California Compliance Potpourri

Torakichi Jesús Oba Pérez, EA, CPA, and Kelly Blocker, CPA; CalCPAs

 

Being a born and raised Californian, I have come to accept certain truths about the California taxation system, which I tend to forget does not necessarily apply outside of my state. Here are a few pointers to consider when dealing with former Californians who could still very much have California income tax to consider although they may have successfully (or unsuccessfully) ceased to be California tax residents.

 

1. Estate Planning

Make sure that inbound Californians update their estate plans for Texas laws/considerations. As much as I love California, I don’t think that feeling would extend to someone passing away without a will with assets in California and Texas. In such cases, it is more than likely that two probates would have to be administered, which ranks low on the scale of desired outcomes for beneficiaries.

Additionally, non-resident beneficiaries of California situs assets would also be subject to backup withholding on any income from the assets of the estate, so when completing the updated estate planning, be sure to keep an eye on any California situs assets and understand the eventual implications of inheriting those assets.

 

2. California LLC Considerations

A good resource to understand what the compliance implications are for California LLCs is FTB Publication 3556. It is filled with information that may be particularly eye catching for non-California practitioners:

        a. Single Member LLCs

Keep in mind that a single member LLC is a disregarded entity for federal tax purposes, but still must file a California Form 568 for every year it has conducted business, as well as pay their applicable LLC annual tax and LLC fees.

        b. Doing Business in California

The section of Pub. 3556 gives an overview of what doing business in California is considered to be and gives specific examples for non-California LLCs that run into California filing requirements because they are interpreted to be doing business in California.

I would pay particular attention to the examples that give an overview of non-California LLCs that are considered to be conducting business in California.

 

3. Management of an LLC

If an LLC is located, operated or managed in California, the LLC is considered doing business in California. This remains true even if the LLC is not a California LLC. If the LLC is located or operated in another state with no business activity in California and no management decisions are made by the California resident manager, the LLC is not considered doing business in California. This becomes especially important because management activities, location and source of sales drives income sourcing.

 

4. Income Sourcing on Sale of an LLC Interest

When an LLC member sells their interest, the sourcing rules vary depending on the assets/interest held/sold. For former Californians considering selling their LLC interests, a few key considerations to ask a potential client are – did the LLC hold inventory, have receivables, have other tangible property subject to depreciation recapture? California generally treats the sale of an LLC interest as a sale of intangible personal property, generally sourced to the seller’s current state of residence. However, per FTB Legal Ruling 2022-02, unrealized receivables or appreciated inventory necessitate the treatment of the sale as two separate sales – (1) the sale of the member’s interest in any unrealized receivables and/or appreciated inventory (is likely to have gain sourced to California) and (2) the sale of the remaining LLC interest (treated as an intangible).

 

5. 1031 Exchange - Isley Brothers Edition

I had a great idea once to take a client’s unrealized gains on their California situs real estate investments and 1031 exchange it to non-California situs property thereby getting rid of any future California tax bill. I was, however, foiled by the forward-thinking folks at the Franchise Tax Board, which requires an annual information return, Form FTB 3840, to be filed annually until the gain is realized and tax is paid to the state of California.  

Much like the haunting refrain from the Isley Brothers’ “Voyage to Atlantis,” the Franchise Tax Board will always come back to you to request their share of the tax on the eventual gain recognition, and if you do not file your 3840 in a timely manner, the Franchise Tax Board may issue a Notice of Proposed Assessment to adjust the income for the California sourced deferred gain and assess tax plus any applicable penalties and interest.

 

In summary, a good rule of thumb may be to assume that anything from California comes with certain strings attached, and the work remains to understand and explain those strings to our clients.

Comments

[don grefe]

I ran into the fact that CA wants NR tax for 1099 income paid to non-residents by a CA corp.
Like the Eagles said about Hotel California -"you can check out any time you want but you can never leave".