Over 40 Years of Experience
“Getting Out With Your Skin,”
a Cross-Border Tax Newsletter for People
Moving Out of a High-Tax State or the U.S.
Dear Clients and Friends,
It is almost April at the time of this writing and, after some less than perfect weather this winter, the California desert is in bloom. A perfect time to launch a new Cross-Border Tax Newsletter.
This is the maiden edition of “Getting Out with Your Skin,” a quarterly Cross-Border Tax Newsletter designed for income tax residents of California and other high-tax states, US lawful permanent residents, foreign citizen expats working in the US, dual citizens and US citizens generally, any of whom are contemplating a move out-of-state or out of the country at some point, possibly to a lower tax destination. It is a distinct newsletter from my Cross-Border Tax Newsletter for Snowbirds, which provides information designed for persons whose primary focus is living part-time in California without becoming a California income tax resident.
This edition addresses the following three foundational topics in departure tax planning, which I consider to be a good starting point for this newsletter: (i) “tax effective” abandonment of California residence and domicile; (ii) California tax planning for deferred compensation income – a lesson for Canadian expatriates and U.S. citizens working in California for deferred compensation; and (iii) pre-residence tax planning as the best time to start departure tax planning.
If someone you know falls within one of the above-mentioned categories, or may just have a future interest in these topics, please forward this newsletter to them and ask them send me an email if they would like to join the email list for this particular Newsletter.Tax-Effective Abandonment of Residence and Domicile in California or Another “High-Tax” State
Long-time California residents are leaving California in droves. Many reasons are given. The 13.3% top income tax bracket (the highest in the country), the recent introduction of a bill in the California Assembly to further increase that rate for high-earning taxpayers, the proposed adoption of the first of its kind state-imposed wealth tax, a proposal to re-introduce a transfer tax on the estates of California residents and a proposal to increase the top corporate tax rate rank at the top. (Whether the tax proposals just mentioned will ever be enacted is anybody’s guess, but some folks are not waiting around to find out.) For others, a move by the company they work for to another state, the prospect of a better paying job in another state or country, or living in a state that better suits their political affiliations have them heading for the border, literally. Other high-tax states are experiencing a similar exodus for similar reasons.
What is not generally known among most considering a move out of California (or any other high-tax state) is how difficult it can be to stop paying income taxes to California (or that other high-tax state) after an alleged change of residence. California relinquishes taxing jurisdiction over its residents very reluctantly and sometimes only after they prove to the Franchise Tax Board that they have effectively abandoned California residence and domicile. Simply because you have physically left the state for another locale and claim residence there does not mean that California will cease to exercise taxing jurisdiction over you.
Rather, long-time residents who have established a California domicile remain California income tax residents (even if they are also considered to be resident elsewhere for tax purposes by another jurisdiction) unless and until they can prove that: (i) they have changed their domicile to that other jurisdiction; or (ii) even though their domicile remains in California, they are now outside the State for other than “temporary or transitory” purposes.
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. In order to change one’s domicile to a new place of residence, a person must 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 actually physically present and intend to stay permanently or indefinitely.
(It is worth noting that similar systems of tax residence and domicile apply in most high-tax U.S. states. Thus, the foregoing information is basically the same whether you are domiciled in California, Oregon, Illinois, New York, New Jersey, Connecticut, Vermont, Iowa, Minnesota, Wisconsin or any other high tax state, although the rules of who is a domiciliary and how you go about proving you have relinquished domicile or residence may differ slightly from state to state).
Many residence and domicile changes executed without professional help are ineffective at shedding ongoing exposure to tax in the state one leaves. That is borne out, in my experience, by the fact a very high percentage of those noticed by their former state for a residence audit lose their tax cases. Such a situation can also result in double state taxation if the state you are moving to also taxes your income. If you are contemplating a domicile change and want to “get out with your skin,” or you have tried to execute a domicile change yourself recently and would like a professional review of what you have done or what you are contemplating, please call for an appointment. I am often able to “repair” poorly-executed or conceived plans for domicile or residence abandonment if oversights or mistakes are caught early enough.Tax Planning for Deferred Compensation Income – A Lesson for Canadian Expatriates and Residents of Other U.S. States Working in California
California’s Office of Tax Appeals (“OTA”) just released a new decision concerning the taxation of deferred compensation earned by individuals working in California, which highlights the need for early tax planning for deferred compensation income, especially for expatriates. In Appeal of Prince, the OTA determined that a California nonresident working for Facebook outside California at the time his restricted stock units vested, was nevertheless subject to a substantial amount of California income tax, based on a formula comparing the number of workdays he spent in California after the date of grant and before the deferred compensation vested, to his total work days during that period.
