It’s no secret that California has a high state income tax rate. In fact the Golden State competes with New York and Hawaii for the highest rate in the nation — and usually wins. 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. And as e-commerce continues to grow in market share, a physical presence in California becomes less and less necessary. In cases like this, 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 legal resident for tax purposes and who isn’t get very complex and fact specific. I won’t get into them here. 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?
To evaluate this, the distinction between Rule #1 (California income taxes incurred due to residency), as opposed to Rule #2 (California income taxes incurred due to sourcing) is extremely important. Taxpayers are more or less in control of their residency; they can pull up stakes and move. However, the source of income is not as easily controlled. In many cases, the operations that bring in the income rely on California’s market, which is often the market the owner knows and understands. There is no point in moving out of state to avoid the application of Rule #1, if Rule #2 is still going to apply.
But let’s look at the nuts and bolts. It’s not unusual for a business owner to have a corporation and several related tax pass-through entities, such as limited liability companies or limited partnerships, which produce income by providing goods or services here in California. The corporation often provides the LLCs with administrative services, and charges accordingly. Generally, the owner will hold the corporate stock in a family trust. In cases like this, creative relocation can have worthwhile tax benefits. Here’s how.
First, remember Rule #1. Since the point of most business enterprises is to get money into the pockets of the owner, if the owner remains a California resident, relocating the corporation won’t help a bit by itself. Assuming all the income from operations passes through the entities (including the trust) to the owner, it will be taxed by California because of Rule #1. All of a resident’s income is taxable by California. So in situations like this, if a strategic relocation is in the cards, step one is for the owner to change residency to a lower tax or non-income tax state. Obviously that’s a big step. It means major change. But if reducing state income taxes is the goal, it’s the sine qua non of residency tax planning.
Second, remember Rule #2. Moving out-of-state won’t change anything if the source of the income derives from California. The premise here is that the owner’s market is in California, so he can’t move the operations. Paying California income taxes on that is the price we pay for benefiting from the Golden State’s large market. That said, what doesn’t have to be performed here is the administrative services: the management, accounting, etc., that the corporation carries out for LLCs. The source of income from personal services is the location where the services are performed, and not where the nonresident lives, the location where the contract for services is entered into, or the place of payment. Cal. Code Reg §18662-5. Therefore, if the services aren’t performed in-state, it may not be California source.
Thus step two involves creating a new entity in a lower tax or non-tax state (or the owner can perform those services upon changing residency) to provide the administrative services. In that situation, neither Rule #1 nor Rule #2 applies to the fees charged by the corporation. The services are not rendered in California, so they are not California source. Neither the entity nor the owner are residents, so their global income isn’t subject to California taxation.
Now, there are complexities with this, as with any tax situation.
The rule about location of performance is strict. If even some of the work is performed in California (say by the owner coming to California to inspect the business), the payment, or a portion thereof, will be deemed California source under special allocations rules. Cal. Code Regs.18 18662-2. Indeed, if the entity is performing other services in-state, or otherwise doing business in California, all the income from the services may be taxable by California. In the Matter of the Appeal of William-Sonoma, Inc., and Subsidiaries (June, 26, 2012). Therefore, to avoid the application of Rule #2, it is very important to “wall-off” any nonresident entity or person from doing any business in California.
Furthermore, new and complex rules went into effect in 2011 regarding what constitutes “doing business in California” for entities. Partnerships and LLCs are considered doing business in this state if they have general partners or members in this state. Likewise, partners and members are considered doing business in this state if the partnership or LLC is doing business in this state. Further, if a partnership or LLC has employees working in California, it might result in the entity being deemed doing businesses in California, even if most of its operations have nothing to do with California. The regulations include thresholds for amounts and percentages of income derived from the California market. The point is, depending on how the owner’s entities are interrelated, one or all of them might be deemed “doing business in California” for taxation purposes. Therefore, relocators need to carefully scrutinize those relationships to insure none of them can be used to impute “doing business in California” to the nonresident entity.
It’s also noteworthy that any equity distributions from the California entities to the out-of-state entity or the owner derives from operations in this state. California applies a source-based concept of taxation for full-year nonresident partners. Appeal of Lore Pick, 85-SBE-066; (June 25, 1985), Appeal of George D. Bittner, 85-SBE-111 (October 9, 1985), Appeal of Estate of Marion Markus, 86-SBE-097 (May 6, 1986); FTB Legal Ruling 2003-1. Essentially, California requires owners of pass-through entities to treat items of income, deduction and credits earned by such entities as if the items were earned by the owners at that time.
Similarly, nonresident shareholders are taxed on the portion of their distributive shares of an S corporation’s income or loss, which are derived from sources within the state. Valentino v. Franchise Tax Board (1993) 25 Cal.Rptr. 282; Rev. & Tax. Cd, §17951. This is a bright-line rule that can’t be avoided. (Dividend income from C-corps is treated differently and generally is sourced not to operations but to where the recipient resides, but that’s another story).
So, in my scenario, while you may be able to free service contracts from California taxation, the same isn’t true for the profits of the companies engaged in operations.