Articles Posted in Nonresident Tax/Audits Issues

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California Residency AuditsHundreds 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.

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Doing Business in CaliforniaThe Franchise Tax Board, California’s taxing authority, has consistently taken an aggressive stance in claiming out-of-state businesses have income tax reporting requirements for “doing business in California.”  The FTB reached a limit in Swart Enterprises, Inc. v. Franchise Tax Board, Cal. Ct. App. (5th App. Dist.), 7 Cal. App. 5th 497 (2017).  In that case, a California appeals court ruled against the FTB’s claim that a foreign corporation with a passive .02% ownership in a California LLC was doing business in California.  As a result, the FTB was forced to modify its ruling on doing business in California by members of multi-member limited liability companies.

FTB Walks Back Prior Ruling

Specifically, the FTB has modified California FTB Legal Ruling No. 2014-01, 07/22/2014, which sets forth the FTB’s analysis on a number of “doing business” scenarios involving members of multiple-member LLCs that are classified as partnerships for tax purposes.  The ruling had asserted that the distinction between “manager-managed” and “member-managed” LLCs, made no difference in determining whether a member of the LLC was doing business in California.  The reasoning in Swart Enterprises made that assertion untenable.  As a result, the FTB has removed the language and replaced it with the innocuous phrase: “a narrow exception may apply in limited circumstances.”  Continue reading →

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boomerang image for manes residency articleIt’s no trick to leave California to avoid its high income taxes – if that’s all you want to do.  But in fact, most people who change their legal residency from California have more in mind.  They also want to retain contacts with the state.  That might mean a vacation home, it might be managing a California business remotely, it might involve meeting potential clients or investors in California for an out-of-state entity.  The last situation, which is fairly common, requires planning, since changing residency may not be enough to avoid California income taxes if your work for your out-of-state business brings you back to California.

When Changing Residency Isn’t Enough

A typical situation involves a business owner who changes legal residency and moves his business out of state.  Well and good.  Unless a taxpayer changes legal residency, everything else is moot from a tax perspective, and if the company operates out of California, distributions to its out-of-state owner are also subject to California tax.  But the fact is California is an economic powerhouse.  Few businesses, especially those in high-tech and financial services (which are increasingly the same thing), can succeed without participating in the California market.  And that often means meeting with and cultivating potential clients or investors in Los Angeles or Silicon Valley, where the capital, expertise and demand resides.

If that’s the case, it’s important to understand the differences between personal residency as opposed to doing business in California versus working while present in California.  These are three separate tax issues, which require different approaches to manage. Continue reading →

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ill-never-make-that-mistake-again-ill-never-make-that-mistake-again-lyric-1-233x300With Tax Day having come and gone, the Franchise Tax Board, California’s tax authority, is now busy sending out its annual 4600 Notices, also known as “Request for Tax Return” letters.  Almost all 4600 Notices are sent to nonresidents, mostly those who own a vacation home or have a business interest in California, and have made one of several common mistakes.  For a full discussion of what a 4600 Notice is, see “They’re Back: FTB 4600 Notices Coming Soon to You.”

If you receive a 4600 Notice, the first order of business is to timely and effectively respond.  Whether that means filing a nonresident tax return (a Form 540NR) or providing a proper legal explanation for why you don’t have to, depends on the circumstances.  Second, assuming the notice gets resolved favorably, the next task is preventing the same problem from recurring in future years.

Automatic vs “Reviewed” Triggers

4600 Notices don’t just happen.  They are triggered.  The trigger is usually one of several common, avoidable mistakes by nonresidents.

In my practice, the typical 4600 Notice involves a nonresident who owns a vacation home in California with a mortgage.  Out of convenience or just as an oversight, the nonresident tells the mortgage lender to send the Form 1098 Mortgage Interest Statement to the vacation home.  Form 1098 is the “information return” mortgage lenders generate to report loan interest.  They send one copy to the FTB and another to the borrower.  If the “Payer/Borrower” address on the 1098 is in California, and the borrower doesn’t file a state tax return, the FTB will automatically send a 4600 Notice.  Continue reading →

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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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Bitcoin-California-Residency-300x300The fortunes currently being made in Bitcoin and other cryptocurrency investments and trading offer unique opportunities for tax planning that other appreciated assets often do not.  This article discusses one of those aspects: the importance of residency planning in reducing cryptocurrency tax liability at the state level.

What Makes Cryptocurrency Conducive To Residency Tax Planning?

Bitcoin and other cryptocurrencies are unique assets in many ways.  But for residency tax planning purposes, these three factors make all the difference.

First, much of the taxable gain in appreciated cryptocurrency investment remains unrealized – that is to say, the investors have yet to sell or exchange their initial investment.  This is due to the volatile nature of cryptocurrency values, but it’s also a result of the second factor.

Second, unlike traditional investments, the Bitcoin phenomenon has been driven by young disruptive investors, not the usual Wall Street sages with briefcases stuffed with earnings-to-value reports.  Many of my clients made relatively small investments, either directly or through mining, in their early twenties, and now, as they enter their thirties, they find themselves sitting on millions or even tens of millions of untaxed appreciated cryptocurrency.  Because younger people tend to be mobile, they can move anywhere before cashing out.  Which brings us to the third factor. 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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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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Wave-goodbye-300x300It’s no secret that California has a high state income tax rate.  In fact the Golden State competes with New York and Hawaii for the highest rate in the nation — and usually wins (as of 2017 California is in fact the winner).  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 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.  In cases like this, some strategic use of out-of-state entities can result in large tax savings that might make the major step of relocation worthwhile.

The Rules Of California Residency Taxation

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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 ways of mitigating the taxes due to California.  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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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, if not 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 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 not so obvious.  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 distributions 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.]

So the stakes are high when determining whether a taxpayer is a California resident or not.

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