Tax Planning and Compliance

Avoiding California Residency

 

California is often referred to as the "Golden State" ... a mecca for successful business owners, real estate moguls, and Internet entrepreneurs. Some of California's luster is lost, however, when the "gold" is the Franchise Tax Board's claim for 9.3% of the gain from major asset or business sales. At that time, many entrepreneurs contemplate changing residence from California's golden shores to other places that let them hold on to more of their gold.

Unfortunately, California is very aggressive in attempting to tax its ex-residents, and to make matters worse, there is some misinformation concerning what steps a California resident should take to relocate to a different State in order to avoid California income tax.

Basic Rules. There are two basic rules an individual needs to keep in mind if they wish to avoid California tax. The first is that a California resident pays California tax on all their income.

For example, if a California resident is a partner in a Texas S corporation or a member of a Nevada LLC, they will be taxed on their distributive share of each entity's income, even if each entity earned all its income completely outside the State of California.

In addition, California generally taxes California-source income, regardless of the recipient's residency. Thus, even if someone successfully establishes residency outside California, they will still be taxed on all services they perform within the State of California, rental income from California property, proceeds from sales of California real estate, and other types of California source 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 the state 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 underlying theory of the Revenue and Taxation Code is an attempt to establish a person's residency by determining the State that the person has the closest connection to during a taxable year.

Unfortunately, the meaning of "temporary or transitory" is completely subjective. It depends upon the facts and circumstances of each case. (Whenever you hear a tax lawyer say something like "depends upon the facts and circumstances of each case", what he really means is that if you are audited, the taxing authorities will do everything possible to focus on all unfavorable factors and completely ignore all favorable factors.)

The concept of "domicile" is similarly subjective. A person's tax "domicile" is typically that place where they have their true, fixed and permanent home to which they intend to return. As with "temporary" or "transitory", the domicile issue is typically determined based upon "all the facts and circumstances" (i.e., be prepared for a fight). However, the more objective factors you can create, the more likely your chance of winning.

For example, with respect to "domicile" issues, if one taxpayer sells their beachfront home in California to move to an expensive oceanfront condominium in Florida, it is more likely that they will be able to win a "domicile" argument than the taxpayer who retains his beachfront home in California, keeps all his furniture and personal effects there, and claims he lives in a modest 2-bedroom condominium in Las Vegas.

Presumptions. In determining residency, California law also provides two presumptions. The first presumption is that a taxpayer who, in the aggregate, spends more than 9 months of a taxable year in California will be presumed to be a California resident. This presumption is not conclusive, and may be overcome by satisfactory evidence that the individual is within the State for a temporary or transitory purpose. However, for someone planning to avoid California residency, they should do their best to avoid being in California for more than 9 months.

The second presumption is that an individual whose presence in California does not exceed 6 months within a taxable year and who maintains a permanent home outside California, is considered as being in California for temporary or transitory purposes provided the taxpayer does not engage in any activity or conduct within the State other than as a seasonal visitor, tourist, or guest. For most business people, this is a very difficult test to meet. It would be applicable, however, for someone who establishes residency outside the State, sells the stock in their business, and then spends 5'/2 months in California vacationing and counting all the California tax they saved by their out-of-State move.

"All Facts and Circumstances". In Corbett v. Franchise Tax Board, the California Supreme Court listed 29 residency factors to be evaluated with respect to a taxpayer who had homes in both California and Illinois. The Corbett factors, while not universally applicable, are nonetheless helpful in planning to establish nonresident status in California. 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 year;
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. Most days within state;
25. Country club membership;
26. Plaintiff’s intended state of residence;
27. Presence of, and visits by, other family members;
28. Social event attendance; and
29. Professional memberships.

If you truly want to establish that you are a non-resident of California, it means that, under Corbett, there are a number of steps you can take (such as getting out-of-State driver's licenses, joining churches and country clubs, and registering to vote) to substantiate the fact that you are not a California resident. However, if your establishment of non-resident status is close in time to when you plan on selling major assets that otherwise would be subject to California tax, you can still expect a fight because California realizes that (at least temporarily) this is their "last bite at the apple"!

Rules Applicable to Corporations. There is also some misunderstanding about the use of an out-of-State corporation to reduce California taxes. Advertisements and seminars touting the use of Nevada corporations are a good example, because they imply that the simple expedient of forming a Nevada corporation will save California taxes.

That is true only if the Nevada corporation does not have any California source income and does not have a California "commercial domicile". In addition, income escapes California tax only as long as it is not distributed to a California resident, either actually or under pass-through taxation rules applicable to S corporations, partnerships and LLCs.

Example: A California resident forms a Nevada corporation. The Nevada corporation is engaged in the business of buying and selling used cars. All of its operations are conducted in Las Vegas, and all car sales are to Nevada residents. The corporation will avoid California tax, and its California owner will also do so, unless (i) the Nevada corporation is a C corporation and actually makes distributions to the California owner or (ii) the Nevada corporation is an S corporation, partnership, or LLC, in which case the California owner will pay tax on their distributive share of income regardless of whether it's actually distributed or it is not.

With respect to business income, California apportions such income based upon a three-factor property, payroll and sales factor (with the sales factor being weighted doubly). This means that, for example, a Nevada corporation that derives half of its revenues inside California and has half of its property and payroll there will be subject to California tax on half its income. California also has so-called "unitary tax" rules, which basically let California apply the above factors to "unitary" groups of businesses.

Although an explanation of the unitary tax is beyond the scope of this article, a simple example would involve three corporations that conduct a completely integrated business, with centralized management, purchasing, etc. The fact that one corporation operates in California at a loss while two operate profitably in Nevada does not stop California from treating the three corporations as a combined entity and taxing a portion of the overall profit.

Commercial Domicile. For a corporation, certain types of intangible and investment income can be taxed in California if the corporation is deemed to have its "commercial domicile" in California. California can raise a commercial domicile argument even if a corporation has no California operations and is located completely outside California. The authority for this position is set forth in the Norton Simon case.

Commercial domicile looks to where a corporation is actually managed and controlled. Unfortunately, as with so many other residency-related issues, commercial domicile is based on "all the facts and circumstances". Frequently, California will attempt to ignore the formal exercise of authority and board and shareholder meetings that are held outside California in an attempt to impute management and control to California shareholders. However, assuming there is not de facto day-today control of the corporation in the State of California, a corporation's management and control can be evidenced by formal board and other corporate action outside California.

Conclusion. Successful residency planning requires a logical, organized approach. Even if you believe you have most of the factors in your favor, the correct approach is thinking about how clearly you can prove each of the factors with documents and other hard evidence.