California is known for having some of the highest taxes in the country for both individuals and businesses. California’s tax rate for individuals ranks among the highest of all states, while the corporate income tax and sales tax rank in the top ten for all states. This does not include the additional growing number of local retail and payroll taxes in the state. It also does not include hints of a potential wealth tax down the road.
California individuals and business owners are feeling the financial strain of the state and local tax system. The growing tax burden levied by the state has many looking, or at least more open to considering, ways to reduce their tax burden. This is how a move from California becomes a common consideration and choice for many. It appears to make good sense at first glance, but if you do not plan carefully, it can be a trap.
Tax regulations can be complicated and confusing, but they should be taken into careful consideration when planning a move from California for tax purposes. Before deciding, let us explore whether a move would really result in lower taxes for individuals or businesses.
Nonresident Income Sourcing: A Snare for the Unaware
Individuals who leave California for other states frequently discover that they must pay personal income tax in California. A state can tax a resident’s entire worldwide income, subject to credits for taxes paid to other states, with some exceptions. Individuals who relocate from California but maintain earnings from real estate or closely-held businesses within the state will be subject to California nonresident income tax. Community property laws can be problematic when a high-earning married couple relocates out of California but the spouse does not. Although the individual is no longer a resident of California, California may still tax them on such income. As a result, if the bulk of a taxpayer’s revenue originates from within the state, the anticipated tax cut may not materialize.
Business Operations Impact Taxes
Businesses confront the same problem. Individuals frequently believe that they can reduce their taxes by making a business move from California or by reincorporating or establishing a token office in a low-tax state. There are several circumstances in which permanent residence or domicile might be necessary – mainly when selling intangibles such as stock. But, for the most part, business activity determines where a corporation pays tax. If a firm does not significantly alter its operations or customer base after relocating, it will probably not realize significant tax savings.
This is due to state-based regulations that dictate how much of a business’s profits may be taxed. If the firm spans multiple states, each state may tax only its fair portion of the profits. The size of each slice is determined using allocation and apportionment rules, intended to provide a reasonable approximation of the volume of business done in that state.
The state of California, like many other states, has the power to create its standards for determining the proportion of business done within its borders. Like many other jurisdictions, California uses a single sales factor apportionment method. The state apportionment percentage is applied to overall business income to determine the amount of income taxed in each state.
Of course, there are some anomalies on the margins where relocating may result in lower California taxes. Each situation is unique, which is why company executives must consult their accountants and model how a relocation might influence their California tax liability before deciding.
Why Worry About Wealth Taxes?
The California state legislature considered a bill (AB 2088) in 2020 that would have implemented the country’s first wealth tax, a 0.4% yearly levy on assets worth more than $30 million. In addition, the bill would have extended the tax for ten years after a resident leaves California, recognizing its potential to induce flight. However, the constitutionality of this 10-year clause is questionable. Ultimately, the wealth tax failed to pass.
Although it lacked approval, advocates of this concept plan to reintroduce it in future legislatures. Those considering departing California should keep a close eye on these developments and possibly leave the state before such a tax is passed.
What to Know Before Changing Tax Residence?
Individuals and firms who wish to leave California for tax reasons need to make sure they understand residency laws before proceeding. Keep in mind that the internet is rife with misinformation (e.g., moving for six months out of state does not constitute residency). Residency auditors will also discover half-baked efforts to establish out-of-state residency.
Residency determinations entail personal inquiries on family and social relationships; thus, it is no surprise that they may be invasive. However, they may be simple for taxpayers who carefully develop a strategy for leaving the state, establish a new home, and keep copious records. The latter is crucial; several years later, auditor demands for documentation could be called into question.
Changing residency is a unique process for everyone and may include selling or renting their primary California residence, purchasing a new property, obtaining new driver’s licenses and vehicle registrations, registering to vote, getting involved with local causes, establishing ties to the new community, and terminating business relationships in California.
Many relocating individuals anticipate sizeable liquidity events, such as selling a business or putting a home up for sale. Therefore, in addition to ensuring that changing residency will save on taxes, they should be conscientious about following through with their residency change ahead of the liquidity event.
It is essential for taxpayers who are contemplating a change of residency to consult with their individual tax preparation experts for professional guidance. Whether you are a current company owner or a high-net-worth individual, Windes tax experts can help with business accounting services for a sound relocation strategy from California.