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.