Many California residents wish to avoid paying US capital gains tax and California income tax on their crypto assets, but don’t wish to give up their US citizenship and pay an expatriation tax (to learn more about expatriation tax planning, click here).  With Congress and the IRS now taking steps to ensure that tax is being paid on the sale of virtual currency (which the US treats as the sale of property for tax purposes), many crypto investors are looking for a solution.  Moving to Puerto Rico is an alternative that could slash capital gains tax rates on crypto assets to between zero and 5%, while retaining your US citizenship and avoiding acceleration of tax on your virtual currency gains on the way out of California.

First, to cut off California’s right to tax the subsequent sale of the cryptocurrency, your move must be planned and executed to effectively terminate your California tax residence and domicile prior to the sale.  For a discussion of when a domicile change becomes effective for California tax purposes and why you should wait to sell appreciated assets until you are sure your domicile change is effective, click here.

Second, post-move income and gains earned outside the U.S. may be permanently exempt from U.S. tax if certain requirements are met.  Importantly, the crypto investor must take steps to qualify as a “bona fide resident” of Puerto Rico (“PR”) after the move.  To so qualify, three tests must be satisfied: (i) a “presence” test (referring to time spent in PR each year); (ii) a “tax home” test (requiring that your principal place of business (or if you gave none, your principal residence) be located in PR; and (iii) a “closer connection” test (which requires that you develop and retain a closer personal connection to PR than to the US for the tax years in question).  Each of these tests have detailed rules that must be satisfied.

It is a common in my practice to have one spouse become vulnerable to being treated as a California income tax resident, while the other does not.  Most often this happens because one spouse remains in California when the other returns home to run a business or work.  It can also happen when one spouse stays longer in California to supervise children in school, to undergo medical treatment or to complete a work assignment in California.  In still others, the situation arises because one spouse simply doesn’t want to return to a cold, snowy or rainy environment just because their “six months” is up.

Whatever the reason, California’s residence rules are applied to each spouse separately.  Thus, each spouse’s residence-related factors, benefits and protections derived from California’s laws and government, time spent in California each year and possible qualification for the presumption of nonresidence, must be analyzed separately.

However, the fact that the tests are applied to each spouse separately does not mean that the “nonresident” spouse will not be impacted by a determination that his or her spouse has become a California tax resident.  To the contrary, having a California resident spouse becomes a potentially very important connection to California for the “nonresident” spouse, which weighs heavily in the analysis of the state (or province) with which the “nonresident” spouse has the closest connections in determining his or her residency (to learn more about California Nonresident Tax Planning, click here).

In Part I of this Blog entry (click here), we discussed the facts of the Bracamonte Case and some of the observations about them made by the Office of Tax Appeals.  In Part II of this Blog entry, we discuss the panels’ remaining observations, what they mean for future domicile changes and the date that a change of domicile occurs:

  1. The panel was most influenced by the extent of the Bracamontes’ continuing physical presence in California – beginning with the date they claim they moved out of California through the date of the business sale. Their presence in California during this period “far outweighed their presence in any other state,” including Nevada, their “purported state of residence” where they “did not spend much time.”  The appeals panel found the “sheer amount of time spent in California, the breadth of [the taxpayer’s] activities here and the average length of their stays in their respective homes significant.” In this regard, they observed that “physical presence is a factor of greater significance than mental intent and the formalities that tie one to a particular state.”
  2. In the end, the Tax Appeals panel agreed with the conclusions reached by the Franchise Tax Board in the residence audit (for more information about California residence tax audits, click here). In particular, they found that the Bracamontes “availed themselves of the benefits and protections of California the most” during the period leading up the business sale.  Consequently, the taxpayers were California residents on the date of the business sale.

No one who claims to be a nonresident of California wants to receive a letter from the Franchise Tax Board (“FTB”).  In most cases, up to that point, you probably thought you were completely off their “radar.”

Then comes that day when you receive a form letter (i.e., FTB Form 4600) requesting/demanding that you file a tax return and inquiring about your California residence status.  For many of my nonresident clients, such an event is beyond their imagination.

