California Residency Tax Planning
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.
Overview: Good News, Bad News
The good news is in most cases the Notice is a result of a mistake or some misinformation, discussed below at length, which can often be easily explained, resolving the matter. The bad news is, in some cases the Notice may put at risk the recipient’s nonresident status if they haven’t been careful in planning how their contacts with California compare with their home state. This is particularly true for former residents who recently moved from California, retained substantial connections with the state, and may not have disentangled themselves sufficiently from California residency to meet the legal standard. But it also can raise problems for longstanding nonresidents who have been spending more time at their California vacation home than their primary residence. The 4600 Notice is not the start of an official residency audit, but in cases like the ones just mentioned, it can be the prelude to a full audit if a proper, timely response isn’t made.
4600 Notice Risk vs. Audit Risk
There is a vast difference between the magnitude of California’s 4600 Notice program and its residency audit regime. Despite internet myths that California issues residency audits as readily as Chrissy Teigen issues apologies, California is actually somewhat sparing in bringing full residency audits. The restraint is not out of the kindness of the FTB’s heart. It’s a simple matter of resources. California’s residency rules are complex, and a great deal of resources have to be expended to make a residency adjudication; not to mention the fact that California has a population of about 40 million highly mobile people. In contrast, the State of New York audits virtually every taxpayer in the top brackets who leaves the state, a task made feasible due to the fact that New York’s residency rules are notably straightforward.
In short, the risk of a nonresident being audited for residency is low, except for those in specific high-risk categories (high income, a residency change shortly before a large liquidity event, marriage to a California spouse, work performed while physically present California for a significant amount of time, etc.). But unlike residency audits, 4600 Notices are issued by the bucketful. In 2019 over 430,000 4600 Notices were sent to nonfilers, according to FTB’s annual report to the legislature. Over half of these led to nonfilers filing a return. Not all of these taxpayers were nonresidents. But a large percentage were. Accordingly, the risk of receiving a 4600 Notice is high and somewhat indiscriminate compared to the risk of being audited for residency. The problem is, as discussed in this article, the 4600 Notice itself can increases the risk of a residency audit.
The Purpose of a 4600 Notice
The official purpose of the Notice is to instruct nonfiler recipients to either file a California tax return for the activity referred to in the Notice or provide an explanation of why they aren’t required to. Hence the “Request for Tax Return.” The Notice should be distinguished from a “Demand for Tax Return,” FTB Form 4684B, which is directed at out-of-state companies ostensibly doing business in California without filing the required returns.
The Notice is accompanied by a “Reply to FTB” questionnaire, which the nonresident must use if claiming a California tax return isn’t required. The questionnaire is potentially problematic. It can cause trouble for recipients who have been lax in establishing or maintaining their nonresident status. The FTB uses the questionnaire to gather financial/tax information: a person’s global income, where they work, what sort of California real estate they own. Needless to say, an entrepreneur or actor making $1 million a year and spending significant time in a Malibu beach house is likely to get more scrutiny from the FTB than a minimum wage worker.
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The FTB isn’t searching out the information. It’s like coral: it just has to wait for taxpayer information to come to it, usually by mistake
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The Deadline
The first page of the Notice will always indicate the due date for responding. It is critical that recipients either reply by the deadline or get an extension. Failure to timely respond can result in the taxpayer losing various administrative rights, and it usually means the FTB will issue a Notice of Proposed Assessment, which is much more difficult and costly to respond to than a 4600 Notice. Therefore, the first thing a recipient should do is calendar the deadline. It’s usually about 30 days from receipt. Most nonresidents receiving the Notice should retain a tax professional to assist in the response, so prompt action is in order.
A 30-day extension to the due date can usually be obtained merely by calling the number on the Notice and requesting it. The FTB’s historic practice has been to grant the first extension no questions asked. A second extension is another matter. That usually requires the assistance of a tax professional to jump through the hoops.
