The Part-Time Resident Tax Trap
THE PART-TIME RESIDENT TAX TRAP
Most of the world knows the Palm Springs area for its picturesque golf courses, celebrity homes and halcyon weather. Among the taxing authorities in Sacramento, however, the words "Palm Springs" conjure up less carefree images.
Spurred by the state's appetite for tax revenues, the Franchise Tax Board, California's main taxing authority, has tapped into a new revenue source; taxing seasonal visitors to our area as state residents.
This is how it works; California taxes residents on their worldwide income, from whatever source, no matter how far-flung. In contrast, California taxes nonresidents only on their income derived from California sources. These might include a limited partnership or rent from an investment property. Since California has some of the highest income tax rates in the country, visitors who suddenly find themselves defined as "residents" may face a large and unexpected tax liability.
Obviously, the Franchise Tax Board would like to claim everybody who sets foot on California soil as a resident and subject everybody's income to California tax. As many seasonal visitors have discovered, the FTB's policies don't fall short of its wishes.
Over the past five years, a special division of the FTB has systematically targeted part-time residents for audit. Though Santa Barbara, Los Angeles and Sonoma counties experience their share of audits, the typical casualty is the Palm Springs affluent snowbird who wings his or her way to a California vacation home to escape the winter blasts of home. In fact, many of the major cases in residency taxation are eerily similar: They usually involve Midwesterners who own vacation homes in the Coachella Valley. If the FTB finds significant taxable income coupled with any meaningful contacts with California (such as a vacation home, business interest or long visits to the state), the FTB likely will launch a full-blown residency audit.
These audits are the equivalent of the old-fashioned speed trap, with the difference that a speed trap usually nets the state about $50 while these residency audits can often fill the state's coffers with thousands upon thousands of dollars. Not to mention years and years of legal wrangling.
To establish legal residency, the FTB auditors appear out of nowhere to interview neighbors. They subpoena the taxpayer's utility bills, credit card records and country club charge slips. They solicit affidavits from friends (and enemies!). In general, they pry into the taxpayer's private affairs.
Unfortunately for most taxpayers, "residency" is a legal term of art, one that may have nothing to do with a person's honest belief that his or her real home lies outside California. As a result, the outcome of a residency audit often turns on seemingly trivial facts with no legal significance for a non-lawyer.
For example, our firm handled a case in which the FTB concluded that a Texas woman was a California resident despite the fact that all of her business, social and family ties were in Texas and her sole California contacts were a second home in the desert and a country club membership. The basis of the FTB's decision was that the woman put her local subscription to the Los Angeles times on hold when she left the desert and returned to Texas. The times, it so happens, calls that a "vacation hold." In the auditor's creative mind, this meant that her Texas trips must be vacations, which made California her permanent home. We won the case on appeal.
Under California law, a person who stays in the state for other than a temporary or transitory purpose is a legal resident, subject to California taxation. Basically, brief vacations or transactions, such as signing a contract or giving a speech, constitute temporary or transitory purposes that do not confer residency. Every other kind of visit can confer such a status, including coming to California for health reasons, extended stays, retirement or employment that requires a long or indefinite period to accomplish.
How does the Franchise Tax Board determine whether a visit has a temporary or permanent purpose? It applies the "Closest Connection Test." This refers to the state with which a person has the closest connection during the taxable year. For the FTB, this literally means counting all the California contacts a person has and comparing that number with the non-California contacts. Of course, some contacts simply weigh more than others. A job or real estate ownership indicates a closer tie than merely enjoying a round of golf at a country club or a concert at the McCallum. The weightiest factors for residency are:
- Ownership or lease of real estate.
- Business interests or employment.
- Schools used by children.
- Membership in clubs.
- Bank accounts or safety deposit boxes.
- Use of professional services such as accountants, doctors, dentists and lawyers.
- Automobile registration and license.
- Family ties and social life.
- Appearance in telephone or social directories.
- Location of personal belongings such as clothing, family photo albums or kitchenware.
- Jury duty.
The FTB, which can be somewhat impressionistic in its application of the law, often disregards these factors and bases its decisions on quirky logic as our Texas client discovered. In another case our firm handled, the FTB argued that an elderly South Dakota couple with a second home in Pam Springs were residents because during their seasonal stays here, they would fly overseas or go on a cruise. According to the FTB, if the couple left Palms Springs to go on a vacation, they could not be on vacation while in Palm Springs. Again, the FTB eventually lost, but not until taxpayers incurred tens of thousands of dollars in legal and accounting fees.
Here are ten warning signs of a possible FTB audit:
- Six Months. You spend more than six months in California, and especially if you spend more than nine. (This creates a legal presumption of residency).
- Second Home. You work out-of-state, but own a second home in California and regularly visit or vacation, especially if your stays here total more than six months during any year.
- Property Storage. In anticipation of moving to or retiring in California in the future, you begin to ship personal property ahead of your move for storage here.
- Keeping Contacts. You plan to move away from California, but you retain business interests, a vacation home or other contacts.
- Point of Department for Vacations. You come to your vacation home in California, and go on to other vacation spots from here, and return from vacation to California.
- Multiple State Contacts. You have contacts with multiple states, including California.
- Low-Tax State. You're selling stock or other property in a state with low or nonexistence income taxes, while having California ties.
- Selling out-of-state Residence. You own a second home in California, and sell your out-of-state residence.
- Employment. Your firm sends you to California to work for an extended period of time.
- FTB Notice. You receive an FTB notice asking information about why you didn't file a nonresident return for income reported to the FTB (through a Form 1099) from a California bank or broker.
The key to winning a residency audit, therefore, is to avoid one in the first place. If any red flags are fluttering over your desert vacation paradise, you may want to minimize your exposure by carefully examining the rules of residency thereby decreasing your chances of getting one of those dreaded audit letters in the mail.