California Residency Tax Planning
It’s no trick to leave California to avoid its high income taxes – if that’s all you want to do. You can sell all your California assets, including your home, terminate all business contacts, never spend any time in the state after your move, close all your financial accounts, sever all your professional and social connections. And so forth. Taxpayers who leave California lock, stock, and barrel don’t really have to worry about residency issues (despite scary stories on the internet). But in fact, most people who change their legal residency from California have something else in mind. They also want to or have to retain contacts with the state. That might mean a vacation home or income properties; it might be managing a California business remotely, with operations in the state; it might involve working while in California, from meeting potential clients or investors to working at a branch of an employer for designated periods. The last situation, which is fairly common, requires planning, since changing residency may not be enough to avoid California income taxes if your work for an out-of-state or in-state employer brings you back to California.
When Changing Residency Isn’t Enough
A typical situation involves a business owner who changes legal residency and moves the business out of state. But it can also involve an executive who moves out of state, but still has to make business trips to California, because that’s where the company’s client base or operations are located. Well and good. Unless a taxpayer changes legal residency, everything else is moot from a tax perspective. But the fact is California is an economic powerhouse. Few businesses, especially those in high-tech and financial services, can succeed without participating in the California market. And that often means meeting with and cultivating potential clients or investors in Los Angeles or Silicon Valley, where the capital, expertise and demand resides, or spending time working at a California branch of the company.
If that’s the case, it’s important to understand the differences between personal residency versus doing business in California versus working while physically present in California. These are three separate tax circumstances, which require different approaches to manage.
Personal Residency and Business Trips
Here’s the rule for individual residency: if you taken the steps sufficient to established legal residency in another state, traveling back to California for a temporary or transitory purpose won’t make you a resident. You would have to return to California for purpose involving a permanent or indefinite stay to risk reestablishing legal residency. Generally, traveling to California for a specific business purpose, such as meeting with potential investors, making a sales pitch for your company, or working on limited tasks for your employer, is consistent with a temporary or transitory purpose.
Of course, the outcome might be different if your business activities bring you to California so regularly and for such long periods of time, that you begin to accumulate the indicia of permanent residency. This might involve long-term living accommodations (a second home), even if paid for by the company; a vehicle registered in California, again even if your company holds title; final accounts; professional licenses; important social connections; etc. The details matter in those cases. The test used by California to determine residency is summarized here.
However, you can plan around this problem. If a nonresident needs to make business trips to California, a little foresight can avoid most of the traps that confer legal residency or trigger audits. You can stay in hotels or use Airbnb. You can rent a vehicle. You can limit your time in-state and use Zoom – or the old fashion telephone. There are always costs and inconveniences involved in planning for nonresidency for taxpayers with significant contacts with California. But they are manageable.
Doing Business In California
That said, even if your trips to California don’t make you a resident, they may result in your company “doing business in California,” subjecting it to the state’s income taxes. What constitutes doing business in California can be a complex issue, involving whether the clients are individuals or entities, how much revenue is derived from California, the nature of the service or the product sold (intangible versus tangible). Meeting potential clients in California might not ever rise to the level of doing business. But entering into contracts during those meetings easily can.
If your company pays you for your work while in California, you may have California-source income, even if your work produced no actual revenue
Ultimately, the legal standard for doing business in California is spelled out in excruciating detail under California Rev. & Tax Code section 23101 and its intricate NFL-like regulations I won’t get into the standard here. The point is, even if your presence in California doesn’t create a residency status problem for you personally, it may result in a taxable nexus for your out-of-state business. For companies already doing business in California, because that’s where the market is, this is a moot point.
Working While Present In California
But there’s more to it than that for the individual nonresident. Even if you aren’t a resident, and even if your presence in California doesn’t rise to the level of your company doing business here for tax purposes, the next question is, does any particular trip to California produce California-source income for you individually? This is the third way California taxation might impact a former resident who returns for business purposes.
The rule is this: if you perform work for your employer (whether the employer is located in California or in another state, and whether you’re a principal of the company or not) while physically present in California, the W-2 compensation for that work may be taxable by California as California-source income. Let’s say you meet with a potential client in California but no contracts are ever executed, and no revenue generated. There is no California-source income to tax for the company. But if your company pays your salary for your work while in California, you may have taxable California-source income, even if your work produced no actual revenue.
