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Failure to Properly Terminate State Domicile Has a Taxing Result

Posted on June 7, 2021
Lauren A. Ferrante
Lauren A. Ferrante
Stanley R. Kaminski
Stanley R. Kaminski

Stanley R. Kaminski and Lauren A. Ferrante are partners in the Chicago office of Duane Morris LLP.

In this installment of DM SALT Masters, Kaminski and Ferrante discuss the importance of properly changing state tax domiciles to achieve desired tax results — focusing on the California Office of Tax Appeals’ recent ruling in Bracamonte.

Copyright 2021 Stanley R. Kaminski and Lauren A. Ferrante.
All rights reserved.

The COVID-19 pandemic and increased state tax burdens have forced and accelerated change worldwide on all aspects of individuals’ lives, including where they live. As a result, it is becoming increasingly common for people now facing higher state taxes on their earnings, profits, and gains — and benefiting from the ability to remotely work from home — to look to permanently move to no- or low-tax states to avoid state taxation. While the domicile and state taxation issue is not new, especially for retirees, the COVID-19 pandemic has exacerbated it. Therefore, properly terminating one’s tax domicile in one state and creating a new tax domicile in another is paramount to achieving the desired tax results.

The principle at the heart of these domicile moves is that states can tax their residents’ income on a worldwide basis (from whatever source derived) while nonresidents can only be taxed on income derived from sources in the state.1 Thus, an individual’s residency or domicile determines her personal income tax liability. This is especially true for high-income individuals and those who have potential capital gains that they want to shelter from high state income taxes. So if an individual earns income (especially a large item of income, such as from the sale of a business) derived from sources outside the state in question, that individual’s residency status — and the timing thereof — often determines that income’s taxability.

Sometimes the residency determination is not clear-cut, characterized by circumstances in which individuals intend to move to another state but take actions that may be viewed as inconsistent with that intent. While there are hundreds of court cases on residency and state taxation, a recent California decision illustrates this push-pull dynamic of properly terminating and creating a new state tax domicile. This case should also serve as a cautionary tale to those looking to move to a low-tax state: Individuals must effectively cut ties to their prior state and plant roots in their current state for state tax authorities and courts to recognize a change in residency.

In Bracamonte,2 the California Office of Tax Appeals (OTA) issued an opinion on whether a couple (appellants) were residents of California on July 18, 2008, in order to determine if California could impose tax on the proceeds they derived from the sale of a corporation (sale) on that date (sale date).3 The facts of the case center on the circumstances surrounding the appellants’ move from California to Nevada, beginning in February 2008, approximately five months before the sale date.

Before the sale, the appellants were California residents, where they had purchased a home in 1988. In late February 2008 the appellants were contemplating a move to Nevada and, as a result, drove to Henderson, Nevada, for a three-day stay. While there, they took a number of actions consistent with their intent to move: They rented an apartment (and took possession about a week later) with an extended rental period of about six months, obtained a post office box to receive forwarded mail, registered to vote in the state, obtained Nevada driver’s licenses, obtained a cell phone number with a Nevada area code, and opened new Wells Fargo bank accounts at a bank in Henderson.

Following their initial trip to Nevada and before the sale, the appellants took numerous other actions indicative of their intent to move, such as:

  • changing the address of their preexisting Wells Fargo account to reflect their Nevada mailing address;

  • updating a life insurance policy to reflect their Henderson address;

  • the appellant-husband getting an eye exam in Nevada;

  • purchasing, having serviced, and registering vehicles in Nevada (but also purchasing and registering vehicles outside the state);

  • hiring a Nevada firm to change their family trust from California to Nevada;

  • hiring a Nevada real estate broker to help them find a house (which they did not purchase until several months after the sale); and

  • executing the sale-closing documents in Nevada.

The appellants did not list their California home for sale during presale time periods because of the 2008 economic recession, continuing family obligations in California, and the appellant-husband’s focus on starting a new business in Nevada; rather, the home was listed in 2015. For approximately 145 days before the sale, the appellants spent about 20 percent of the time in Nevada and over 60 percent of the time in California (most of the remaining time was spend at their property in Arizona). For approximately 167 days after the sale, the appellants spent about 43 percent of the time in Nevada and about 14 percent of the time in California.

In determining if the appellants were California residents on the sale date, the OTA looked to the tax code’s definition of resident, which is either “every individual who is in this state for other than a temporary or transitory purpose” or “every individual domiciled in this state who is outside the state for a temporary or transitory purpose.”4 The appellants argued that they ceased being California residents and became Nevada residents on February 26, 2008 — the day that they secured a rental apartment in Henderson and approximately five months before the sale. The Franchise Tax Board, on the other hand, contended that the appellants were California residents on the sale date and did not become Nevada residents until September 29, 2008 — a week after they closed on a home in Nevada.

