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. But in fact, most people who change their legal residency from California have more in mind. They also want to retain contacts with the state. That might mean a vacation home, it might be managing a California business remotely, it might involve meeting potential clients or investors in California for an out-of-state entity. 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 your out-of-state business brings you back to California.
When Changing Residency Isn’t Enough
A typical situation involves a business owner who changes legal residency and moves his business out of state. Well and good. Unless a taxpayer changes legal residency, everything else is moot from a tax perspective, and if the company operates out of California, distributions to its out-of-state owner are also subject to California tax. But the fact is California is an economic powerhouse. Few businesses, especially those in high-tech and financial services (which are increasingly the same thing), 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.
If that’s the case, it’s important to understand the differences between personal residency as opposed to doing business in California versus working while present in California. These are three separate tax issues, which require different approaches to manage.
Personal Residency and Business Trips
Here’s the rule for individual residency: if you have established legal residency in another state, traveling to California for a temporary or transitory purpose won’t make you a resident. You would have to return to California for a permanent or indefinite reason 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 signing a contract, is not deemed a permanent purpose under California law. Case closed.
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, even if paid for by the company; a vehicle registered in California, again even if your company holds title; gym memberships, professional licenses, important social connections, etc. The details matter in these cases. And it might particularly matter if you are the owner of your business, and the company’s presence in California is essentially for your benefit (a luxury condo in San Francisco, for instance).
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 Facetime or Skype – or the old fashion telephone.
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 (if it is intangible and not a widget). 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 problem for you personally, it may result in a taxable nexus for your out-of-state business.
Working While Present In California
But it gets even more complicated. 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? This is a third-way California can tax a former resident who returns for business purposes.
The rule is this: if you perform work for your out-of-state company while physically present in California, 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, right? Not necessarily. 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.
The concept is this: the FTB can argue that a portion of any wage income you receive from your out-of-state business is allocable to your visits to California. For instance, if a S-corp pays $500,000 to a shareholder/officer, and if the officer performed service while in California for two months out of the year, 1/6 of the compensation, or about $80,000, is California-source, taxable by California. As a practical matter, wage income is usually only a small portion of the total distributions business owners receive from their companies, unless they are highly compensated officers So the amount at issue may not be significant However, that’s not always the case, particularly in the financial services industry.
Nonresident business owners have some control over how this income 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. This can be particularly helpful at limiting the California-source income of officers whose work in California often consists of a few short meetings or reviews over several days. Whether the FTB would accept these characterizations is another matter.
Note that, for good or ill, LLCs 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 dollars 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. 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 is no de minimis rule for California-source income. If you make even a small amount of W-2 income in-state, it technically has to be reported on a nonresident return, unless your total income is under certain very low thresholds. As a practical matter, this means most business owners who perform any work while physically present in California have a filing requirement, unless they take measures to avoid the problem.
Finally, 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 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 start to hurt. That’s why if you are going to work in California for your out-of-state company, you should have a written agreement that specifies what constitutes “duty 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 under which California can tax a former resident who returns to the state for business purposes. If the trips fail to meet the temporary/transitory standard, they can confer residency (though this is rarely the case). The trips may also result in your company doing business in California. 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 California residency tax planning, on a fixed-fee basis. We have over 25 years of experience in successfully assisting Californians to change their legal residency, businesses relocating 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 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: www.calresidencytaxattorney.com.