California Dreaming (or Nightmare?)
It is no secret that California tax rates can be brutal, with the top rate reaching 13.3% on all income (including capital gains), so it is important for individuals to understand the scenarios in which they will become liable to California taxes, and how not to get caught out and inadvertently subject to tax.
California taxes individuals regarded as ‘resident’ in California on their worldwide income and gains. A non-resident of California is subject to tax on California source income only (gains, other than real estate gains are exempt). California source income does not usually include investment income such as interest and dividends; however, if income is related to a business in California, real estate or an LLC based in California, it may need to be reported as California source income. If you are employed, working in California will result in California source income that is subject to tax. Similarly, gains from stock options where you worked in California in the period to vesting could be California source.
If you are regarded as resident in California then you will be subject to tax on your worldwide income. If the income is also taxed by another state, California will usually allow a credit to be claimed for state taxes against the California tax. However, and critically, California will not allow a credit for foreign taxes meaning the imposition of Californian state tax is an “additional tax” that doesn’t qualify for treaty relief. For example, if you are not a US citizen or green card holder and are able to utilise a tax treaty (e.g. the US/UK double tax treaty) to claim non-residence for federal purposes, the treaty position would not impact the California resident position, with the result that you would only be taxed on US source income for federal purposes, but on a worldwide basis for California state tax purposes.
The Californian Test for Residence
The pressing question then, is how does California determine residence? California uses a “facts and circumstances” test to determine residence status. Generally, you will be considered a California resident if you are present in California for any reason other than a ‘temporary or transitory’ purpose. For example, if your employer assigns you to an office in California for a long term or indefinite period, or if you retire in California and have no specific plans to leave, you will be resident.
If you are in California for more than 9 months, you are presumed to be a resident. However, it is possible that you will be considered a resident in California if you are present for less than 6183 days of presence, if the facts and circumstances indicate your ties (closer connection) are greater to California than any other state or territory. Essentially, this is a centre of vital interests test, which widens the net significantly. As such, if your main base of employment is in California or you own or operate a business in California then you may be considered a California resident, even if you are rarely in the state.
In order to determine a closer connection to California, the Franchise Tax Board (FTB) considers the facts and circumstances including intent. Factors to be considered include, but are not limited to:
Number of days spent in California vs. days spent elsewhere
Where your immediate family reside (spouse and children)
Location of your principal residence
Location of real estate, partnerships, LLCs and financial investments
State in which you are registered to vote
State which issued your driver’s license
Location of your bank accounts
Location of your social ties, i.e. country club memberships, place of worship
Location of doctors, dentists and other healthcare providers
Location of main base of employment
If you are considered resident in California it is likely that you will also be considered “domiciled” there for the period of your residence. Domicile is defined as “the place where an individual has his true, fixed, permanent home and principal establishment and to which he has, whenever he is absent, the intention of returning”. You can only have one domicile and the domicile remains permanent, until the taxpayer establishes a domicile in another state or territory.
Given the nature of domicile and the closer connection test, if you are intending to leave California to take up residence in another state, it is important to break as many ties with California as possible.
The Safe Harbour
There is a safe harbour rule which applies if you are considered domiciled in California but leave to take up an employment contract in another state or country. The assignment in the other state or foreign country needs to be for at least 18 months before you can be presumed to be non-resident. In addition, you would also need to limit your presence in California to less than 45 days in a calendar year.
This safe harbour cannot be used in cases where the individual has intangible income exceeding $200,000 in any tax year, during which the employment related contract is in effect, or where the principal purpose of absence from California is to avoid personal income tax.
The FTB is very active in auditing and will tenaciously probe into how and when you stopped being resident in their state. The burden is on you to prove your non-residence. If you do not file a California return because you do not believe you are resident and the FTB disagrees, they may have an unlimited time frame to look into your status as there is no statute of limitations. If you have California source income as a non-resident and it is a small amount, it may be worth filing to activate the statute of limitations.
Steps to Take
It is best to sever all ties with California when you leave, but if this is not possible you should take all possible steps to reduce your ties. How this can be accomplished will depend on an individual’s specific assets, family and circumstances, but some common steps to be taken are listed below:
sell or rent your California property as soon as possible upon making the decision to leave California, retaining all records of hiring real estate professionals as back up documentation;
if returning to California at all, do not stay in your former residence, stay with family or in hotels;
change the location of doctors or medical providers to another state;
cut ties with any social memberships (i.e. golf club memberships). If you are unable to cancel the membership, at least retain proof that you tried to cancel such memberships; and relocate all vehicles to your new state of residence, where possible.
Each of these steps would help to aid the breaking of your California residency and domicile, but it is important to note that each taxpayer will be assessed on a case by case basis and your tax adviser should be consulted before making any changes to your residence circumstances.