What Triggers a 4600 Notice?
4600 Notices are triggered by different kinds of tax or financial information coming to the attention of the FTB with respect to nonresidents who don’t file a California tax return. For the most part, the FTB isn’t actively searching out the information. It’s more like coral: it just has to wait for taxpayer information to come to it, usually by mistake. And this happens with alarming regularity. In the vast majority of cases, the information involves an official tax document, such as a Form W-2, 1099, 1098, K-1, etc., known by the IRS as an “information tax return.” If the information tax return involves a California-based payor or has a California address for the nonresident (which it never should, but often does), wheels start turning. The concept is, if an information tax return contains either type of data, the FTB has reason to believe that the recipient may be receiving California-source income or may be a resident, which if true, a California tax return would have to be filed. At that point, once the information tax return indicating a filing requirement makes its way to Sacramento, the FTB has to be persuaded otherwise, using the reply questionnaire.
The Integrated Nonfiler Compliance Program
That’s not to say the FTB is entirely passive when it comes to acquiring the information that might lead to the issuance of 4600 Notices. Since 2004, the FTB has had in place the so-called Integrated Nonfiler Compliance Program. The program is essentially a data base of tax and income information, which the FTB can then cross-reference with taxpayers who haven’t filed California returns. The information involves not only the aforementioned information tax returns, but also federal returns using a California address, occupational and professional licensing data, which the FTB culls from the records of California’s licensing boards (such as the State Bar of California, the California Board of Accountancy, the Contractors State License Board, and so forth), and even car leases (at least, the FTB has indicated it reviews vehicle lease data; I have never seen such a case in over 20 years of practice in this field, and I expect it is empty braggadocio on the FTB’s part). If you read appellate cases on residency, the INC program is sometimes mentioned as the procedural trigger of the action, resulting in a 4600 Notice being issued, leading to a notice of proposed assessment, and ultimately an appeal.
Automatic vs. Discretionary Notices
Information tax returns will automatically trigger a 4600 Notice if it has a nonresident’s name, tax ID number, and a California address, such as a vacation home or business address, and the taxpayer didn’t file a nonresident return (the last item applies to the vast majority of nonresidents). The FTB uses an algorithm to cross-reference the two conditions, as part of the INC program. Where both exist for a particular taxpayer, the result is a Notice being sent. In other words, an information tax return with a nonresident’s tax information sent to a California address almost inevitably provokes a 4600 Notice. The vast majority of 4600 Notices are issued under this automated system (over 360,000 in 2019, about 85%). For this reason, it’s critical that nonresidents who do not file California tax returns, never use a California address for any K-1, 1099, W-2, etc. It invites the problem.
To give an example of a common mistake. If the nonresident owns a second home in California, and has a mortgage on it, the mortgage lender will generate an annual Form 1098 Mortgage Interest Statement, reporting the interest from the loan to California tax authorities. If the nonresident uses the address of the California property in the “Payer’s/Borrower’s” section of the form (rather than using their primary out-of-state residence), then as far as the FTB algorithm can tell, there is a person living in a house in California (often a big expensive house, which can often be discerned by the size of the mortgage), but hasn’t filed a tax return.
But the Notice may also be sent when the information tax return appropriately uses an out-of-state address for the nonresident. In that case, however, an examiner needs to review the information to see if it indicates that a tax return is required. It’s discretionary. That decision to send the Notice will turn on whether the information tax return involves a California-based business or financial institution, which might indicate the nonresident is receiving California-source income, or working while in California, or hiring employees in-state and running a business here, and so forth.
It should be noted, however, that the problem is in many cases not caused by the nonresident. The FTB often receives false or garbled information from third parties, and the only tool the FTB has to sort the matter out is a 4600 Notice. They can’t just call taxpayers up and ask.
