Helping Clients Thrive!
Helping Clients Thrive!
Tax Strategies
MAJOR DONATION TO THE SALVATION ARMY, GOODWILL & OTHERS REQUIRE FORM 8232 & AN APPRAISAL
In a recent case, Duncan Bass worked hard, two jobs, and always gave to charities. In two years, he claimed $13,852 & $11,594 in 173 donations of $250 per group to avoid the need for an appraisal. On audit & in court proceedings, these deductions were denied.
Duncan failed to realize that under IRC Section 170(f) (11) (F), the grouping of similar items of property that tally over $5000 require an appraisal.
So if you are at a high level of donations, follow the rules, gain an appraisal and file IRS Form 8283. Otherwise you’ll not gain the deductions and be taxed.– you’d have to file a tax return without the charitable deduction – so there will be taxes, penalties & the costs of tax returns, state & federal.
CALIFORNIA SOURCE INCOME
California nonresidents are subject to California state income tax on their California Source Income. The State of California taxes its residents on all their income, including income acquired from sources outside the state. Nonresidents are also subject to California income tax, but only on their California-source income. The Franchise Tax Board (FTB) is aggressive in pursuing its taxes and audits individuals with California ties who claim residency in another state.
How does California determine residency for tax purposes? California’s definition of residency is very broad. The Franchise Tax Board looks to 19 factors to determine whether California is the state to which you maintain the “closet connection.” These factors include (but are not limited to) where you spend the majority of your time; which state provided your current income; where you are registered to vote; where you earn your income; and your personal connections such as your primary doctor, country club, and church.
FTB Publication 1031 provides guidelines on the California nonresident tax rules for California Source Income:
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Wages and Salaries. Wages and salaries for services performed in California, regardless of the location of the employer or the employee (or where the payment was issued), are taxable to nonresidents.
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Community Property Income. If your spouse is a California resident, your income is considered community property and is split equally between the two of you. Your community property share of that income is taxable to you in California even if you have never lived nor worked in the state.
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Business Income. Nonresidents may be taxed on any income from a business, trade or profession that is carried out in California. In addition, income from partnerships, S-Corporations and trusts are taxed to nonresidents if it comes from sources within California. If you are a nonresident with a business, trade, or profession that conducts business both within and outside California, the income generated from business you conduct within California is California Source-Income and is taxable in California.
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Real Estate Sales. The source of any gain or loss for the sale of real estate in California is source income. California therefore taxes nonresidents on gains from the sale of their California real estate.
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Stocks and Bonds. Gains and losses from stocks and bonds have a source where you reside at the time of the sale. If you are a nonresident, you will not pay California tax on income from stocks, bonds, notes, or other intangible personal property unless (1) the property has its business situs in California (meaning, it is located here by law) or (2) you regularly, systematically, and continuously buy and sell such property in the State of California (California Revenue and Tax Code § 17952).
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Retirement Income. In accordance with federal law, the State of California does not tax retirement income received by a California nonresident after December 31, 1995. This includes, but is not limited to, IRA distributions, SEPs, Keoghs, Roth IRAs, and qualified annuities.
Credit for Income Taxes Paid Elsewhere. California residents can receive a credit on their California State tax return for taxes they paid in most other states. Nonresidents generally take the credit for their California taxes on the tax return of their state of residence. Check with your tax attorney to see if a state tax credit is available to you.
AVOIDING SELF-EMPLOYMENT TAXES FOR PARTNERS IN PARTNERSHIPS (GENERAL & LIMITED) AND LIMITED LIABILITY COMPANIES
Self-employment taxes are substantial – 15.3% of an individual’s wages. Here are the general rules governing partnership (general and limited) and limited liability companies:
1. If you are a general partner in a general partnership or other entity taxed as a general partnership, you must pay self-employment tax on your entire distributive share of the ordinary income earned from the partnership’s business.
2. Limited partners don’t pay self-employment tax on their distributive share of the partnership’s profits.
3. Both general and limited partners pay self-employment taxes on any guaranteed payments for services performed for the partnership.
4. LLC members classified as general partners pay self-employment taxes on their distributive shares but avoid such tax if classified as limited partners, i.e., separate your participation.
5. IRS proposed regulations provide that LLC members are classified as limited partners only if they lack authority to enter into contracts for the LLC or work less than 500 hours per year in the LLC business.
6. IRS proposed regulations always classify members of service LLCs as general partners.
7. The Tax Court has held that LLC members can be classified as limited partners for self-employment tax purposes only if they are passive investors who do not actively participate in the LLC’s business.
Be sure that your partnership and limited liability company’s Operating Agreements properly restrict your activities, duties and responsibilities they should be consistent with these Rules. The IRS has proposed regulations, but Congress has not approved them. The Tax Court is developing its own criteria for inclusions/exclusions of self-employment tax liability with partnerships and LLCs. Cease being a partner and legally avoid self-employment taxes if you are not actually a partner in the business with decision making entitlements. Under number 5. It is possible for participants to be general and limited partners in these entities and thereby avoid being classified as “employees”.
Be Careful; Don’t be overzealous; Don’t have your documentation undermining your position when you are audited by the IRS.
OUT-OF-STATE TRUST CAN AVOID CALIFORNIA TAXES ON OUT-OF-STATE INCOME
Many individuals from States with no state taxes (Nevada, Texas) enter California and become California residents. Properly structured, income from outside of California can legally avoid California state taxes, the highest state taxes in the United States. Out-of-State Trusts with Out-of-State Trustees and administration will only be subject to California taxes on the income received by the California resident. North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 1395 S.Ct. 2213 (2019). Without proper structuring, an individual may be subject to tax on 100 percent of such income as being California sourced. Steuer v Franchise Tax Board (2020).
