By Anthony Diosdi
Just like many Americans, executives from foreign countries are drawn to California for its natural beauty, nearly perfect weather, and its economy. To take advantage of California’s economic opportunities and natural beauty, many foreign executives establish a “part-time” residence in California. This may result in the executive being classified as a California resident for income tax purposes and being subject to California state income tax on the executive’s worldwide income. This article will discuss the factors the California taxing authorities consider in determining whether “part-time” resident can be classified as a resident for state income tax purposes.
In order to go through the various tests the California taxing authorities use to determine tax residency, we will utilize a hypothetical individual named Tom. Let’s assume that Tom and his wife Sue were awarded green cards by the Department of Homeland Security in 2016. Tom and Sue are citizens of China. Tom’s children attended school in California. Tom had an automobile registered in California and obtained a California driver’s license. In 2016, Tom filed his individual income tax returns as married filing joint. Tom timely filed a California nonresident income tax return for the 2016 tax year. Tom had his tax returns prepared by a California licensed CPA. Tom spent approximately 190 days in California. During the 2016 calendar year, Tom held 85 percent of the shares in a Chinese corporation known as PK technologies (hereinafter “PK”). At the same time, Tom was acting as a CEO of a U.S. branch of PK. The branch was incorporated in California. In 2016, Tom received an annual salary from PK in the amount of $500,000.
In 2017, Tom filed individual income tax returns as married filing joint. Tom timely filed a California nonresident income for the 2017 tax year. Tom also had his 2017 tax returns prepared by a California licensed CPA. Tom spent approximately 95 days in California in 2017. Tom also purchased a home in Newport Beach, California for $5,000,000. In January of 2017 Tom sold a number of his PK shares for approximately $49,000,000. In August of 2017, Tom and his immediate family left the United States and returned to China. For the remainder of the 2017 calendar year Tom and his immediate family resided in a home that he owned in Shanghai, China. Tom’s Shanghai home is much smaller than his California home.
The Legal Framework and Standards of California Tax Residency
The law for determining California residency is simultaneously simple and complex. The “simplicity” comes from the fact the relevant legal standard for residency is defined in a single section of the California Revenue and Taxation Code in only 32 words. See Cal. Rev & Tax Code Section 17015; see also Cal. Code of Regs. tit Section 17014(a). The “complexity” comes from the fact that beyond these 32 words, bright-line standards and formal guidance are next to nonexistent. Lacking further statutory rules, the residency analysis instead involves the consideration of a multitude of factors, all of which are potentially relevant, but none of which are controlling on the ultimate legal residency determination.
The legal analysis of residency always must begin with Section 17014(a), which defines “resident” to include 1) “Every individual who is in [California] for other than a temporary or transitory purpose;” and 2) “Every individual domiciled in [California] who is outside the state for temporary or transitory purpose.” Conversely, any individual who is not a California resident is a “nonresident.” See Cal. Rev & Tax Code Section 17015. Regulations promulgated by the Franchise Tax Board (“FTB”) echo the language of Section 17014 to define residency: “[t]he term ‘resident,’ as defined in the law, includes 1) every individual who is in the State for other than a temporary or transitory purpose, and 2) every individual who is domiciled in the State who is outside the State for a temporary or transitory purpose.” See Cal. Code of Regs. tit. 18 Section 17014(a). Again, and as mentioned above, note the absence here in the controlling statute or in the FTB’s own regulation of any bright-line rules for determining residency.
The closest metric to a bright-line rule in the entire body of California residency law, in statute, regulation or decisional law, is a rebuttable presumption of California residency when an individual is present within California for more than nine months of a taxable year. See Cal. Rev. & Tax Code Section 17016; Cal. Code Regs. Tit. 18 Section 17016. However, the converse is not true, and there is no presumption of nonresidency when a taxpayer spends less than nine months of the year in California. See Appeal of Walter W. and Ida J. Jaffee, Cal. St. Bd. of Equal., July 6, 1971. Indeed, the FTB’s regulation states, “it does not follow, however, that a person is not a resident simply because he does not spend nine months of a particular taxable year in the State. On the contrary, a person may be a resident even though not in the State during any portion of the year.” See Cal. Code Regs. tit. 18, Section 17016.
To further complicate matters, California has very few court decisions addressing California residency or interpreting either Section 17014 or the corresponding regulation. In 2004, for the first time in decades, a California Court of Appeal issued a published decision interpreting Section 17014 in Noble v. Franchise Tax Board, 118 Cal. App. 4th 560 (2004) Prior to Noble, the most significant and most significant and most cited judicial residency case was the 1964 Court of Appeal decision in Whittel v. Franchise Tax Board, 231 Cal. App. 278 (1964) There have been no published Courts of Appeal residency decisions subsequent to Noble in 2004. As such, both cases are important landmarks in interpreting California residency law.
