California Taxpayers: You Can['t] Check Out Any Time You Like
For California's high-earners and business owners, Proposition 30's passage in November 2012 was a "cross the Rubicon" moment. First, Proposition 30 increased tax rates retroactively to the beginning of 2012. Second, it increased the top California rate from 10.3 percent to 13.3 percent — the highest marginal individual rate in the nation, and one that makes moving to even "middling"-tax states (e.g, North Carolina and Louisiana) attractive along with "no"-tax states (e.g., Texas and Nevada).
Ending California tax residence is not a simple matter of finding a crash pad in Las Vegas and sending a goodbye note to Sacramento via a final Form 540 California resident return. Instead, that move requires a commitment to sever California ties and upend personal and business relationships. How, then, does a California tax resident terminate that status, and what continuing California tax obligations might he still have?
California Taxation of Residents Versus Nonresidents
California taxes its "residents" on all income but "nonresidents" only on California-source income such as
- rents and gains from California real property;
- compensation for services performed in California; and
- income passed through from businesses conducted through a fiscally-transparent entity — like an S corporation LLC or partnership — based on the sales and other business activity apportioned to California relative to other states.
California-source income generally does not include other investment income such as dividends, interest, or stock capital gains (even if the company is a California corporation or does business in California).
For example, if a California resident owns 100 percent of an S corporation, which apportions business income one-half to California and Nevada, she pays California tax on a pass-through basis on all that income. By ceasing to be a California resident, she avoids personal California tax on the one-half apportioned to Nevada, but still pays California tax on the one-half apportioned to California. To avoid any personal California tax on a pass-through basis from the corporation, she would need to terminate the S election so that the corporation becomes a C corporation. (The corporation then must pay federal corporate taxes, and higher California C corporation franchise tax rates on the one-half of its income apportioned to California.)
As another example, if an ex-California resident owns investment real property in California, she must file a nonresident Form 540NR California return reporting her rents from that property and any gain from sale. Further, upon a sale, escrow must withhold 3⅓ percent of the gross sales proceeds and pay that over to the California Franchise Tax Board ("FTB") toward any California capital gains tax. She can apply to the FTB for a waiver from withholding — if, for example, she is doing a tax-free like-kind exchange under Internal Revenue Code section 1031, or will have a loss on sale — but should do so at the start, not the end, of escrow.
As another example, a California client may want to leave California before a big "cash-out" event. On the one hand, if there is an asset sale of a California-based business or a sale of California real estate, exiting California does not avoid the resulting taxes: The gain is still sourced to California, and subject to California tax. On the other hand, if the event is a sale of ground-level stock from an Internet startup then terminating California residence may indeed avoid California taxes if the move is both completed and "old and cold" before the event: The FTB will be sure to challenge if the client exits California shortly before the event (especially if the sales terms have already been negotiated), or the client retains substantial California contacts. The latter set of facts were present in Noble v. Franchise Tax Board, 118 Cal. App. 4th 560 (2004), where the FTB argued that the taxpayer did not "get out of Dodge" before a big stock sale and the court agreed.
Tests for California Residency
The California FTB's tests for California residency differ from the IRS's tests for determining federal income tax residency. An individual may well file a resident federal Form 1040 return without being a resident for California tax purposes, or file a resident California Form 540 .return without being a resident for federal tax purposes.
The IRS follows the bight-line tests in Code section 7701(b): In general, an individual is "resident" in the United States if he has a green card or he is physically present in the U.S. above a threshold of days during the current and prior two years, and is "nonresident" otherwise. California, however, considers as a resident:
- every individual who is present in California for other than a "temporary or transitory purpose" and
- every individual who is "domiciled" in California even if he is outside California for a "temporary" purpose.
(18 Cal. Code Reg. § 17014.) This inquiry is based on the facts and circumstances, and not the taxpayer's protestations about what he intended.
"Domicile" basically means the taxpayer's fixed home to which she ultimately returns after business, personal or other sojourns, and a taxpayer can have only one domicile at a time. Once "domiciled" in California, a taxpayer must prove that he has changed his domicile to another state. and the FTB's determination of residence is presumed correct. Courts and the California State Board of Equalization ("BOE," which is the administrative agency to which a taxpayer may appeal an adverse FTB decision) rarely reverse an FTB finding against the taxpayer. The FTB has also followed an aggressive audit program to continue taxing as residents persons trying to leave California.
