Posted on December 17, 2020
We hear many of corporations are moving out of California and many of our clients are seriously thinking about it. Before you make the decision, here are 10 items (in no particular order) that you need to be aware of if you want to survive a residency audit.
1. You must break meaningful ties with California.
It is not enough to build new ties with another state if your ties with California do not decrease — significantly. If you are a California resident/domiciliary, it will be presumed you continue to be a California resident/domiciliary, and you need to overcome that presumption. For example, keeping the family home in California, the business office in California, and/or continuing to use long-time professionals in California, even if you are acquiring a new home, new office, and new professionals in the “new” state, can cause significant problems in an audit and should be carefully thought out.
2. You must build solid new ties with another state that are, at a bare minimum, comparable to the ties you had in California.
It is not enough to break California ties if you do not reestablish yourself permanently somewhere else. The analysis in an audit by the FTB is going to be California ties versus ties to a single new state where residence/domicile is claimed. For example, if you spend 40% of your time in California, 30% in the new state, and 30% travelling and in miscellaneous other states, that is not a strong factual scenario, even though you spend less time in California than elsewhere in total.
3. The times you do return to California after the move need a solid case for being for a temporary or transitory purpose.
You can become a resident/domiciliary of another state and still spend time in California as long as that time in California is for a “temporary or transitory purpose.” Returning back to California to visit family, for vacations, for business trips, for a course of medical treatment, etc., should all be fine as a nonresident as long as they are carefully managed and fall within that standard.
4. Watch the timing of the change.
It is one thing to move out of California and successfully change your residency/domicile to another state, but precisely when did that change take place? For example, buying a home in Nevada on July 1 and having a large income realization event on September 1 will accomplish nothing in terms of changing your California tax situation if the FTB on audit agrees that you moved from California to Nevada, but that the date of the move is October 1 when all factors are taken into consideration. Although one is perfectly free under the law to change their residence/domicile to achieve tax savings, remember that auditors often take a dim view of changes that are claimed to occur very soon before a large income event, often resulting in a tougher burden to show a genuine move took place. Pick your move date carefully.
5. Watch out for California–source income issues.
Carefully consider and understand if there is income that has a California source, a change of residency will not keep that income from being taxed by the FTB. For instance, stock options that vested while a California resident, rent from a California real property, and income from passthrough entities that have a California source are all taxable to a nonresident of California. It is very common for the FTB to take alternative positions in residency audits, i.e., the individual is still a California resident, but even if they became a nonresident, some/all of the income is still taxable because it has a California source. Nonresident sourcing was a major issue on appeal in the infamous Hyatt residency case, even though the FTB did not even rely upon that argument at audit. (Appeal of Hyatt (January 14, 2019) Op. on Pet. For Rehearing)
6. Watch your conduct — for several years — after the move.
California has a four-year period to audit after the filing of the return (R&TC §19057). For example, assume you move in Year 1, but in Years 2 and 3 you begin to spend significantly more time back in California. If you are audited during Year 3 (or 4) for the change of residency/domicile in Year 1, it is extremely likely that your conduct in Years 2 and 3 (or 4) are going to be examined as part of that audit, even if the audit is technically only for Year 1. (It is also likely those later years will be added to the audit.) That is because the FTB may see subsequent conduct reflecting on prior conduct, i.e., maybe you really did not move in Year 1 after all, if you increased your ties back to California in the immediate subsequent years.
7. Watch for different treatment of spouses.
It is possible, although not frequent, that spouses may have different residences/domiciles, either as filed or as a result of audit. If this is the case, keep in mind that community property must be divided between them (Appeal of Misskelley (May 8, 1984) 84-SBE-077).
8. Be prepared for an audit.
Then be pleasantly surprised if it does not happen. The larger the potential tax effect from a change on audit, the more likely the audit because of the way the FTB allocates audit resources. Much of the audit selection process is done by computer programs. A California resident who moves and then stops filing returns (i.e., not filing nonresident returns to report California-source income) might generate audit interest, especially involving a high wealth individual. A part-year return that shows a move during a calendar year might generate audit interest. A subsequent nonresident return that shows large amounts of income but with little of it reported to California is very likely to generate audit interest. Remember also that for tax years in which no return is filed, the FTB has an open, unlimited, period in which to audit and assess a deficiency.
9. Do your best to document your case contemporaneous with the move.
The FTB’s strong preference is for “contemporaneous” documentation, as opposed to documentation created at a later time, e.g., at audit. So try to give the FTB what it wants. However, there is no legal limitation that documentation in a residency case must be “contemporary,” and, for instance, it is common practice to obtain affidavits/declarations from the taxpayer, his or her friends, employers, or business associates in responses to issues raised by the FTB at audit (18 Cal. Code Regs. §17014(d)(1)).
10. Live your life.
Life is short and one should not live it constantly looking over their shoulders and worrying about the threat of an FTB audit or assessment. Taxes are simply an expense that is a part of life, so maintain perspective. For example, do you really want to give up your family doctor (or specialist) in California whom you have seen for 20-plus years to start a new relationship with a new doctor elsewhere, simply because it might incrementally strengthen to some degree your argument that you moved out of California? Choosing the best tax-driven decision may not be the same as the best life-driven decision.
Call us with any questions if you are considering moving out of California.