“How did this happen??,” they always ask.  The answer is usually simple.  These days, a request (demand) for a tax return is usually the result of an electronic disclosure made to the FTB from any of several sources, including the IRS, other state tax authorities, payors of various types of income (think Form 1099), certain business or investment entities in which you may be invested that are doing business in California and financial institutions to which you are making mortgage payments, among others.  Other taxpayers make themselves targets for a Form 4600 inquiry letter by filing their federal tax return using a California address.  After such disclosures are compared to the FTB database of filed tax returns with no match, the residence status inquiry letter, a questionnaire and a request for a tax return are generated automatically.

For California income tax purposes, a person has their domicile in California if, at any point: (a) California has become their true, fixed and permanent home where they have their most settled and permanent connections; and (b) they have not effectively changed their place of domicile to a new location thereafter.  To change one’s domicile from California to a new place of residence, a person must (i) effectively abandon their California domicile, with no intent to return; and (ii) establish a new domicile in a new place of residence where they are physically present and intend to stay permanently or indefinitely.

But at what point does a change of domicile to a new place occur? Notwithstanding that the Franchise Tax Board requires taxpayers to identify a specific date on which a domicile change occurs, they have provided little or no guidance as to how that day is determined.  Indeed, changing domicile usually involves a process of transition, rather than an act occurring on a single day.  Indeed, in advising clients who are planning to change their domicile, we identify and recommend changes with respect to as many as 50 lifestyle factors used by courts and the Franchise Tax Board to determine whether someone’s domicile has changed.  To implement that many changes to one’s lifestyle takes time.  It does not happen in a day.

Is the domicile change considered to occur when the last relevant factor has been accomplished?  What about the point at which the majority of the factors favor the new location as the new domicile?  Are there “super” factors that must all be addressed before a change in domicile will be considered effective, without regard to those involving mere “formalities” of a taxpayer’s lifestyle?

Whether you are a U.S. or foreign citizen, if you have lived in California as a tax resident for any period of time, unshackling yourself from the California tax authorities when you want to leave can be a very tricky affair.  The California tax authorities do not relinquish jurisdiction to tax you lightly and are known to try to hold on as long as possible, including through litigation, if necessary.  Moreover, since a determination of the local tax authorities that you remain a California resident is presumptively correct, a departing former resident bears the burden of proving that the tax authorities’ determination is incorrect.

California has been contending with its tax residents leaving for lower-tax or no-tax states such as Nevada and Washington State for decades and, as discussed below, is extremely wary of claims that a California resident has moved to Nevada, in particular.  The cause of that concern is not so much a person who actually gives up all contacts with California, truly establishes a permanent home elsewhere and spends little time, if any, in California following the move.  Rather, California is very wary of its tax residents allegedly moving out of California, but continuing to own property here (including the taxpayer’s former residence), maintaining all of their former contacts here and spending considerable amounts of time here, while establishing few contacts with Nevada (other than setting up a post box there), spending less time in Nevada than California after the alleged “move” and making little or no investment in setting up a lifestyle in Nevada.

California imposes tax on the worldwide income of its tax residents at rates reaching 13.3%, but only taxes nonresidents on California source income.  This potentially significant difference has become even greater for U.S. citizens or residents after recent Federal tax reform capping the Federal tax deduction for state taxes at $10,000, which many California residents reach on their property tax bill alone.  Thus, where the after-tax cost of California income tax was once considerably lower for Federal tax, it is now a full 13.3% of worldwide income for many high-income California tax residents whose California property tax bill already exceeds $10,000.  This situation creates an even greater incentive for long-time California residents to claim they have left California and become resident elsewhere (where the state tax rate is low or zero).

(and why you should care)

If you spend a considerable period of time in California each year and have developed significant contacts here you should be asking yourself this question.  The State of California is hungry for tax revenue and believes that people who are present in California enjoying the benefits of all California has to offer for significant blocks of time each year should be paying their way. 

“How will the California Revenue authorities become aware of my existence here?” The Franchise Tax Board has a number of programs designed to identify people who are here under circumstances that make them liable for filing a California income tax return.  Those programs include, for example, looking at California homeowners who have a mortgage on their California property (and receive a Form 1098 from their lender), but don’t file a California tax return.  They can also examine property tax payments made by persons having an out of state address on their tax bills.  Rumor has it that they even resort to taking down out-of-state and foreign license plate numbers on luxury cars driving through the desert. Sometimes, somebody (like a disgruntled former spouse, lover or employee, or a jealous or vindictive neighbor) just turns you in.