In its analysis of the residency issue and in accordance with the state statute, the OTA first examined if the appellants were domiciled in California on the sale date, then determined if they were “outside the state for a temporary or transitory purpose.”

Regarding domicile, California — like other states — defines the term as “the one location where an individual has the most settled and permanent connection, and the place to which an individual intends to return when absent.”5 An individual can have only one domicile at a time, and “in order to change domicile, a taxpayer must: (1) actually move to a new residence; and (2) intend to remain there permanently or indefinitely.”6 The OTA held that on the sale date, the appellants were domiciled in California. The basis for this ruling largely was the fact that for presale time periods, the appellants temporarily rented an apartment in Nevada while searching for a Nevada home. The OTA reasoned:

Appellants’ possession of a rental apartment was part of their plan to find a permanent home, but was not the actual move to a new residence with the intent to remain there permanently. The impermanence of the apartment evidences their intention of returning to their California home until they found a suitable Nevada replacement.7

The OTA’s reasoning raises an interesting question whether the agency would have ruled differently if the appellants had, before the sale, taken all or some of the following actions: sold or listed for sale their California home, moved their “near and dear” items to Nevada, and signed a longer-term apartment lease. If any of these events had occurred, then perhaps their “transition” apartment would have appeared more permanent and like the place where they intend to return when absent.

The OTA next examined if the appellants were outside California for a temporary or transitory purpose, which would support a finding of residency. Here, the OTA — in circumstances in which the appellants had significant contacts with more than one state — observed that “the state with the closest connections during the taxable year is the state of residence.”8 Of the facts that the OTA found persuasive (including where vehicles were registered, maintenance of post office box address, and where the appellants conducted business), it said that where the appellants were physically present during presale periods was the most significant. The OTA found that the appellants’ presence in California “far outweighed their presence in any other state” for presale time periods and “most persuasive” — “despite appellants’ actions to transition to becoming Nevada residents.”9 Further, the OTA rejected the appellants’ argument that their time in California in the months before the sale was temporary and transitory (time spent taking care of family members and occasional business); the quantity of time in California ultimately was too big of a hurdle for the appellants to overcome.

This demonstrates that if the appellants could have waited to make the sale at the end of the year at issue, this case may not have been brought by the OTA; the FTB agreed that the appellants were domiciled in Nevada as of late September 2008, at approximately the time when they closed on their Nevada home. Indeed, in addition to purchasing a new home, after the sale the appellants spent more time in Nevada and started a business there. But unfortunately for the appellants, the OTA found “the relevant date for this appeal . . . [to be] July 18, 2008 [the sale date], and . . . subsequent events unpersuasive to the residency determination as of that date.”10

As our country emerges from what appears to be the worst of the pandemic, many people find themselves transitioning to a new home in another state or considering such a move. In doing so, properly changing one’s state tax domicile is imperative to avoid state tax surprises. While Bracamonte involved an attempt to avoid tax on a large capital gain, it is still a good reminder for anyone trying to change state tax domicile that despite every intention to relocate, you should always make sure that your big-picture actions are consistent with that intent. This includes moving into the new home where you intend to reside indefinitely, spending most of your time in your new state, and, if possible, disposing of your old home. And if time is of the essence, you — like the appellants — may not have much time to transition, lest you find yourself with an unexpected tax bill.

FOOTNOTES

1 See Jerome R. Hellerstein, Walter Hellerstein, and John A. Swain, State Taxation, Part IV, ch. 20, para. 20.03 (2001), with updates through Apr. 2021 (online version accessed on Thomson Reuters Checkpoint May 13, 2021).

2 Matter of the Appeal of Bracamonte, OTA Case No. 18010932 (Mar. 22, 2021).

3 The parties seemingly agreed that the corporation did have a California business situs that would cause income from its sale to be taxable by the state for the 2008 tax year in the absence of a California residency determination. Id. at 5.

4 Cal. Rev. & Tax. Code section 17014(a). This case focuses on the second definition of resident. Illinois’s Income Tax Act contains a similar definition of resident (35 Ill. Comp. Stat. 5/1501(a)(20)), and most states use these concepts to define resident for tax purposes.

5 Bracamonte, No. 18010932, at 6 (citations omitted).

6 Id. (citations omitted).

7 Id. at 7.

8 Id. at 8 (citation omitted).

9 Id. at 9.

10 Id. at 8, n.9.

END FOOTNOTES

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