Articles Posted in California State Tax Issues

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Promissory note sourcingNonresident individuals and out-of-state companies often make loans to California-based borrowers. It’s not unusual for those promissory notes to be secured with California real estate. The scenarios take many forms. A person may inherit the note from a parent, or they may feel obliged to make a loan to a child purchasing their first home. Or the note may be on the books of an out-of-state company as a result of the sale of assets or a subsidiary to a California buyer. Clients in these circumstances often ask me whether the interest from the note is California-source income. The short answer is, generally no. The long answer is, it depends.

Why It Matters

It obviously makes a financial difference if loan interest is California-source income. Nonresidents are taxed by California on income sourced to this state. If the interest on such loans are California-source income, the nonresident must file a nonresident return and pay California income taxes. An analogous situation applies to out-of-state companies that hold such notes. If the interest is revenue sourced to California, the lender is “doing business in California” and owes California taxes on that revenue. But even if the amount of tax is minor, there may be a larger downside. For nonresidents, a California income tax reporting requirement means that the Franchise Tax Board, California’s tax enforcement agency, will know everything about the taxpayer’s global income. That’s because the nonresident must attach a federal return, Form 1040, to the nonresident state return, Form 540NR. It’s not the end of the world, and it by no means guarantees a residency audit, but if the person’s global income is particularly high, and if there are indications of other significant contacts with California, then it could increase the chances of the FTB initiating a residency audit, something that promises unique unpleasantries for nonresidents. See, California Residency Audits: Three Year-End Tasks to Reduce the Risk for Nonresidents.

For business entities, having California-source income raises similar complications. An out-of-state company doing business in California has to register as a foreign entity and file all appropriate entity tax returns, regardless of how de minimis its California taxable income is. And, if the entity is a pass-through, the reportable California-source income may also require the principals to file nonresident returns. A double whammy. Continue reading →

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Manes Law Blog Tax Trap Most of the world knows the Palm Springs area for its picturesque golf courses, celebrity homes and halcyon weather. Among the taxing authorities in Sacramento, however, the words “Palm Springs” conjure up less carefree images. Spurred by the state’s appetite for tax revenues, the Franchise Tax Board, California’s main taxing authority, has tapped into a new revenue source; taxing seasonal visitors to our area as state residents.

Seasonal Visitors As Tax Targets

This is how it works. California taxes residents based on their worldwide income, from whatever source, no matter how far-flung. In contrast, California taxes nonresidents only on their income derived from California sources. For instance, these might include a limited partnership operating in California or rent from an investment property. Since California has the highest income tax rate in the country, visitors who suddenly find themselves defined as “residents” may face a large and unexpected tax liability.

Obviously, the FTB  would like to claim everybody who sets foot on California soil as a resident and subject their income to California tax. That’s their job, after all. As many seasonal visitors have discovered, the FTB’s policies sometimes seem not to fall too far short of that mark.

A special division of the FTB has for years systematically targeted seasonal “part-time” residents for audit (I use the term “part-time” loosely, since we are talking about nonresidents who spend part of the year here, not part-time legal residents per se; but the term has stuck). Though Santa Barbara, Los Angeles and Sonoma counties experience their share of audits, historically the most common casualties are affluent “snowbirds” who own vacation homes in the Palm Springs area as an escape from the winter blasts of the Midwest or northern states.  In fact, many of the major cases in residency taxation are eerily similar: they usually involve Midwesterners who own winter vacation homes in Palm Springs and environs. If the FTB finds significant taxable income coupled with meaningful contacts with California (such as a vacation home, business interests or long visits to the state), it can lead to the launch of a full-blown residency audit.

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sfHo7Ho8_400x400The global economy has enabled growing numbers of California residents to find employment overseas, often in Pacific Rim or European countries.  Many of these jobs are in financial services or high-tech industries and can be very lucrative.  The temptation is to pack up and leave without thinking about the California tax consequences.  But that can be a costly mistake.  California has special rules for changing residency to another country.  If they aren’t scrupulously followed, expatriates can find themselves facing a large California tax bill along with the cheerful balloons at their welcome home party.

Changing Residency To Another State vs Another Country

Changing legal residency from California to another state has fairly straightforward rules, if you’re willing to seriously pull up stakes.  If you keep a vacation home, or a business, or work remotely, then it gets complicated.  But the concept is direct enough: to change your legal residency from California to another state you have to (a) intend to change your residency (that is, intend to leave for other than temporary or transitory purposes) and (b) physically move to the new state (you can’t just think about moving).

