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graphic to Manes Law residency tax blog

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.

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Burn notice 4600 notice

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.

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California Tax Fraud

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.

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Working Remotely Rules

The Issue

With the rise of ecommerce, advanced telecommunications, and the new prevalence of remote work due to the COVID emergency, more and more people are choosing the option of living in one state while working for an employer in another, 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 of that, remote workers need to be careful and understand the tax rules for nonresidents working for California firms, at least for highly compensated former residents.

California Tax Rules For Remote Employees

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 employer. This is true even if you are a nonresident, even if the employment agreement with the employer is made out-of-state, and even if the wages are paid to you outside of California.

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graphic for NFT article
Hot as a Recalled MacBook Battery

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 for $2.9 million.zero-like-tweet-1

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 photo

The Issue

E-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

The Issue

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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graphic for six month presumption article

The Six-Month Mythos

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 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 would say 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 enforcement agency) 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.

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separate residency marriage

The Cases

Two 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.

The first case, In the Matter of the Appeal of Hyginus Offor, OTA Case No. 18011264, affirms the longstanding and often misunderstood rule that while married couples can have separate residency, their income remains reportable community income unless the nonresident spouse also changes domicile from California or maintains out-of-state domicile. The decision starkly illustrates how domicile and residency are related, if legally distinct concepts; and sometimes both have to be managed to avoid California income taxes for spouses planning to have separate residency status.

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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 potential huge tax consequences for nonresident traders, investors, and users of cryptocurrency, at least to the extent they have financial connections with California, through an exchange or via cryptolending. This is all the more true with the recent IRS announcement that it is scrutinizing thousands of cryptocurrency investors to determine if they have properly reported taxable income relating to crypto. Where the IRS finds taxes due from cryptocurrency transactions, the Franchise Tax Board, California’s main tax enforcement agency, 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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