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).
Also, in a recent case involving a nonresident spouse who left California for employment reasons, the fact that his spouse remained in California was held to be a significant factor in demonstrating that the “nonresident” spouse was still enjoying the benefits and protections of California’s laws and government. Appeal of Cooper (May 22, 2013) Cal. St. Bd. of Equal., Case No. 570236.
It is also possible that being part of a “mixed” residence couple will increase scrutiny of the “nonresident” spouse’s California residence status.
Such a situation can also affect the couple’s choice of filing status – (i.e., whether they file a joint return for federal income tax purposes, or elect to file separate federal returns, so that the resident spouse may file separately for state tax purposes without attaching a copy of their federal joint return – see below).
Finally, if one spouse has to file a resident tax return and the spouses file a joint return for federal income tax purposes, the newly resident spouse must attach a copy of the joint federal return to his or her California tax return even if he or she files separately for state purposes. This potentially puts all of the other spouse’s sensitive financial information in the hands of the California tax authorities gratuitously.
For any or all of these reasons, California pre-residence tax planning for both spouses may be critical to reducing the possible tax cost of a determination that one spouse has become a resident. It may also be an important hedge against the tax risk that the other spouse could be “dragged” into California residency by his or her spouse’s new status.
Pre-residence tax planning can also have the added benefit of reducing the couple’s federal income tax burden, possibly sufficiently to offset the tax cost of one spouse paying resident taxes to California. In such a case, the affect of such planning may be to dissuade the California tax authorities from incurring the cost of pursuing the first spouse into residency status.
Such pre-residence tax planning can take several forms, in addition to the strategic use of filing status mentioned above to prevent gratuitous disclosures of sensitive financial information. Some of the planning options include: (i) tax loss harvesting (e.g., recognizing recent “bitcoin” losses in 2021, even if a reinvestment in crypto currency is planned or desired); (ii) entering into a “post-nuptial” agreement to restructure the ownership of assets and income as between the spouses to reduce income shown in the resident spouse’s tax returns; (iii) creating a non-grantor irrevocable trust (an “ING”) in a zero-tax state to remove investment income from the couple’s tax returns; (iv) creating a charitable remainder trust to reduce both spouses’ taxable incomes (and to derive numerous other tax benefits); (v) transferring “pass-thru” entity interests to an LLC taxable as a corporation; and (vi) restructuring ownership of California rental properties (including your vacation residence, if you rent it while you’re gone) to move the rental income out of your personal income tax returns, among others. (To learn more about Pre-Residence Tax Planning for Future California Tax Residents, click here).
You have to be pro-active to succeed with this kind of tax planning. The time to act is in the year the vulnerability arises, rather than waiting until a residence inquiry letter is received (to learn more about residence inquiry letters, click here), a residence tax audit begins (to learn more about residence tax audits click here), or a final determination of residence status is made by the FTB, which must be appealed (to learn more about appealing the results of a residence tax audit, click here). In each of the latter-mentioned situations, it will be too late to affect the amount of California taxable income for the tax year or years in which the vulnerability arose.
Lance Cross-Border Law and Tax is the premier cross-border tax law firm in California advising nonresident clients concerning California tax and residency problems. In addition to California tax planning, we also assist our clients to resolve residency tax audits and tax appeals. Learn more about our complete range of services concerning California tax issues by visiting our website: www.lancecrossborder.com