Over 40 Years of Experience
Cross-Border Tax Newsletter
Dear Snowbird Clients and Friends,
First of all, I hope you and your families are well and staying safe. Let us hope that it will once again be safe to travel soon and we can look forward to another beautiful season in the California Desert in 2021!
This summer edition of the Cross-Border Newsletter addresses four topics:
- A proposed California wealth tax;
- A proposed increase in the California “millionaires” tax;
- The current state of California’s thinking on the impact of COVID-related health and economic issues on California income tax residence determinations; and
- A probate-avoidance technique for California personal residences that some are turning to in lieu of a more expensive trust or entity-ownership solution or more troublesome joint tenancy arrangements.
Anyone watching the Democratic presidential debates earlier this year will be aware of Senator Elizabeth Warren’s proposal to impose a 2% wealth tax on the wealthiest US citizens (i.e., those owning US$50 million or more). As everyone knows, Senator Warren did not become the nominee of the Democratic party and it is hoped that her wealth tax proposal died along with her hopes of becoming the next U.S. president. Never ones to wait for the Federal government to act, however, a group of California legislators has seized on her idea and proposed that California adopt a similar, first-of-its-kind, wealth tax at the state level, without regard for whether the next federal government ever takes action on Senator Warren’s proposals.
The proposed tax would be imposed at a rate of 0.4% of net worth (excluding real estate) for single taxpayers and married taxpayers filing joint tax returns whose net worth exceeds US$30 million and at a US$15 million threshold for married individuals filing separate tax returns. According to the bill language (AB 2088), the tax would be computed based on wealth determined in the same manner as for the U.S. Estate Tax (which generally includes all worldwide assets other than those specifically excluded by statute).
Wealth would be measured for purposes of this proposed tax on December 31st each year (transactions, the primary purpose of which is to reduce the valuation of a taxpayer’s worldwide net worth as of that date, are to be disregarded, according to the bill). Directly held real estate would be excluded, since it is already subject to the California real property tax at a higher rate (approx. 1.25%). Valuations of all but publicly-traded assets are to be made using the “best available methodology and information.” Assets held indirectly, as through trusts, are to be assessed based on the taxpayer’s indirect ownership rights in them. No discounts would be allowed (e.g., for lack of marketability or lack of control) in making the valuations. Allowances would be made for “liquidity-constrained” taxpayers, who may enter into a contract with the FTB to defer payment of the tax until assets are liquidated. Credit would be allowed for wealth tax paid to another jurisdiction on assets located outside California (but it is doubtful whether this would apply to taxes imposed by jurisdictions located outside the U.S.).
The tax would be imposed on income tax residents, as well as on “temporary residents.” A "temporary resident” for this purpose is a taxpayer who spends 60 days in California in a given calendar year, but who does not qualify as either a resident or a part-year resident (i.e., a taxpayer who moves into or out of California in a given tax year). Temporary residents would be taxed on their worldwide net worth, multiplied by the percentage of days in the year the taxpayer was present in the state.
For income tax residents, the portion of the taxpayer’s wealth subject to tax would be determined by a fraction, the numerator of which would be the number of years of California income tax residence over the last 10 years and the denominator of which would be 10.
The tax would also be applied to so-called “Wealth Tax Residents,” loosely defined as those with “extreme wealth” sourced in California.
The tax has been proposed to fill an expected gap between revenues and expenditures borne out of COVID-19 and related economic upheaval. According to the bill’s authors, it is expected to apply to about 30,000 taxpayers and raise approximately US$7 billion.
In order for this bill to pass and become law, the California legislature must garner the votes of 2/3 of the membership of each house, as required by the California Constitution for tax bills. Whether this threshold will prove an insurmountable obstacle for such a proposed tax is unclear. It is also unclear whether such a tax, if adopted, would satisfy constitutional requirements. The bill is unlikely to be heard before the legislature adjourns on August 31st. However, it is expected to be re-introduced in the next legislative session. Presently, my advice is not to lose any sleep over this bill.Proposed Increase in the California “Millionaire's Tax”
Presently, California’s top personal income tax rate is 12.3%. On top of that, California also presently imposes another 1% tax (colloquially known as the “millionaire’s tax, although technically dubbed the “mental health services tax") on taxable incomes of resident and nonresident taxpayers over US$1.0 million each year. Not satisfied with the fact that this already makes California’s income tax the highest in the nation, the California legislature has now proposed (in AB 1253) to add a further tax on top of the existing 1% millionaires tax with (a) 1% tax on the portion of a taxpayer’s taxable income over an inflation-adjusted $1.0 million threshold, but not over $2.0 million; (a) a 3% tax on the portion of a taxpayer’s taxable income over an inflation-adjusted $2.0 million threshold, but not over $5.0 million; and (c) a 3.5% tax on the portion of a taxpayer’s taxable income over an inflation-adjusted $5.0 million threshold.
