Tax Prophet ®
Distributions from Non-qualified Benefit Plans
and California Non-residency Issues
Taxpayer has lived and worked in California since 1990. and is retiring on April 1, 2001. He is building a home in Mexico and plans to live there permanently when it's completed in late 2001.
Taxpayer plans to sell his residence in California in spring, 2001. As soon as it sells, taxpayers will enter into a long term lease of a condominium in Reno, Nevada while his Mexican home is under construction. Taxpayer has a mail box in Reno and has changed all of his brokerage accounts, credit card accounts and other accounts to his Reno address. Ultimately, taxpayer plans to be a Nevada resident living in Mexico. Once the Marin residence is sold, taxpayer will have no assets, employment or business ventures in California.
Once taxpayer leaves California, his income will consist of dividends and interest on investments.
Taxpayer has two retirement income issues. First, he has a trust for highly compensated employees under the so-called "rabbi trust" rules (hereafter "Trust") comprised substantially of his company's stock. At the time, the taxpayer was a participant in the corporations ERISA retirement plan, which was liquidated in 1998. The purpose of the Trust was to offer retirement benefits in excess of the benefits provided by the ERISA retirement plan.
1. Once taxpayer leaves California in 2001, what steps are necessary to become a non-resident for California income tax purposes?
2. Will receipt of the Trust distributions be subject to California income tax?
3. Will receipt of the deferred compensation annunitized over 10 years be subject to California income tax?
1. Whether taxpayer is a non-resident for California income tax purposes depends on a variety of factors. The principal factors are whether taxpayer is physically present in California and whether he maintains his residence in California. Taxpayer plans not to be physically present in California and will not own any real property or business interests in California. Based on these factors, taxpayer becomes a non-resident once he permanently leaves the state.
2. Distributions from the Trust are considered retirement distributions and as long as taxpayer is not a resident of California when the distributions are received, he is not subject to California income taxes on the Trust distributions.
3. Receipt of the deferred compensation as a California non-resident is not subject to California income taxes, since the deferred compensation plan is considered a retirement plan under IRC Sec. 3121(v)(2)(C) of the Internal Revenue Code and payments are to be received in substantially equal amounts not less frequently than once a year for a period of not less than 10 years.
A. Factors Involved in the Determination of Whether the Taxpayer is not Resident in California
1. Residency Defined
Residents are individuals who are present in California for other than a temporary or transitory purpose. Nonresidents are any individuals who are not residents.
A taxpayer may have only one domicile at any one time and that domicile continues until it is shown to have changed. A taxpayer's domicile is the taxpayer's true, fixed, and permanent place of abode. The concept of domicile requires both physical presence and intention to make a place one's home.
Although numerous factors are evaluated in determining residency, the most important ones include physical presence in California, location of employment, business interests, bank accounts and other investments, ownership of real estate, location of family, and children attending California schools.
An individual is a resident of the state in which he has the closest connections during the tax year. A taxpayer is ordinarily found to be a resident of the state or country with which the taxpayer has the closest connections, determined by comparing contacts retained within and outside California. Thus, the more complete the severance of California ties, the more likely a finding of nonresidency.
2. Proving Non-Residency
Establishing the exact number of days a taxpayer is in or outside of California several years after the fact can be difficult. Evidence to support a taxpayers contention that he lives outside of California includes
(1) employment records detailing work performed inside or outside of the state;
(2) credit card charges, checks, or similar items (such as bills for local services) that establish the taxpayer's presence at a particular location (the existence of only short periods between charges at a single location can lead to an inference of presence at the same location between the two charge dates);
(3) testimony from neighbors of social contacts and the amount of time the taxpayer was present in a particular place; and
(4) phone or utility bills that demonstrate presence at a particular residence
Note: The above evidence does not conclusively establish a taxpayers residence, since the accuracy or conclusions drawn from any particular item may be questioned, and other factors may outweigh the above list.
