Articles Posted in Nonresident Tax/Audits Issues

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zj4_-300x212E-commerce, advanced telecommunications, and the gig economy 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 higher 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 advantages of the other spouse having nonresident status is 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 it is specifically permitted under California law.  In the past, this situation was so uncommon it hardly raised a blip on the radar scope of the Franchise Tax Board, California’s tax authority.  Typically it involved 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; more recent ones feature professional athletes and corporate managers).  That’s changed.  Split-residency marriages are now more about a lifestyle choice involving where to live and do business in a global economy that can allow people to work from anywhere.

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shutterstock_business_beach-1-300x199The 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, 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 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 taxable by California regardless of residency status.  That’s inescapable because the work is performed in California.  If all the income the worker receives during that tax year comes from the project, it doesn’t make any difference what his residency status is.

However, if the taxpayer has other sources of income, it makes a big difference.  The FTB only taxes nonresidents on income sourced to California.  But it taxes residents on all their income, from whatever source.  And the top rate is 13.3% (in 2017).

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It’s that time of year again.  The time when the Franchise Tax Board sends out its 4600 Notices, “Request for Tax Return,” the bane of snowbirds and other part-time residents of California, especially those with vacation homes.  And a potential trap for the unwary.

What is a 4600 Notice?

A 4600 Notice is sent by the FTB because it believes the recipient, usually a nonresident, was required to file a California tax return, but didn’t.  The notice usually goes out a month or two after the April 15 tax filing deadline, but it can show up any time after that, even years later.  There is no statute of limitations.  As a practical matter, however, the FTB generally sends the notice within a short period after the tax filing deadline or not at all.  That’s because, as explained below, the notice is usually triggered by information provided by third parties (such as banks, mortgage lenders, employers) in the same tax year at issue.

The notice requires you to file a return, or explain why you are exempt.  It’s usually directed at nonresidents, who for various reasons discussed below, have the misfortune of popping up on the FTB’s radar scope.

Why did you get a 4600 Notice?

When I say the FTB believes a nonresident was supposed to file a California tax return, I’m speaking metaphorically.  4600 Notices are mostly sent out through an automated system.  No thinking is involved.  The typical scenario goes like this.  You’re a nonresident who doesn’t file a California tax return because you don’t live in California and didn’t have any California source income.  But you do have a mortgage on your vacation home, or a small local bank account that bears interest, or you work remotely for a California firm which for convenience sake uses your local address for correspondence.  As a result, the bank, lender or employer sends a Form 1099 INT (bank interest) or Form 1098 (mortgage interest) or a Form W-2 (wage income) to Sacramento with your name and local address on it.   Come April 15th, FTB computers cross-reference these “information returns” with filed tax returns.  When nothing comes up, a 4600 Notice issues.

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In “Nonresidents Working Remotely for California Businesses” I discussed how the internet economy, ecommerce and constant connectivity has allowed increasing numbers of nonresidents to provide services to California businesses without setting foot here.  As long as those nonresidents meticulously follow the rules, they can work remotely free from California income taxes.  Or at least they can minimize the amount they do have to pay.

But the remote economy is a two-way street.  The technology that lets a Colorado resident work for a Los Angeles firm from his offices in Boulder, also allows him to run his Colorado business while vacationing at a Southern California beach house.  More and more nonresident business owners are doing just that.  And that can lead to California tax problems.

This isn’t a theoretical issue.  The idea of taking a vacation of any significant length without doing any work is obsolescent.  Research shows over 50% of employees work while on vacation, and as to business owners, the figure is around 85%.  Moreover, since business owners can increasingly operate their business from anywhere, including a California vacation home, the lines between an extended vacation and running a business remotely are becoming blurred.  Whether this is a good or bad development, it can result in unexpected and unpleasant tax consequences.

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How to Take Paul Newman’s “The Sting” Out of Your Taxes

paul_newman0final.jpgWith the rise of the internet, cloud and smart phone economy, more and more people have the option of living in one state while working in another – remotely. The possibilities for reducing state income taxes through this scenario haven’t been lost on savvy hi-tech employees and business owners in California. By simply moving across state borders and working for a California business (or even running it) through the internet, 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 taxing authorities either. Because of that “remote workers” need to be careful and understand the tax rules for nonresidents working for California firms.

