The non-partisan Tax Foundation ranks California’s individual state tax environment 49th out of 50. Only New Jersey scores worse. If the pinch of state income tax has you thinking about moving out of state, here are some important things you need to consider.
California’s tax collection agency, the Franchise Tax Board, is notoriously aggressive in chasing down anyone it believes should be paying California income tax. In fact, the FTB has a special division that systematically targets “part-time” residents for what are called “residency audits.”
Residency audits are not like financial audits. The purpose of the audit is to determine if California has any chance of extracting additional tax revenue from you by establishing your connection to California. If the stakes are high enough, they will go to extreme lengths to establish their claim. They will interview neighbors, subpoena utility bills, check registers, credit card statements, and other records to determine how closely you are connected to California. If they decide that your ties to California are strong enough to qualify you as a California resident, they will pursue you relentlessly.
The case of Gilbert Hyatt is a sobering example. In 1991, Hyatt moved from Southern California to Nevada just as royalties from a lucrative patent were beginning to roll in. In 1991 and 1992 he reported total profits from his patents of $101.8 million, but claimed only $600,000 was earned while he was a California resident. The timing of the move to Nevada struck the FTB as suspicious and they opened a formal investigation in 1993. As a result of their investigation, they claimed Hyatt owed $13.3 million in back taxes and penalties.
Hyatt vigorously contested the charge. After 24 years, and numerous court rulings, including two by the U.S. Supreme Court, the case was settled on appeal in 2017. Hyatt prevailed on most of the charges, but it was not a complete win. The state Board of Equalization, decided 3-2 the he owed tax on some portion of the 1991 income. The amount of tax Hyatt ultimately paid was not disclosed, but a report in the Sacramento Bee estimates it was $1.9 million plus accumulated interest.
The Hyatt example is not meant to discourage you from making smart choices about where to live for tax purposes. However, it is a good reminder that you need to be smart about how and when you make such a move. Hyatt could have saved himself a lot of money and mental anguish if he would have been smarter about his relocation from California to Nevada.
Contrary to what many people believe, tax domicile is based on a lot more than the number of days you spend in a particular location. While the number of days you spend in California versus your new location is obviously important, determining tax domicile is primarily about taxpayer intent.
If a taxpayer has only one home, it is pretty clear that she intends that location to be her home base—the place she returns to after temporary stints elsewhere. However, if the taxpayer has homes in two different states, the question of intent is murkier.
California looks at several factors to determine where you intend to set up your home base. These include the location of your spouse or registered domestic partner, the state that issued your driver’s license, the state where your vehicles are registered, the origination point of financial transactions, and the location of your healthcare providers, club memberships, church memberships, community involvement, etc. The more you can do to demonstrate a deep connection to your new location, the more likely you are to prevail in a residency audit.
You can get more information directly from the Franchise Tax Board in their publication 1031, “Guidelines for Determining Resident Status.”
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to email@example.com.