Hundreds 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.
It’s critical to understand that California residency audits are not typical financial audits. Most taxpayers – and tax professionals – are only familiar with tax audits involving financial and business matters. These usually revolve around underreported income, disputed deductions and losses, charitable gifts, business expenses. The taxpayer’s role in the examination is often limited to instructing a CPA to handle the matter and enduring a disagreeable meeting or two with the auditor.
But again, California residency audits are not financial audits. They rarely involve the usual suspects found in standard tax examinations. Rather, they turn on a taxpayer’s legal status with California as a result of his lifestyle. That is, the auditor inquires into where the taxpayer spends his time, what he is doing while in California as opposed to other states, what assets he owns and where, what organizations he belongs to and why, what goods and services he purchases, the location of the gym where you can find him running on a treadmill. In short, a residency audit is very intrusive and pries into a taxpayer’s private life more than his business activities.
The idea is, if a taxpayer has sufficient contacts with California to confer residency, then all his income from whatever source is taxable by California. But what makes a person a resident of California has nothing to do with tax concepts per se. It is a separate body of law, built up helter-skelter over many years, through regulations, FTB rulings and court decisions, none of which are particularly intuitive. For this reason, not a few qualified tax professionals don’t even think about residency in giving tax advice . . . until it’s too late.
In addition, unlike typical tax audits, residency audits don’t just happen. They have to be triggered, outside the usual process of suspicious auditors examining tax returns for discrepancies. In most cases, with nonresidents, there isn’t even a California tax return to examine. Rather, residency audits tend to be triggered by mistakes or situations that can be avoided.
An example: many nonresidents own second homes in California purchased with a mortgage. To report the interest income, the mortgage lender prepares a Form 1098 Mortgage Interest Statement, and sends it to Sacramento with the nonresident’s name, social security number and address on it. Unless told otherwise, the mortgage lender will use the vacation home as the borrower’s address. If the borrower hasn’t filed a California tax return (and nonresident borrowers don’t unless they have reportable California-source income), come tax time, the FTB will send out a “4600 Notice” asking what’s going on. If the nonresident doesn’t explain the situation to the FTB’s satisfaction, a full audit will follow.
The point is, residency audits are almost always triggered by something going to the FTB, often by mistake. They don’t follow the normal scrutiny of tax returns.
Let’s turn to the three most common scenarios that can be avoided before the end of the year.
1. Check The Information On “Information Returns”
As just discussed, most residency tax audits result from documents going to Sacramento with your name and address on it. Usually this involves so-called “information returns” – a Form 1098, 1099, K-1, W-2. Information returns report distributions, payments or income with respect to some other taxpayer. If the taxpayer is a nonresident, then in many cases either the address should not be a local California address, or the document shouldn’t go to Sacramento at all.
In the Form 1098 example, the nonresident should inform the mortgage lender not to use the encumbered vacation home as the borrower’s address. The borrower’s address should be his home state address. Mortgage lenders don’t care one way or the other. Only by default do they use the local address. So, tell them not to. Otherwise, it almost always leads to a residency audit.
This applies to other information returns. For instance, many of my clients are nonresidents who work remotely for a California company. Their employer will, of course, generate a W-2 reporting their income. It’s critical that nonresidents in this situation instruct the employer not to report the income as California source, which means the W-2 should only use the nonresident’s out-of-state address. Most large companies understand these reporting rules. But smaller employers may not. To get certainty, always raise the issue.
The good news is, information returns aren’t usually prepared and filed with Sacramento until the end of the year. Often, they don’t go out until the deadline, which is the end of January of the next year. So, there is still time to fix any problems. If some information returns have already been prepared (a 1099 might be issued upon performance of a service), then have them corrected before the new year. That will forestall this problem.
2. Eliminate Unnecessary California-Source Income Through Family Gifts
There is also time to manage sources of California income, and possibly get them off your books. Remember the general rule: the FTB doesn’t typically initiate a residency audit unless something comes to them. Income sourced to California will almost always result in an information return going to Sacramento. Thus, a small bank account that bears even minor interest (something many nonresident vacationers have in California) will result in the bank issuing a 1099. Even if it doesn’t have your local address, the fact that it is sent to Sacramento raises your audit risk. If interest has already accrued, you may not be able to prevent a 1099 from issuing this year. But ask. The bank may allow you to waive the interest upon request. And if you close the account by year end or change it to a non-interest-bearing account, at least the problem won’t be repeated next year. As a practical matter, with interstate and internet banking, there is usually no reason nowadays for a nonresident to have a bank account located in California at all.
That’s an easy case. The hard case is where the California-source income is significant, such as distributions from California-based companies or from angel investments. That scenario will inevitably require the nonresident to file a nonresident tax return (a Form 540NR) and pay taxes on the California-source income. That’s not the end of the world. Few 540NRs are audited for residency. But remember the general rule. Sending anything to Sacramento increases the risk of a residency audit for nonresidents. If you file a 540NR, you have to attach your federal tax return (Form 1040). If your global income is significant, the 1040 will alert the FTB about it, giving an incentive to audit for residency.
Of course, it’s always better to make money and pay taxes on it rather than not make any money at all. However, many high-income taxpayers often have estate plans with gifts to their children or other family members upon death. If the plan is to give your family members gifts from your estate anyway, one solution to the California-source problem is to make the gift now, either outright or through an irrevocable trust. This is especially true if the income at stake isn’t critical to your lifestyle. That’s often the case of rentals of California real estate, or small LLC interest in California companies.
In short, you have to evaluate whether the income at issue is worth the increased residency audit risk. If the income is not significant in the context of your total income, some gift planning may make sense to reduce your audit risk. And of course, you can always sell the interest to a family member as an alternative. It’s often the case that younger adult children have lower income, so the total tax burden to your family is lessened.
If it is an option to gift or sell the property, now is the time to do it. Although it won’t forestall a requirement to file a nonresident return for this tax year for any income already accrued, it will prevent the problem being replicated next year. Obviously, before taking any action like this, you should discuss the matter with your estate planning attorney.
3. Inventory Time in California
Finally, they say time heals all wounds, but it also increases the risk of a residency audit. The more time spent in California, the more a nonresident risks triggering something going to Sacramento. It could be something obvious, like a 1099 to a California professional whose services you use. Or something arcane, like a “use tax” inquiry by California over a product you bought on an online store, which was sent to your vacation home, without paying sales tax.
Worse, if the amount of time you spend in California exceeds six months (or even if it only exceeds the time you spend in your home state), you risk an unfavorable audit result, depending on the circumstances. See, “The Six-Month Presumption in California Residency Law: Not All It’s Cracked Up To Be.” If significant taxable income is at risk, it might make sense to curtail your vacation plans for this year and go back home or spend the waning months of the tax year traveling elsewhere. Now is the time to figure that out.
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. We serve a clientele of successful innovators and investors, including entrepreneurs selling their companies, 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.