Articles Tagged with California Residency Audit

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Manes Law Blog imageNobody needs reminding that California is a high income tax state. Most people know there can be tax benefits from changing residency or maintaining nonresidency status where California is involved. With a top bracket rate of 13.3%, California residency at the time of a large capital gains event (such as a startup sale or IPO, for instance), can result in millions of dollars of state income taxes, while across the border in Nevada, the tax would be zero. But details matter. The amount of tax savings, if any, achievable through strategic residency tax planning depends on various moving parts: sources of income, types of compensation, connections people want to or must maintain with California, community property rules (for married couples), the cost and inconvenience of acquiring nonresident status, to name a few. The refrain found everywhere on the internet that huge tax savings beckon every resident to flee the state is simplistic at best. Accordingly, considerable forethought, usually with CPA assistance, is advisable before committing to a residency plan. This article discusses why.

How California Taxes Residents vs. Nonresidents

First the basics.

California residents are subject to California state income tax on all their taxable income regardless of the source. It doesn’t matter if the income comes from the moon, if it is taxable, then California tax system claims jurisdiction. It’s possible a California resident to qualify for a credit for taxes paid in another state for out-of-state income, and some income types are exempt on their face in California (such as social security retirement benefits), but the default rule remains: a resident’s worldwide income is subject to California income tax. Period.

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Manes Law residency myth busting articleI discussed my top five internet myths about California tax residency rules in a previous article. Here are five more. Again, they’re in no particular order, but my comments should provide some indication about how important they are and why.

Myth #1: Leave California, Sell Your Business And You’re Home Free

Many of my clients are founders exiting startups, either through an IPO or purchase by another company. Or they are long-term business owners in traditional industries who plan to sell their California-based company after retiring out of state. The widespread internet meme insists these scenarios always result in zero California income tax on the gain, even though the sale is of a California business.

The basic concept is correct: if a nonresident sells his interest in a California business (that is, corporate shares, limited liability company memberships, partnership interests), the traditional rule is California can’t tax the gain. But not so fast. Numerous factors play a role in determining whether a business sale by a nonresident will escape California’s tax system.

The first is, the transaction must in fact be the sale of a business interest, not the sale of business assets. For good tax reasons, purchasers often prefer to buy assets, not business interests, if the value in the company is in the assets, not the brand. And in some industries, an asset sale is the standard for a business purchase. But take note: if the assets are situated in California, an asset sale by a nonresident results in California-source income, taxable by California regardless of the residency status of the seller. Generally, only interest sales are eligible for tax-free treatment by California when the owner is a nonresident.

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Manes Law Blog Tax Trap Most of the world knows the Palm Springs area for its picturesque golf courses, celebrity homes and halcyon weather. Among the taxing authorities in Sacramento, however, the words “Palm Springs” conjure up less carefree images. Spurred by the state’s appetite for tax revenues, the Franchise Tax Board, California’s main taxing authority, has tapped into a new revenue source; taxing seasonal visitors to our area as state residents.

Seasonal Visitors As Tax Targets

This is how it works. California taxes residents based on their worldwide income, from whatever source, no matter how far-flung. In contrast, California taxes nonresidents only on their income derived from California sources. For instance, these might include a limited partnership operating in California or rent from an investment property. Since California has the highest income tax rate in the country, visitors who suddenly find themselves defined as “residents” may face a large and unexpected tax liability.

Obviously, the FTB  would like to claim everybody who sets foot on California soil as a resident and subject their income to California tax. That’s their job, after all. As many seasonal visitors have discovered, the FTB’s policies sometimes seem not to fall too far short of that mark.

A special division of the FTB has for years systematically targeted seasonal “part-time” residents for audit (I use the term “part-time” loosely, since we are talking about nonresidents who spend part of the year here, not part-time legal residents per se; but the term has stuck). Though Santa Barbara, Los Angeles and Sonoma counties experience their share of audits, historically the most common casualties are affluent “snowbirds” who own vacation homes in the Palm Springs area as an escape from the winter blasts of the Midwest or northern states.  In fact, many of the major cases in residency taxation are eerily similar: they usually involve Midwesterners who own winter vacation homes in Palm Springs and environs. If the FTB finds significant taxable income coupled with meaningful contacts with California (such as a vacation home, business interests or long visits to the state), it can lead to the launch of a full-blown residency audit.

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boomerang image for manes residency articleIt’s no trick to leave California to avoid its high income taxes – if that’s all you want to do. But in fact, most people who change their legal residency from California have more in mind.  They also want to retain contacts with the state. That might mean a vacation home, it might be managing a California business remotely, it might involve meeting potential clients or investors in California for an out-of-state entity. The last situation, which is fairly common, requires planning, since changing residency may not be enough to avoid California income taxes if your work for your out-of-state business brings you back to California.

When Changing Residency Isn’t Enough

A typical situation involves a business owner who changes legal residency and moves his business out of state. Well and good. Unless a taxpayer changes legal residency, everything else is moot from a tax perspective, and if the company operates out of California, distributions to its out-of-state owner are also subject to California tax. But the fact is California is an economic powerhouse. Few businesses, especially those in high-tech and financial services (which are increasingly the same thing), can succeed without participating in the California market. And that often means meeting with and cultivating potential clients or investors in Los Angeles or Silicon Valley, where the capital, expertise and demand resides.

If that’s the case, it’s important to understand the differences between personal residency as opposed to doing business in California versus working while present in California. These are three separate tax issues, which require different approaches to manage. Continue reading →

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Image for Guidelines for Determining California Residency

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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