Over 40 Years of Experience
The Cross-Border Tax Newsletter
Dear Clients and Friends,
It is early April at the time this Newsletter is being assembled and it is warming up in the California desert. I hope many of you are still here to enjoy it! If so, this edition has a couple of articles that should be of particular interest to you.
As some of you may know, I have split my former Cross-Border Tax Newsletter into two separate Newsletters, in order to better direct content of interest to the intended users of each newsletter. This newsletter, which will retain the original name and focus, is designed to be of interest to the following groups of individuals, wherever they may live outside California:
- Those who wish to vacation on a seasonal basis or live part-time in California without becoming a California income tax resident;
- Individuals who own or are considering the purchase of a vacation home in California and who need help with probate avoidance, a tax-efficient investment structure and/or estate planning for that investment; and
- Persons who are able to live a nomadic lifestyle without a home base, who wish to spend some of their time each year in California;
including, any of the foregoing who may receive a Form 4600 inquiry letter from the California Franchise Tax Board asking them to file a California income tax return.
As an added bonus, this Newsletter will start to include content of interest to:
- Individuals working remotely from outside California with California employers or California-based customers;
- Investors based outside California who own California rental property (whether residential, commercial, industrial or agricultural) or investments in entities conducting business in California;
- Entrepreneurs based outside California wishing to establish or expand their business into California, or conduct business with California customers; and
- Trustees or beneficiaries of trusts located outside California, but having California source income, and/or California resident trustees or beneficiaries.
For all of the foregoing classes of persons, the focus of the articles in this newsletter directed at them will be on avoiding California income tax to the greatest extent possible through strategic, cross-border tax planning and by reducing disclosure of critical information that may lead to a California residence audit.
In contrast, the new Newsletter, entitled “Getting Out with Your Skin, a Cross-border Tax Newsletter for People Moving Out of a High-Tax State or the U.S.,” will (as the name implies) be focused on topics of interest to persons based in California (or another high-tax state) who may be thinking of changing their residence or domicile to a low-tax environment, perhaps in conjunction with a job relocation, a move home or a move to a location better suited to their political views. It will also contain articles of interest to anyone thinking of relinquishing a U.S. lawful permanent residence visa or giving up US citizenship (whether now or in the future). More specifically, it will include content of interest to:
- Canadian expats planning their return to Canada;
- US lawful permanent residents thinking of relinquishing their green cards;
- Dual citizens considering abandonment of US citizenship (e.g., to avoid the cost and trouble of filing US income tax returns, FBARs and US information reports);
- California residents moving to another state (or country) to avoid high California state income tax rates or taking a job assignment outside California;
- US citizens moving to another state to avoid high home-state income tax rates or state-imposed estate or inheritance taxes;
- US citizens considering a move to a US possession to avoid US income tax without abandoning U.S. citizenship; and
- US citizens wanting to take a second citizenship overseas and abandon U.S. citizenship.
In each of the foregoing cases, the focus will be on reducing or curtailing exposure to ongoing income tax in California, another high-tax state or the United States federally, through strategic and timely cross-border tax planning.
If you or someone you know is described in one of the categories mentioned above, or may just have an interest in these topics, please feel free to forward a copy of that newsletter to them and ask them to send me an email asking to join the email list for that separate newsletter, if interested.
This edition of the Cross-Border Tax Newsletter addresses the following three topics:
- Income tax legislation proposed by the Biden Administration and democrat members of Congress that may affect “well-to-do” snowbirds;
- California income tax issues for U.S. citizens and Canadian snowbirds staying longer in California than six months in a tax year; and
- US Federal information reporting implications for Canadian and other foreign snowbirds staying longer in the United States than six months in a tax year.
