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 that accrued while working in Ohio, California will tax that income. The resident may get a credit for payment of taxes on income earned in other states or other countries (if a tax treaty permits), but the default rule is, the income is subject to California income tax. With a rate that is currently the highest in the nation (the distinction tends to go back and forth with New York), 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, from rents derived from California real estate to business operations to performing temporary work in-state. To give a rather public example, when LeBron James, an Ohio resident, not a California resident, plays the Lakers at Staples Center, he pays California taxes on the income he made on game night, which in his case is no small amount.
So the stakes are high when determining whether a taxpayer is a California resident or not.
Who Is A 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. “Temporary and transitory” is a term of art. Vacations or brief transactions, such as signing a contract or giving a speech, constitute temporary or transitory purposes that do not confer residency. But time is less important than purpose. If a person is so inclined and has the resources to vacation for a whole year in California he theoretically would not be a resident. But at some point, the time spent here indicates an intent that is other than transitory or temporary. The Franchise Tax Board, California’s taxing authority, looks to intent not by what people say, but by what they do.
Thus, you often hear of the six-month presumption, with the suggestion that if you stay six months or less, you are not a resident, and if you stay more than six months, you are. The six-month presumption is more complex than that, but the idea is sound. The more time you spend in California, the more likely you will be deemed a resident as a matter of law. And the converse is also true.
Coming to California for an indefinite time or purpose falls outside the temporary or transitory category. There are numerous (older) cases of taxpayers staying in California to soak up the warm weather for health reasons with no definite date for leaving in mind. The results are always the same: they were deemed residents. Similarly, extended stays for retirement or employment that involves an indefinite period with no obvious termination date, confers residency.
The Closest Connection Test
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 count more than others. A job or real estate ownership tends to indicate a closer tie than merely enjoying a couple weeks at a beach house. 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 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 which tend to show up in case law. Other facts loom large in audits, but rarely show up in appeals. For instance, if a nonresident puts the address of his California vacation home on his federal tax return, he is asking for an audit. The same is true if you uses a California address for tax forms generated by businesses, employers or financial institutions (W-2s, K-1s, 1098s and 1099s). But it’s important to note that no one thing makes a person a resident or nonresident. It is all the facts and circumstances taken together.
So What’s A Snowbird To Do?
Tax issues aside, nonresidents like to vacation in California, especially if they come from wintry states (the so-called snowbirds). And many even invest and start businesses here, while planning to retain their residency elsewhere. They have a right to do so. Again, no one thing makes a person a California resident. The key is to take precautions and undertake some planning to avoid making common mistakes that confer legal residence, or at least that open the door to a residency audit.
First, know the rules for keeping your status as a nonresident. Snowbirds 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 six months or less. 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 (something that isn’t even necessary anymore with interstate on online banking). You can have a membership in a local country club. Limit your California contacts to these, and you will probably avoid a lengthy audit. This won’t guarantee you won’t be deemed a resident, but it will keep the law on your side during an initial review.
Second, keep your local profile low. 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 dollars 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, make sure any informational tax forms (such as a Form 1098 for mortgage interest) are not sent to your vacation home. Make sure the lender, broker or other financial institution uses your out-of-state address, even if it’s inconvenient. The most common mistake a nonresident can make is to use a local vacation home address for financial and tax documents. The problem is, copies may be sent to the FTB, and when the FTB cross references them with your name and finds no tax return has been filed, they send out a special notice (called a 4600 Notice), asking about it. This can be a precursor to a residency audit.
The same is true for bills from all local professional services.
Finally, it’s important to treat your vacation home like a vacation home, not a principal residence. That requires some planning. More on this later.
Sanger & Manes LLP is the premier law firm in California residency tax planning, consultations, audits and appeals. We have over two decades of success assisting Californians who want to change their legal residency, businesses moving their situs to other states, and nonresidents purchasing vacation homes or investment property in California. Learn more at our website: www.calresidencytaxattorney.com.