3. A Non-exclusive List of Relevant Factors
An FTB Publication entitled "Guidelines for Determining Resident Status 1997 (FTB Pub, 1031) lists the following factors to be considered in the determination of residency
(1) The amount of time spent in California versus amount of time spent outside California;
(2) The location(s) of the taxpayers spouse and children;
(3) The location of taxpayers principal residence;
(4) Where the taxpayer was issued his drivers license;
(5) Where the taxpayers vehicles are registered;
(6) Where the taxpayer maintains his professional licenses;
(7) Where the taxpayer is registered to vote;
(8) The location of banks where the taxpayer maintains accounts;
(9) The locations of the taxpayers doctors, dentists, accountants and attorneys;
(10) The locations of the church or temple, professional associations and social and country clubs where the taxpayer is a member.
(11) The locations of the taxpayers real property and investments;
(12) The permanence of the taxpayers work assignments in California; and
(13) The locations of the taxpayers social ties.
Applying these factors to the facts in the present case, Taxpayer will not have sufficient contacts with California since he will not be physically present in California and his residence will be located outside California. Also, every important business, investment and social contact will be outside California.
4. Inconsistent Statements and Actions Cut Against a Non-Residency Claim
Taxpayers who make inconsistent statements with respect to residency usually have a difficult time proving they are not California residents. In addition to filing nonresident returns in other states, and claiming the California homeowner's property tax exemption, taxpayers may make other statements on federal returns, applications for membership in local clubs, and death or marriage certificates which are inconsistent and, therefore, damaging. Another problem area includes statements made in applications for admission to California colleges in which residency status is claimed for purposes of eligibility for in-state tuition.
5. The Residency Determination is Made After the Close of the Tax Year
A determination of residency is made after the close of the tax year when all activities and conduct can be evaluated. The determination requires an evaluation of the taxpayer's presence in or absence from California to determine if presence in or absence from the state is temporary or transitory. Based on an evaluation of all contacts, the state with which the taxpayer has the closest connections or contacts is ordinarily the state of residency. Contacts with California that seem relatively minor may take on a greater significance and may result in a finding of California residency if the taxpayer fails to show more significant contacts developed elsewhere.
6. Visitors and Tourists
Taxpayers who split their time between California and other states but whose business activities and social contacts are exclusively elsewhere are usually held to be nonresidents of California, even if they spend more time in California than in any other one state. Typically these cases involve wealthy taxpayers who spend winters in California vacation homes and who travel extensively. The regulations provide an administrative guideline stating that nondomiciliary seasonal visitors, tourists, and guests can be present in California for up to six months during a tax year without being residents, provided that they maintain a permanent abode at their place of domicile and do not engage in any activity or conduct in California other than that of a seasonal visitor, tourist, or guest. The six-months guideline in the regulations has been leniently construed, and taxpayers in the state for between six and nine months may be found to be nonresidents.
B. Distributions From the Trust to a Nevada Resident are not Subject to California Income Taxes.
1. Rabbi Trust Distributions
Taxpayer will receive distributions from the Trust (a rabbi trust) once be becomes a Nevada resident. A rabbi trust is an irrevocable trust which, because of retained administrative powers, is treated as a grantor trust under IRC Sec. 671-679. Consequently, beneficiaries of a rabbi trust are not currently subject to income tax on contributions to the trust by the employer, because the trusts assets remain subject to the claims of the employers creditors. The employee-beneficiary is taxed on trust distributions only when the trust funds are actually paid to him.
So-called "top-hat" plans, which are unfunded deferred compensation plans maintained by the employer for a select group of management or highly compensated employees, are exempt from most ERISAs provisions. A rabbi trust is one type of top-hat plan.
2. Pension Income Tax Limits Act
The Pension Income Tax Limits Act, 4 USC Section 114 [P. L. 104-95 (Jan. 10, 1996)] ("PITLA"), prohibits a state from imposing taxes on certain retirement income of individuals who are not residents or legally domiciled in that state. PITLA applies to amounts received after December 31, 1995.
The determination of an individual's residence or domicile will be made in accordance with the laws of the taxing state. Among the distributions it protects from state taxation are distributions from nonqualified deferred compensation plans, programs, or arrangements described in Section 3121(v)(2)(C), which includes the rabbi trust deferred compensation arrangement as discussed below.
