It’s no secret that California has a high state income tax rate. In fact, it has been the undisputed income tax champion for the past decade or so (the middle brackets are more compressed, and some states even have higher middle bracket rates). 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, Texas and Washington State. Often those businesses have to operate in California, since that’s where the market for the product or service is, or there is valuable cachet in having a California location such as Silicon Valley or Orange County. And often for small businesses and startups, the owner has to be present in-state for the enterprise to operate and 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. Moreover, as e-commerce continues to grow in market share, a physical presence in California becomes less and less necessary for many businesses, and relocation may result in tax savings for sales to non-California customers. Some companies may have started in California, but as they’ve prospered, they can operate from any state. In cases like these, some strategic use of out-of-state entities can result in large enough tax savings to make the major step of relocation worthwhile. But details matter.
The Rules Of California Residency Taxation
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 individual residency and business domicile. Changing residency is not a panacea for every tax problem. It only works in certain situations. And to determine where it works requires understanding the basic rules of how California taxes individual residents, nonresidents and businesses.
California taxes individual residents with respect to their “global” income. 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 ways to mitigate taxes due to California. But leaving that aside, California residents generally must pay 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.
In contrast, nonresidents only have to pay California income taxes to the extent that the income derives from a California source. If a nonresident has no California-source income, the taxpayer isn’t liable for any California income tax. California-source income generally means income derived from a business or assets with a situs in California, or from work performed here. That income is subject to taxation by California, even if the taxpayer never sets foot in California. Let’s call this Rule #2: taxation based on the source of the income being situated within California.
There are corollaries for the taxation of business entities. California may tax businesses operating out of California on all their taxable revenue, no matter where their customers are, if the entity isn’t a pass-through. In contrast, a business that doesn’t operate out of California is only taxed on sales relating to the business’s California customers, though, what constitutes “sales in California” isn’t always obvious, especially where online services or intangible property, such as SaaS, is involved, and a statutory analysis is often required to figure that out. If the business is a pass-through entity, like an LLC or S corporation, then that tax falls on the owners (to the extent distributions are capital-related), even if they’re nonresidents. 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. This is a bright-line rule that can’t be avoided. Dividend income from C-corporations and other non-pass-through entities, is treated differently and generally is sourced not to operations but to where the recipient resides. But it is taxed at the corporate level. Let’s call this bundle of concepts Rule #3, the business situs rule.
To Relocate Or Not To Relocate
To decide whether to relocate or not requires evaluating how these rules interact. 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, or where the goodwill exists. There is no point in moving out of state to avoid the application of Rule #1, if Rule #2 and Rule #3 are still going to apply. Becoming a nonresident doesn’t usually benefit a business owner whose company has to operate out of California (unless he has other significant non-California-source income unrelated to the business); and moving the company out of state doesn’t help much if most of its customers are in California.
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, which produce income by providing goods or services in California. The corporation often provides the LLCs or other entities with administrative services, and charges accordingly. Often, 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.
Moving out-of-state won’t change anything if the source of the income derives from California
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 company won’t help a bit by itself. Assuming all the income from operations passes through the entities to the owner, it will be taxed by California because of Rule #1: all of a resident’s income is taxable by California. In situations like this, if a strategic relocation is in the cards, step one has to involve the owner changing residency to a lower or non-income-tax state. Obviously, that’s a significant change in lifestyle. But if reducing state income taxes is the goal, it’s the sine qua non of residency tax planning. (Note that some tax planners try to get around this with an incomplete-gift non-grantor trust, set up in Nevada, Wyoming or Delaware – affectionately known as NINGs, WINGs and DINGs – a problematic strategy I discuss at length in a separate article).
Second, remember Rule #2 and Rule #3. Moving out-of-state won’t change anything if the source of the income derives from California. In contrast, if a large part of the company’s revenue come from customers who aren’t located in California, changing individual residency and business situs should have built-in tax savings. That’s the easy case. But let’s say the owner’s market is in California, so he can’t easily move operations, or if he can, most of his customers will be located in California, meaning the revenue to his relocated business will be sourced to California regardless. In that situation, California’s high income tax rate is the price paid for benefiting from the Golden State’s large and lucrative market.
That said, what often doesn’t have to be performed here is the company’s administrative services: the management, accounting, etc. If the services can be performed outside of California, the opportunity exists for the income to escape California sourcing, at least in part. That’s because, the wages of employees who work out of state, even for a California-based company, are generally not subject to California taxation.
