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The Part-Time Resident Tax Trap

Featured Articles on California Residency Tax Issues

THE PART-TIME RESIDENT TAX TRAP

by
Christopher Manes

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Christopher Manes has started the firm, Manes Law, focused exclusively on California residency tax planning. He can be reached through his website: www.calresidencytaxattorney.com, or contact him at:

MANES LAW
1775 E. Palm Canyon Dr., Ste 110
Palm Springs, CA 92264
T. 760.558.9534
F. 760.537.4363
E. [email protected]

An updated version of this article can be found at Manes Law's residency tax blog.

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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.

Seasonal Visitors As Tax Targets

This is how it works. California taxes residents based 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. For instance, these might include a limited partnership operating in California or rent from an investment property. Since California has the highest income tax rate in the country, visitors who suddenly find themselves defined as "residents" may face a large and unexpected tax liability.

Obviously, the FTB would like to claim everybody who sets foot on California soil as a resident and subject their income to California tax. That's their job, after all. As many seasonal visitors have discovered, the FTB's policies sometimes seem not to fall too far short of that mark.

A special division of the FTB has for years systematically targeted seasonal "part-time" residents for audit (I use the term "part-time" loosely, since we are talking about nonresidents who spend part of the year here, not part-time legal residents per se; but the term has stuck). Though Santa Barbara, Los Angeles and Sonoma counties experience their share of audits, historically the most common casualties are affluent "snowbirds" who own vacation homes in the Palm Springs area as an escape from the winter blasts of the Midwest or northern states. In fact, many of the major cases in residency taxation are eerily similar: they usually involve Midwesterners who own winter vacation homes in Palm Springs and environs. If the FTB finds significant taxable income coupled with meaningful contacts with California (such as a vacation home, business interests or long visits to the state), it can lead to the launch of a full-blown residency audit.

In some ways, these audits are the equivalent of the old-fashioned speed trap, with the difference that a speed trap usually nets the state about $500, while these residency audits can often fill the state's coffers with tens of thousands of dollars in back taxes. And for the taxpayer this may also mean years of legal wrangling.

Case in point: Gilbert Hyatt, inventor of microchip technology that ultimately resulted in the modern consumer computer industry, found himself audited in 1993 on the issue of whether he was a resident of California or Nevada - states where he owned homes - for a tax year when his invention earned him about $90 million. Hyatt won (mostly). But the case took over 25 years to resolve. See the Appeal of Gilbert P. Hyatt hearing summary for all the gory details.

The Intrusive Unintuitive Resident Audit

A resident audit isn't like a typical tax audit (see California Residency Audits: Three Year-End Tasks To Reduce Risk for Nonresidents for a dicussion of the distinctions). If a large enough tax liability is at stake, to establish legal residency, FTB auditors may appear out of nowhere to interview neighbors. They can subpoena a taxpayer's utility bills, credit card statements and check register. They solicit affidavits from friends (and enemies). In general, they pry into a taxpayer's private affairs.

Unfortunately for many nonresidents, "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 auditor concluded that a Texas woman was a California resident despite the fact that all of her significant business, social and family ties were in Texas and her California contacts were limited to a second home in the desert and a country club membership. The basis of the auditor's decision focused on the fact that the woman put her local subscription to The Los Angeles Times on hold when she left the state and returned to Texas. The Times, it so happens, calls that a "vacation hold." There were other bad facts, but in the auditor's mind, vacation holds loomed large. It meant that my client's Texas trips must be vacations, which made California her permanent home. Thankfully, we won the case on appeal.

Temporary Visits And The Closest Connection Test

Under California law, a person who visits 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 result in residency status, including coming to California for an indefinite stay for health reasons, extended stays (usually over six months), retirement, or employment that requires a long or indefinite period to accomplish.

How does the FTB determine whether a visit has a permanent purpose versus a temporary one? It applies the so-called "Closest Connection Test." This refers the comparing contacts a person has with various states during a taxable year: the one with the "closest contacts" is the state of legal residence. 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 obviously indicates a closer tie than merely enjoying a round of golf at a country club or attending a music festival. The weightiest factors for residency are (based on case law, regulation and the practice of auditors):

  • Ownership or lease of real estate.
  • Business interests or employment.
  • Financial accounts, such as banks and investments, safe deposit boxes.
  • A spouse's residency (they don't have to be the same)
  • Schools children attend.
  • Voter registration.
  • Automobile registration and license
  • Use of professional services such as a primary physician, dentists, accountants and lawyers.
  • Professional licenses.
  • Family ties and social life.
  • Representations of residency in social media or websites (where does your Twitter account say you're tweeting from?).
  • Address used on various tax documents, such as a federal return (form 1040) or W-2s, 1099s, K-1s, etc.
  • Location of important personal belongings such as family heirlooms, art, or important documents.
  • Membership in clubs and gyms.
  • And of course, where you spend most of your time.

I hasten to add, these are just factors. No one thing makes you a resident; and no one thing makes you a nonresident. California doesn't follow bright-line rules to determine residency, but rather employs a "facts and circumstances" standard. That means the FTB can be somewhat impressionistic in its application of the law and downplay the main factors in favor of 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 Palm Springs were residents because during their seasonal stays here, they would fly overseas or go on a cruise. According to the auditor, if the couple left Palm Springs to go on a vacation, they could not be on vacation while in Palm Springs. Again, the FTB eventually lost, but not until the taxpayers incurred tens of thousands of dollars in legal and accounting fees.

Warning Signs of a Residency Audit

Here are ten warning signs of a possible FTB audit to keep in mind and to avoid, if possible:

  1. Six Months. You spend more than six months in California, and especially if you spend more than nine. Spending more than nine months creates a legal presumption of residency, though it is rebuttable. But note, the six months is not a "rule"; it's often more important why you're spending time in California than the length of time spent (see The Six-Month Presumption in California Residency Law, at our blog). You can spend no time in California and still be a resident; and you can spend the whole year here and remain a nonresident - under the right conditions (but I wouldn't recommend it).
  2. Second Home. You live out-of-state but own a second home in California and regularly visit or vacation there, especially if your stays here total more than six months during any year (or more than the time you spend in your home state).
  3. 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 (an important consideration if you want to sell stock or a business in a low-tax state while still a nonresident before moving to California).
  4. Keeping Contacts. You plan to move away from California, but you retain business interests, a vacation home or other significant contacts.
  5. Point of Departure 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.
  6. Multiple State Contacts. You have contacts with multiple states, including California. This is especially true if you spend more time in California than any other state, even if the total is under 6 months.
  7. Low-Tax State. You're selling stock or other intangible property in a state with a low or zero income tax rate, while having significant California ties.
  8. Selling Out-Of-State Residence. You own a second home in California, and you sell your out-of-state principal residence.
  9. Employment. Your firm sends you to California to work for an extended period of time.
  10. FTB Notice. You receive an FTB notice asking information about why you didn't file a tax return for income reported to the FTB from a California bank, broker or mortgage lender (the dreaded "4600 Notice, Demand for Tax Return"). This can be a prelude to a full-blown audit.

The key to winning a residency audit is to avoid one in the first place. If any red flags are fluttering over your California vacation paradise, you may want to minimize your exposure by carefully examining the rules of residency and applying them to your situation.

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Christopher Manes has started the firm, Manes Law, with a practice limited to California residency tax planning.  He can be reached through his website: www.calresidencytaxattorney.com, or contact him at:

MANES LAW
1775 E. Palm Canyon Dr., Ste 110
Palm Springs, CA 92264
T. 760.558.9534
F. 760.537.4363
E. [email protected]

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