California Residency Tax Planning
With 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.
Nobody makes this determination. It’s automatic. FTB software cross-references nonfilers with payers on information returns showing California addresses, and the notice goes out. 
Contrast this with a situation where a nonresident instructs the lender to use his home-state address on the 1098. In that case, there is no automatic issuance of a 4600 Notice. FTB staff would have to review the 1098 to determine if grounds exist for suspecting a tax return is due. One ground might be that the mortgage on the vacation home is substantial, so the FTB knows the property has a high market value. When compared with the taxpayer’s out-of-state accommodations, this may indicate it’s a principal residence and not a vacation home at all. Most residents have their bigger, better home in their home state (though I hasten to add this is not a bright-line rule). The point is, this analysis involves a conscious review. It isn’t automatic. Hence it is much less common.
The example uses a Form 1098, but the same outcome follows from a 1099, W-2, K-1, or any other information return. For instance, if a nonresident opens a local interest-bearing bank account, and the statements are sent to his California vacation home, the 1099-INT will generate an automatic 4600 Notice. If the nonresident instructs the bank to use his out-of-state address, some review would have to precede a notice being sent. For instance, if the local account had $1 million in it, that fact might coax the FTB into sending the notice.
Two Ways To Respond
Nonresidents have two options for responding to a 4600 Notice.
The first is the FTB may be right; the nonresident may actually have a duty to file a nonresident tax return. This would follow if the nonresident received California-source income during the tax year. For instance, if a Texas resident owns an interest in a pass-through entity operating in California, he would generally have to pay California taxes on the distributions. That’s almost too obvious. But California-source income comes in many forms, some more subtle than others: rent, compensation for working in California, nonqualified stock options or severance pay from a California business, trading Bitcoin from a California office. Nonresidents who receive California-source income usually have to file a nonresident return.
You don’t necessarily need a tax attorney to figure that out. The first page of the 4600 Notice always describes the putative reason the FTB suspects a tax return may be required. Any CPA competent in California sourcing rules should be able to tell whether the FTB’s reasoning is valid or not, after discussing the details with the nonresident.
The second option is to explain why a tax return isn’t required. That’s more complex. It usually means demonstrating that the recipient is a nonresident under California law or that the income at issue isn’t California-source (and if it has to be explained it’s because it falls into a problematic category, such as a noncompete clause in a stock purchase agreement). Supporting documentation may also be required. Responding in this way is best handled by a tax attorney familiar with residency law.
But even then, nonresidents need to evaluate the stakes. If only a few thousand dollars of California tax is at issue, hiring a tax attorney might defeat the purpose, since fees to competently handle a 4600 Notice response would probably exceed the taxes due. If, on the other hand, tens or hundreds of thousands of dollars in taxes are at risk, then retaining an attorney is almost obligatory. Put another way, if the FTB is angling for a residency claim against a high-income taxpayer, which is often the case in a 4600 Notice, then the taxpayer shouldn’t respond without tax counsel. Period. Nonresidents who respond to a 4600 Notice by themselves wind up in full-blown audits with remarkable regularity. In contrast, when an attorney with an expertise in residency law assists, the 4600 Notice response more often than not persuades the FTB to send a “release letter,” and the matter is closed.
Never Make That Mistake Again
Unfortunately, even a release letter may not be the end of it. If you receive a 4600 Notice for the prior year, and you keep doing the same thing, you are likely to receive notices in subsequent years. That’s why it’s important not only to respond properly, but to identify the cause of the notice being issued. As indicated above, if the notice is being generated automatically, it’s relatively easy to identify and fix. You have to determine the source of the information return and instruct the issuer to use your out-of-state address.
To reduce the risk of future notices being sent after review is another matter. That takes more planning. Here again, tax counsel may be in order, starting with a review of the taxpayer’s residency status. Essentially this involves undertaking an “internal” audit to itemize all the contacts the taxpayers has with California and other states, and analyzing how applicable residency law would rule under those facts. With that, a taxpayer and tax counsel can put together a plan to manage those contacts in a way that reduces a residency audit risk in the future, as well as limits the likelihood of an unfavorable result if a 4600 Notice is sent.
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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. We assist a clientele of successful innovators and investors, including founders exiting their startups through a sale or IPO, Bitcoin traders and investors, professional actors and athletes, and global citizens able to live and work anywhere. Learn more at our website: www.calresidencytaxattorney.com.
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