Nobody needs reminding that California is a high income tax state. Most people know there can be tax benefits from changing residency or maintaining nonresidency status where California is involved. With a top bracket rate of 13.3%, California residency at the time of a large capital gains event (such as a startup sale or IPO, for instance), can result in millions of dollars of state income taxes, while across the border in Nevada, the tax would be zero. But details matter. The amount of tax savings, if any, achievable through strategic residency tax planning depends on various moving parts: sources of income, types of compensation, connections people want to or must maintain with California, community property rules (for married couples), the cost and inconvenience of acquiring nonresident status, to name a few. The refrain found everywhere on the internet that huge tax savings beckon every resident to flee the state is simplistic at best. Accordingly, considerable forethought, usually with CPA assistance, is advisable before committing to a residency plan. This article discusses why.
HOW CALIFORNIA TAXES RESIDENTS VS. NONRESIDENTS
First the basics.
California residents are subject to California state income tax on all their taxable income regardless of the source. It doesn’t matter if the income comes from the moon, if it is taxable, then California tax system claims jurisdiction. It’s possible a California resident to qualify for a credit for taxes paid in another state for out-of-state income, and some income types are exempt on their face in California (such as social security retirement benefits), but the default rule remains: a resident’s worldwide income is subject to California income tax. Period.
For nonresidents, California state income tax applies only to their “California-source” income. California-source income takes many forms, some obvious, some downright elusive. It could be rents derived from California real estate, or income from in-state business operations (obvious). Or it could be a portion of the sale proceeds allocated to a noncompete clause when a founder sells his California startup, or the gain from non-statutory stock options vested while the employee worked in California, or residuals for acting credit in a rerun of an old television series, but not royalties for creating the show (not obvious).
WHAT IS RESIDENCY TAX PLANNING?
Changing legal residency or maintaining nonresident status requires planning, at least where significant tax liability is at stake or substantial connections with California exist. California’s tax enforcement agency, the Franchise Tax Board, employs a complicated analysis to determine residency for tax purposes, with few bright-line rules. This involves weighing all the connections an individual has with California against every other tax jurisdiction. Put another way, no one thing makes you a resident, and no one thing makes you a nonresident. Context matters, and the context means examining all residency related contacts. Since the FTB uses this “facts and circumstances” test to determine residency, taxpayers and their tax advisers have to do the same if they expect their residency planning to survive audit scrutiny. Therefore, residency planning requires systematic fact-gathering to itemize all of a taxpayer’s connections with California and elsewhere, either current or planned. Anything less isn’t tax planning; it’s more like improv.
Further, once all the contacts are assembled, the residency rules have to be systematically applied for the plan to work. There is a persistent internet myth that California lacks any residency rules, and that the entire process of determining residency is “subjective,” and hence impossible to plan for. Quite the contrary, California is bursting at the seams with residency rules. The problem isn’t that there are no rules, but that the rules aren’t intuitive. Rather, California residency law is a messy amalgam of fact-specific rules accumulated over decades of case law, ever-changing regulations, chief counsel rulings and audit practices. To navigate this minefield requires a systematic guide. For that purpose, taxpayers generally need checklists relating to their particular situation to walk them through all the facts that require management under applicable law. That may mean eliminating or minimizing the connection, such as moving financial accounts out of California; it may mean managing the contact, such as making sure a vacation home isn’t treated as a primary residence or shipping an expensive vehicle in and out of California rather than leaving it in state year round; or it may mean business restructuring — for example, by forming an out-of-state S corporation after changing residency to convert distributive share from revenues derived from California customers to out-of-state W-2 earnings. It all depends on all the facts. Our firm’s experience is this can’t be done without detailed residency checklists handling every significant connection in context.
As the above discussion indicates, residency tax planning can have a lot of moving parts. Often, they all have to align for there to be significant tax savings
WILL YOU BENEFIT FROM A RESIDENCY PLAN?
Whether you need a residency plan is best answered by first describing the category of taxpayers who usually aren’t benefited by one.
- First, for those planning to pull up all stakes from California and move lock, stock and barrel to a new state, special planning with attorney input isn’t usually required. If you sell your home, terminate all your business and financial interests, change your legal relations with the state (driver’s license, voter registration, primary care physicians, professional licenses, etc.), without returning to California for stays of any significant length, the FTB is unlikely to prevail in a residency audit, or even initiate one. In this scenario, a departing taxpayer usually doesn’t have enough at risk to warrant the cost of attorney involvement. The exception involves those with extraordinarily high income, who want to minimize audit risk as much as possible because they are particularly risk averse. An attorney knowledgeable in residency rules can reduce a taxpayer’s risk of a residency audit, since such audits are often triggered by common, avoidable mistakes. See, California Residency Audits: Three Year-End Tasks To Reduce The Risk For Nonresidents.