In that case, after the owner changes legal residency, step two to an effective residency plan might involve an employment contract between the California entity and the nonresident owner, to perform administrative/management services. So long as the owner carries out the services remotely, and so long as the payments are W-2 income (not distributive shares of capital), then Rule #1, Rule #2 and Rule #3 do not apply. The owner could also establish an intervening pass-through entity out of state to perform the services. It will be taxed under Rule #3, because it would be doing business in California. Still, if the owner works for the out-of-state entity, and receives a salary for that work, only the portion of the California revenues that pass-through as distributive share will be taxed by California, not the W-2 income. A part of the taxable California-source income will have essentially been converted to the out-of-state wages of a nonresident not subject to California income tax. If the entity is a S corporation, federal rules require a portion of the revenues to be paid to the owner as W-2 compensation in any case, so there’s no issue of improper tax avoidance. A third scenario involves establishing a non-pass-through C corporation out of state to provide the services. Under Rule #3, that entity pays California taxes on income for services performed for the California business, but the dividends paid to the owners are not taxable by California.
It’s Never That Simple
Problem solved, right? No.
The obvious issue here is that even if a nonresident escapes California income tax, that won’t affect federal taxation. Converting California-source distributive share to wage income or non-pass-through dividends may reduce California’s individual income taxes, but it subjects the income to unfavorable federal tax treatment. For federal tax purposes it’s usually better to take a larger distributive share from an S corporation rather than wages (which is why the IRS requires S corporations to pay owners reasonable W-2 salaries rather than only pass-through dividends). And of course, using a C-corporation introduces a second layer of taxation at the federal level. Accordingly, this structure has to be carefully calibrated between California and federal tax to result in savings. The company’s CPA will have to prepare pro formas to get the right mix of distributive share and W-2 income under federal law to make relocation under this scenario economically feasible.
In addition, the type of entity plays a role in the strategy. LLCs, unlike S corporations, generally are excluded from this type of planning altogether. While guaranteed payments by LLCs are treated like salary for some tax purposes, that doesn’t mean the member receiving a guaranteed payment is an employee of the LLC. This is in fact a grievous area of tax law, and the IRS’s position is that an LLC member can never be an employee, though the case law is less clear. Accordingly, nonresident members performing services to a California-based LLC can’t avail themselves of the option of being hired as out-of-state employees not subject to California income taxes. They receive distributive share, which if sourced to California revenue, is subject to California income tax regardless of the member’s residency status.
Moreover, the rule about location of performance is strict. If even some of the work is performed in California, the income generated by that work will be deemed California source. It’s a rare situation for a nonresident owner of a California business to be able to avoid any trips to California to oversee operations. Therefore, a written employment contract should spell out how those “duty days” are defined, and how they are compensated, with the goal of limiting what counts as a duty day. Without written terms regarding duty days, the FTB can make whatever unfavorable inferences it wants. For a discussion of the duty day concept for remote workers, see Nonresidents Working Remotely for California Businesses.
The Non-Qualified Stock Option Jackpot
However, there is one situation where the tax savings can be enormous in the long run, despite the unfavorable federal tax consequences for nonresidents converting distributive share to wages. This involves non-qualified stock options (or qualified stock options disposed of in a nonqualifing sale). If the business is a startup, and if the owner receives stock options that vest over time as part of the compensation package, it can make a big difference if the owner works in California or out-of-state.
Generally, California taxes NSOs as compensation for work. The rule is, to the extent the NSOs vested with respect to work performed in California, the proceeds of the ultimate sale are taxable by California in proportion to where the work was performed. Thus, if a nonresident is granted NSOs and during the vesting period works for the company while physically present in California 50% of the time, then 50% of the taxable gain on the options is California-source income. In contrast, if the vesting period doesn’t involve any work performed in California, then none of the gain is subject to California tax. If the company hits the jackpot, and the stock options soar, the difference can be huge.
At California’s top rate of 13.3%, if the stock options sell at $10 million, the nonresident owner who worked 50% of the time in California faces a state income liability of over $650,000. In contrast, the nonresident owner who planned ahead and didn’t physically work at the company’s in-state location during the vesting period pays zero California taxes. A resident owner, of course, gets hit the hardest, with a state tax bill presumably around $1,300,000.
Note that this same analysis applies to qualified stock options sold in a disqualifying sale (which essentially converts them to NSOs).
Beware The Quick Fix
As the above discussion indicates, moving a business out of California involves complex tax implications. The tax savings, if any, depend on the interaction of rules governing individual residency, California-source income and business situs. Sometimes the savings are obvious, such as where the business has a large non-California customer base. But not all owners of California enterprises will benefit from relocation. For residency tax planning for businesses to work, a thorough understanding of the rules, including the benefits and burdens, is necessary.
Manes Law is the premier firm in preparing “departure plans” for individuals and businesses who want to change their legal residency to another state. Many of our clients are successful entrepreneurs selling their businesses or making a public offering, retirees moving to a lower-tax state, professional actors or athletes or artists who can live anywhere, e-commerce innovators who can work remotely. Learn more at our website: www.calresidencytaxattorney.com