Over 40 Years of Experience
Cross-Border Tax Newsletter
Dear Clients and Friends,
It is late February at the time of this writing and the California Desert scene is in ¾ swing. I hope many of you were able to get here and stay here despite governmental restrictions and health threats and are managing to enjoy the wonderful weather.
This edition of the Cross-Border Tax Newsletter addresses five recurring topics in my practice:
- The importance of having a pre- or post-nuptial agreement that satisfies California legal standards when one spouse is a California domiciliary;
- Using an LLC taxed as a corporation to hold title to your California vacation residence in cases where California residence is in question, or if you rent the residence;
- Three potential US and California tax risks associated with Canadian holding companies;
- Gift tax problems with gifting an interest in a California vacation residence; and
- Recent and pending California decisions, which shed light on what it means to be here for a “temporary or transitory purpose” in determining California income tax residence status.
I am seeing more and more mixed nationality or mixed-residence couples, especially Canadian individuals marrying a US citizen and California resident spouse. I also see many out-of-state resident US citizens marrying US citizen California residents, as well. It is common in such cases for the Canadian (or out-of-state) spouse to want to have a pre-nuptial arrangement to protect his or her Canadian/non-California assets. Such agreements are almost always drafted by the Canadian (or out-of-state) spouses’ attorneys who insert a Canadian/provincial/out-of-state choice of law clause. Indeed, I have never seen one yet drafted with California marital property law in mind.
What those couples often don’t realize is that, if the California spouse is earning income in California from employment or operating a business generating California source income, such income may be characterized as community property income under California law and be attributed one-half to the non-earning, non-resident spouse. Such an attribution of income will give rise to a California income tax return filing obligation for the nonresident spouse (and possibly a U.S. income tax return filing obligation for my Canadian clients, as well).
Which brings us to the question whether an out-of-state or foreign country pre- or post-nuptial agreement will be enforced by a California court. While it’s possible that a California court may enforce a choice of law clause in such a pre- or post-nuptial agreement, it is also possible that they will not. The latter situation is most likely to occur if something in the pre-or post-nuptial agreement is contrary to a fundamental California state public policy (of which there are many). As an example, we have a no-fault system of divorce in California. Many out-of-state or foreign pre- or post-nuptial agreements I see contain provisions that are triggered by the fault of one of the spouses. Another examples of such public policy differences between California and other states or countries arises where there differing disclosure requirement, time passage requirements between execution and marriage, and so on.
It is also likely that the subtleties of whether a foreign or out-of-state pre- or post-nuptial agreement is enforceable under California law may be lost on a FTB auditor.
For these reasons, I recommend that my mixed-residence or mixed-nationality couples put in place a “mirror” pre- or post-nuptial agreement drafted by a California lawyer with California law in mind. The point is to be sure they do not find themselves surprised by an assessment of back taxes, penalties and interest for failure by the nonresident spouse to file returns and report his or her half of such community property income. When no returns are filed, the statute of limitations on assessment does not begin to run and the audit can plausibly reach back to the date of the marriage.
Likewise, having to file a California nonresident return can also lead to a host of disclosures to the FTB that could themselves lead to a California residence audit (see the next section of this newsletter about that).
There may also be marital property issues in play, as well, if a foreign or out-of-state pre- or post-nuptial agreement is not enforced by a California court where there are significant marital assets subject to the jurisdiction of the California court.
If you wish to discuss this strategy further or have me review your foreign or out-of-state pre- or post-nuptial agreement for these risks, please contact my office at your convenience.Using an Entity “Blocker” to Hold Title to Your California Vacation Residence to Avoid Disclosures to the FTB, or to Report Rental Income
I have many clients who spend close to six months or more per year in California and are looking for an edge to prevent their being discovered and questioned by the FTB about their California residency status. Most of those own vacation homes in California in their own names, some have mortgages on them and others rent those residences out to help with carrying costs.
Even a dollar of gross rental income triggers a requirement to file a California nonresident tax return to report income and the return must be filed whether or not the rental operation shows a profit. Most problematic in those cases is the amount of information that must be disclosed to California with a nonresident individual income tax return. Such disclosures include your worldwide income (even if not all taxable in California), a copy of your federal income tax return if you file one, whether you own a home in California, the number of days you spent in California that year, the location where you claim to be resident and domiciled, whether you have ever previously lived in California and whether you have ever previously been audited by the FTB. All of that information is used by the FTB in its “cost-benefit” analysis to determine whether the owner might make a good candidate for a residence audit. Those of you residing in a low- or no-tax state or any foreign country make especially good targets because the FTB does not have to give up a credit for residence-based taxes you pay to that state or country in calculating the potential California tax that if the FTB prevail in their residence audit.
