The California individual income tax rate is the highest in the nation. Its corporate income and sales tax make the top ten. On top of this is a growing list of onerous local gross receipts and payroll taxes. There have even been hints of a first-of-its-kind state wealth tax.
Individuals and businesses feeling the California tax pinch are looking towards an exit from the state as the best option to relieve their tax burden. Before committing to a relocation, taxpayers must investigate the intricacies of California residency to truly verify the effect on their tax bill. This article explores these considerations.
The method with which California determines taxable income and its aggressive auditing of residency causes tax saving difficulties for individuals leaving the state. Each of these issues is discussed below.
Nonresident income sourcing: A trap for the unwary
Individuals moving from California often find themselves still paying CA individual income tax. The answer as to why this happens lies in two bedrock principles of individual income tax. First, a state may tax 100% of a resident’s worldwide income (subject to credits for taxes paid to other states). Second, states may also tax a nonresident on income from sources in the state.
For example, an individual may move from California and continue to receive income from California real estate investments or a closely-held business that operates in California. There are even instances where one high earner in a married couple moves, leaving their spouse behind only to learn that community property rules throw their plan in disarray. Although the individual is no longer a California resident, California may still tax the individual on these types of California-source income. Therefore, if most of a taxpayer’s income is California sourced, the anticipated tax savings may not materialize.
Business operations control taxes
Businesses run into a similar difficulty. Taxpayers often think that reincorporating or establishing a token office in a low-tax jurisdiction will allow them to escape California corporate income taxes. Commercial domicile may be a relevant consideration—typically when selling certain intangibles (e.g., stock)—but for the most part, actual business activity drives where a corporation pays tax.
This is due to nexus laws that determine how much of a business’s income a state may tax. If the business operates across state lines, each state may tax only its fair slice of the pie. Rules for determining the size of the slice are called allocation and apportionment and are meant to roughly approximate the amount of business conducted in the state.
California, like many other states, uses a single sales factor apportionment formula. This means that the California formula for determining state taxable business income is: sales sourced to California divided by all sales.
What does this mean for the relocating business? If the business moves its facilities and employees outside California without changing the relative mix of California v. non-California sales, its California tax bill may remain static.
This of course, assumes that the business retains sufficient connection (nexus) with California to remain subject to its taxing jurisdiction – the following constitute “engaged in business” within California and require businesses to pay tax, per the California Revenue and Taxation Code, RTC § 23101:
Of course, there are exceptions that may apply to different client situations. This is why it is vital for business leaders to sit down with their accountants to model how a move may affect their California tax liability.
Taxpayers who decide to leave California for tax purposes should avoid two cardinal mistakes: (1) misunderstanding residency laws and (2) not genuinely moving.
Residency determinations involve personal questions of family and social connections; it should be no surprise that these audits can be extraordinarily invasive. But they can be straightforward for taxpayers who thoughtfully prepare a plan for exiting the state, establishing a new residence, and retaining key documentation. The latter is quite important; the types of documentation that auditors request years down the road tend to evaporate quickly.
California’s FTB Publication 1031 goes into detail on the guidelines for establishing residency in the state. Strength of ties, not number of ties, is what will determine residency (where you have the closest connections). Potential factors to consider include:
Each plan for changing residency will be unique. That said, a few examples of steps that one should consider in changing residency include: disposing of a California home (or converting to a rental), acquiring a new home, changing drivers licenses and vehicle registrations, registering to vote, forming relationships with new medical, financial, and other professionals, and joining social and civic organizations. Small details matter: some cases have turned on where the family pet lived or where cell phone calls originated.
Taxpayers anticipating large liquidity events, such as selling a business or stock holdings, often intend to change their residence before that event. In addition to verifying that a changing residency will save California taxes, these individuals also should take great care to follow through with their residency change well in advance of the liquidity event to ensure that the timing is clear.
Key Takeaways
If you are considering a move out of California, contact your HCVT tax professional or the tax professionals listed below. Our team can provide guidance and insights about the tax implications and key considerations individuals and businesses should address as they contemplate a change in residency.
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