- Second, if your income is derived substantially from California sources, changing residency offers little benefit. Remember, nonresidents have to pay taxes on California-source income regardless of residency status. Accordingly, changing residency only makes economic sense if the taxpayer has substantial income not sourced to California. Or, if the income is California source, it’s the type that is subject to relocation or restructuring. The classic case of changing sourcing is relocating a California business out of state. But note the complications here. Not all sourcing is responsive to business relocation. If the income is derived from rentals located in California, moving the company that owns the rentals out of state accomplishes nothing. The income is still traceable to California, and subject to California income tax. Similarly, if the customers of a business are mostly in California, relocating the business may not result in significant tax savings, since the revenues from doing business in California remain California source even if the business is operating out of state. See, Leaving California – Relocating Your Business Out of State.
- Third, California may have the highest income tax rates in the nation on the top brackets, but the middle and lower brackets are a different story. In the mid-brackets, there is often only a small difference in income taxes between California and lower tax states; and some states even have higher mid-bracket rates. In addition, income taxes aren’t the only taxes in town. Many low income tax states have high property taxes. Some have an estate tax. Others impose higher sales taxes. In a recent study comparing the overall tax burden of the states, California didn’t even rank in the top 10 (though make no mistake about it, zero income tax destination states like Nevada, Washington State, Texas and Florida, still come out ahead in tax savings). See,Study of Total Tax Burden by State: Some Expected and Not-So-Expected Results. The point is, before changing residency, California taxpayers should run the numbers not just on income taxes, but overall taxes. The results may show only minor benefits for taxpayers who aren’t in the top brackets, especially considering the costs of changing residency.
So, who can benefit from residency tax planning?
- Residents who are highly compensated by a California-based firm, but can work remotely or can arrange transfer to an out-of-state branch.
- Residents who expect to recognize a large capital gain not sourced to California in the near future (for instance, from a stock sale, a startup IPO, or Bitcoin conversion), especially if they have or plan to maintain complex connections with California, such as a vacation home or business interests.
- Residents who receive significant income not sourced to California or where the sourcing is subject to relocation or restructuring (for business owners, typically this involves establishing new entities out-of-state or converting a portion of distributive share to W-2 earnings accrued for work outside of California).
- Startup founders residing in California who want to plan ahead for their exit in a way that will minimize California taxes and residency audit risk when a cash-out occurs.
- Highly compensated nonresidents working temporarily in California, usually pursuant to a contract with a term of less than 18 months or one with periodic work limits, such as professional entertainers or athletes, executives tasked with establishing a branch in state or preparing a startup for sale or IPO, software engineers with a specific project located in California.
- Remote workers with currently vesting nonqualified stock options, who want to limit the taxable California compensation component upon recognition of gain.
- Highly compensated nonresidents with significant or complex connections with California, such as businesses managed from out of state, vacation homes where they spend a substantial part of the year, agreements with consulting companies for startup development which take an equity interest as partial compensation, or a spouse with California residency.
- Nonresidents who plan to retire in California after a large liquidity event not sourced to California (usually an asset sale, business buy-out, or cryptocurrency conversion), particularly if they already have substantial California contacts which put them at risk for an unfavorable residency determination.
A more detailed list of the scenarios where residency tax planning may make economic sense is here.
As the above discussion indicates, residency tax planning can have a lot of moving parts. Often, they all have to align for there to be significant tax savings. In most cases, this means a preliminary review by a CPA is in order. By having a CPA run the numbers through a pro forma to estimate the potential best-case scenario tax savings, a taxpayer will be in a position to determine whether the benefits outweigh the burdens.
Manes Law focuses exclusively on residency tax planning. To learn more about whether residency tax planning makes sense for you, visit our website.
Manes Law is the premier law firm focusing exclusively on California residency tax planning, consultations, audits and appeals. We have over 25 years of experience in successfully assisting Californians who want to change their legal residency, businesses moving their situs to other states, and nonresidents purchasing vacation homes or investment property in California. We serve a clientele of successful innovators and investors, including founders exiting their startups through a sale or IPO, Bitcoin traders and investors, professional actors and athletes, and global citizens able to live and work anywhere. Learn more at our website.