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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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FAQ-300x169Manes Law has decades of experience in advising clients on California residency law, handling residency audits, assisting businesses relocate out of California, and appealing residency determinations. Based on this experience, we have assembled this list of frequently asked questions and provided brief answers.

1.Q. How does California tax residents versus nonresidents?

A. California taxes residents on all their income, from any source, no matter where it is generated. In contrast, nonresidents are only taxed by California on “California-source” income; that is, income generated in California. If a nonresident has no California-source income, then the nonresident should owe no taxes to California.

2.Q. I am a nonresident who owns a California vacation home. If I spend more than 6 months in California, am I automatically a resident?

A. No. There is a lot of mythology on the internet about the “six-month presumption.” While it’s always better from a residency perspective to spend less time in California, spending more than 6 months in California does not make you a resident. In fact, no one thing will ever make you a resident. The test for legal residency is complex and involves many factors. You can spend more than 6 months in California without becoming a resident, but you should plan carefully to make sure an extended stay plus other contacts don’t result in an audit or unfavorable residency determination. See our article, “The Six-Month Presumption In California Residency Law: Not All It’s Cracked Up To Be“.

3.Q. I’ve heard that if I spend more than 9 months in California, I am definitely a California resident. Is that true?

A. California law applies a “nine-month presumption” to visitors. That is, if you spend more than 9 months in California in any tax year, you are presumed to be a resident. But the presumption is rebuttable. Other factors may apply that result in you not being a legal resident, despite the extended stay. Prudence, however, suggests you shouldn’t tempt fate with so long a stay.

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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, and sometimes 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 top bracket 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 more subtle. 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 the gain 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 (see, “Nonresidents Working Remotely for California Businesses: How to Take Paul Newman’s ‘The Sting’ Out of Your Taxes“).

So, the stakes can be 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 during any calendar year.  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 during any calendar year, 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 tax 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 during the year, 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 owning a vacation home, having a local bank account for local personal expenses, and belonging to a “social club” (read “a country club”).

These qualifiers call for some parsing. Continue reading →

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In an earlier article, I discussed how the internet economy, ecommerce and constant connectivity has allowed increasing numbers of nonresidents to provide remote 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.

The Issue

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 and key employees are doing just that. And that can lead to California tax problems.

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residency planning married couplesE-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 high-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 benefits of the other spouse having nonresident status are 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 enforcement agency. 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 in Saudi Arabia; more recent ones prominently feature professional athletes and corporate managers. That’s changed. Split-residency marriages are now more about a lifestyle choice involving a global economy that can allow people to live and work 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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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 and other telecommunications, 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 tax enforcement agencies either. Because of that, remote workers need to be careful and understand the tax rules for nonresidents working for California firms.

California Tax Rules For Remote Employees

Generally if you work in California, whether you’re a resident or not, you have to pay income taxes on the wages you earn for those services. That’s due to the “source rule”: California taxes all income with a source in California regardless of the taxpayer’s residency. And for purposes of taxing employees, the source of income from services is the location where the services are performed. This is true even if you are a nonresident, even if the contract with the employer is made out-of-state, and even if the wages are paid outside of California.

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One of the perennial questions my Canadian clients ask me is how they should take title to their US real estate, usually a vacation home.  My answer is, it depends on a number of considerations, but the right choice probably involves a revocable trust specially drafted to hold US real estate.  But in any case, some thought has to go into the decision.  Thousands of dollars may be at stake if the wrong method of title is used.  The choice shouldn’t be made casually while signing escrow papers, which regrettably often happens.

The best way for Canadians, and foreign nationals in general, to hold US real estate depends on their plans for the property, its value, the owner’s age and net worth, whether the property has appreciated since it was purchased, the expectation of rental income, and what issues loom large for the owner (avoiding probate, escaping the US estate tax, selling the property with a minimum of capital gain, limiting personal liability).  Let me go over the basics.

  1. The Probate Issue.  A probate in Canada can’t transfer real property located in the US to the decedent’s heirs.  Neither a California court nor the local county recorder will recognize foreign court orders when it comes to US real estate.  So, if you are a Canadian and you own a vacation home in California in your individual name (or both the names of you and your spouse), when one of you dies you will have to probate the real property (the exception is property held in joint tenancy, discussed below).  Another probate will be required when the surviving spouse dies if the spouse hasn’t sold the property.  Probate is the process whereby a court oversees and orders the transfer of assets from a decedent to the decedent’s heirs.  Like any court process it tends to be time consuming, public, and involves significant attorney’s fees.  It isn’t the end of the world to have to probate US real property, but most Canadians are justified in trying to avoid it.
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