How the Franchise Tax Board, California’s taxing authority, determines intent and what constitutes “moving” is another matter.  California residency law has few bright-line rules, and its “facts and circumstances” test can sometimes seem like a Kafka novel in its excruciating focus on seemingly casual details used to punish the unwary.  That said, if you follow the regulations and case law, and avoid common mistakes, you can have some degree of certainty about establishing yourself as a nonresident in another state, just by leaving and not looking back.     Continue reading →

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bribe-300x150Whistleblower awards are big business.  In 2016 alone, the IRS paid over $60 million to whistleblowers.  The SEC awarded a similar amount.  A patchwork of other whistleblower laws involving 57 federal statutes and 44 states, including California, also result in tens of millions in annual payouts.  Not all whistleblower laws involve awards, but rather damages for retaliation.  For instance, Penn State was ordered to pay coach Michael McQueary $12 million after firing him for reporting the notorious Jerry Sandusky to college officials.  Though the amounts vary widely year to year, the trend is more tips filed, more whistleblower cases, bigger awards.

Whistleblower cases usually take a long time, with many obstacles along the way that can derail final payment.  The average is three years.  It’s a long wait, but it does provide an opportunity for tax planning for those who don’t want to be taxed by California for an award that can run from hundreds of thousands to tens of millions of dollars (my practice has involved tax planning for clients who received awards along most of this spectrum).

How Are Whistleblower Awards Taxed?

At the federal level, the taxation of whistleblower awards has been highly litigated and subject to Congressional tinkering.  But the ultimate result is the proceeds of the award are taxed as ordinary income.  How to calculate the amount of the “proceeds,” and whether a deduction for attorney’s fees (which are usually a large percentage of the award) is allowed, depends on the particular federal statute that applies.

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9baf90353963d26daaa1c54235b10b38-cool-pumpkin-carving-carving-pumpkins-300x300California’s Franchise Tax Board (FTB) sends out 4600 Notices “Request for Tax Return” when it gets a tax “information return” with a California address on it, but the taxpayer doesn’t file a California return, either as a resident (a Form 540) or as a nonresident (a Form 540NR).  An “information return” are documents like a 1098, 1099, K-1 or W2.  There are other reasons, but this is a major one.

To give a common example, if a nonresident owns a vacation home in California with a mortgage, and he told the lender to send the Form 1098 mortgage interest form to his vacation home address, he has likely just earned a 4600 Notice.  That’s because the FTB will see a 1098 with a local address associated with a person who hasn’t filed a California tax return.

This is a common mistake.  It also happens with Form 1099-INT involving bank interest from a local bank account (often involving de minimis amounts), or payments from brokerage accounts or out-of-state pensions.  The lesson is, nonresidents should never use a California address (whether it’s a vacation home or a relative’s place) for any tax information document.

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wireless-internet-connection-500x500-300x237With more and more companies forgoing brick and mortar by operating their business through the internet, tax authorities find it increasingly difficult to determine which enterprises are subject to state income taxes and which aren’t.  Typically, California has taken an aggressive stance.  In 2011, it passed a new law that defined “doing business” in California beyond being physically present by having offices or operations.  Instead California sought to define what constituted an “economic nexus” to the state, using factors such as sales, payroll, and inventory. In 2013, comprehensive regulations went into effect casting a broad net over the activities of out-of-state corporations and pass-through entities (LLCs, partnerships, S corporations) as doing business in California.  Judicial decisions interpreting those rules are just starting to trickle in.  The picture that is emerging indicates that non-California internet businesses need to be wary or they may find themselves subject to California taxation.

Why Does It Matter Whether Your Company Is “Doing Business” in California Or Not?

First, why does it matter if California determines an internet company is “doing business” in California?  It may matter a great deal.  The determination that an out-of-state entity is doing business in California is one of the ways California can impose income taxes on that business, even if they have no physical presence in California (the other is based on the entity earning California-source income).  In some cases, there may be a tax liability even if the company made zero income from California sales.

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FAQ-300x169Manes Law has decades of experience in advising clients on California residency law, handling residency audits, assisting businesses relocate out of California, and appealing residency determinations. Based on this experience, we have assembled this list of frequently asked questions and provided brief answers.

