The California Franchise Tax Board (FTB) conducts residency audits to ascertain whether a taxpayer is a California resident, a non-resident, or a part-year resident, to determine the correct amount of that taxpayer’s California income tax obligation. The outcome of a residency audit can radically alter the amount of your tax obligation. The tax specialists at the Ben-Cohen Law Firm strive to help our clients understand what is entailed in a residency audit, and then provide the highest quality representation in these residency audits. Working with our firm, you will have the benefit of having both an experienced residency audit attorney, certified by the State Bar of California Board of Legal Specialization as a Taxation Law Specialist, and a licensed Certified Public Accountant (CPA), working hard to achieve the most favorable outcome possible on your behalf.Residency Audits May Be Singularly Focused or Wide-Ranging
Residency audits differ from other audits in their focus and nature. In contrast with most tax audits, which center on specific claims made within a return, such as amounts of income, deductions, or credits, residency audits attempt to deduce the taxpayer’s state of residence. Do not be misled though – a residency audit can also extend to issues of income, deductions, or credits, in addition to residency matters.Resident of California
Pursuant to California Revenue & Taxation Code (“R&TC”) Section 17041(a), taxes are imposed upon the entire taxable income of every resident of California in each tax year. For purposes of this Section, “resident” is defined to include:
- Every individual who is in this state for other than a temporary or transitory purpose.
- Every individual domiciled in this state who is outside the state for a temporary or transitory purpose. R&TC Section 17014(a).
An individual is considered a “part-year resident” if she:
- Is a resident of California during a portion of the tax year; and
- Is a non-resident of California during another portion of the tax year.
Domicile means “the place where an individual has his true, fixed, permanent home and principal establishment, and to which place he has, whenever he is absent, the intention of returning.” California Code of Regulations (“CCR”) Section 17014(c). An individual may leave the state and still be domiciled in California as long as she has a definite intent to return to California. Furthermore, the concept of domicile is distinct from residence. An individual may only have one domicile at a time but may have multiple residences. Therefore, an individual domiciled in California who leaves the state loses her California domicile the moment she abandons any intention of returning to California and relocates outside of California with the intention of staying there indefinitely.
Whether an individual is outside of California for a temporary or transitory purpose depends on the facts and circumstances. Generally, “if an individual is simply passing through this State on his way to another state or country, or is here for a brief rest or vacation, or to complete a particular transaction, or perform a particular contract, or fulfill a particular engagement, which will require his presence in this State for but a short period, he is in this State for temporary or transitory purposes, and will not be a resident by virtue of his presence here.” CCR Section 17014(b). Furthermore, an individual who spends at most a total of six months in a taxable year in California, and who maintains a permanent abode at the place of her domicile located outside of California, will be considered as being in California for temporary or transitory purposes so long as she does not engage in any activity in California other than that of a seasonal visitor, tourist, or guest.
If, however, an individual is in California for a particular objective which requires a relatively long or an indefinite period to accomplish, she may be considered a resident of California for tax purposes even though she may retain her domicile elsewhere.
Taxpayers claiming a change of domicile bear the burden of proving the establishment of a new domicile outside of California. The FTB may consider the following non-exhaustive list of factors when determining residency:
- The location of all of the taxpayer's residential real property, and the approximate sizes and values of each of the residences.
- The state wherein the taxpayer's spouse and children reside.
- The state wherein the taxpayer's children attend school.
- The state wherein the taxpayer claims the homeowner's property tax exemption on a residence.
- The taxpayer's telephone records (i.e., the origination point of taxpayer's telephone calls).
- The number of days the taxpayer spends in California versus the number of days the taxpayer spends in other states, and the general purpose of such days (i.e., vacation, business, etc.).
- The location where the taxpayer files his tax returns, both federal and state, and the state of residence claimed by the taxpayer on such returns.
- The location of the taxpayer's bank and savings accounts.
- The origination point of the taxpayer's checking account transactions and credit card transactions.
- The state wherein the taxpayer maintains memberships in social, religious, and professional organizations.
- The state wherein the taxpayer registers his automobiles.
- The state wherein the taxpayer maintains a driver's license.
- The state wherein the taxpayer maintains voter registration and the taxpayer's voting participation history.
- The state wherein the taxpayer obtains professional services, such as doctors, dentists, accountants, and attorneys.
- The state wherein the taxpayer is employed.
- The state wherein the taxpayer maintains or owns business interests.
- The state wherein the taxpayer holds a professional license or licenses.
- The state wherein the taxpayer owns investment real property.
- The indications in affidavits from various individuals discussing the taxpayer's residency.