In his pre-election campaigning, President Biden indicated that he was planning historic changes in the extent to which “wealthy” individual and corporate interests would bear a share of future taxes to support his infrastructure redevelopment plans. The first drafts of that future tax legislation and related fact sheets being released piecemeal make it clear that big changes are coming. It is expected that all of the separate draft bills will ultimately be bound up into one large piece of legislation, which is likely to be introduced as a “Budget Reconciliation” bill in October 2021. Such a bill will not be subject to the usual Senate filibuster rules, allowing passage by a simple majority of Senators, rather than the 60 Senate votes normally needed to end a filibuster. If the thin democrat majority in the House of Representatives (seven votes) and the razor thin democrat “majority” in the Senate (essentially, the tie-breaking vote of the Vice President) hold up, this extraordinary legislation could pass in some form with historic repercussions.
The tax portions of the bill are expected to be wide-ranging and impact many classes of taxpayers. A brief summary of the income tax portions of the bills that may affect my “snowbird clientele” follows. (For a summary of the proposed US estate tax changes that will affect snowbirds, see the Winter 2021 edition of this Cross-Border Tax Newsletter).1. The “Sensible Taxation and Equity Promotion Act of 2021”
Under current law, no US capital gains tax is imposed on the unrealized gain inherent in a decedent’s assets at the time of death, but the heirs’ new income tax basis in the decedent’s assets is nevertheless increased (or decreased) to the fair market value of the assets at the date of death. This facilitates sale of appreciated assets at little or no income tax cost to the decedent or the heirs (although the decedent may be subject to US estate tax on the value of such assets, if his or her total estate exceeds in value his or her remaining estate tax exemption amount). This bill was originally promoted as one to eliminate the untaxed “step up” in the income tax basis of property held by a decedent at death, which is an unquestioned loophole in the US income tax system favoring the wealthy.
However, what the bill actually does goes well beyond eliminating the current law “step-up” in tax basis to fair market value, which could have been accomplished by forcing the heirs to accept a “carryover” (or “rollover”) of the decedent’s tax basis in the property, preserving the gain inherent in those assets until later sale by the heirs. Rather than adopt that approach, the draft bill instead proposes a Canadian style “deemed” disposition of a person’s assets at their fair market value at the time they are gifted, transferred in trust or transferred upon death of the owner. Thus, realization of capital gains would be triggered on any of such events, with certain deferrals for spousal transfers and transfers to a certain trusts, the assets of which are still considered to be owned for tax purposes by the transferor.
Unlike the Canadian system (which imposes no estate, inheritance or gift tax), the U.S. tax system may additionally impose a gift or estate tax (and possibly a generation-skipping transfer tax) on such “deemed” transfers, in addition to the capital gains tax. This can occur where the value of the gift or estate exceeds the donor/decedent’s remaining unified estate and gift tax exemption amount. In such cases, the maximum rate of transfer tax is presently 40% of the net value of the assets transferred (i.e., not just the gain). That maximum transfer tax rate is proposed to be increased soon to 45% under the proposed legislation. The two (or more) taxes imposed together may create a confiscatory tax environment for decedents or donors going forward.
The impact of realizing U.S. capital gains at death may not hit my Canadian snowbird clients who own U.S. vacation homes or U.S. rental real estate and/or significant U.S. stock portfolios in their individual names as hard as it will hit my U.S. snowbird clients. This is due to the anticipated application of the Canadian foreign tax credit mechanism to eliminate most double taxation on such gains. On the other hand, the proposed increase in the U.S. individual capital gains tax rate from 20% to 28% (and possibly higher for those earning over US$1.0 million), may increase the overall tax cost of such a “deemed sale” to a Canadian decedent (if the latter rate exceeds the effective rate imposed by Canada on such gains). Such a scenario may prevent use of all US taxes paid on such gains as a foreign tax credit against Canadian (and provincial) taxes imposed on the gain resulting from the deemed disposition of such assets under the Canadian system.2. The Wealth Tax Bills
Both Senators Warren and Sanders have introduced “wealth” tax bills that could impact the wealthiest among us, if enacted. However, this week, sources within the White House sought to downplay the likelihood that such bills will be part of the larger anticipated tax legislation. This is stark contrast to their overt promotion of the other new tax provisions they plan to incorporate into the larger bill. We will keep an eye on these wealth tax bills just the same, especially if there is any change in the mood in the White House or Congress as to their potential inclusion in the larger tax bill.3. The “Stop Tax Haven Abuse Act” and the “No Tax Breaks for Outsourcing Act”
Numerous other proposed provisions designed to end offshore tax breaks for U.S. corporate interests have been proposed in draft legislation. If those provisions find there way into the larger legislation, a few may impact my dual citizen clientele who own Canadian companies, much as the 2017 “repatriation” tax and the US tax on “GILTI” income did. In particular, these bills would increase the amount of ”GILTI” income that must be recognized by shareholders of some Canadian companies who are US citizens, green card holders or Canadian expats working in the US and also impose an interest charge on taxes previously deferred by election under the “repatriation” tax.
