Articles Posted in Nonresident Tax/Audits Issues

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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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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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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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2982476-300x225Let’s go over the basics of California residency taxation.  They can be 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 that accrued while working in Ohio, California will tax that income.  The resident may get a credit for payment of taxes on income earned in other states or other countries (if a tax treaty permits), but the default rule is, the income is subject to California income tax. With a rate that is currently the highest in the nation (the distinction tends to go back and forth with New York), 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, from rents derived from California real estate to business operations to performing temporary work in-state.  To give a rather public example, when LeBron James, an Ohio resident, not a California resident, plays the Lakers at Staples Center, he pays California taxes on the income he made on game night, which in his case is no small amount.

So the stakes are 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.  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, 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 taxing 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, 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 own a vacation home, have a local bank account for local personal expenses, and belong to a “social club” (read country club).

These qualifiers call for some parsing. Continue reading →

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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, 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 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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