3. Analysis of the Pension Income Tax Limits Act
Congress limited the power of the states to impose an income tax on retirement income of non-residents. Subsection (I) of 4 USC 114, exempts
any plan, program or arrangement described in Section 3121(v) (2)(C) of the Code, if such income
(i) is part of substantially equal periodic payments (not less frequently than annually) made for
(I) the life or life expectancy of the recipient (or the joint lives or joint life expectancies of the recipient and the designated beneficiary of the recipient), or
(II) a period of not less than 10 years; or
(ii) is a payment received after termination of employment and under a plan, program, or arrangement (to which such employment relates) maintained solely for the purpose of providing retirement benefits for employees in excess of the limitations imposed by 1 or more of sections 401(a) (17), 401 (k), 401 (m), (403(b), (408(k), or 415 of such Code or any other limitation on contributions or benefits in such Code on plans to which any of such sections apply.
The Trust falls under (ii) above since it is a plan maintained solely for the purpose of providing retirement benefits for employees in excess of the limitations imposed by the Internal Revenue Code. The taxpayer was a participant in the companys ERISA plan at the time the Trust was formed, and the sole purpose of the Trust was to provide retirement benefits in excess of the limitations imposed by the Internal Revenue Code. The Trust is a non-qualified deferred compensation plan described in IRC Sec. 3121(v)(2)(C) since it is not otherwise described in IRC Sec. 3121(a)(5). Both statutes are set forth below.
Because the Trust qualifies under (ii) above, federal law prohibits California from imposing an income tax on distributions to employee-beneficiaries who are non-residents of California. In addition, there is no legal authority in California discussing the taxation of rabbi trusts, much less attempting to impose an income tax on distributions to non-residents.
IRC Section 3121(v)(2)(C) reads as follows:
(C) Nonqualified Deferred Compensation Plan
For purposes of this paragraph, the term "nonqualified deferred compensation plan" means any plan or other arrangement for deferral of compensation other than a plan described in subsection (a)(5).
IRC Section 3121(a)(5) involves statutory compensation plans, and reads as follows:
(5) any payment made to, or on behalf of, an employee or his beneficiary--
(A) from or to a trust described in section 401(a) which is exempt from tax under section 501(a) at the time of such payment unless such payment is made to an employee of the trust as remuneration for services rendered as such employee and not as a beneficiary of the trust,
(B) under or to an annuity plan which, at the time of such payment, is a plan described in section 403(a),
(C) under a simplified employee pension (as defined in section 408(k)(1)), other than any contributions described in section 408(k)(6),
(D) under or to an annuity contract described in section 403(b), other than a payment for the purchase of such contract which is made by reason of a salary reduction agreement (whether evidenced by a written instrument or otherwise),
(E) under or to an exempt governmental deferred compensation plan (as defined in subsection (v)(3)),
(F) to supplement pension benefits under a plan or trust described in any of the foregoing provisions of this paragraph to take into account some portion or all of the increase in the cost of living (as determined by the Secretary of Labor) since retirement but only if such supplemental payments are under a plan which is treated as a welfare plan under section 3(2)(B)(ii) of the Employee Retirement Income Security Act of 1974,
(G) under a cafeteria plan (within the meaning of section 125) if such payment would not be treated as wages without regard to such plan and it is reasonable to believe that (if section 125 applied for purposes of this section) section 125 would not treat any wages as constructively received;
(H) under an arrangement to which section 408(p) applies, other than any elective contributions under paragraph (2)(A)(i) thereof, or
(I) under a plan described in section 457(e)(11)(A)(ii) and maintained by an eligible employer (as defined in section 457(e)(1));
C. Deferred Compensation Annunitized over 10 Years
Taxpayer has a deferred compensation plan that will be paid to him after retirement in 10 equal annual installments. Since the plan is a nonqualified deferred compensation arrangement within the meaning of IRC Sec. 3121(v)(2)(C) and the payments are substantially equal, then it should qualify under 4 USC 114 (I) and California cannot impose an income tax on non-residents receiving distributions from such a plan.
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