As new draft pieces of the anticipated legislation are introduced, we will summarize their possible future impact on snowbirds in coming Newsletters. If you have questions about how the anticipated legislation may affect you personally or wish to do some pre-enactment tax planning to blunt their impact, please make an appointment to discuss the possibilities, at your convenience.California Income Tax Issues Associated With Spending More Than Six Months in a Tax Year in California – Can You Live With Them?
Whether it is due to difficulties traveling, crossing the border, a longer, colder winter, the requirements and cost of quarantining oneself upon to return to Canada, the ability to stay outside Canada for up to seven months and still remain qualified for provincial health care coverage, or just a perceived safer COVID environment in the Desert than where they live, in the last year I’ve seen a significant uptick in the numbers of both my US and Canadian snowbird clients staying in California longer than six months in a calendar year. I am often asked about the potential tax consequences of doing so, so I will briefly provide some insight here into one of the lesser-appreciated impacts of a longer stay in California.
My seminar participants and clients domiciled outside California know that their vulnerability to being treated as a California income tax resident taxed on their worldwide income depends on the purpose for which are present in California and whether it may be accomplished by a relatively short, “temporary” stay or, instead, will require a long or “indefinite” amount of time to accomplish. How a long “seasonal” stay in California will be characterized in that paradigm will, in turn, be influenced by: (ii) the degree to which a snowbird is considered to benefit from the protections of California law; and/or (ii) whether the snowbird has a closer connection to California than to another state or province in the tax year in question.
In the above-described paradigm for separating nonresidents from residents, one of the most important impacts of staying longer than six months is to disqualify yourself from claiming the statutory presumption of California non-residence. That presumption is available to those present in California for fewer than six months in total in a calendar year (and who satisfy three other conditions). Once you demonstrate that you qualify for that presumption, the burden of proof shifts from the taxpayer to the Franchise Tax Board (”FTB”) to prove that you are a resident. Otherwise, the FTB need only make the minimum showing necessary to justify assessing resident-based taxes, which then shifts the burden of proof to you to prove that you were not a resident. Shifting the burden of proof back to the FTB may impact the FTB’s decision-making about whether you are worth the cost of a residence audit.
That said, where one or more temporary stays in a tax year clearly evidence a “temporary” purpose for being here (i.e, that of a nonresident on a seasonal vacation), spending the extra month in the Desert may not be fatal to your non-residence claim, despite not having the benefit of the presumption of non-residence. As an example, I just handled a case involving a snowbird client who had almost no connections with California, other than a half interest in a small Desert vacation condo, a few local friendships in his condo association and a local checking account he used to pay his expenses when in town. Except as just mentioned, he also had done nothing to avail himself of the benefits and protections of California law.
On the other side of the “closer connections” ledger were a vast array of continuing and long-lasting connections with his long-time place of residence outside California, where he spent the remainder of the tax year in question. With facts like these (or something close), I was able to make a strong case that he was not a California resident, even if he spent seven months in California and bears the burden of proving that he is a nonresident. On the other hand, a taxpayer who has developed equally close connections with California as he or she has with his or her claimed place of residence and who spends much of the balance of the year vacationing outside that state or province, may have a much harder time meeting his or her burden of proof.