In considering the above factors, the FTB is analyzing whether you have substantially severed your California connections and have taken steps to establish significant connections with your new domicile. The FTB may not be persuaded by mere formalisms. For example, it may not be enough that you changed your voter registration, driver’s license, and car registration to another state. Conversely, a visitor will not be automatically considered a California resident just because she owns a home or opens a bank account in California.Presumption of Residence
R&TC Section 17016 provides for a rebuttable presumption of California residency for individuals who spend more than nine months of a tax year within California. A satisfactory showing that an individual is in California for a temporary or transitory purpose may rebut the presumption. R&TC Section 17016 further provides that spending less than nine months of a tax year in California does not result in a presumption of non-residence. In fact, an individual who was not in California during the tax year may still be considered a resident of California. This is because a taxpayer may be domiciled in California while being physically outside of California.Safe Harbor
There is a narrow safe harbor provision for tax years beginning on or after January 1, 1994. Pursuant to R&TC Section 17014(d), an individual domiciled in California who is absent from the state for an uninterrupted period of at least 546 consecutive days due to an employment-related contract will be considered to be outside of California for other than a temporary or transitory purpose. Visits to California that do not exceed a total of 45 days during the tax year will not be counted towards the 546 consecutive days. The non-resident status also applies to an accompanying spouse of an individual who meets the requirements of the safe harbor.
The safe harbor does not apply to an individual or spouse who earns more than $200,000 from stocks, bonds, notes, or other intangible personal property during any tax year in which the employment-related contact is in effect. Furthermore, the safe harbor will not apply to an individual whose principal purpose is to avoid taxes imposed by California.California Source Income
In addition to distinguishing between residents, non-residents and part-year residents, California law differentiates between categories of income. California residents are taxed on their total income. Non-residents are only taxed by the FTB on their California source income. R&TC Section 17951. Part-year residents are taxed on their entire income earned while they were residents of California and on California source income earned during their time as non-residents.
California source income includes:
- Income from real or tangible personal property located in California;
- Income from a business, trade, or profession (i.e. sole proprietorship, partnership, S corporation, or limited liability company) carried on within California;
- Compensation for personal services performed within California;
- Income from stocks, bonds, notes, bank deposits, and other intangible personal property having a business or taxable situs in California; and
- Rentals or royalties for the use of, or for the privilege of using in California, patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like property having a taxable or business situs in California.
Situs means the location of the property for legal purposes. With respect to intangible personal property, the doctrine of mobilia sequuntur personam applies which means “movables follow the person.” Therefore, income earned from stocks and bonds while a non-resident of California is not taxable in California even if they were purchased while a resident of California. Business situs may be established in California if possession and control of the intangible property has been localized in connection with a business, trade, or profession in California so that its substantial use and value attach to and become an asset of the business trade or profession in California.Stock Options
An individual who exercises a non-statutory stock option while a California resident must pay California income taxes in connection with the option exercise. The difference between the fair market value of the stock on the exercise date and the option price constitutes income that will be taxed as ordinary wages. TO the extent services were performed in California, the same is true for individuals that exercise a non-statutory stock option while a non-resident of California. This prevents a former California resident who rendered services only in California from avoiding a California tax assessment on such options. If services were performed both in and out of California, non-residents must allocate to California a portion of compensation reasonably attributed to services performed in California.
The California tax code conforms to the federal tax code’s treatment of incentive stock options (“ISO”). Pursuant to Internal Revenue Code Section 422, income from a grant or exercise of an ISO will be taxed as long-term capital gains, not ordinary income, as long as the holding period requirements are met. To take advantage of Section 422, a taxpayer may not dispose of stocks obtained from an ISO until two years after the grant date or until one year after the transfer date. Furthermore, the recipient of such ISO must have been an employee during the period starting on the grant date and ending three months before the exercise date. If a stock received through an ISO is sold before meeting the holding requirements, it is a disqualifying disposition and the income will be taxed as ordinary income, not capital gains.
A California resident who makes a qualifying disposition of stocks received from an ISO, which was exercised while she was a non-resident, may be taxed in California on the capital gains, because California may tax its residents on their entire income. Similarly, if she makes a disqualifying disposition while she is a California resident, any income from the disposition may be taxed in California. A California tax credit that will offset the taxes paid to another state may be allowed on double-taxed income.
A non-resident who makes a qualifying disposition of stocks received from an ISO, which was exercised while she was a California resident, will not be taxed in California on capital gains earned from the disposition because it is categorized as capital gains, which are considered sourced from the seller’s residence at the time of the sale. Income from intangible property is considered to have originated from the seller’s place of residence at the time of the sale. Therefore, even though the services rendered that gave rise to the ISO are performed in California, it is not considered California source income if, at the time of the sale, the seller is a non-resident.
If a California resident or non-resident exercises an ISO, and subsequently sells the stock in a disqualifying disposition while a non-resident, the portion that is subject to California taxes depends on the price sold in relation to the fair market value on the exercise date. If the price sold is greater than the fair market value on the exercise date, then the difference between the fair market value on the exercise date and the option price is considered ordinary income, which may be taxed by California if the services were performed in California. The difference between price sold and fair market value on the exercise date is considered capital gains, which cannot be taxed in California if the seller is a non-resident. If the price sold is less than the fair market value on the exercise date, then the difference between price sold and option price constitutes ordinary income. The difference between price sold and fair market value on exercise date is not taxable if the seller is a non-resident.