1.Q. How does California tax residents versus nonresidents?

A. California taxes residents on all their income, from any source, no matter where it is generated. In contrast, nonresidents are only taxed by California on “California-source” income; that is, income generated in California. If a nonresident has no California-source income, then the nonresident should owe no taxes to California.

2.Q. I am a nonresident who owns a California vacation home. If I spend more than 6 months in California, am I automatically a resident?

A. No. There is a lot of mythology on the internet about the “six-month presumption.” While it’s always better from a residency perspective to spend less time in California, spending more than 6 months in California does not make you a resident. In fact, no one thing will ever make you a resident. The test for legal residency is complex and involves many factors. You can spend more than 6 months in California without becoming a resident, but you should plan carefully to make sure an extended stay plus other contacts don’t result in an audit or unfavorable residency determination. See our article, “The Six-Month Presumption In California Residency Law: Not All It’s Cracked Up To Be“.

3.Q. I’ve heard that if I spend more than 9 months in California, I am definitely a California resident. Is that true?

A. California law applies a “nine-month presumption” to visitors. That is, if you spend more than 9 months in California in any tax year, you are presumed to be a resident. But the presumption is rebuttable. Other factors may apply that result in you not being a legal resident, despite the extended stay. Prudence, however, suggests you shouldn’t tempt fate with so long a stay.

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Wave-goodbye-300x300

It’s no secret that California has a high state income tax rate.  In fact, it has been the undisputed income tax champion for the past decade or so (the middle brackets are more compressed, and some states even have higher middle bracket rates).  Nonetheless, despite somewhat overblown media reports, most Californians aren’t in a position to tear their businesses up by the roots and transplant them to low- or zero-income tax havens like Nevada and Florida.  Often those businesses have to operate in California, since that’s where the market for the product or service is, or there is cachet in having a California location such as Silicon Valley or Newport Beach.  And often for small businesses and startups, the owner has to be present in-state for the enterprise to operate and grow.

But that’s not always the case, especially when a taxpayer owns numerous entities and some of the income derives from service contracts (usually for management work) among the entities or between the entities and the owner.  Further, as e-commerce continues to grow in market share, a physical presence in California becomes less and less necessary for many businesses, and relocation may result in tax savings for sales to non-California customers.  In cases like this, some strategic use of out-of-state entities can result in large enough tax savings to make the major step of relocation worthwhile.

The Rules Of California Residency Taxation

But before we can address the benefits and pitfalls of relocation, we need to first give an overview of California’s income tax system relating to residency.  Changing residency is not a panacea for every tax problem.  It only works in certain situations.  And to determine where it works requires understanding the basic rules of how California taxes individual residents, nonresidents and businesses.

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Image for Guidelines for Determining California Residency

Out-of-state visitors who own vacation homes in California or otherwise spend significant time here are often anxious about their residency status. Let’s go over the basics of California residency taxation. They can be confusing, and sometimes brutal.

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 accrued while working out-of-state, California will tax that income. The resident may qualify for a credit for paying taxes to other states, but the default rule is, a resident’s global income is subject to California income tax.  Period. With a top bracket rate that is currently the highest in the nation, 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, some obvious, some more subtle. It could be rents derived from California real estate or income from business operations or wages for performing temporary work in-state (obvious). Or it could be a portion of the sales proceeds attributed to a noncompete clause when a founder sells his California business, or the gain from non-statutory stock options vested while the employee worked in California (not obvious). To celebrity name drop, when LeBron James, an Ohio resident, used to play the Lakers at Staples Center for the Cleveland Cavaliers, he paid California taxes on the income he made on game night, which in his case was no small amount. [By the way, now that James signed with the Lakers, he has a different problem: whether he can work for a California employer, train and practice here for a significant part of the year, and still remain a nonresident – the answer is yes, but that’s a different analysis (see, “Nonresidents Working Remotely for California Businesses: How to Take Paul Newman’s ‘The Sting’ Out of Your Taxes“).

So, the stakes can be high when determining whether a taxpayer is a California resident or not.

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keep-calm-and-happy-6-months-257x300You 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 here 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.  It does.  But the real rule is more complex.  In fact, relying on the six-month figure as somehow magical can get a nonresident in tax trouble.

What Is The Six-Month Presumption?

The six-month presumption is established by regulation.  You would think it says 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 authority) 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. Continue reading →