In a case where it feels like you may be “sailing close to the line,” there are several tax planning steps that may reduce to the point of disinterest the income California could tax if the FTB were to be successful in re-classifying you as a resident. I refer to such planning as “poison pill” planning, because its purpose is to make a possible future victory by the FTB not worth the cost of the fight. As with the issue of who bears the burden of proof (and the associated cost), this kind of planning can impact the FTB’s decision-making as to whether you are worth the cost to them of a residence audit.
Thus, for my U.S. citizen snowbird clients whose facts resemble those recited above (or with a few more connections to California) and who are willing to do some pre-residence tax planning, staying a bit longer than six months may not prevent you from successfully defending your claim of non-residence. This is especially so if your electronic footprint in California is minimal or non-existent (something I routinely advise about, to reduce the chances of receiving a Form 4600 inquiry letter from the FTB). If you find yourself thinking about staying longer than normal this year, consider making an appointment with me (whether in person or via video conference) to discuss your specific circumstances.
For my Canadian snowbird clients, however, the decision to stay longer than six months is more complex, due to U.S. federal information reporting obligations that may arise from becoming an income tax resident under US internal law. The information reporting and other implications of staying longer than six months and, thus, becoming a U.S. income tax resident for purposes of US internal law, even for a single year, are discussed below in the following section of this Newsletter.
The US Federal Information Reporting Obligations of a Canadian Spending More Than Six Months in a Tax Year in the United States – You Might Not Want to Live with These!
As my seminar participants and clients also know, the manner in which US income tax residence is determined for a foreign-citizen snowbird differs dramatically from the tests used for California residence. Assuming that you are neither a dual citizen nor a US green card holder, your US income tax residence status is determined under the “substantial presence” test, which is a weighted-average, day-counting formula applied over a rolling, three-year period. If you spend an average of 121 or fewer days in the US each year, you will not become a U.S. income tax resident under that formula. Even if your weighted-average days of presence exceeds 183 days under the formula for any tax year, US income tax residence may nevertheless be avoided if you timely file with the IRS a Form 8840 Closer Connection Statement, demonstrating your comparatively stronger connections with Canada than the US for the tax year in question.
However, if you exceed 183 days of US presence in any tax year, you will become an income tax resident under US internal law for that tax year, in addition to being a resident of Canada under Canadian internal law. In such cases of “dual residence,” residence “tie-breaker” rules in the Canada – US Income Tax Treaty (the “Treaty”) will determine, as between Canada and the U.S., which country has the right to tax your worldwide income. The Treaty-based residence “tie-breaker” rules are a series of cascading inquiries, which prioritize specific types of connections with each country to determine your residence for purposes of applying the Treaty. In most cases, the residence “tie-breaker” rules treat “dual resident” Canadian snowbirds as exclusively residents of Canada for purposes of applying the Treaty (sometimes referred to as “Treaty Nonresidents” of the US).
If you are found to be a US “Treaty Nonresident,” income you earn outside the U.S. will not be subject to U.S. income tax, despite the fact that you become an income tax resident under U.S. internal law. This can be especially important to dual resident shareholders in Canadian companies who, if they were not Treaty Nonresidents, may be required to pay US income tax on the Canadian corporation’s undistributed income, in some circumstances.
Notwithstanding status as a Treaty Nonresident, the IRS and Treasury still take the position that you remain a US tax resident for most US information reporting purposes. This can result in a Treaty Nonresident having to file several information reports with the IRS and/or US Treasury with respect to specified types of income, transactions or assets, even though no US tax can be collected under the Treaty. Although it has been pointed out to the IRS that this position is inconsistent with US Treaty obligations, unnecessary since no US tax can result from it and self-defeating in some situations, the IRS persists in demanding most such information. Such reporting requirements can include:
- Form 1040 NR (U.S. Nonresident Individual Income Tax Return), attaching Form 8833, Report of Treaty-Based Return Position, in order to claim the benefit of the Treaty to exclude Treaty-protected income from US tax.