price sold – option price
= capital gain
Disqualifying disposition where price sold is greater than FMV on exercise date
FMV on exercise date – option price
= ordinary income
price sold – FMV on exercise date
= capital gain
Disqualifying disposition where price sold is less than FMV on exercise date
price sold – FMV on exercise date
= capital loss
price sold – option price
= ordinary income
If a taxpayer is a California resident on the date that restricted stock vests, she must pay taxes in California on the difference between the fair market value of the stock on the vesting date and the price she paid for it. If, on the other hand, a taxpayer is a non-resident, income from the stock vesting is considered compensation for services rendered and will be taxed in California to the extent services were rendered in California. Therefore, California may tax all of the income if a taxpayer renders all services for a corporation in California and the stock vests after she terminates employment and becomes a non-resident.Installment Sales
If the property is located in California, the proceeds of an installment sale are taxable in California. Any interest income is taxable in California if the seller is a resident. Even if the property is located outside of California, the installment proceeds are taxable in California if the seller receives the proceeds while a resident of California. The domicile at the time of the payments is the key element for this analysis, regardless of residency at the time of the sale. If she receives the proceeds while a non-resident of California, the installment proceeds are not taxable by California. This is true even if, at the time of the sale, she was a resident of California.Estates and Trusts
Income distributed to non-resident beneficiaries is taxable in California only if the income of the estate or trust is derived from California sources. Pursuant to R&TC Section 17953, a non-resident beneficiary is deemed owner of any intangible personal property from which income of the estate or trust is derived.Royalties and Residuals
Royalties from copyrights and patents are considered intangible assets. This means they will be taxed in California if they are received by a California resident, but will not be taxed in California if the recipient is a non-resident. Residuals received as a percentage of future sales are considered income from services performed, and therefore, are taxable in California if the services were performed in California.Alimony
Alimony received by a resident of California is taxable in California regardless of the payor’s residency. A California resident may deduct alimony paid to a resident or non-resident of California. Pursuant to R&TC § 17302, a non-resident or part-year resident who pays alimony to a resident or non-resident may deduct a portion of the alimony payments from her California adjusted gross income.Net Operating Losses
The treatment of net operating losses is another area that trips up taxpayers when they change their residency in or out of California. California allows a net operating loss (NOL) deduction under R&TC Sections 17201 and 17276. A non-resident of California must separate her total income from her California source income when computing NOL. A California non-resident may have a California-source NOL even if her total income from all sources results in no NOL. If a taxpayer becomes a California resident and has NOL carryovers, she must restate her carryover amounts for 20 years as if she were a California resident during all prior years. Similarly, if a taxpayer becomes a non-resident and has a NOL carryovers, she must restate her carryover amounts as if she were a non-resident for all prior years.
For losses incurred in tax years 2013 through 2018, California resident and non-resident taxpayers may carry back their California NOL to the past 2 years. A taxpayer who wants to carry forward an NOL from those tax years must waive her carryback option on her tax return. For losses incurred in tax year 2019 and after, NOLs can no longer be carried back to the past 2 years. For tax years 2020, 2021, and 2022, California has suspended the NOL deduction for taxpayers with net business income of $1 million or more.Residency Audits Are Protracted, Detail-Oriented Processes
During your residency audit, you may expect the auditor to request certain information and documentation tending to establish your residency status. An auditor may request a broad range of documents, including business records, financial records, and personal records. The scope of the information request may also cover items relating to real estate and personal property. Due to the sensitivity of this information, auditors are obligated to handle such personal information in a confidential manner. In the experience of the residency audit attorneys at our Los Angeles firm, you could reasonably expect an auditor to request: information about the purchase, sale or lease of your home, escrow documents, homeowners or renters’ insurance information, documents regarding your vehicles or watercraft, travel logs, personal calendars, employment agreements, cancelled checks or bank statements, credit card receipts and/or statements, or even voter registration information.
Residency audits take a long time to complete. While the FTB sets its goal at 18 months to complete a residency audit, that is generally a best-case scenario. Some residency audits can take years to complete. Our residency audit attorneys will guide you through every step of the process until the final resolution of your audit.Tax Cuts and Jobs Act of 2017
The Tax Cuts and Jobs Act of 2017 significantly limits the amount of state and local taxes (SALT) that may be deducted from federal taxes. Prior to the passage of this law, the federal government allowed taxpayers to deduct payments made to their state and local governments for property taxes and income or sales taxes. The SALT deduction is now limited to $10,000 ($5,000 for married persons filing separate tax returns) per year. Therefore, residents of states with high tax rates like California may consider changing their residence to another state with lower tax rates. What they may fail to consider, however, is that the FTB has an unlimited amount of time to audit taxpayers who do not file a California income tax return. This means a taxpayer who leaves California and does not file a part-year California tax return may receive a deficiency notice from the FTB years later.
The FTB’s audit process and residency calculation can be both very exacting with regard to certain details and confusing unless you retain a Los Angeles residency audit lawyer to advise you. California residency audits are often very complicated, and their outcomes can make huge differences in the amount of your tax obligations. For diligent, knowledgeable and personalized representation in your residency audit, contact the tax attorneys at the Ben-Cohen Law Firm.