax issue, with huge potential tax consequences for nonresident traders, investors, and users of cryptocurrency, at least to the extent they have financial connections with California. This is all the more true with the recent IRS announcement that it is scrutinizing thousands of cryptocurrency investors. Where the IRS finds taxes due from cryptocurrency, the Franchise Tax Board, California’s taxing authority, is sure to follow.

Why It Matters

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

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

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

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graphic for 4600 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 →

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

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

The Results

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

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

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Manes Law residency myth busting articleI discussed my top five internet myths about California tax residency rules in a previous article. Here are five more. Again, they’re in no particular order, but my comments should provide some indication about how important they are and why.

Myth #1: Leave California, Sell Your Business And You’re Home Free

Many of my clients are founders exiting startups, either through an IPO or purchase by another company. Or they are long-term business owners in traditional industries who plan to sell their California-based company after retiring out of state. The widespread internet meme insists these scenarios always result in zero California income tax on the gain, even though the sale is of a California business.

The basic concept is correct: if a nonresident sells his interest in a California business (that is, corporate shares, limited liability company memberships, partnership interests), the traditional rule is California can’t tax the gain. But not so fast. Numerous factors play a role in determining whether a business sale by a nonresident will escape California’s tax system.

The first is, the transaction must in fact be the sale of a business interest, not the sale of business assets. For good tax reasons, purchasers often prefer to buy assets, not business interests, if the value in the company is in the assets, not the brand. And in some industries, an asset sale is the standard for a business purchase. But take note: if the assets are situated in California, an asset sale by a nonresident results in California-source income, taxable by California regardless of the residency status of the seller. Generally, only interest sales are eligible for tax-free treatment by California when the owner is a nonresident.

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