After inflation adjustments, the thresholds mentioned above are $1,181,484, $2,362,968 and $5,907,420 for taxable years beginning on or after January 1, 2020. Thus, if your taxable California income for 2020 approaches $6.0 million, your new tax top California income tax rate could be as high as 16.8%! When considering the impact of that number, keep in mind that California has no special tax rate on capital gains and that those California taxes will not be deductible for Federal income tax purposes (other than the first US$10,000 of income or property taxes).
This tax increase has also been proposed to reduce the expected budget gap mentioned above, borne out of COVID-19 and the related economic upheaval. According to the bill’s authors, it is expected to apply to about 70,000 taxpayers and raise US$6.5 billion dollars. The bill is sponsored and promoted by the unions and the Democrat party. Despite the fact that the California Chamber of Commerce has called the bill “catastrophic” and a “job killer,” it may well become law.
In that regard, the bill has passed the California Assembly and is now pending in the Senate Governance and Finance Committee. It requires a two-thirds vote of the Senate and signature by the Governor to be enacted into law.Covid-Related California Tax Residence Issues
Still no word from the California Franchise Tax Board (nor the tax authorities of any other states) about whether they will follow the Federal government’s lead providing relief for those forced to stay longer in California in 2020 than they originally planned due to a COVID-19 related health issue (including related travel problems) when it comes to determining your status as a California resident or nonresident for 2020. In the meantime, “planning" remains the operative word. Some of the steps that snowbirds may take now to support their claim to nonresidence were discussed in the Spring edition of the Cross-Border Newsletter. If you would like advice about those recommendations, especially concerning the affect of plans to return to California in the fall, please contact me at your convenience.Transfer on Death Deed as an Alternative Probate Avoidance Device for California Personal Residences
In the cross-border estate planning seminars I lead, I am often asked about California probate-avoidance techniques for California personal residences that are both less expensive than setting up a cross-border trust or other entity structure to hold title to the residence and less problematic from a tax point of view than using a joint tenancy. In some situations, a Transfer on Death (“TOD”) deed may be an appropriate substitute.
In general, a TOD deed allows a homeowner to transfer title to their residence upon their death without a will and without having to put the successor in interest (referred to herein as the “beneficiary”) thru the California probate process, which can be long and expensive. No gift or transfer is considered to occur at the time of executing or recording the deed for U.S. federal gift tax purposes – the transfer is deemed to occur only at your death and the interest of the beneficiary is contingent until that time. Thus, unlike a joint tenancy, tenancy in common or life estate deed, the property is not subject to the debts of your beneficiaries during your life and no taxable gift arises upon execution of the deed.
Nor does execution of the TOD deed constitute a “change of ownership” for California property tax purposes – thus, it is not an occasion for reassessment of the property. You will also continue to be treated as the owner of the property for Federal and California income tax purposes, such that, at your death, under current law, the income tax basis in the property will stepped up (or down) to its then fair market value in the hands of the beneficiary. The latter result is important as it effectively eliminates income taxation of any previously unrealized gain on the property at your death (for Federal and California income tax purposes, but not for Canadian income tax purposes). Until your death, you may transfer the residence or encumber it and it will remain subject to the claims of your creditors. The property is transferred subject to any liens or encumbrances, for which the transferee will become liable.
There are many other considerations of using a TOD deed, which are beyond the scope of this introduction.
The TOD deed is a relatively new development for California. The sections of the law that support it only came into effect on January 1, 2016. Moreover, the law that authorizes the use of a TOD deed expires by its terms on January 21, 2021, unless the legislature takes steps to renew it. Upon its expiration (should that occur), deeds recorded before that date will remain effective. Calif. Prob. Code Sec. 5600(c). Thus, you should not delay, if you wish to explore the possibility of using a TOD deed further.
Please don’t hesitate to call if you would like to discuss how the proposed taxes discussed above may affect you, any California tax residence issues or the use of a TOD deed or other cross-border estate planning technique.
Please feel free to share this Cross-Border Newsletter with friends or family who may have an interest in its contents.
As always, the foregoing summary is for information purposes only and is not intended to be relied on as or constitute legal advice. If you wish to be removed from this Newsletter list, please send me an email to that effect.
Brent Lance, LL.M. Tax - NYU