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 more complicated. But the concept is clear 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 tax enforcement agency, determines intent and what constitutes “moving” is another matter. The FTB doesn’t ask taxpayers what they intended; rather, it derives intent from their conduct. For that, the FTB uses the “facts and circumstances/closest connection” test, which compares all of the taxpayer’s California contacts with all of the taxpayer’s contacts in their new home state, and weighs them, in totality. But not every contact weighs the same, and since there are few bright-line rules, an audit can sometimes seem like a Kafka novel in its excruciating focus on seemingly casual details used to punish the unwary. A more detailed discussion of the closest connection test is here. That said, if you follow the regulations and case law, avoid common mistakes, and endure the cost and inconvenience built into establishing and maintaining nonresidency status for taxpayers with significant California contacts, you can have some degree of certainty about establishing yourself as a nonresident in another state.

Not so when it comes to changing residency to another country. The residency case law has a strong bias against expats. It assumes California residents who move overseas are leaving for temporary purposes, not to change their legal residency. This is especially the case if they keep significant contacts which indicate an intent to return, at least in the eyes of the FTB, such as bank accounts or a driver’s license, not to mention real property. But even if a resident sells his home or terminates his lease or otherwise gives up his accommodations in California, that might not be enough to change residency if the plan is to work in a foreign country.

The worst part is, while the US has tax treaties with most other nations, which prevent double taxation at the federal level, California is not a party to any US tax treaty. For federal tax purposes, expats may receive a credit for paying income taxes in one country reducing their taxes in the other. Not so with California income taxes. The result can be paying a double tax.

Merchant Marines, Oil Workers, And Going All The Way To China

There are literally scores of cases involving California residents leaving the state to go overseas for employment purposes, only to find they owe taxes for income earned while out of the country. In the early part of the last century, the cases often involved members of the merchant marines, who might leave the state for years at a time before returning (often to a patient spouse who remained in the state). During the 1960s, it was oil workers who contracted for long-term work in the Middle East. And more recently, it’s the global economy of marketing and financial services that lures residents to jobs abroad.

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The stark lesson: even going all the way to China might not make you a nonresident

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Appeal of Hoog, decided in 2017, demonstrates the problem. The taxpayer was a lifelong California resident who took a job in China marketing industrial lasers. He spent four years overseas, with the majority of his time in China, where he lived in an apartment paid for by his employer and had a bank account. In the particular year at issue he only spent about 30 days in California. Unfortunately, he came to China on a short-term visa (for trade and business), and kept his California bank accounts, driver’s license and home (where his wife and child lived), aduntil he sold it several years after starting his employment out of the country. Despite spending the vast majority of his time in China for four years, the court ruled his move overseas was never intended to be permanent. As such he remained a California resident and his income (about $200,000 in the year at issue) was taxable.

The stark lesson: even going all the way to China might not make you a nonresident.

Here’s The Part Where We Discuss Domicile (Not Residency)

What was going on in Hoog? Here we have to introduce a new concept: domicile. “Domicile” as used in California residency law, is the location where a person has the most settled and permanent connection, and the place to which a person intends to return when absent, not merely for a limited purpose, such as going to college or working, but as a taxpayer’s “true, fixed, permanent home” (the phrase endlessly repeated in case law). It is the place where, whenever you are absent, you intend to return. So, you can be a domiciliary of California even while your residence is elsewhere. And vice versa. Some states treat domicile and residency as identical. Not California.

An individual may claim only one domicile at a time. A California domiciliary who leaves California retains his California domicile as long as there is an intention of returning to California, regardless of the length of time or the reasons for the absence. The FTB doesn’t ask taxpayers what they intend; it derives intent from conduct. With respect to that, domicile is usually evidenced by voter registration, driver’s licenses, employment, social and family connections (including philanthropy), financial accounts, living accommodations. But as a practical matter, it means setting up a household in the new jurisdiction with indications that the move isn’t for a special, temporary purpose.

