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Seasonal Visitors to California and Residency Anxiety

Out-of-state visitors who own vacation homes in California or otherwise spend significant time here on a seasonal basis (traditionally known as “snowbirds” because the season is inevitably winter) are often anxious about their residency status. There’s good reason to be. California rules for determining residency are notoriously difficult to grasp. It’s altogether possible for the innocent actions of a nonresident to trigger a residency audit. And sometimes the audit has a bad outcome, with tax consequences that bite. Let’s go over the basics of how California determines residency for tax purposes. 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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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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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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So we’re on to Part 2 on this topic. Here, we’re talking about a US citizen who owns a California home (maybe in Palm Springs), but lives in Illinois.

Presumptions Generally

Let’s review the FTB’s presumptions on time spent in California. If you spend more than 9 months (in a calendar year) in California- you are presumed to be a California resident that year (but you can rebut it by going to the checklist). You can find this presumption in Cal Rev. & Tax Code §17016. There is also a lesser presumption (found in regulations as opposed to the Cal Rev and Tax Code) which provides if you are present in California less than 6 months a year, you are presumed to not be a California resident. This “lesser” presumption is found at 18 Cal. Code of Regs. §17014(b). I consdier it a lesser presumption since it comes from the Cal tax regs and not the Code (unlike the 9 month presumption). There is no presumption if you are present in California between 6 months and 9 months. But in all events, you still must go back and review the checklist.

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We next start a detailed series on the consequences of, and how to avoid, being deemed a California state resident for state income tax purposes. We will track this discussion on our Canadian Snowbird blog.

General Rules on California State Taxes

Let’s start with some general principles of California state taxation:

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