Accordingly, filing an individual nonresident tax return is to be avoided at all costs. And even if you don’t rent your California vacation home, having a mortgage on it can likewise lead to an inquiry letter from the FTB about why you are not filing a California tax return. In this regard, mortgage interest reporting by your lender to the California FTB is one of greatest generators of tax return inquiry letters in my practice.
Finally, when you sell a vacation residence in your individual capacity, you will be obligated to file a California income tax return and make such disclosures for the year of sale. For those re-investing here, it creates a reference file for the FTB, should your name show up in their computers later on for any reason.
Filing a nonresident individual income tax return, making extensive disclosures and potentially receiving an FTB inquiry letter may be avoided in these situations by purchasing your vacation home in (or transferring your vacation home to) certain types of entities set up outside California. To avoid the mortgage interest disclosures, the mortgage would need to be in the name of the entity, even if you have to guarantee it (which is often required). I have successfully employed this strategy for my clients in order to allow them to avoid filing an individual income tax return and making such disclosures, which I believe greatly reduces their chances of being noticed for a residence audit.
In some cases, the entity can also be set up to provide for succession to ownership interests without probate in a manner that avoids the disadvantages of joint tenancy, as well as to provide significant protection from potential creditors or claimants (which is particularly needed in California if you renting your vacation residence).
If you would like to learn more about the details associated with this strategy or to put it in place for you, please contact my office for an appointment at your convenience.Potential US and California Tax Risks Associated With Canadian Holding Companies
Many of my Canadian clients operate Canadian holding companies (“Canco”) as investment vehicles or retirement plan substitutes. To those who push the envelope of California connections and length of stay here each year and have to be concerned about a potential residence audit, I often recommend that they (or I) make a “mock” calculation of their exposure to residence-based taxation in California in case the worst happens.
It is common for the Canadian-resident shareholder of such companies (perhaps after conducting a recapitalization of the Canco or lending significant sums to the company) to initiate partial redemptions of their shares or receive “principal repayments” on such loans each year as a way of funding their cross-border lifestyle without paying taxes to Canada on the amounts received. While this may work for Canadian tax purposes, either strategy can lead to calamitous results for a California or federal income tax resident.
Partial redemptions of small amounts of a shareholder’s position in such a company are treated as “dividends” for both US and California income tax purposes. If the Canco is considered to have accumulated or current earnings and profits (as determined for these purposes), such dividends may be taxable to a California resident. Moreover, the California FTB is under no obligation to allow a foreign tax credit under such circumstances.
Likewise, it is also possible that a “loan” to such a Canco by the shareholder, although treated as “debt” for Canadian tax purposes, may nevertheless be recharacterized by the IRS or FTB as “equity” for their purposes. If the FTB can sustain such a position, the annual “loan repayments” will be recharacterized as either amounts paid in redemption of stock (which are treated as “dividends” in the manner described above) or as simple dividends paid with respect to that “equity.”
Canadian resident shareholders of Canco who are dual-citizen or dual resident taxpayers may also become exposed to US tax on their “GILTI” income (i.e., global lntangible low-taxed income) after the 2017 US tax act. President Biden has proposed to increase the amount of GILTI income even further in new legislation that would eliminate the exclusion of income attributable to an investment the Canco has made in tangible assets from the GILTI calculation. There is also a bill now pending in the California Assembly that would tax California individual residents on some portion (50% is being considered) of their GILITI income for the first time.
Thus, if you are following one of the above-described strategies for Canadian income tax purposes and are potentially vulnerable to an accusation by the FTB that you are a California resident, come in for some restructuring and nonresident tax planning advice.US Gift Tax Problems Resulting From a Gift of an Interest in a California Vacation Home
I’m disheartened by the numbers of clients who arrive in my office for advice about the US and California tax implications of selling a California vacation home only to mention, as an aside, that they obtained their interest as a gift from a parent, parent-in-law, grand-parent or favorite aunt or uncle. I also routinely hear similar stories from those who have already made an outright gift of a part-interest in their vacation residence to their son or daughter or a favorite niece or nephew, or put them on title gratuitously.
Gifts of an interest in U.S. real property by a nonresident noncitizen (an “NRNC”) are subject to U.S gift tax at rates up to 40% on the value of the gift (not merely on the gain, as in Canada, for instance). The tax kicks in after a very small annual exclusion amount of US$15,000. Canada’s income tax treaty with the US contains extensive concessions relating to the US estate tax, but provides no shelter from the US gift tax. No income tax treaties with other countries provide shelter from the gift tax either (although some estate and gift tax treaties may – unfortunately, the US has no such treaty with Canada).