This case highlights several important points for foreign or out-of-state expatriates working in California for a compensation package that includes some form of deferred compensation:
- Take Cross-Border tax advice prior to or at the date of the grant of the deferred compensation. In many cases, an election can be made to pay tax on the value at the date of the grant (which is usually very low) and transform the future value of the compensation into a capital gain at the date of vesting or sale, rather than ordinary income. This can have a direct bearing on the Federal income tax rate applicable to such income and for some Canadians, whether the gain will be taxable at all for U.S. federal income tax purposes (or Canadian tax purposes). If you wait too long to make the election, it may become cost prohibitive.
- Moving out of California before the grant vests may not do enough to reduce the tax bill. Because California normally taxes the compensation income associated with a grant of non-qualified compensation based on the ratio of California workdays to total workdays between the dates of grant and vesting, taking a job transfer or moving out of California at or near the end of the vesting period may do little to reduce the California tax bill, even if you are California nonresident at the date of vesting. That said, moving home before the date of vesting or sale may reduce your Federal or California income tax bill dramatically if the election referred to above was made.
- Evidence of the impact of the value of your services on the value of the deferred compensation at vesting may produce a different (i.e., better) tax result. The “California workdays to total workdays” formula is not mandated by statute or regulation. Rather, the regulations state only that compensation for personal services “must be apportioned between [California” and other States or foreign countries in such a manner as to allocate to California that portion of the total compensation which is reasonably attributable to personal services performed in this state.” Thus, if you can prove that your own personal services after becoming a nonresident of California had a significant impact on the increase in the value of the compensation you received, a better tax result may be obtainable. The taxpayer in Appeal of Prince failed in his burden to introduce such evidence.
Usually, I can catch this kind of tax planning opportunity before it is lost and becomes a tax problem, if clients come in for Cross-Border tax advice before or immediately after arrival for employment in California for which they will receive deferred compensation as part of their compensation package (see the following section on the value of “pre-residence” tax planning). However, it is never too late to discuss what may be possible.The Importance of Pre-Residence Tax Planning When Applying for a U.S. “Green Card” or Certain U.S. Non-Immigrant Work Visas
Speaking of pre-residence tax planning, I’m often contacted by Canadians and other foreign nationals who are considering applying for, or who have already applied for a visa allowing them to work and live in the U.S., with or without immigrating. Such visas most often include a lawful permanent residence visa (“green card”), E-visas for “treaty investors,” L-visas for “intracompany transferees,” “O” visas for persons of distinguished merit or ability or “TN visas (for Canadians and Mexicans coming to work in certain professions in the US under the Canada-Mexico-United States trade agreement). Although these folks have usually done hours to months of homework concerning the U.S. immigration requirements to obtain such a visa, few give pre-residence U.S. and California tax planning a thought until the eve of receiving their visa, if then.
Yet, in my experience, one of the best times to plan for your ultimate departure from California or the U.S. is when implementing pre-residence tax planning.
Among the pre-residence tax planning considerations that should be addressed well in advance of entering the U.S. on such a visa are the following:
- Canadian Tax Residence Status. If you are a Canadian resident, a plan to move from Canada to the U.S. can have an effect on your Canadian residence status and the way Canada taxes you after the move. Taking tax advice about whether to sever or attempt to maintain Canadian tax residence can be crucial to a good tax outcome.
- Canadian “Departure” Tax. Likewise, when a move to the US results in a loss of Canadian tax residence or the application of treaty residence “tie-breaker” rules in favor of U.S. residence, the Canadian “departure” tax can be triggered. The “departure” tax deems a former Canadian resident to have sold his or her taxable Canadian property (with certain exceptions) at fair market value, triggering capital gains tax on the gains from the deemed sale of all such affected property (whether it is actually sold or not), as of the date he or she becomes nonresident. Notable exceptions include Canadian real or immovable property, certain Canadian business property, pension plans, RRSPs, interests in certain personal trusts and certain inherited property, although you can elect to have such property included in the deemed disposition, if that is tax efficient.
Significant planning opportunities exist to minimize the departure tax if the individual’s departure is orderly and planned ahead when the U.S. visa application is first being considered.