Finally, not all 4600 Notices are issued due to an information tax return. Other, desultory information can come to the FTB and result in a Notice. For instance, it’s not uncommon for the FTB to receive a copy of the taxpayer’s federal return (Form 1040), and for whatever reason, the nonresident used a California address on it. This can happen when a nonresident moves overseas and uses the address of a relative or friend living in California on their federal return out of convenience, because they don’t have any other local US address. Or the problem can arise for “digital nomads,” who have no fixed address and use a California P.O. Box or other California address for official business. Needless to say, that can be a costly mistake. In cases like that, all the FTB knows is that a taxpayer indicated on their federal return that they live in California, but they didn’t file a California return. Again, the FTB can’t just call the nonresident up and ask for a clarification. It’s only tool is the 4600 Notice.
Don’t Make that Mistake Again
If the 4600 Notice is the result of a mistake, typically a misdirected information tax return, the misstep needs to be identified to properly respond. But not only that, resolving the matter for the year at issue won’t prevent another 4600 Notice in subsequent years if the mistake is repeated. Indeed, it’s not unusual for a nonresident nonfiler to receive a 4600 Notice one year after the next, based on the same underlying error, even though the prior year Notice was resolved in the taxpayer’s favor. Accordingly, the goal should be to identify the trigger to the Notice for the year at issue, and then fix the problem so it doesn’t happen again. As discussed below, every 4600 Notice can potentially lead a taxpayer into a minefield waiting to explode into a full residency audit. So, it behooves nonresidents to avoid making the same mistake again.
Types of 4600 Notices
There are different types of 4600 Notices. The types more or less correspond to the different categories of information tax returns triggering the Notice. Some inquire into investment income from California sources, others involve purported work in California, and so forth. The FTB has a designation for each type, indicated by a letter after the number. For instance, a 4600B usually involves income sourced to CA banks/financial institutions; a 4600C relates to information about operating a business in California; a 4600F usually stems from a federal return with a California address on it; a 4600J is looking for proceeds from a broker or barter exchange; a 4600K, earned income from a 1099 or interest income from a 1098. But there is significant overlap, and the categories aren’t completely rationalized. Moreover, the FTB constantly revises the Notice in all its many variations.
The FTB Explanation
Fortunately, recipients don’t have to rely totally on the FTB’s ambiguous categorization system. The first page of the Notice always has a brief explanation of what triggered the Notice, beginning with verbiage such as: “We believe you need to file a [year] California return. We received information that you . . .” The explanation will refer to the information tax returns at issue, or other documents which piqued the FTB’s interest. That’s usually enough to determine what probably went wrong. This assumes that the documents in fact contain faulty or misleading information (like the wrong address), and the nonresident isn’t required to file a California tax return, but in some cases, a tax return actually is required, and the only mistake was the failure to file one.
Responding to a 4600 Notice.
Responding to a 4600 Notice can be tricky and involves multiple steps. You do not want to scrawl down a response and send it to the FTB, hoping for the best. Nonresidents need to proceed systematically. The steps are discussed below.
Step 1: Determine Whether a Tax Return Is Due
The first thing recipients have to determine is whether they are in fact required to file a California nonresident tax return (Form 540NR). Some nonresidents do indeed receive taxable California-source income which they mistakenly fail to report. It’s best to retain a CPA to determine that. The information tax returns or other documents referred to in the Notice will point the CPA in the right direction as to what possible income sourcing issue exists.
If, after reviewing your books and records, your CPA determines that you do have to file a 540NR, then the appropriate response to the Notice is to do just that before the Notice deadline (and again, you can usually receive a no-questions-asked extension of 30-days in situations where preparing the tax return involve complexities requiring extra time). That will resolve that particular Notice. But, of course, there will likely be penalties and interest assessed for the late filing. Moreover, and more important, the return may provide additional information to the FTB, such as the number of days spent in California during the tax year or a large liquidity event in the year at issue reported on your federal return (which must be attached), and that might encourage an examiner to initiate a full residency audit. And the FTB examiner doesn’t have to agree with how you reported the income, or whether additional taxes are due. But that’s the risk all nonresidents with reportable California income have to take. All the more reason to plan ahead to try to eliminate California-source income, if feasible; and if not, to understand what the risk-enhancing information an examiner will see on your nonresident return, with the goal of managing it to your favor.