As indicated above, such gifts can arise inadvertently by putting someone else on title who has not contributed proportionately with their own funds to the purchase of the property, as often happens when property is acquired as “joint tenants” (beware taking advice from your US real estate agent about how to take title, as they often suggest holding property in joint tenancy as a way to avoid probate, being oblivious to the tax problems it can cause).
Although some of these taxable gifts go undiscovered at the time they are made, they are often exposed on the death of the grantor or the grantee, or when applying for a withholding tax exemption or reduction certificate based on the maximum tax liability of the transferor. In the former case, filing an estate tax return is often required to obtain the benefit of a treaty exemption or statutory deduction, which can lead to a discovery of the unpaid gift tax. In the latter, a surprise discovery that the amount of the taxable gain is larger than expected occurs because the grantee’s tax basis in the property is the old tax basis of the grantor and not the property’s value at the date of the gift.
Even gifts between spouses can be taxable, although a larger exemption amount is allowed. For 2021, otherwise taxable gifts to an NRNC are entitled to an annual exemption of US$159,000. Thus, unless the gift is structured to qualify for a gift tax treaty exemption (which is possible where an estate and gift tax treaty is in effect between the US and the grantor’s country of residence, such as is the case with the U.K.), a gift of an interest in US real estate exceeding US$159,000 in value will result in a US gift tax.
To reduce this ongoing problem (at least among your friends, family and associates), please circulate this newsletter as widely as you may wish. If you someone you know has this problem, please send them in for advice concerning what may be done about it.Recent and Pending Decisions Shed Light on the Meaning of “Temporary or Transitory Purpose” in Determining California Income Tax Residence Status
Those of you who have attended my seminars or a private video conference on the subject of living part-time in California without becoming income tax resident know that you must enter California for a “temporary or transitory” purpose in order to remain a tax nonresident. Whether the purpose for which you have entered is “temporary or transitory, on the one hand, or “long, permanent or indefinite” on the other, often comes down to gleaning your intent from the type of connections you’ve made in California and the length of your stays here.
In a recent decision of the California Office of Tax Appeals (OTA”), to whom FTB determinations that one has become a California income tax resident are first appealed, the OTA opinion stated that maintaining a post office box in California, which the taxpayer used as his address of record for some purposes, “creates a reasonable inference that the appellant was a California resident.” Appeal of Jamie Ibarra, 2019-OTA-103. Although previous cases have listed maintenance of a California post office box as one of many factors showing contacts with California (Noble v. Franchise Tax Board (2004) 118 Cal. App.4th t60, 579), the statement in Ibarra seems to raise the significance of this factor in the analysis. Although the Ibarra decision does not have precedential value, the amount involved was paltry and the taxpayer did a poor job defending himself, in future residence audits the FTB may treat the maintenance of a California P.O. Box as significantly prejudicial to the taxpayer. Accordingly, if you are keeping a California post office box as a matter of convenience (and particularly using it as an address of record for any purpose in California), especially on a year-round basis, I have to recommend that you consider closing it.
In another case that is expected to be of importance on the subject of residence and domicile (although no decision has yet been issued), the FTB, in oral arguments at the hearing, reiterated the purpose underlying all residence decisions: “The purpose behind California’s pursuit of income taxation based on residence is to ensure that individuals who are physically present in the state enjoying the benefits and protections of its laws and government contribute to its support, regardless of the source of the taxpayer’s income. . . this purpose underlies all residency decisions. Therefore, the ultimate question in this residency dispute is whether these taxpayers received these benefits and protections from California.” The FTB representative then went on to summarize the benefits and protections of California law received by appellants in that case, which included filing litigation in California and maintaining significant relationships with California professional advisers, including physicians, pharmacists, accountants, investment advisers and attorneys.
I point this language out because in planning to avoid California income tax residency while living here part-time, it is not all about day-counting and comparing contacts you have in California and your home state or province from the state’s point of view. Rather, the degree to which you seek out the benefits and protections of California laws while you are here, in any of many ways, can also significantly influence the outcome of any residency audit or appeal determination.
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.
Please also feel free to share this Cross-Border Newsletter with neighbors, friends, family or colleagues 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. Always seek professional help with respect to your specific fact situation in determining how US or California legal provisions may affect you.
Finally, 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. 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 list.
Brent Lance, LL.M. Tax - NYU