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California Guidance on Other State Tax Credit and Reciprocity

 

At a Glance

Main Takeaway

Understanding and navigating the complexities of state tax laws can be challenging for individuals earning income across state lines. The presence of other state tax credits, reciprocity agreements, and their interplay with other existing credit programs can impact taxpayers’ potential tax liabilities and filing requirements.

Next Step

Breaking down how the California Other State Tax Credit (OSTC) works is crucial for estimating taxes, reducing liability, and avoiding overpaying. Windes’ state and local tax professionals can help you understand how these credits apply to your specific situation.

 

California OSTC General Guidance

California calculates tax based on worldwide income. The primary purpose of California’s OSTC is to prevent double taxation at the state level. OSTC eligibility varies depending on residency and the other state involved, as not every state offers similar tax credits and incentives.

Reciprocity agreements require that the OSTC be taken on the nonresident state return instead of the resident return. California currently has reciprocity agreements with Arizona, Oregon, and Virginia. This means taxpayers who are California residents with income sourced to Arizona, Oregon, or Virginia must file nonresident returns with those jurisdictions and claim OSTC on these states’ nonresident returns instead of California resident returns. Similarly, an Arizona, Oregon or Virginia resident with California source income must file a California nonresident return to claim the OSTC on a nonresident California return.

 

Filing Requirements

The OSTC is not refundable and has no carryforward provisions. Credit ordering rules are also to consider, most notably related to the pass-through entity (PTE) elective tax credit. California enacted Senate Bill 113 (S.B. 113) to, among other things, allow the OSTC to be taken before the PTE for tax years beginning on or after January 1, 2022, rather than after. This is especially beneficial because unused PTE credits can be carried forward for up to five years.

 

Who Can Claim OSTC?

Owners of the following pass-through business entity types may be eligible for the OSTC:

  • Partners in a partnership
  • Members of an LLC classified as a partnership
  • Shareholders in an S corporation

Effectively, if you receive a Schedule K-1 package from a pass-through entity that includes state taxes withheld or composite taxes paid by the entity on your behalf to states other than your resident state, you may be eligible for the Other State Tax credit.

 

How to Determine Eligibility for OSTC

To claim the California OSTC, you must also meet the following requirements:

  • You must be a California resident.
  • You must have paid income taxes to another state, either directly or indirectly.
  • The income must be subject to double taxation (taxable in California and the other jurisdiction).
  • You must have a California income tax liability greater than zero.
  • If the other jurisdiction has a reciprocity agreement with California, you must file a nonresident income tax return with that jurisdiction.

The amount of the credit is equal to the lesser of:

  • The amount of income tax you paid to the other state on income that is double-taxed in California.
  • Your California income tax liability (or the other states’ income tax liability for jurisdictions with a reciprocity agreement).

 

How California Determines Tax Character for OSTC

The following are the steps to determine the tax character of a non-California tax:

  1. Is the tax measured on income? This depends on the activity and tax base on which the tax applies. If the tax base is any metric other than ‘net income,’ such as total receipts or equity, the tax will likely be considered by California to be ‘not based on income’ and, therefore, not eligible for the OSTC. One common example of this is the Texas Franchise tax. The tax base is calculated as whichever of the four methods results in the lowest amount:
    1. 70% of revenue,
    2. Revenue less $1,000,000,
    3. Revenue less COGS
    4. Revenue less wages

Since none of these calculations calculate the tax on net income, California does not allow the Texas Franchise tax for the OSTC.

  1. Is the tax imposed by another state? If the income tax is imposed or collected by a subdivision of another state, such as a city or county, the tax is not eligible for the OSTC. Only income taxes imposed by/paid to another state can be considered for the OSTC.

 

Trust Windes to Manage Your Company’s Multi-State Taxes

Understanding taxation systems, taxes owed, and the credits available can be overwhelming when earning income from multiple states.

Windes is here to help. Let our team of taxation experts help you understand out-of-state taxes and determine your eligibility for each credit and deduction. We can also provide expert guidance tailored to your tax needs. Connect with us today to learn more about our business tax services.

 

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