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In cases where the taxpayer hasn’t been cautious about their residency status, especially where the taxpayer is in the highest income bracket, responding to the Notice can be a minefield
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Step 2: The (Possible) Informal Approach
Assuming a California tax return is not required, then, subject to your CPA’s counsel, if this is a simple matter of a wrong address on an information tax return or a 1040, you may want to just call the FTB at the number on the Notice and carefully and politely explain the mistake. Sometimes, if there was an obvious error and the FTB agent can verify it by looking at your digital file, the entire matter can be resolved over the phone, particularly if this same type of misinformation caused a 4600 Notice in prior years and was resolved in your favor. If the agent does close on the file based on a telephone call, it’s not because of the FTB’s largesse. The reason a phone call sometimes works to settle a 4600 Notice is that the FTB sees the same types of mistakes over and over again. Rather than going through the formal process to reach what will be the inevitable outcome, the FTB agent may have an incentive to end the matter without using more FTB resources for no purpose.
This is not a formal process. The FTB doesn’t offer it as an option. The FTB agent has no obligation the close the file based on a phone call. Some agents won’t even entertain an explanation over the phone. I am not recommending it. You should discuss the matter with your CPA or other tax professional before going forward to determine if the informal approach makes sense in your particular case. I can only state from experience that it sometimes works in the simplest cases.
Note that if you do avail yourself of the informal method, you have to be extremely careful not to offer any information other than necessary to communicate the simplest explanation possible. You don’t want to get into any details about your residency status besides indicating you are nonresident and a simple, easily understood mistake occurred. Any other information could open up a can of worms and be used against you if the 4600 Notice process goes forward.
Step 3: The Formal Reply
Getting back to the official response: most nonresident recipients of a 4600 Notice don’t have to file a return. Rather, as already indicated, 4600 Notices are overwhelmingly sent as a result of a mistake involving a misdirected or otherwise garbled information tax return. The FTB sends a reply questionnaire along with the Notice to be used to provide the explanation. Usually, a sufficient reply is as simple as pointing out that the nonresident mistakenly used an address of a second home in California rather than their primary residence out of state; or that the nonresident used a California address of a friend or relative, because they were out of the country; or the sale of the property that generated the information tax return was in another state. And so forth. The common mistakes are well-known to the FTB. They happen over and over and over again. So, the examiner is receptive to a plausible excuse for what happened if it falls into the usual categories of gaffes.
The Key Section
The reply can be submitted in hard copy or online. In either case, the key is usually the narrative to be provided in the “Explanation” section, variously labeled Part C or Part 3 in the reply questionnaire. The other parts of the questionnaire involve questions that have to be responded to, but there isn’t much strategy to that. The questions are straightforward (discussed in more detail further on). Since the reply is under penalty of perjury, the answers have to be truthful and to the point.
Where a common mistake has occurred, the focus should be on the narrative explanation. That’s where the nonresident convinces the examiner that there was a mistake of some kind, which may have indicated the recipient was a resident or had filing requirements. The explanation must be drafted to put that misimpression to bed. Part C or Part 3 usually only provides a few lines on the questionnaire. Accordingly, it’s wise to attach an exhibit if the explanation requires more space, and in most cases, it does.
Everything disclosed in the explanation should argue for nonresidency and refer to documentation supporting it in an orderly fashion. The explanation has to be backed up with documentation. Enough documentation should be attached to support the claim, but not so much that other questions are raised. The documentation should be carefully reviewed by a tax professional to insure there are no disclosures in it which are inconsistent with nonresidency.
