Chapter 6
How To Survive A California Residency Audit
If you have decided to relocate to another state to escape California’s high tax rate, then you need to do so with caution. Or, maybe you divide your time between California and another state(s).
The state is very aggressive about collecting state income tax they believe you owe, and trust me, they will track you down.
Many of our clients have had their residency challenged when it comes to filing their taxes. The Franchise Tax Board (FTB) will scrutinize your bank records, records of purchases and other transactions to make their case that you, indeed, are a resident of California.
The FTB comes down particularly hard on individuals whom they believe left the state to avoid paying the high taxes.
Any activity that raises a red flag with the FTB can trigger a residency audit. It can be something as simple as living in another state and having a second home in California, to a tip-off from the IRS or another third party. (The IRS and individual states share information, BTW.)
My advice is to document, document, document all of your activities in other states, such as conducting business or making purchases. All of this information will be advantageous when defending an audit.
If you are facing a residency audit, call me. I know how to take the control of the audit, so you are not burdened by overkill from the auditor. We can prepare your case to prove your residency and that you are not liable for extraneous state income tax.
Proving Residency
In order to survive a residency audit for California, a taxpayer needs to prove that not only are they a resident of California, but that they took steps to establish domicile.
As we’ve discussed, a variety of factors go into this. Such factors can include where your spouse and your children are, where they go to school, what are the locations of your bank accounts, where you go to church, where you visit your doctors, where you are registered to vote, where your car is registered, and so on.
Moving presents a few challenges from a tax perspective, especially for high income earners moving to states with lower income tax rates. While anyone can be audited, the state derives more taxes from high income earners and thus, they are more likely to scrutinize any moves out-of-state to confirm that they are legitimate and not just attempts to evade state taxes.
With California state taxes being the highest among the nation at 13.3 percent and with taking into account the recent proposals to further raise the taxes, many high net worth individuals and businesses have left or are considering leaving the state.
However, because the tax rate increases are aimed at increasing revenue, it is no surprise that the California taxing authorities are intent on conducting audits.
While any taxpayer must keep records of their tax-related documents, the need is especially great for those considering moving out of state.
Along with going through the residency factors mentioned above to determine your risk of being pursued for tax liability, the most important step you must take is to meticulously document your time in California.
From cell phone and flight records to bank statements, your transactions and activity are fair game for the taxing authorities to review.
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Moving Out of State
If you have recently moved out of state, look at the period of time you have spent in your previous resident state and make note of any trips you made there and for what purposes.
It is simply not enough to move into a new home out of state to consider yourself a nonresident. Before you even reach the audit stage, be sure to make the proper assessment as to whether you owe taxes to your old state either as a resident or even a part-year resident.
Given that California can audit you up to eight years after the tax filing date if you do not file a tax return, it is in your best interest to get your residency status right at the time taxes are due.
Residency audits are complex because there is not one particular factor that is dispositive, and you can have factors in certain situations that may support both sides. The issue is particularly challenging for clients who view themselves as residents of one state and not the other.
It is really important to deal with these issues. In particular, California has been very aggressive in coming after out-of-state people who they claim are residents of California for one reason or another.
How the FTB Finds You
Many of our clients’ biggest questions are how audits are initiated by the state and where the state gets its information. In many cases, auditors are tipped off by information they receive from businesses, agencies, or third-party data sources, to name a few sources. See Publication 76, Audits, 6.
The tip-off may come from something you purchased and had sent to a California address or from a tax filing in which you or your employer listed a California address. Even the minimal act of holding property such as a second home in your name can trigger a residency audit.
It is very important to respond to these notices because the tax consequences are significant.
Because of all the moving pieces, residency audits are difficult. They are fact-specific and can touch on any area of a person's life. Most clients we have are not coming to prevent this from happening but are coming to us after the fact.
However, the more that we can do to build your case to structure these substantial connections, the better off you are going to be to survive a challenge in this sense.
Can the State Get Ahold of Your Federal Tax Returns?
Our firm gets asked if the State of California can request anyone's federal tax return when desired. The answer is that it can. The FTB can request tax returns for residents of California, and it can request tax returns for people that it believes owe them a tax obligation or even to help establish a case that a California tax liability is owed.
Unless there is a law in place such as the new candidate tax return law, the FTB just cannot request your tax returns and make you turn them over if you are not a resident of the state. However as with all states, there is an information-sharing agreement between California and the IRS. So, if California wants to obtain a copy of your federal tax returns, it likely can.
Your Next Steps in a California Residency Audit
Determining residency in California is tricky. The FTB, intent on recovering as much tax revenue as it will, as they say, leave no stone unturned to hunt down taxpayers who they suspect may be withholding tax payments to the state. This can result in a residency audit, where the FTB will put the onus on you to prove that California is your domicile.
If you are facing a residency audit, then please call us. This is not something that you want to try to handle yourself. The laws are just too complex.
Our firm looks to structure your case to help build a record of your intent as well as identify crucial facts for this fact-based inquiry. We look to prepare your case as if it's going forward towards an appeal.
We get facts on record, submit documentation, and negotiate over the auditor's initial document request.
We work on presenting the factors and pieces of evidence that we think are going to strongly benefit our clients.
You can't erase a bad fact, but we work to control the order in which you play bad facts and frame the facts to support our client’s intent and situation.
