California Residency Tax Planning
THE TEST: “MORE, BIGGER, AND BETTER”
The Franchise Tax Board, California’s tax enforcement agency, uses a “facts and circumstances/closest connection” test to determine residency status.
The simplest way to understand it is as a ledger. In a residency audit, the FTB lists all your contacts with California, all your contacts with your home state, and then it weighs them, in totality. Not every contact or category of contacts weighs the same.
The important categories for residency audits involve comparing physical presence in California vs. your home state (that is, time spent in each jurisdiction); your living accommodations when you’re in either state (that is, homes or rentals); the location of your work; the situs of your assets; where your immediate family resides (and that usually means a spouse or minor children, if you have separate residency, not other family members); and official representations of residency, such as health care policies, loans, tax exemptions, information tax returns (W-2s, 1099s, 1098s, K-1s,etc.), the type of home insurance you have, and of course driver’s licenses and voter registration. Becoming a nonresident is deceptively simple: you have to prevail in these categories, or at least in enough of them, so that your home-state side of the ledger “outweighs” the California side. The way to do that is to have “more, bigger, and better” in enough of the major categories, and even in the minor ones, to tip the scale in favor of your home state. As a practical matter, the vast majority of residency audits are determined by the first two categories: the comparison of homes and physical presence.
Unfortunately, the rules for determining what constitutes “more, bigger, and better” in the context of residency status aren’t particularly intuitive. That’s where planning comes in.
Since the FTB uses this test, taxpayers and their tax advisors have to do the same if they expect their residency planning to survive scrutiny in the event of a residency audit. As a result, residency planning requires systematic fact gathering to itemize all of a taxpayer’s connections with California and elsewhere, either current or planned. And it requires a systematic way to follow the many nonintuitive residency rules that may apply in a particular case. Anything less is conjecture, not residency planning.
Accordingly, Manes Law has developed an integrated, copyrighted system of information gathering, checklist planning, and sample notice forms, to ensure you meet your residency goals. The process is summarized below.
STEP ONE: WEIGHING THE BENEFITS AND BURDENS
Short of leaving California lock, stock, and barrel, the goal of residency planning is establishing and maintaining nonresidency status while retaining the California contacts you want to (or have to) keep. That means relinquishing or minimizing other unnecessary contacts in California, as well as adding contacts to the home-state side of the ledger, even if this results in inconvenience and cost. The cost and inconvenience of minimizing and managing those contacts on the residency ledger is built into the system. If it weren’t, everybody would choose to be a nonresident. Not every taxpayer benefits sufficiently from changing residency to warrant the burdens. Therefore, considerable forethought, usually with CPA assistance, is advisable before committing to a residency plan. This article discusses the major factors for determining the value of residency tax planning.
STEP TWO: THE RESIDENCY QUESTIONNAIRE
Once a decision has been made to change residency (or for nonresidents, to maintain nonresident status while establishing significant contacts, such as a second home, in California), determining what contacts to keep and which ones to minimize or eliminate requires the itemization of all the residency-related connections a person has with California and every other tax jurisdiction, particularly their home state. This step is accomplished through our comprehensive, copyrighted residency questionnaire.
Accordingly, after our firm is retained, we begin the fact-gathering process by sending the questionnaire to collect in one document all the relevant information about a taxpayer’s connections with California and elsewhere. The purpose of the questionnaire is to produce a comprehensive list of all the contacts that need to be disentangled, avoided, or managed under the test. With the questionnaire responses as a guide, clients and our firm can identify the contacts that can be retained and the ones that will need to be minimized or eliminated, in order for the plan to result in the desired residency status, tax consequences, and level of audit risk.
We developed the questionnaire based on handling hundreds of residency audits, appeals, teaching seminars and residency consultations over several decades. Our questionnaire covers all the fact patterns FTB auditors focus on to determine residency status. As evidence, we can cite the fact that none of our plans has ever been overturned in an audit. In fact, our planning has been so successful that, in over two decades of residency tax planning, only three of our plans have ever been audited at all. That result reflects the fact that minimizing residency audit risk is critical to this type of tax advice. Put another way, you win 100% of the residency audits that don’t happen, and by knowing what triggers them, the risk can be minimized.
And note that California’s residency test compares California contacts with those in your home jurisdiction. It’s not California vs. the world, but California vs. your state of residency. Contacts in other states won’t help you in a residency audit. They won’t hurt you, but you can’t rely on them to establish or maintain nonresident status. To give an example that often arises, the FTB compares time spent in California vs. time spent specifically in your home state. Time spent elsewhere usually carries no weight in a residency audit – a situation that can be disastrous for nonresidents who travel extensively or who own vacation homes in other jurisdictions and haven’t taken this rule into consideration.
STEP THREE: THE CHECKLISTS
After receipt of the questionnaire responses, we’re able to tell what checklists apply to the situation. California residency law is an amalgam of rules accumulated over decades by statutes, case law, regulations, FTB Chief Counsel rulings, audit practices. The rules are rarely intuitive and often unclear. Therefore, residency planning has to be integrated, dealing with every aspect of a taxpayer’s contacts with California and other tax jurisdictions (second homes, work, assets, income-sourcing, tax reporting requirements, time spent, and so forth). This requires a systematic guide. Accordingly, Manes Law has developed copyrighted checklists to deal with every aspect of changing legal residency or preserving nonresident status, tailored to the particular the situation.
There are numerous moving parts to residency planning, and the closest connection test requires that all the contacts be taken into consideration to establish and maintain nonresidency. This means residency planning must proceed in an organized, detailed fashion. That’s what the checklists are for. Our checklists are specific, comprehensive, and systematic, with explanations of their purpose and implementation. They are not generalized lists of the type found on the internet. They run the gamut of scenarios: residents moving out of state or overseas, nonresident officers or principals working remotely or managing a California business, founders exiting startups, nonresident professional athletes and actors working temporarily in California, nonresidents with California vacation homes or rental property, nonresidents with spouses residing in California, and so forth.
A comprehensive list of the kinds of fact patterns the checklists address is here.
In addition to the checklists, if applicable, we can provide sample letters and forms to assist clients implement their residency plan. They include notices to social organizations and professionals of the residency change; sample letters terminating memberships and services; and form notices to entities that issue information tax returns to ensure proper tax reporting of the client’s nonresident status. As part of the planning process, we can also provide draft language for employment contracts, remote work agreements, corporate resolutions, partnership agreements, trust agreements and so forth, to reflect the proper nonresident tax status of the client, tax reporting requirements, and any requirements for work in California after the move. Manes Law works with your other professionals to complete this aspect of your residency plan.
STEP FOUR: PRIORITY MATTERS
Along with the checklists, we also prepare a written analysis of items that our clients should prioritize for their residency plan. The items differ depending on the plan. Nonresidents establishing contacts in California, such as a second home or temporary work, may have one set of items to prioritize. Residents moving from California will have another. This priority discussion is particularly important for residents leaving California in anticipation of a large liquidity event (a category which represents the majority of our clients), where timing of the move and the receipt of the income is critical for shielding income from California income taxes. We also provide a deep dive into how California determines residency in an audit or other adjudication, so that our clients will have guidelines for managing their ongoing contacts with California into the future. In addition, we analyze the level of residency audit risk faced by our clients under their tentative plans, and provide options for minimizing the risk.
STEP FIVE: EVALUATION/FINALIZING THE PLAN
Next, we prepare an evaluation of the residency plan to finalize the details. The evaluation may be in writing or discussed at a conference. We typically schedule a consultation or consultations to answer any questions about the finalize plan, to discuss matters we consider to be critical to the plan’s success, and to propose ways to minimize the risk of an audit or an unfavorable residency ruling if an audit does occur.
STEP SIX: FOLLOW-UP
Typically, our clients have additional questions after finalizing their residency plan, particularly when they actually move from California (assuming they are residents changing residency), or after purchasing a second home here (assuming they are nonresidents who want to spend vacation or work time in the state). If we need more conferences to answer those questions, we schedule them. If there’s a question we don’t have an immediate answer to, we research it and get back to the client. Our clients also often have questions when tax time comes around the next year. Our clients generally have excellent tax professionals, but even the best tax professionals don’t necessarily have experience in dealing with the nuances of California tax reporting for nonresidents. Accordingly, while we don’t prepare tax returns, upon request, we coordinate with our clients’ CPAs and other tax professionals if there are issues about properly reporting as a nonresident, or making strategic reporting decisions to reduce audit risk. Depending on the nature of the plan, upon request we also coordinate with our clients’ estate counsel, wealth managers, M&A lawyers, and family law attorneys, with respect to residency and income-sourcing issues. Finally, our clients often have additional miscellaneous questions for a year or so, which we address as part of our fixed-fee package. After that, our clients tend to establish enough deep connections with their new home state that the residency issues become less pressing, and the risk of a residency audit diminishes.
THE FIXED-FEE
We bill a fixed-fee amount for these services. The amount of the fee depends on the nature and complexity of the plan, as well as the tax liability at stake. Some plans are relatively straight-forward. For example, some clients simply want to change their legal residency without maintaining any further substantive contacts with California. Or they are nonresidents who want to own a California vacation home while spending a reasonable time in the state consistent with their nonresident status and without any other significant contacts. But most are complex. They often involve founders or key employees exiting a California startup through an acquisition or IPO with subsequent earn-out obligations; residents moving overseas while maintaining property and assets in state; actors, directors, and professional athletes with loan-out corporations holding California contracts and residual rights while moving to a lower tax state; married couples where one spouse is a California resident while the other spouse is a high-income nonresident or wants to move from the state and establish residency elsewhere. The situation determines the fixed-fee amount. Once we hear the details of your tentative plan, we can quote you the fixed-fee amount that applies to your situation.
A further discussion of our fixed-fee policy is here.
If you have any questions about our residency planning process or services, feel free to contact us to discuss your situation. Due to the large volume of calls we receive, for a speedier reply, it’s best to email us.