Looking first at Whittel, it is important to understand that the definition of “residency” under Section 17014 is closely linked to the concept of “domicile.” The California Court of Appeal in Whittel defined “domicile” as the “one location with which for legal purposes a person is considered to have the most settled and permanent connection, the place where he intends to remain and to which, whenever he is absent, he has the intention of returning.” Similarly, FTB Regulation 17014(c) defines domicile as “the place where an individual has his true, fixed, permanent home and principal establishment, and to which place he has, whenever he is absent, the intention of returning,” as well as “the place where an individual has fixed his habitation and has permanent residence without any present intention of permanently removing therefrom.”
“Residence” and “domicile” are nonetheless separate and distinct concepts for California tax purposes. “Domicile” denotes the one location with which a person has the most settled and permanent connections and where the person intends to remain. “Residence” denotes any factual place of abode of some permanency, that is, “more than a mere temporary sojourn.” An individual may have several residences simultaneously, but a taxpayer will have only one domicile at any given time. Once acquired, a domicile is presumed to continue until it is shown to have changed. In our example, since Tom intended to return to China in 2017, it is unlikely that Tom can be considered to be domiciled in California. Thus, we will not discuss the concept of “domicile” in this article. Instead, we will discuss the concept of “residence” for income tax purposes in detail. There are a number of tests used to determine California tax residency.
The first analysis, and the most widely known and used, is commonly referred to as the “Closest Connection” analysis. This approach compares an individual’s contacts with his or her new place of abode to the contacts with his or her former place of abode. A number of factors traditionally have been included in this “closet connections” analysis, which makes the residency determination an intensely factual one.
While certainly helpful, neither the FTB’s publication nor its regulations attempt to purport to provide a complete list of such factors. However, a 2003 decision of the State Board of Equalization (“SBE”) has done a decent job of identifying the major factors to be considered. Appeals of Stephen D. Bragg, St. Bd. of Equal., May 28, 2003 (“Bragg”) recognized the complexity of the residency question in light of the diverse factual contexts in which the issue could arise. Confronted with the near impossibility of creating a universal test or analysis, the SBE set forth a list of 19 items, now commonly referred to as the Bragg factors, to help determine a taxpayer’s closest connections:
1. The location of all of the taxpayer’s residential real property and the approximate sizes and values of each of the residences;
2. The state wherein the taxpayer’s spouse and children reside;
3. The state wherein the taxpayer’s children attend school;
4. The state wherein the taxpayer claims the homeowner’s property tax exemption on a residence;
5. The taxpayer’s telephone records (i.e., the origination point of taxpayer’s telephone calls);
6. The number of days the taxpayer spends in California versus the number of days the taxpayer spends in other states, and the general purpose of such days (i.e., vacation, business, etc);
7. The location where the taxpayer files his tax returns, both federal and state, and the state of residence claimed by the taxpayer on such returns;
8. The location of the taxpayer’s bank and savings accounts;
9. The origination point of the taxpayer’s checking account transactions and credit card transactions;
10. The state wherein the taxpayer maintains memberships in social, religious, and professional organizations.
11. The state wherein the taxpayer registers his automobiles;
12. The state wherein the taxpayer maintains a driver’s license;
13. The state wherein the taxpayer maintains voter registration, and the taxpayer’s voting participation history;
14. The state wherein the taxpayer obtains professional services, such as doctors, dentists, accountants, and attorneys;
15. The state wherein the taxpayer is employed;
16. The state wherein the taxpayer maintains or owns business interests;
17. The state wherein the taxpayer holds a professional license or licenses;
18. The state wherein the taxpayer owns investment real property; and
19. The indications in affidavits from various individuals discussing the taxpayer’s residency.
While not codified in the statutory scheme of residency or set forth in any judicial case law, the Bragg factors were commonly utilized by the SBE, and are still utilized by the FTB, as a benchmark for determining residency. However, Bragg makes clear this 19-factor list is not by any means “exhaustive” or exclusive, and that these factors “serve merely as a guide” in determining residency.” The overall focus of the Bragg examination is “to determine where an individual is present for other than a temporary or transitory purpose,” and satisfaction of a majority or a significant number of the factors is not necessarily dispositive. According to Bragg, the weight given to any particular factor also depends on the totality of the circumstances.
The second approach to residency is referred to as the “Identifiable Purpose” analysis. Under this approach, the SBE examines if the taxpayer is in a location for an identifiable purpose and the length of time necessary to fulfill that purpose, i.e., to determine whether a taxpayer is in or out of California for other than a temporary or transitory purpose. “[W]here an individual expects to be out of California for an indefinite period which is expected to last more than two years, such individual will be considered to be out of the state for an indefinite period of substantial duration” and, therefore, is no longer considered a resident of California. Section 17014 does not make any distinction with respect to employment, but the SBE has suggested that when a Californian is employed outside California, his absence will be considered to be for other than a temporary or transitory purpose if the position is expected to last a long, permanent or indefinite time.
