Ever think about changing your residence from California as an income tax savings strategy.
With the highest rate of 13.3%, this may seem like a smart plan (particularly in retirement), but fear of being chased by California's Franchise Tax Board can be real.
There is a safe harbor for certain individuals leaving California under employment-related contracts. An individual domiciled in California, who is outside California under an employment-related contract for an uninterrupted period of at least 546 consecutive days, will be considered a nonresident unless either:
- The individual has intangible income exceeding $200,000 in any tax year during which the employment-related contract is in effect.
- The principal purpose of the absence from California is to avoid personal income tax.
Return visits to California that do not exceed a total of 45 days during any tax year covered by the employment contract are considered temporary. But what happens if you don't meet the safe harbor?
Although the IRS can audit 3 or 6 years, California can sometimes audit forever. In fact, several things give the FTB an unlimited amount of time to audit you. California gets unlimited time if you never file an income tax return, even though you might claim that you are no longer a resident and have no California filing obligation.
Some Californians look to flee the state before selling a business. Some get the travel itch right before a public offering, a large stock sale, or settling litigation. Many would-be former Californians have a hard time distancing themselves from California, and they may not plan on California tax authorities chasing them.
The California Franchise Tax Board defines a California resident as someone who is:
- present in California, NOT for a temporary or transitory purpose
- domiciled in California, but physically located outside of California temporarily
The tax law concept of domicile, or the place one considers their permanent home, is important to determining residency. A person may be domiciled in California, even if they live elsewhere or have several residences. This is determined by many factors, which can include:
- Amount of time spent in California versus outside of California
- Location of the taxpayer's spouse/RDP and children
- Location of principal residence
- State that issued the taxpayer's driver's license
- State where vehicles are registered
- State in which professional licenses are maintained
- State in which you are registered to vote
- Location of the banks where accounts are maintained
- The origination point of financial transactions
- Location of medical professionals, accountants, and attorneys
- Location of social ties, such as a place of worship, associations, or clubs
- Location of real property and investments
Most of all, domicile is determined by intent.
Remember, The Franchise Tax Board defines a California resident as any individual who meets any of the following criteria:
- Is present in California for other than a temporary or transitory purpose.
- Is domiciled in California but located outside California for a temporary or transitory purpose.
The cases which follow will illustrate how this definition leaves plenty of grey area, and how the courts have historically decided. Although some of these cases are decades old, because the United States operates under common law, they are important because current legal decisions may be based on the precedence set by such cases as these.
Whittell v. Franchise Tax Board (1964)
In an important judicial decision over residency, George and Elia Whittell challenged the Franchise Tax Board of California when they were assessed income taxes for the years 1940-1958.
Starting after their marriage in 1919, the Whittells lived in California on what can only be described as an estate, complete with six-car garage, a theatre, and servant's cottages. From 1940 to 1958, the Whittells transferred ownership of the property to Whittell Realty company, owned solely by George Whittell. They then "rented" the home, though the deductions for maintenance of the property for corporate income tax purposes exceeded the rental income. Additionally, Mrs. Whittell maintained an apartment in San Francisco from 1929 through 1958.
Between 1929 and 1936, Mr. Whittell rented homes in Reno, Nevada, as well as purchasing 50 acres of land in Nevada near Lake Tahoe. He eventually built another sprawling estate there, near Crystal Bay. Like their California home, the residence was constantly kept ready for them, and no one else occupied it. Insurance policies indicate the home was "partly owner-occupied", while the California home was described as "owner-occupied". The Whittells were multi-millionaires, but lived on income derived mostly from investments, their income from Whittell Realty being around $30,000 per year.
Between 1941 and 1958, eight or nine months of the year were spent in California, and the remainder in Nevada, except for Mrs. Whittell's trips to San Francisco. In 1959, the Whittells were assessed California income taxes for the years between 1940 and 1956, and 1958 (having filed a nonresident return in 1957) on the grounds that they were California residents. The Whittells disagreed.
Evidence of the Whittell's residency was fairly split. Although Mr. Whittell registered to vote in Nevada most years between 1930 and 1953, the couple made charitable contributions in both states. They maintained bank accounts in California, Nevada, and New York.
The circumstances of this case necessitated a distinction between a person's "residence" and their "domicile". The Personal Income Tax law had already been amended in 1937 to reflect this distinction, and the court ultimately found that the Whittells were domiciled in California. This was based on their repeated and lengthy presence in the state each year, their family and business connections in the state, their maintenance of professional connections there, and the description of their California property as their "home residence" (among other things).
The Whittells were determined to be residents of California, and therefore liable for the taxes assessed on them by the state.
Klemp v. Franchise Tax Board (1975)
This case was brought after the Franchise Tax Board levied tax assessments against Fred Klemp and his wife for the years of 1960 - 1964. Upon receipt of the tax assessment, the Klemps appealed to the State Board of Equalization, who upheld the assessment. This resulted in the lawsuit we'll examine.
Both parties agreed on the material facts: that the Klemps had been involved in activities in California and had business interests and affiliations in the state.
The Klemps originated from Chicago, where they owned a corporation (The Dale Oil Company) They built a number of motor freight terminals which were eventually leased to others, and a business manager took care of the day-to-day matters. Free to do as they pleased, the Klemps travelled. They spent time in California, Hawaii, Chicago, Idaho, and Europe regularly. From 1960 to 1965, they slowly sold their interests in the business they owned.
During this five-year period, the Klemps maintained residency in Illinois, including:
- Voter registration
- Vehicle registration
- Driver's licenses
- Presence of business offices
- Banking accounts, except a small household account in California
- Insurance accounts
- Medical patronage
- Church membership
In contrast, the only evidence of their residency in California were a house in Rancho Mirage, the Klemps' membership to Thunderbird Country Club, and Mrs. Klemp's service as the chairman of the Women's Golf Association for two years.
Section 17014 of the Revenue and Taxation Code states,
"Every individual who spends in the aggregate more than nine months of the taxable year within this State shall be presumed to be a resident. This presumption may be overcome by satisfactory evidence that the individual is in the State for a temporary or transitory purpose."
While the Klemps were indisputably domiciled in Illinois, the state Board of Equalization questioned whether they were in California for a temporary or transitory purpose.
The California Administrative Code Title 18, 17014-17016(b) also states that generally, an individual whose presence in the state does not exceed 6 months will be considered temporary (i.e. not a resident) as long as "he does not engage in any activity or conduct within this State other than that of a seasonal visitor, tourist or guest." The Administrative Code also states that "An individual may be a seasonal visitor, tourist or guest even though he owns or maintains an abode in California or has a bank account here for the purpose of paying personal expenses or joins local social clubs."
Ultimately, the court found that the Klemps were not California residents during the years from 1960-1964, thus absolving them of the tax assessment.
While determining the tax impact of changing residency or domicile can be complex, for many individuals it could be an important piece of their overall plan. Many clients grind it out through their working years in California as they accumulate wealth, then deciding to retire to a new state while enjoying a lower tax environment.
Contact us today to learn how this could impact your tax & financial future.