Articles Posted in Nonresident Tax/Audits Issues

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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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