The attempts to clarify California residency standards with “Identifiable Purpose” and “Closet Connections” analyses and, specifically, with Bragg’s factors, are all helpful approaches for analyzing the residency issue. However, the fact remains there is a dearth of judicial guidance, or even formal guidance from the FTB. As discussed above, the California Courts of Appeals have only published two California residency decisions since 1964. Even with the Bragg factors, a taxpayer’s ability to grasp the details of California residency is further limited because of insufficient written precedential SBE decisions interpreting California residency law. The Bragg factors are nonexclusive and are too easily and often conditioned on subjective interpretations.
California Residency As Applied to Our Example
As discussed above, California uses the Bragg 19-factor test and the “Identifiable Purpose” analyses to determine residency for California tax purposes. In the event that the FTB and/or the SBE audits Tom’s 2016 and 2017 California individual income tax returns and utilizes the 19 factor Bragg test, the FTB and/or the SBE would likely determine that Tom was a California resident for tax purposes in 2016 and 2017 for the following reasons:
1. Tom owns a residential home in California that is larger and worth more than his home located in China.
2. Tom’s wife and children resided in California for most of the 2017 calendar year.
3. Tom’s children attended school in California for a significant portion of the 2017 calendar year.
4. Tom utilized a firm located in California to prepare and file your 2017 federal and state of California individual income tax returns.
5. Tom maintains at least one automobile in California and Tom has a California driver’s license.
6. Tom is employed at least part time by an entity that conducts business in the state of California.
Tom should understand that under the Bragg test the state taxing authorities would likely determine that he was a resident of California in 2017. Fortunately for Tom, the Bragg test is not the only analysis utilized to determine tax residency in California. The “Identifiable Purpose” analysis is also utilized by the California taxing agencies to determine tax residency. Under this approach, the California taxing authorities examine if an individual is in a location for an identifiable purpose and the length of the time necessary to fulfill that purpose. In the event of an audit, it can be argued that in 2016 and 2017 Tom was the president and executive of a large Chinese multinational corporation that was establishing a branch in California. Tom’s work in California in 2016 and 2017 was for an “Identifiable Purpose” – that is to establish a California branch for PK. If it can be argued that Tom’s work in California in 2016 and 2017 was temporary and transitory, it may be possible to avoid classification of residency for state tax purposes.
Although Tom’s family lived in California for part of the 2016 and 2017 calendar year, it is not usual for an executive who is on a temporary work assignment to relocate his or her family while the executive is performing tasks in a foreign jurisdiction. Given that Tom should not be expected to live without your family while you performed temporary and transitory work in California. Under the “Identifiable Purpose” analysis, the fact that Tom’s family resided in California while he performed temporary and transitory work in California is not fatal. With that said, acquiring a home in the state in 2017 will not easily escape the attention of the California taxing authorities. California taxing authorities will likely view the acquisition of a home in California as an intent on Tom’s part to remain in the state for an indefinite period of time. In order to rebut this presumption, in the event of an audit, Tom will need to establish that in 2017, the California home was acquired as a vacation property. That may be a difficult hurdle to overcome.
Recall that Tom claimed to be a nonresident of California in 2016 and 2017. Nonresidents are taxed only on their California source income. This means that Tom would have paid state income tax on his $500,000 annual salary received from PK’s California branch. If Tom is reclassified as a California resident, Tom would be taxed on his worldwide income. This means that Tom would be subject to California tax on the gain of his PK shares for $49,000,000. Tom will also be subject to California income tax on any other foreign source income.
Statute of Limitations on Civil Assessments
In this section of this article we will discuss the time period in which the FTB can make income tax assessments against Tom for income tax liabilities. Understanding the statute of limitations on assessments is critical in any potential dispute with a taxing agency.
Revenue and Taxation Code Section 19066 sets forth the general rule on assessments by the FTB. The law generally requires the FTB to mail a proposed deficiency assessment to a taxpayer within four years after the filing of the individual’s return. Returns filed before the original due date of a personal income tax return (April 15 of the year after the tax year) are considered as filed on the original due date. See Revenue and Taxation Code Section 19066. If a tax return is filed on the due date of the return or if it is filed after the due date, the tax must be assessed within the succeeding four-year period, or else it is uncollectible. Please note that the time permitted for a tax “assessment” is different from the time period for its collection. This rule applies not only to the underlying tax, but also to interest and penalties that would have been assessed on the principal amount of the tax.