- FinCen Report 114, Report of Foreign Bank and Financial Accounts (an “FBAR”), which reports to the US Treasury certain non-US bank or other foreign financial accounts having balances exceeding $10,000 at any time during the year. (Notably, a dual resident who files Form 8833 is not required to file the more comprehensive “Statement of Specified Foreign Financial Assets” on Form 8938, that is required of internal law or Treaty residents.)
- Form 926, Return by a US Transferor of Property to a Foreign Corporation, requiring disclosure of transfers of cash or other property to a Canadian corporation (including transfers that occur entirely within Canada).
- Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Foreign Gifts, requiring disclosure of interests in certain foreign trusts and gifts from a foreign (including Canadian) person exceeding $100,000 in a tax year.
- Form 3520-A, Annual Information Return of Foreign Trust with a US Owner, requiring disclosure of a foreign trust which is treated as owned by a US person under the US “grantor trust” rules.
- Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations, which is a comprehensive report of the income, assets and transactions of a US-controlled, Canadian corporations of which the taxpayer is an officer, director or 10% or more shareholder. However, if the snowbird shareholder is included in such a report filed by another US resident, they may be excused from filing a separate version of that form. In some cases, a dual resident may substitute an audited financial statement for a completed Form 5471.
- Form 8865, Return of US Persons with Respect to Foreign Partnerships, requiring disclosure of interests in Canadian or other foreign partnerships.
- Form 8858, Information Return of US Persons with Respect to Foreign Disregarded Entities, requiring disclosure of an ownership interest in a Canadian or other foreign entity whose separate status is disregarded for US tax purposes, whether by default or election.
The foregoing requirements can become a significant administrative burden in complex trust and entity-ownership situations, even if no income tax consequences result from these filing obligations. Nevertheless, an even worse fate may await those who don’t file such reports when required to do so. In this regard, penalties for failure to file some of these forms can reach into tens of thousands of dollars. If you find yourself in such a situation inadvertently, waiver or reduction of such penalties may be possible if you qualify to enter an IRS tax compliance program, which allows penalty-free, back-filing of required information reports in cases of non-willful failure to file.
Thus, persons to whom several of the above-mentioned reporting requirements (and/or penalties for non-filing) may apply may question whether another month in the sun each year is worth saddling themselves with these reporting obligations. However, for other Canadians who do not own shares in a privately-held Canadian corporation, are not beneficiaries of a foreign trust, did not receive a large gift from a foreign person and whose Form 8833, Form 1040NR and FBAR filings will be abbreviated, staying an additional month or so in the US may be worth the additional filings. This might especially be the case in a one-off situation like 2021, if there is a realistic hope that the presently applicable Canadian quarantine arrangements may be lifted before you are forced to head home.
If you find yourself thinking about staying longer than normal this year, consider making an appointment with me (whether in person or via video conference) to discuss your specific circumstances. Likewise, if you have stayed longer than six months in a previous tax year and failed to file required returns or information reports, I recommend that you make an appointment to discuss your back-filing options for penalty abatement with me as soon as 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.
Circulation: Please feel free to share this Cross-Border Newsletter with neighbors, friends, family, clients or colleagues who may have an interest in its contents. If you received a copy of this newsletter from a family member, friend or colleague and would like to receive future editions of this newsletter, please send me an email and I will happily add your name to the list.
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 US 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
Removal: If you wish to be removed from this Newsletter email list or the list for the new Newsletter entitled “Getting Out with Your Skin,” please send me an email to that effect and I will cheerfully remove your address from my email list.
Brent Lance, LL.M. Tax (NYU)
April 7, 2021