Surviving a Residency Audit

A few years ago, one of my clients (call him Bob) moved from California to Nevada.  He then had a very large capital gain (but while a Nevada resident).  At the time, I advised him that a residency examination (audit) from California’s Franchise Tax Board (California’s income tax agency) was likely.  Bob’s audit just concluded with a “no change” letter being issued.  Why did he have a successful result?

1. Bob engaged with me prior to the move.  We discussed what he needed to do, the records he needed to keep, and things not to do after his move.  Bob listened, and (as noted below) kept his records.

2. Bob moved.  Seriously, the most important aspect of not being domiciled in the state you’ve been residing in is to establish a new domicile in another state.  That means actually moving!  Did Bob’s family all move with him, or were his children still attending schools in California?  Did Bob purchase a home (or rent a home)?  Did Bob either put his old home for sale or rent it out long-term?  Was Bob’s new home a real home, and a not a summer cottage?  The Franchise Tax Board has seen all the dodges you can imagine (and probably some you haven’t) in moving without moving.  The key aspect is to really move.  Bob did.

3. Do all the little things.  Bob changed his addresses with his financial institutions, registered to vote in Nevada, obtained new Nevada driver’s licenses and registered his cars as quickly as possible; he and his family divorced themselves from California.

4. Keep your records!  Bob kept all the records that were needed: the contract with his movers, his lease of his new home, the sales contract for his old (California) home, etc.  Digital (electronic) copies are just fine (but they need to be accessible and, depending on the tax agency, you may need to print them all out).

5. Cooperate with the auditor.  The auditor is doing his job, and if you treat them well and send everything as requested, you will likely get a better result than when you don’t cooperate.

6. Realize a residency audit might happen years after your move.  Bob’s residency audit occurred over two years after he filed the tax return noting the move.  That’s typical for California.  (I’ve only dealt with a residency audit from one other state, New York, and that also occurred two years after the return was filed.)  California’s statute of limitations is four years from due date or date of filing (whichever is later).  We recommend you keep your tax records for seven years (from the year in question); if you’re filing a California return, we recommend nine years (California’s extended statute of limitations is eight years; the IRS’s extended statute is six years).

7. A residency audit will take some time to resolve.  Bob’s residency audit ended six months after it began–about what I expected.  Residency audits involve the auditor reviewing records, and the more records you have the longer it will take.  And you want to have all the records.

8. If you’re going to have a large capital gain after moving, try to make sure the gain occurs as far after the move as possible.  Let’s say that today (May 7th) you’re moving from New York to Florida.  You then sell some stock for a $30 million capital gain.  Ideally, you would want that sale to be as late as possible after the move (not the next day).  In Bob’s case, that time period was supposed to be weeks after the move but ended up being just days after.  Bob still survived the audit–because he really did move when he said he did.  The more time between the move and the gain, the less likely a residency audit; the best audits are the ones that don’t happen.

9. Try to stay out of your old state after the move.  Bob kept out of California after his move to Nevada in the tax year in question (except for one trip related to the sale of his old home).  If you’re spending all your time in your new state and not your old state, it reinforces that you have established a new domicile.

If you have a high income and you move from a high-tax state (such as California or New York) to a low-tax state (such as Nevada or Florida), you should expect a residency audit.  If you prepare in advance for it–and you really moved–you can end up with a no change result.

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