That shouldn’t be a problem if the nonresident has taken care to maintain nonresidency and understands the test the FTB uses to adjudicate residency status. The test is discussed at length here.
Danger, Will Robinson!
Unfortunately, not all nonresidents do take care. Generally, responding to a 4600 Notice which resulted from a common mistake on an information tax return should be left to a tax professional. A knowledgeable CPA is usually sufficient. But this assumes that the nonresident doesn’t have significant contacts with California and has engaged in informed planning to establish or maintain nonresident status. Where this planning is lacking, then the nonresident may have taken actions inconsistent with nonresidency or apparently inconsistent with it: spending more time in California than their home state; buying a bigger, better second home than their primary residence; making representations of California residency in their loan or insurance documents; moving expensive vehicles or watercraft to California – the types of conduct that can shift the weight of the residency ledger to the Golden State, or at least appear to from the perspective of the FTB.
In cases where the taxpayer hasn’t been cautious about their residency status, especially where the taxpayer is in the highest income bracket, responding to the Notice can be a minefield. The taxpayer has to truthfully disclose information to explain the mistake (the response is under penalty of perjury), but too much information or equivocal facts may result in additional questions being raised in the mind of the FTB examiner. The last thing a taxpayer wants is a tax official with questions. It can lead to a full residency audit.
The FTB is cognizant of this. Depending on which type of 4600 Notice is sent, the reply questionnaire asks questions that are pertinent to whether the recipient had unreported California-source income or had contacts with California that might be inconsistent with nonresidency. The questions may include whether the nonresident worked while physically present in California, what their gross income was, whether they received a K-1 from any company doing business in California, whether they sold or rented any California real estate or other assets, the location of their employer, whether they cosigned a loan for the purchase of California property, whether a third party paid their mortgage on California property, and if they moved from California during the year at issue, what date they moved.
Since these and other questions like them are raised on a 4600 Notice, a nonresident with significant connections with California might want to plan accordingly to be able to answer the questions in a manner that would defang them and truthfully indicate nonresidency status to an examiner reviewing the reply.
Professional Assistance
When the response threatens to enter into areas that put the recipient’s residency status at issue, and where the potential tax liability is large, the taxpayer should retain not only a CPA (you should always do that), but also a tax attorney with experience in responding to 4600 Notices. But even more effective is to have a plan in place beforehand to minimize the risk of a Notice being sent, or if it is sent, will result in ready, truthful answers that strongly support nonresidency.
The FTB’s Next Step
If the mistake is clearly explained in a timely response to the Notice, the matter is usually resolved. The FTB indicates this by sending a “confirmation letter,” stating the explanation is accepted. That closes the matter. At least for the year at issue. If the same mistake is made in subsequent years, another 4600 Notice may arrive in the mail. The FTB doesn’t look to history in deciding whether or not to send a Notice. Each year stands on its own.
In contrast, if the FTB doesn’t accept the explanation, things can go downhill fast. The FTB can demand the nonresident file a tax return, or initiate an audit for residency or for unreported California-source income. A full-blown audit can quickly become expensive and put at risk all the taxable income received by the nonresident during the year at issue. And this may put subsequent or prior years into residency limbo. It pays, therefore, to take the Notice seriously and deal with it with professional assistance.
Manes Law’s 4600 Notice Response Services
Manes Law has a decades-long record of success in assisting 4600 Notice recipients. Please note that Manes Law only accepts 4600 Notice cases where the potential tax liability is over $100,000. We only work on a fixed-fee basis as a consultant to the team handling the response, which should include a CPA. Contact us for information on our fixed-fee amount. Simple 4600 Notices, involving smaller tax liabilities or common mistakes that are easily explained without much risk of exposing the recipient to an unfavorable residency audit, are usually best handled by a knowledgeable CPA or other tax professional billing at an hourly rate.
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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, and retire where they want. Learn more about our services at our website: www.calresidencytaxattorney.com.
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