RELOCATING SERVICE CONTRACTS: THE RESIDENCY TAX PITFALLS (Part I)

October 8, 2012
By Michael Brooks on October 8, 2012 3:59 PM |

It's no secret that California has a high state income tax rate. In fact the Golden State competes with New Jersey and New York for the highest rate in the nation. Nonetheless, despite somewhat overblown media reports, most Californians aren't in a position to tear their businesses up by the roots and transplant them to low or zero income tax havens like Nevada and Florida. Often those businesses have to operate in California, since that's where the market for the product or service is, and typically for small businesses, the owner has to be present here in state for the enterprise to grow.

But that's not always the case, especially when a taxpayer owns numerous entities and some of the income derives from service contracts (usually for management work) among the entities or between the entities and the owner. In that case, some strategic use of out-of-state entities can result in large tax savings that might make the major step of relocation worthwhile.

But before we can address the benefits and pitfalls of relocation, we need to first give an overview of California's income tax system relating to residency. California taxes residents with respect to their "global" income. This means that for a California resident, income from whatever source - whether in-state or out-of-state - is subject to California taxation. There may be credits for payment to other states, and there may be other mitigations of the taxes due. But leaving that aside, California residents generally must pay significant state income taxes on all the income they make, from whatever source. Let's call this Rule #1: taxation of all income based on the California residency of the taxpayer.

In contrast, nonresidents only have to pay California income taxes to the extent that the income is "California source." If a nonresident has no California source income, the taxpayer isn't liable for any California income tax. California source income means income derived from a business or real property with a situs in California, or from work performed here. That income is subject to taxation by California, even if the taxpayer is not a resident. Let's call this Rule #2: taxation based on the source of the income being situated within California.

The rules relating to who is a resident and who isn't get very complex and fact specific. I won't get into them here. See Christopher Manes' A GUIDE TO SUCCESSFUL (TAX-FREE) SNOWBIRDING and THE PART-TIME RESIDENT TAX TRAP, on the Sanger & Manes website. Suffice it to say that if a taxpayer follows the necessary steps, he can change residency to a lower tax state. The issue is, when is such a major relocation worthwhile? We'll review question that in Part II.