Or to use another common example: a former resident comes to California to stay at a vacation home. While there, the taxpayer performs work for his employer, which can be an out-of-state business or a California company, and the taxpayer can be either an owner (who receives W-2 income because the entity is an S or C corporation), or an officer/executive with no ownership interest. In the normal course, the W-2 income related to that work is subject to California income taxes.
For California income tax purposes, W-2 salary is sourced to where the work related to the compensation was performed, not to the location of the employer who pays the salary. For instance, if a S-corp pays W-2 salary of $500,000 to a nonresident shareholder/officer, and if the officer performed services to the corporation while in California for two months out of the year, one-sixth of the annual compensation, or about $80,000, is California-source, taxable by California. As a practical matter, wage income is often only a small portion of the total distributions business owners receive from their companies, unless they are highly compensated officers. They are more likely to have higher K-1, distributive share, the sourcing rules for which are entirely different. So the amount at issue may not be significant However, that’s not always the case, particularly with highly compensated executives who aren’t founders, or taxpayers who use loan-out corporations, such as actors, artists, and musicians.
The tax implications can be even worse if a vesting equity compensation plan is part of the nonresident’s compensation package. Non-qualified plans are generally taxed as wage income, not capital gains. California’s approach to taxing such plans is to multiply the taxable income by a factor equal to the number of work days in California during the vesting period divided by the total number of work days during the vesting period. The resulting income is deemed California source. Needless to say, if the stock options or other vesting equity are related to a startup that hits the jackpot in an IPO or a merger and acquisition, the value of the equity compensation and hence the income tax potentially due to California may be enormous.
Nonresident business owners have some control over how this income from work performed in California is characterized and calculated. For instance, if the out-of-state company is a S-corp, an employment agreement can state that no portion of a shareholder’s wages shall be related to work in California. Or perhaps, more reasonably, the agreement can state that that the work shall be calculated on an hourly basis, not a work-day basis, which the employee will keep track of. Or the owner can allocate the time in California to paid vacation. Or the books and records of the company can attribute the work to distributive share (K-1) not salary (W-2). Whether the Franchise Tax Board, California’s tax enforcement agency, would accept these characterizations is another matter.
Note that, for good or ill, LLCs and other partnerships don’t provide this type of flexibility when it comes to work in California. While guaranteed payments are treated like wages for certain federal tax purposes, for California sourcing purposes, it doesn’t matter whether guaranteed payments are paid for work in California or out of state. California sources all LLC revenues and taxes it accordingly. It doesn’t matter if the revenues are distributed to members as distributive share or guaranteed income. If the revenues are sourced to California, California requires the nonresident member to report the income on a nonresident tax return (Form 540NR), regardless of the amount of work performed by the member in California, if any. This can have advantages or disadvantages, depending on how much revenue the company derives from California sales, and how much work is required by the member in-state.
Note further, there are threshold reporting requirements for nonresidents with W-2 income. Some de minimis income may not need to be reported. Your CPA can provide guidance on that. But generally, for highly compensated executives and key employees, even a short amount of time in California may generate California-source income that exceeds the reporting limits.
To add more complexity, former residents often make return trips to California for more than one purpose at a time. It may be a business trip, but it also may involve vacation time or visiting family and friends. Be careful about mixed purposes. If you come to meet a client or otherwise work on a task within the scope of your employment duties, and then you also stay several weeks for non-business purposes, unless there is a written agreement with your company that specifies otherwise, the FTB could interpret the entire trip as business-related. If that time adds up, and if you have high-wage income, then the taxable amount allocated to the trips can result in significant a significant tax obligation. That’s why if you are going to work in California as a nonresident, you should always have a written agreement that specifies what constitutes “work days” and what doesn’t, and you must keep track. See, “Nonresidents Working Remotely for California Businesses: How To Take Paul Newman’s “The Sting” Out Of Your Taxes.”
To summarize: there are three separate conditions which might result in a former resident who returns to the state for business purposes having to pay California income taxes. If the trips fail to meet the temporary/transitory standard, they can confer residency, which means all of the taxpayers taxable income is subject to California income taxes. The trips may also result in your company doing business in California and hence having tax filing obligations at the entity level. Finally, your work while in California may produce taxable California-source income. If a significant amount of tax liability is at stake for any of these situations, some planning is in order.
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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.
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