California residents who plan to move to another (by definition lower income tax) state, either to retire or for business purposes, often face the problem of how to handle their business interests situated in California. Mostly these interests are LLCs, the preferred entity for many modern business operations. The taxpayer often wants to hold onto the LLC interests and continue to get the income stream until some later date after the move. The question that arises is, what are the California income tax consequences of selling a California LLC interest after the taxpayer changes residency to another state?
I’m assuming the business owner has already weighed the risk of retaining his California business interests while disentangling himself from California by reducing his contacts here and establishing residency elsewhere. Obviously any continued contacts with California are red flags for California’s tax enforcement agency, the Franchise Tax Board, which determines residency in part through the facts and circumstances/closest contacts test (discussed here), evaluating which state the taxpayer has the most contacts with. Business interests are just the type of substantial contact that can weigh heavily in determining residency, and can trigger a costly residency audit. In addition, under many circumstances the income allocated from the LLC to the taxpayer will be California source even after the taxpayer leaves the state (this is determined by where the revenue from the company’s sales derive). That means the former Californian will have to file nonresident tax returns with Sacramento (the Form 540NR), and the FTB will know about the taxpayer’s global income. If the income is high, it again sends up a red flag that could lead to a residency audit.
But assuming that this decision has already been made, and the taxpayer decided to keep his California business interests despite the risks of an audit, the next issue is planning for the eventual sale of the interest as an out-of-state resident.
The Rule For Doing Business in California
On its face, the rule is relatively simple. California residents are subject to California income taxes on their entire taxable income, regardless of source; in contrast, nonresidents are taxed by California only on income from California sources. (Ca. Rev. & Tax. Code, Section 17041(a), (b), & (i); 17954.). With businesses, broadly speaking, California taxes income to the extent the company is doing business in California and derives income for sales within the state. It can make a difference if the business is selling goods or services, whether it has offices or employees in the state, whether its operations are “unitary” within and outside of the state, but that’s another topic. The basic rule is, if the business is a passthrough tax entity, such as an LLC, the income passes through to the owners with the same sourcing character as it had when recieved by the entity. The result is, the nonresident members of an LLC have California-source income, subject to California income taxes, to the extant the LLC is doing business in Calfornia an receiving California-source income.
The Mobilia Rule
The foregoing rule applies to regular business operations. In contrast, income from the sale of intangible interests (stocks, bonds, notes, and LLC memberships) is not considered derived from California sources. This is the so-called “mobilia rule.” The concept is the taxable situs of intangible interests is situated in the jurisdiction where the owner lives (technically, where the owner is domiciled). The name comes from the latin phrase, mobilia sequuntur personam, which means “movables follow the person.” Accordingly, if nonresident members of an LLC sell their membership interest in an LLC doing business in California, the income is capital gain not sourced to California. The result: California can’t tax it.
There’s a statutory exception to the mobilia rule. If the intangible property itself takes on “business situs” in California, the income derived from its sale becomes California source. The law isn’t crystal clear about how stocks or LLC membership interests could have a situs in the state. Franchise Tax Board regulations offer a single example of a nonresident who pledges intangible personal property in California as security to pay indebtedness or taxes related to a California business. This is the LLC owner who takes out a loan to pay the debts or otherwise capitalize a related LLC, and the LLC interest is pledged as collateral. In that case, the intangible property acquires a business situs in California. It is no longer “non-California situs intangible property.” When the interest is sold, California can tax the gain, even though the owner is a nonresident. Nonresidents can also get into trouble if they buy and sell LLC interests in California (or place orders with brokers in this state to buy or sell such intangible property) so regularly, systematically, and continuously as to constitute doing business in California. In that case the sales themselves are deemed California source.
Fortunately, the instances where the matter was even an issue are rare, and only appear in a few cases. The prudent appoach by nonresident LLC members selling their interests, is to avoid pledging the interest if sourcing will be important aspect to avoiding taxation by California.
Such are the basics. There are other complications, however. In 2017, the FTB adopted a regulation (CCR § 25136-2), which imposes income taxes on the net profit from the sale of intangible personal property based on various formulas. The formulas allocate a portion of the profit to California using various factors. It should be noted the applicability and even the validity of CCR § 25136-2 as a whole is disputable. Regulations are not statutory law, but merely the rules of the implementing agency, in this case, the FTB. The regulation appears to contradict the old law on its face, which is ingrained in case law, statutory law and other regulations. That said, it is an adopted regulation, entitled to deference by a court, and is enforceable if the FTB chooses to apply it.
In addition, nonresident LLC members selling their interest have to be careful about so-called Section 751 “hot” assets. While sales of LLC interests generally give rise to capital gains, IRC Section 751 recharacterizes a portion of the amount realized as ordinary income. These “hot assets” include accounts receivable, inventory, and ordinary income depreciation recapture.
The takeaway is, for nonresident members selling their interest, the basic rules are in their favor for avoiding taxable California-source income. But there are complications that require careful analysis by a CPA or other tax professional, who understand the pitfalls.
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, and global citizens who are able to live, work, or retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.
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