However, the Revenue and Taxation Code provides an extended limitation period for situations where a taxpayer non-fraudulently omits more than twenty five percent of his gross income. When a taxpayer non-fraudulently omits more than twenty five percent of his gross income, the FTB may “at any time within six years after the return was filed” make an assessment against the taxpayer. If a taxpayer files a false or fraudulent tax return with the intent to defeat tax, the FTB may assess tax at any time.
Since Tom did not have any foreign source income in 2016, the statute of limitations on California assessments expires on April 15, 2021. This is four years from April 15, 2017 (the due date of his 2016 individual income tax returns). Since Tom excluded $49,000,000 of stock gains from his 2017 income tax return, the statute of limitations on additional tax assessments is extended to six years. This means that the statute of limitations on state income tax assessments is April 15, 2024 (six years removed from April 15, 2018- the due date of Tom’s 2017 individual income tax return).
Civil Fraud Penalty
If the FTB and/or SBE determines that Tom was a resident of California for the 2017 tax year, not only will the state taxing agencies assess income tax liabilities on his omitted worldwide income, the taxing agencies will likely add penalties and interest to the assessment. The first and most significant penalty that the state taxing agencies could attempt to assess against Tom is a civil fraud penalty against you. California Revenue and Tax Code Section 19164 models a civil fraud penalty on Internal Revenue Code Section 6663. The penalty may equal 75 percent of the underpayment of tax attributed to fraudulent conduct.
The term “fraud” is not defined in either the California Revenue and Tax Code or its regulations. However, case law has held that fraud may be established through conduct which was intended to mislead or conceal. Once the FTB and/or SBE establishes that any portion of the underpayment was attributable to fraud, the entire underpayment is treated as attributable to fraud, unless the taxpayer establishes otherwise. The FTB and/or SBE has the burden of proof that any portion of an underpayment was attributable to fraud.
To meet the burden of proof, the FTB and/or SBE must establish the following: 1) the taxpayer has underpaid his or her taxes; and 2) some part of the underpayment was due to the taxpayer’s intent to conceal, mislead, or otherwise prevent the collection of such taxes. Fraud may not be found under “circumstances which at the most create only suspicion.” Merely underreporting or failing to report income is insufficient to establish fraud. However, a pattern of consistent underreporting of income may be strong evidence of fraud, especially when accompanied by other circumstances showing intent to conceal. Fraud is an intentional wrongdoing by a taxpayer that is designed to evade tax believed to be owed.
Over the years, courts have developed a nonexclusive list of factors that demonstrate fraudulent intent. Courts have referred to this nonexclusive list known as “badges of fraud.” These “badges of fraud” have included the following: 1) understating income; 2) maintaining inadequate records; 3) failing to file tax returns; 4) implausible or inconsistent explanations of behavior; 5) concealment of income or assets; 6) failing to cooperate with tax authorities; 7) engaging in illegal activities; 8) an intent to mislead which may be inferred from a pattern of conduct; 9) lack of credibility of the taxpayer’s testimony; 10) filing false documents, and; 11) dealing in cash. Besides the above-mentioned factors, courts also tend to weigh a taxpayer’s intelligence, education, and tax expertise for purposes of determining fraudulent intent. The above-mentioned “badges of fraud” are illustrative. Thus, the IRS or a court should consider the totality of the facts and circumstances of each case to determine whether there is fraudulent intent.
Accuracy Penalty
In the alternative to a civil fraud penalty, the state taxing agencies may assess a negligence penalty to a tax liability. California Revenue and Tax Code Section 19164 imposes an additional tax of twenty percent on the portion of an underpayment attributable to “negligence or disregard for rules and regulations.” California Revenue and Tax Code is modeled after Internal Revenue Code Section 6662. “Negligence includes any failure to make a reasonable attempt to comply with provisions of the tax law.” Negligence is defined as the “lack of due care or failure to do what a reasonable or ordinary prudent person would do under the circumstances.” Negligence frequently takes the form of a failure to report income. However, understatement of income does not necessarily establish negligence. However, large discrepancies between actual and net reported income are strong evidence of negligence.
Delinquency Penalties
In addition to the fraud and negligence penalties, Revenue and Tax Code Section 19132 imposes delinquency penalties for the failure to timely pay tax. This code section is modeled after Internal Revenue Code Section 6651. A delinquency penalty is assessed on a tax liability not timely satisfied. The penalty is imposed at one half of one percent per month up to a maximum of twenty five percent. In essence, this penalty is imposed upon the “net amount due.”
Conclusion
California residency is a complicated matter. If you are unsure if you are a resident of California or if you are facing a California residency audit, you should consult with a tax attorney licensed to practice law in California.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.