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California residents who plan to move to another (by definition lower income tax) state, either to retire or for business purposes, often face the problem of how to handle their business interests situated in California. Mostly these interests are LLCs, the preferred entity for most modern business operations. The taxpayer often wants to hold onto the LLC interests and continue to get the income stream until some later date after the move. The question that arises is, what are the California income tax consequences of selling a California LLC interest after the taxpayer changes residency to another state?

I’m assuming the business owner has already weighed the risk of retaining his California business interests while disentangling himself from California by reducing his contacts here and establishing residency elsewhere. Obviously any continued contacts with California are red flags for California’s taxing authority, the Franchise Tax Board, which determines residency in part through a “contacts test,” evaluating which state the taxpayer has the most contacts with. Business interests are just the type of substantial contact that can weigh heavily in determining residency, and can trigger a costly residency audit. In addition, unless the circumstances are very unusual, the income allocated from the LLC to the taxpayer will be California source even after the taxpayer leaves the state. That means the former Californian will have to file nonresident tax returns with Sacramento (the Form 540NR), and the FTB will know about his global income. If the income is high, it again sends up a red flag that could lead to a residency audit.

But assuming that this decision has already been made, and the taxpayer decided to keep his California business interests despite the risks of an audit, the next issue is planning for the eventual sale of the interest as an out-of-state resident.

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…To evaluate this, the distinction between Rule #1 (California income taxes incurred due to residency), as opposed to Rule #2 (California income taxes incurred due to sourcing) is extremely important. Taxpayers are more or less in control of their residency; they can pull up stakes and move. However, the source of income is not as easily controlled. In many cases, the operations that bring in the income rely on California’s market, which is often the market the owner knows and understands. There is no point in moving out of state to avoid the application of Rule #1, if Rule #2 is still going to apply. The tax is the tax is the tax.

But let’s look at the nuts and bolts. It’s not unusual for a business owner to have a corporation and several related tax pass-through entities, such as limited liability companies or limited partnerships, which produce income by providing goods or services here in California. The corporation often provides the LLCs with administrative services, and charges accordingly. Generally, the owner will hold the corporate stock in a family trust. In case like this, creative relocation can have worthwhile tax benefits. Here’s how.

First, remember Rule #1. Since the point of most business enterprises is to get money into the pockets of the owner, if the owner remains a California resident, relocating the corporation won’t help a bit by itself. Assuming all the income from operations passes through the entities (including the trust) to the owner, it will be taxed by California because of Rule #1. All of a resident’s income is taxable by California. So in situations like this, if a strategic relocation is in the cards, step one is for the owner to change residency to a lower tax or non-income tax state. Obviously that’s a big step. It means major change. But if reducing state income taxes is the goal, it’s the sine qua non.

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It’s no secret that California has a high state income tax rate. In fact the Golden State competes with New Jersey and New York for the highest rate in the nation. 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, and typically for small businesses, the owner has to be present here in state for the enterprise to 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. In that case, some strategic use of out-of-state entities can result in large tax savings that might make the major step of relocation worthwhile.

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. California taxes residents with respect to their “global” income. This means that for a California resident, income from whatever source – whether in-state or out-of-state – is subject to California taxation. There may be credits for payment to other states, and there may be other mitigations of the taxes due. But leaving that aside, California residents generally must pay significant state income taxes on all the income they make, from whatever source. Let’s call this Rule #1: taxation of all income based on the California residency of the taxpayer.

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California residents are subject to California state income tax on all income regardless where earned. Frequent visitors to California who are not deemed California residents are only subject to California state income tax on their California source income. So the stakes are big when determining whether one is a California resident.

Under California law, a person who stays in the state for other than a temporary or transitory purpose is a legal resident, subject to California taxation. Basically, brief vacations or transactions, such as signing a contract or giving a speech, constitute temporary or transitory purposes that do not confer residency. Every other kind of visit can confer such a status, including coming to California for health reasons, extended stays, retirement or employment that requires a long or indefinite period to accomplish.

How does the Franchise Tax Board determine whether a visit has a temporary or permanent purpose? It applies the “Closest Connection Test.” This refers to the state with which a person has the closest connection during the taxable year. For the FTB, this literally means counting all the California contacts a person has and comparing that number with the non-California contacts. Of course, some contacts simply weigh more than others. A job or real estate ownership indicates a closer tie than merely enjoying a round of golf at a country club or a concert at the McCallum. The weightiest factors for residency are: