Aug 20

Written by: David Keligian
8/20/2012 11:25 AM  RssIcon

We get frequent questions about how to avoid California’s high income tax rates by claiming residency in another state. Since California is very aggressive in residency matters, it is important to understand the basic rules determining California residency.

BASIC RULES. There are two basic rules you need to keep in mind if you wish to avoid California tax. The first rule is that a California resident pays California tax on their worldwide income.

For example, if you are a California resident and own part of a Nevada LLC, you will pay California tax on your distributive share of the Nevada LLC’s income, even if that LLC earned all of its income completely outside the state of California.

The second rule is that California will tax California-source income, regardless of where you live. Thus, if you live in Florida but own California real estate, you will still have to pay California tax on the California real estate income.

WHO IS A RESIDENT? California has a very expansive definition of residency. An individual is treated as a California resident if they are in California for other than a “temporary or transitory” purpose, or if they are outside California for a “temporary or transitory” purpose but still maintain a domicile in California. The residency question is ultimately decided by trying to establish the state with which you have the “closest connection” during a taxable year.

Because the above tests are completely subjective, the Franchise Tax Board looks to factors set forth in the California Supreme Court case Corbett v. Franchise Tax Board, which listed 29 residency factors. These factors look to the state in which the following occurred:

1. Birth, marriage, raising family;
2. Preparation of tax returns;
3. Resident state income tax returns filed;
4. Payment and receipt of income;
5. Ownership and occupancy of custom built home;
6. Service as officer and employee of business corporation;
7. Holding of licenses for conduct of profession;
8. Ownership of family corporation;
9. Ownership and occupancy of vacation home;
10. Ownership of cemetery lots;
11. Church attendance;
12. Church donations;
13. Church membership and committee participation;
14. Family doctors and dentist;
15. Car registration;
16. Driver’s license of taxpayer;
17. Driver’s license of taxpayer’s spouse;
18. Voter registration and actual voting;
19. Charge accounts;
20. Predominant banking and financial accounts;
21. Accountant, lawyer, and professional advisors;
22. Wills prepared and located;
23. Education of children;
24. Majority of time spent in that State;
25. Country club membership;
26. Intended state of residence;
27. Presence of, and visits by, other family members;
28. Social event attendance; and
29. Professional memberships.

PROBLEM WITH THE FACTORS. Unfortunately, the Corbett factors are sometimes relied on as a defense in circumstances where the taxpayer actually spends most of their time in California. For example, it won’t matter if you have your tax returns prepared in Nevada, get a Nevada driver’s license, join a country club in Nevada, and buy a condo in Las Vegas if the Franchise Tax Board is still able to show that you spend more time in California.

The Franchise Tax Board will do internet searches and review charge card receipts to see where you’re actually spending your time. Having a Nevada cell phone number and your mailing address at a Las Vegas condo will do you no good if your charge card receipts show you are constantly buying things in Fashion Island, the Spectrum shopping center, or nice restaurants near your Laguna Beach beach house.

BUSINESS SALES. The question of changing residency sometimes comes up in situations involving the sale of a substantial business. Let’s assume, for example, that you have a business which will be sold for $20,000,000 and it’s conducted by a Nevada S-Corporation, but most of the business assets and operations are in California.

Under these circumstances, the only way California taxes can be saved by a change in your personal residency is if you sell the stock of the S-Corporation after you are no longer a California resident. Unfortunately, even if you do validly change your residence to another state, if (as most buyers prefer) the assets of the S-Corporation are sold, there will be California-source income from the sale. That California-source income will be taxed by California at the S-corporation level and will also flow through the S-Corporation and be taxed by California to you individually, even if California agrees you changed your residency.

IT CAN WORK. Under the right circumstances, especially in the context of a major business sale, a change in residency can save substantial California taxes. However, it must be planned for and analyzed correctly from the beginning.

In addition, you must be prepared to actually leave and stay out of California for the sale year and some time thereafter, since the state can still make an argument that someone who leaves for only several years to avoid tax from a major sale still kept their California “domicile”. Thus, someone planning to end their California residency should understand the rules, the steps required, and the practicalities of the entire process.

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Categories: Income Tax
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