And here’s the critical corollary: if a taxpayer is domiciled in California, and leaves for a temporary or transitory purpose, the taxpayer remains a California resident. The Hoog court ruled that the expat was a domiciliary of California who left for a temporary purpose: employment. It didn’t matter that the employment lasted four years. To turn it around, if the taxpayer in Hoog had been a domiciliary of China and left California to work there, he would not have remained a resident of California.

By the way, the decision in Hoog might have been different if his wife and child hadn’t remained in California at the home the family owned (which the FTB calls a “marital abode”), hadn’t used that California address on his tax returns, hadn’t retained his California driver’s license and bank accounts, and had obtained a permanent visa in China instead of a short-term visa related to commercial and trade activities. In short, his conduct didn’t show an intent to live in China permanently (under California rules), and so the taxpayer fell into the domicile/residency trap.

And that’s the crux of the problem for expats. It’s relatively easy to change domicile from California to another state (register to vote, get a driver’s license, obtain long-term living accommodations, find a job, open financial accounts, all while reducing California contacts). But it’s difficult to do that in a foreign country, especially if all you are doing is working under an employment contract, and especially if you don’t obtain a permanent visa. As a result, expats often have to take extraordinary steps to change their residency. This may involve changing domicile and residency to another US state first, and then moving overseas. Or it may mean taking on the cost and inconvenience of establishing contacts showing permanent residency status in the other country, even if the real purpose of the move is only to work for a period of time. At the very least, it requires thoughtful planning, not just buying a plane ticket and taking off.

The Other State First Strategy

This leads to a discussion of a useful strategy for expats: moving to another US state first before moving abroad.

What problem does that solve? Often expats want to keep certain basic continuing contacts with the US, such a bank accounts, voting rights, health insurance, driver’s licenses, even if they fully intend to move out of the country permanently or indefinitely. If an expat keeps those contacts in California, they risk suffering the fate of the taxpayer in Hoog. They won’t be able to show their move was for other than temporary purposes because they kept connections with the state which argue for an intention to return at some point. Accordingly, to keep those contacts in the US, a taxpayer contemplating expatriation is often best served by first moving to another state (ideally a zero-income-tax state) and establishing those valued contacts there. Once that is accomplished, they can then move abroad. This takes California out of the picture.

However, it can be a relatively complex and expensive course of action. The taxpayer has to meet the requirements of the target state for obtaining a driver’s license, voter registration, in-state financial accounts, etc. That almost always means having an actual street address. And it means signing various attestations under penalty of perjury about establishing residency in the state. Often that requires a rental, though some taxpayers use the address of a family member or friend. That said, most low-income-tax states also have low standards for moving into the state. Once the taxpayer’s contacts are moved into the state, the state government and its agencies are usually happy to have them, and don’t tend to care what the new purported resident does next. For potential expats, what happens next is they move abroad, while keeping the US contacts they value in the new state.

Now, it’s quite possible that if the expat is audited by California for residency, the FTB will challenge the change of residency to the new state, particularly if the expat leaves the country shortly after the move. But that usually doesn’t matter. The point is the expat can subsequently change residency to their new jurisdiction abroad without further California interference while keeping the US contacts. California can’t call up Texas and insist the Lone Star State cancel an expat’s driver’s license, financial accounts, voter registration, and send everything back to California. That can’t happen.

The only residency issue for California at that point is whether the taxpayer’s contacts with their new jurisdiction abroad are sufficient to demonstrate a permanent or indefinite move with respect to California. Since the contacts in question are no longer in California, they don’t count against the taxpayer, making it easier to demonstrate intent to move abroad permanently.

Note that this strategy doesn’t work if a large liquidity event is contemplated before the move from the new US state to the foreign jurisdiction. In that case, timing works against the taxpayer. An expat in that situation needs to demonstrate nonresidency before the receipt of income. For those still in a US state who only intend to stay there for a short time, the FTB would likely deem them residents of California at the time of the receipt of the income, even if they eventually changed residency to an international jurisdiction thereafter.