The United States Supreme Court has determined that States may tax income if there is exists (1) a minimum connection between the State and the person, property, or transaction it seeks to tax and (2) that there is a rational relationship between its tax and the activities occurring within the State. Particularly, States may tax trust distributions to an in-State beneficiary and the Trust income if the Trustee administered the Trust in that State. Safe Deposit and Trust v. Virginia, 280 US 83 (1927) and Brooke v. Norfolk, 277 US 27 (1928).
In summary, it is important to consider all the factors that bear upon the particular situation, all of which, if properly structured, may allow for avoidance of California state taxes on income from outside of the state of California. Some of the factors that the US Supreme Court provided for consideration are:
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Income Distributed to an In-State Resident
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Residence of Trustee
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Site of Trust Administration
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Residence of the Grantor/Settlor
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Control, Composition, and Ability to Use and Enjoy an Intangible Asset in the Trust
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Trustee’s Exclusive Control
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Governing Law
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Physical Location of Trust Record
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Physical Location of Asset Custodians
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Direct Investments in the Taxing State
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The Number of Meetings between the Trustee and Beneficiary
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Geographic Location of Meetings Between the Trustee and the Beneficiary
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Termination of Trust at a Specified Age; Ability of Resident Beneficiary to Become the Trustee, Automatically or Having the Right.
In conclusion, in coming into California, the California Franchise Tax Board will probably consider you to be a California resident (see FTB Publication 1031). By appropriately structuring your assets in an Out-of-State Trust with an Out-of-State Trustee and administration, it may be possible to avoid California State Taxes on the income within your Trust that is not received in California.
CALIFORNIA NON-PROFIT TAX RETURNS – DO NOT DISCLOSE DONORS
For non-profit organizations, it is no longer necessary (or appropriate) to display donors on California’s tax returns. The United States Supreme Court in Americans for Prosperity v. Bonta held on July 1, 2021, that such disclosures on California tax returns violated First Amendment rights.
Chief Justice John Roberts is a strict constitutional constructionist and wrote the majority opinion. He found that the disclosure requirements were overly broad and were not narrowly tailored to meet California’s needs --- this is the legal test for justifying governmental intrusions on all Constitution rights.
What’s next --- striking down the federal IRS donor disclosure requirement and/or the federal campaign financing disclosures. For the moment, do not make donor disclosures on your California state non-profit organizations tax return. As otherwise you may draw a lawsuit for such disclosure by the donor (and the loss of those donations).
CALIFORNIA FRANCHISE TAXES DUE FROM OUT-OF-STATE LLC
Out-of-state limited liability companies are required to pay California’s franchise tax in spite of very limited investments in California LLCs. Recently, a Delaware LLC with a 0.78% membership interest in a Delaware LLC, which owned and managed property in San Diego, was required to pay California’s franchise tax. Under Section 23101(b) of California’s Revenue and Taxation Code, if an LLC’s real and tangible property exceeds Fifty Thousand Dollars ($50,000), as adjusted by inflation, then the LLC is deemed to be “doing business” in California. Under Revenue and Taxation Code section 23101(b), an LLC’s property includes the LLC’s “distributed share of past-through entities”. In this instance, a 0.78% interest equaled $481,000, significantly over the threshold. Thus, if you are an out-of-state LLC invested in a California LLC, please realize that franchise taxes are due to the State of California. In your interest is worth more that $50,000 as adjusted by the cost-of-living rate yearly.
For California corporations, the rule is the opposite under Swart Enterprises, Inc, v. Franchise Tax Board, and Revenue and Taxation Code, Section 23101(a). Swart, a corporation, held a 0.2% membership interest in a manager-managed California LLC. The court determined that it was not “doing business” in California under Revenue and Taxation Code, Section 23101(a). The court found that such a passive interest, without management authority, and did not meet the section’s standard of “actively engaging in a transaction for the purpose of financial profit or gain”. The Franchise Tax Board obviously is frustrated with this decision and vows judicial and/or legislative intervention.
The Takeaway: If you are an out-of-state entity investing in California LLCs, do that investment by an out-of-state corporation and do not have any active involvement in the California entity. It is also highly suggested that you have the entities and investments reviewed by a California attorney, as we have done for other out-of-state investors.
ESTATE TAX AVOIDANCE – FAMILY LLCS AND LIMITED PARTNERSHIPS
If your estate is close to $11.7MM (individually) or $23.4MM (couple), family LLCs or Limited Partnerships are an easy way to legally avoid Federal estate taxes that apply after these levels …………. And place your current estate with your loved ones without including the IRS. This just involves a little estate planning in advance to form one of these entities and include your loved ones for a small splinter of your assets.
The reason for the reduction of the estate from its current (and future) market value is that discounting is applied to the gross value since the full value is not being transferred. The discounts are for the lack of marketability (usually about 25%) and for the lack of control (about 10%). Thus the fair market value of the estate you are transferring falls about 35% total.
This approach was just confirmed in a Tax Court Memorandum (Decision) in Grieve v Commissioner, TCM 2020-28. Parents thru LLCs transferred over $40MM of assets in which they owned 99.8% thru Class B nonvoting ownership interests and their daughter owned .2% interests thru Class A voting interests. Discounts were 35% and 38% so that $25MM passed to the daughter tax-free of any estate taxes.
This result required significant advance planning with attorneys & appraisers. Everyone prostiganites on estate planning but this is an example in which $15,000,000 transferred that otherwise would have gone to the IRS rather than their daughter. Whether your estate is large or small, take the time – do the planning and make sure that your heirs receive the benefits of your hard work over your lifetime.