In addition to Noble, two earlier decisions — the pro-FTB decision in Whittell v. Franchise Tax Board, 231 Cal. App. 2d 278 (1964), and the pro-taxpayer decision in Klemp v. Franchise Tax Board, 45 Cal. App. 3d 450 (1975) — give good overviews of how a court applies the residency rules to the facts. These opinions, however, are relics, decided before globalization, cheap air travel, and cell phones and email. It is also instructive to read the BOE's more recent published decisions at http://www.boe.ca.gov/legal/legalopcont.htm#franchise. These decisions give us some better guidance as to how a California resident makes the best possible case in our modern times that she has indeed dropped that status and become a resident of another state for tax purposes. (Unfortunately, the BOE's volume of published decisions has dropped precipitously over the years.)
1. Establishing a new domicile. A California resident trying to terminate that status will almost always have acquired a "domicile" here; therefore, he must move his domicile to the desired new state because he can have only one domicile at a time. If he somehow retains California domicile, then he must demonstrate that his absence from California is other than "temporary" — a near impossibility, particularly where a quick getaway from California is desired (as with a looming big stock sale in the Noble situation).
Changing domicile means that the taxpayer must acquire a new home — preferably owned, not rented — in the new state. The former California residence must be rendered unavailable for his use should he ever journey back to California: He should either sell the California home, or rent it out. Clothing, artwork, furniture and other personal effects should be moved out of the old home into the new one; and, if there is not enough space in the new one, those items should be stored (preferably in an offsite facility in the new state).
The taxpayer should also be seen as settling into his new life in his chosen state. His spouse and minor children should join him in the new home, and the children should go to local schools. (Also, the parents should not claim California resident tuition rates for a college-age child unless the child can independently establish California residency.) He and his family should redirect mail and "ground" telephone listings to the new address; get driver's licenses and re-register cars, boats, and other vehicles in the new state; retain local doctors, dentists, CPAs and attorneys; open personal checking, savings and investment accounts with local banks and brokers; register to vote in the new state; and join social, community, athletic, religious or professional associations in the area.
2. Limiting physical presence in California. If a California resident moves her domicile from California to her desired new state, she must still monitor any returns to California lest the FTB conclude that she is present in California for other than a "temporary or transitory purpose," in which case (as in the Whittell decision) she is a California resident even if her domicile is somewhere else.
Under FTB regulations (18 Cal. Code Reg. § 17016), presence within California for more than nine months of a taxable year creates a rebuttable presumption of California residence. Although this presumption may be overcome by evidence that a taxpayer is in California for a temporary or transitory purpose, in practice the presumption is rarely rebutted. As a starting point, therefore, she should avoid being in California for more than nine months during any year.
However, physical presence in California for less than nine months does not create a corresponding presumption of nonresidence: Therefore, what kinds of contacts can she maintain with her former state within the nine-month threshold? Occasional returns as a tourist or to visit friends or extended family should be fine, provided that the former California resident acts consistently with that intent. For example, visitors normally stay in hotels or with friends or family for short periods, instead of having a fully appointed and furnished house or apartment available for their use whenever they like. Therefore, she should avoid having a vacation home in California (particularly if she just took the trouble of establishing a domicile somewhere else.)
The former resident's situation becomes more complicated if she continues to own a business operating in California, in which case she will need to find a way for that business to operate day-to-day through trusted subordinates and without her constant presence. Doing so may be difficult with a business where face-to-face client, patient or customer contact or onsite supervision and review is essential (such as a law, medicine, consulting, or architecture) but may be easier with a more turnkey operation such as a store or factory, "Virtual" day-to-day supervision over and contact with the business is much easier today than when the courts decided Whittell and Klemp, so the former resident should use e-mail, telephone conferencing, and services like Skype or GoToMeeting as much as possible. If the owner does return to California to supervise subordinates or otherwise tend to the business, she should make those sojourns as short as possible and, if she must stay overnight, do so in a hotel rather than have a company apartment available for her use.
Owning investment real property in California should be considered in a similar vein: It is the nature of the taxpayer's activities, and not necessarily ownership of such real estate by itself, that is relevant. For example, if a taxpayer owns an apartment building and takes a "hands-on" approach to maintenance and dealing with tenants, then constantly returning to California to do these things will be evidence that the taxpayer is present in California for other than a "temporary or transitory" purpose. She should turn these tasks over to a manager and visit the property only sporadically (again, making these visits short with any overnight stays confined to hotels). If the taxpayer insists on being hands-on (or needs to maintain her hours in order to treat the rental property as ‘active" under the Code section 469 "passive activity loss" rules), then she should consider selling the California property and purchasing another in the new state of residence (perhaps through a Code section 1031 deferred exchange).
Losing California residence is not a case of "you can never leave," but does require foresight by the taxpayer and willingness to make significant changes to his business, investment and personal life. As with all tax planning, the desired tax result must match the realities.