- Tax-Effective Visa Selection. Tax-effective visa selection may play an important role in “getting out with your skin” when you plan to depart. Indeed, some “non-immigrant” visa options facilitate departure without tax, unlike the gold-standard of immigrant visas, viz., the U.S. green card (lawful permanent residence visa), if the latter is held too long. Many planned stays in the U.S. may be accomplished using other visas without exposing the holder to U.S. expatriation taxes on abandonment of the visa.
- Pre-Residence Federal Income Tax Planning. A non-US citizen U.S. visa holder will be treated as a U.S. tax resident for U.S. internal tax purposes from the date he or she first enters the U.S. after being issued the new visa. That is true whether they have a green card, or ultimately exceed the day-counting thresholds necessary for “substantial presence” in the U.S. on a non-immigrant visa. Those who are of the mindset that they will work out the U.S. federal and state tax consequences of their move after arrival (an amazing percentage, believe it or not) lose the chance to implement pre-residency U.S. Income tax planning, for which there are many opportunities. One example is the potential opportunity to “step-up” the U.S. (and state) income tax basis of your investment portfolio before becoming a U.S. resident.
- Pre-Residence California Income Tax Planning. The California State income tax residence rules do not follow the U.S. federal rules. Accordingly, in some circumstances, it is possible to be a U.S. tax resident (e.g., under lawful permanent residence test), but not be a California income tax resident. Whether the Canadian visa holder plans to be present in California more than half of each tax year or not, California tax planning opportunities exist, like those described above in relation to deferred compensation.
Among other things, avoiding California income tax as a resident can save up to 13.3% in additional, non-deductible income taxes. Also, California is not bound by the tax concessions in the Canada-US Income Tax Treaty. Thus, for example, it requires California tax residents to report income earned on RRSPs and other types of savings plans that are deferred for Canadian and U.S. tax purposes and has no tax rate break for capital gains.
- Pre-Residence U.S. Estate Tax, Gift Tax and Generation-Skipping Transfer Tax Planning. Unlike Canada, the U.S. has a fair market value-based system of estate and gift taxes, as well as a generation-skipping transfer tax (“GSTT”), in addition to its income tax. Tax rates reach 40% of the value of assets gifted or included in a taxpayer’s taxable estate, and may be taxed again at a similar rate if GSST is triggered by a generation-skipping transfer. Transfer tax residents are taxed on their worldwide assets, while nonresidents are taxable on a much smaller class of assets considered to have a U.S. “situs.”
- Departure Tax Planning. As will be discussed further in the next edition of this Newsletter, the best pre-residence tax planning for “getting out with your skin” often entails consideration of future U.S. departure tax planning options at or before the time you become resident. I encourage all new clients to consider departure tax planning as an element of pre-residence tax planning. Such departure tax planning is especially important for persons entering the U.S. on an immigrant visa (i.e., a “green card”), to whom the U.S. expatriate tax regime may apply if a stay as long as seven or eight years is a possibility and if they may be a “covered expatriate” at the time of relinquishing their green card.
In cases of high-net-worth individuals who may potentially become exposed to these taxes, significant planning opportunities exist prior to become resident for these purposes. Should you or someone you know be thinking about a new US visa, come in (or send them in) for advice BEFORE ARRIVAL in the U.S., if possible.
Please don’t hesitate to call if you would like to discuss how any of the cross-border issues discussed above or others may affect you. Let me put my 42+ years of Cross-Border tax experience to work for you!
Please also feel free to share this Newsletter with neighbors, friends, family or colleagues who may have an interest in its contents.
Disclaimer: As always, the foregoing summary is for information purposes only and is not intended to be relied on and should not be relied on as legal, accounting, tax or investment advice, or as a substitute for your own research or for obtaining specific legal, accounting or tax advice. Always seek professional help with respect to your specific fact situation in determining how U.S. Federal or state legal or tax provisions may affect you. Additionally, information discussed in this Newsletter is current only as of the date appearing in this material and is subject to change at any time without notice.
Circulation: If you or someone you know is a dual citizen, a Canadian expat, a green card holder or a California income tax resident or U.S. citizen wanting to reduce their state or federal income tax burden, or who may just have a future interest in these topics, please have them send me an email asking to join the email list for this separate newsletter.
Removal: If you wish to be removed from this Newsletter list, please send me an email to that effect and I will cheerfully remove your address from my email list.
Brent Lance, Masters of Law in Tax (LL.M. NYU)