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Returning before the two-year period puts all the taxable income received during the time of claimed nonresidency at risk of being clawed back by the FTB

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The Two-Year Rule

Another critical problem expats face is moving back to California. The fact is many expats do in fact move to a foreign country with the intent of returning to the state. Our expatriate clients often ask us what time frame is safe for them to reestablish their California residency, without jeopardizing their claim of nonresidency while they were living outside of the country.

The brief answer is a taxpayer can’t change residency from California and return within two years of moving without being deemed a resident during the interim period. Returning before the two-year period puts all the taxable income received during the time of claimed nonresidency at risk of being clawed back by the FTB. This two-year rule actually applies to all former residents who move back to the state, but it is enforced with particular rigor against expats, on the assumption, justified or not, that when California residents leave the country, they actually plan to return at some point. There is a narrow exception to this rule, which is difficult to assert successfully in an audit. Moreover, the FTB tends to strictly enforce the time frame. Even getting close to stepping on the two-year line for the return date is likely to result in serious scrutiny in an audit. Prudence suggests exceeding the two years by a longshot. In other words, expats who return to California anywhere close to the two-year window usually do so at their tax peril.

The Safe Harbor Rule, Such As It Is

I mentioned all the cases that ruled against expats. In fact, the California legislature got so fed up with the volume of the litigation that it passed perhaps the only real bright-line rule in California residency law: Revenue and Tax Code §17014(d). The concept of this legislation is that if a California domiciliary leaves the state under an employment contract with a term of over 18 months, and they don’t return to California for more than 45 days during the taxable year, and their income from stocks, bonds, interest, and other intangible income doesn’t exceed $200,000 a year, they are presumed a nonresident for tax purposes. This law applies to working anywhere outside of California, even another state, but it is really directed at expats.

The law offers some certainty. Unfortunately, it can be difficult to comply with. The employment contract has to meet the time period on its face; it can’t do so via renewals. Nor does a series of separate contracts, even with the same employer, adding up to 18 months suffice. And the limit on intangible income can be difficult for those in the financial services industries, as they often invest and trade on their own account. Many have highly appreciated cryptocurrency assets. If they are private traders or investors, they need to plan ahead with respect to this income limit if they want the benefit of the safe harbor.

A Two-Edged Sword 

Also note that the safe harbor protection is a two-edged sword. It’s a tax boon if it can be successfully invoked. But if you can’t meet all its requirements (and experience tells us most expats cannot), then it can be used as a sword instead of a shield by the FTB. That’s because, the FTB can argue that at the very least for Californians working overseas to be a nonresident, they have to be out of the country for 18 months and not return to California for more than 45 days in any taxable year. The argument is specious. An expat should be able to prove nonresidency the old fashion way by showing that they left for other than temporary or transitory purposes. And that can be established by the terms of the contract and the type of contacts maintained in each jurisdiction. There is nothing magical about 18 months in residency case law. Nonetheless, the safe harbor rule invites the FTB to invoke purported legislative intent against those who don’t meet its strict requirements.

Well, a Three-Edged Sword

There’s another downside to the safe harbor rule that affects expats with spouses who remain in California, which is a common situation. To invoke safe harbor protection under §17014(d) requires an admission that you are a California domicile. That’s often the case anyway, so the requirement is meaningless in most contexts. However, where the expat has a spouse who is a resident of California, and the couple doesn’t have a prenuptial or post-marital agreement transmuting their community income to their separate estates, then remaining a domiciliary of California while asserting nonresidency can result in half the expat’s community income being taxed by California. This problem of separate residency and community income reporting is discussed in more detail here. Suffice it to say that any expat who is married to a California resident needs to have this issue thoroughly reviewed by a tax professional before invoking safe harbor.

Planning is Everything

To summarize, planning is everything when it comes to changing residency from California to an overseas location, particularly if employment is the reason for the move. If possible, avail yourself of the safe harbor rule (assuming the community property rules don’t work against you). If not, take the steps necessary to change residency, no matter how inconvenient, if the amount of taxes at stake is worth it. Like Rick’s café in Casablanca, the deck is always stacked against the expats.

Updated 8/1/24

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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.

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