Articles Posted in California State Tax Issues

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Working Remotely Rules

The Issue

With the rise of ecommerce, advanced telecommunications, and the new prevalence of remote work due to the COVID emergency, more and more people are choosing the option of living in one state while working for an employer in another, without ever setting foot at the employer’s place of business. The possibilities for reducing state income taxes through this scenario haven’t been lost on founders, hi-tech C-suite, and other key employees in California. By moving across state borders and working for a California business (or even running it) through Zoom and other telecommunications, they become nonresidents, potentially free of California’s high income tax rates, while still being able to participate in California’s thriving economy.

Of course, this situation isn’t lost on California’s tax enforcement agencies either. Because of that, remote workers need to be careful and understand the tax rules for nonresidents working for California firms, at least for highly compensated former residents.

California Tax Rules For Remote Employees

Generally if you work in California, whether you’re a resident or not, you have to pay income taxes on the wages you earn for those services. That’s due to the “source rule”: California taxes all taxable income with a source in California regardless of the taxpayer’s residency. In other words, nonresidents pay California income taxes on taxable California-source income. With respect to employees, the source of income from services compensated by W-2 wages is the location where the services are performed, not the location of employer. This is true even if you are a nonresident, even if the employment agreement with the employer is made out-of-state, and even if the wages are paid to you outside of California.

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CA residency photo

The Issue

E-commerce, advanced telecommunications, and the new prevalence of remote work have combined to give many married couples more flexibility in their working and living arrangements than in the past. One of these options, rare until recently, is for spouses to assert they live in different states for tax purposes. An increasing number of marriages have the mobility to allow one spouse to reside in California, while the other elects to establish or maintain legal residency elsewhere. This is especially true for high-income couples, where supporting two households is economically feasible, one spouse wants to enjoy the benefits of living in California (often with the couple’s children), and the tax benefits of the other spouse having nonresident status are significant.

That said, it is no simple matter to establish or maintain nonresidency status while married to a spouse who is a California resident. There are traps for the unwary.

To Each His Own Residency

Many taxpayers are surprised to learn California even allows separate residency status for spouses. But in fact, there is no such thing as “marital” residency. Residency status always belongs to an individual, whether married or not. Of course, a spouse’s residency status can have a substantial influence on the other spouse in a residency audit. It’s typical for married couples to live together, and the Franchise Tax Board, California’s tax enforcement agency, has a bias for the typical when it comes to residency determinations. But even leaving that aside, married couple tend to spend time together, and if a substantial amount of that time is spent in California, where one spouse resides, the other spouse can begin to look very much like a resident.

In the past, this situation was so uncommon it hardly made a blip on the FTB’s radar scope. It might involve a scenario where a husband took a long-term job out-of-state or overseas. Older cases are populated with merchant marines and oil-field workers in Saudi Arabia; more recent ones prominently feature professional athletes and corporate managers assigned to overseas offices. That’s changed. Separate-residency marriages are now more about a lifestyle choice involving a global economy and the scenario of remote work that can allow some people to live and work anywhere.

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graphic for six month presumption article

The Six-Month Mythos

You 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 in the state 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. Just the opposite. It’s critical. But the real rule is more complex and has to be understood in the context of how California determines residency. It isn’t by counting days. In fact, relying on the six-month figure as a magical way to avoid California residency can get a taxpayer in tax trouble.

What Is The Six-Month Presumption?

The six-month presumption is established by regulation. You would think it would say 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 enforcement agency) 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.

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casablanca california residency graphic

The Issue: Even Casablanca Isn’t Far Enough Away to Avoid A California Residency Audit

The 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.

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promissory-note-lock2-copy

The Issue

Nonresident 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.

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Cal tax trap image

Sunny Taxxy California

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 tax enforcement agency, has tapped into a new revenue source: taxing seasonal visitors to popular vacation spots in California, where residents often have second home. Palm Springs is one such area. But so is Santa Barbara, Sonoma County, San Diego.

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 other vacation spots 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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temp work in CAWhat’s Happening?

The digital economy has allowed increasing numbers of nonresidents to work remotely for California firms without becoming California residents, and even without paying California income taxes (see my article Nonresidents Working Remotely for California Businesses ). At the same time, more and more nonresidents find themselves being offered lucrative temporary employment in California. This is particularly true for software developers or other information technology and e-commerce specialists who are in high demand by California’s thriving internet firms to complete a particular project. But it’s also true for medical professionals, management strategists, actors, professional athletes, artists, corporate trainers, even part-time teachers in a specialty field.

What all these professionals have in common is project work. The employment in California is temporary in that it involves completing a particular project or term of service. It isn’t permanent. It isn’t open-ended. Of course, temporary is a relative term. Some projects may only last a few months; others may require more than a year to complete. The issue confronting nonresidents working temporarily in California is whether they will be taxed only on their California-source income or become a resident in the eyes of California’s tax enforcement authority, the Franchise Tax Board. To control that, nonresidents working in California should have a plan.

Why It Matters?

At first blush, it might not seem to matter whether a nonresident working on a temporary basis in California is deemed a resident or not. The wages or 1099 (independent contractor) income received while working in California is usually taxable by California regardless of residency status. That’s inescapable because the work is performed in California in the case of W-2 salary. In the case of 1099 income, if the work is in California, that usually means the customer is in the state (the FTB uses “where the benefit is received” for sourcing independent contractor revenue). Accordingly, if all the income the worker receives during that tax year comes from the project, it won’t usually make any difference what his residency status is.

However, if the taxpayer has other sources of income, it can make a big difference. California only taxes nonresidents on income sourced to California. But it imposes an income tax on residents with respect to all their income, from whatever source.  And the top rate is 13.3%.

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Ca residency internet symbol

The Issue

With 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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Manes Law Blog Article Image

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, Texas and Washington State. Often those businesses have to operate in California, since that’s where the market for the product or service is, or there is valuable cachet in having a California location such as Silicon Valley or Orange County. 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. Moreover, 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. Some companies may have started in California, but as they’ve prospered, they can operate from any state. In cases like these, some strategic use of out-of-state entities can result in large enough tax savings to make the major step of relocation worthwhile. But details matter.

The Rules Of California Residency Taxation

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 individual residency and business domicile. 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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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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