Over the last nine months, I have had consultations with dozens of people whose companies were planning to go public or who had gone public and were considering leaving California to avoid income tax on their stock options or restricted stock unit gains. A common question has been, “Can I avoid paying tax on the gain by moving to a no-income-tax state like Nevada or Washington?”
The answer is yes, in theory—but in practice, it is much harder to accomplish.
In this article, I will cover the basics of California income tax and residency factors. In Part 2, I’ll discuss more specific residency issues and provide some resources so you can review your own situation.
First, let’s touch on the basic structure of California income tax. Residents of California are taxed on their worldwide income, regardless of source. That is, any money you make from anywhere in the world the state considers taxable income.
Nonresidents of California are taxed by the state as well, on income from California sources. This is also referred to as a California-source income. Part-year residents are taxed on their worldwide income while they are residents of California, and only on income from California sources while they are nonresidents.
The Franchise Tax Board, California’s equivalent of the U.S. Internal Revenue Service, says that the purpose of the residency rules is “to ensure that all individuals who are in California for other than a temporary or transitory purpose, enjoying the benefits and protections of the state, should in return contribute to its support.”
Said another way, if you are living in California and using the services California provides, you should be paying for those services through your taxes. Fair enough.
But who is a California resident? This is where it gets interesting.
A resident is any individual who is (1) in California for other than a temporary or transitory purpose, or (2) is domiciled in California, but who is outside California for a temporary or transitory purpose. A nonresident is simply an individual who is not a resident.
The underlying theory of residency is that you are a resident of the place where you have the closest connections. This depends on the facts and circumstances of your individual situation.
What is a temporary or transitory purpose? If an individual comes to California for a vacation, to complete a transaction, or is simply passing through, the individual’s purpose is temporary or transitory. For example, you might think about the digital nomad living the van life and traveling around the country. They would not be in California for other than a temporary or transitory purpose.
The Franchise Tax Board looks at several factors to determine whether you might be in California for a temporary or transitory purpose. For example, if you were assigned by an employer to an office in California for a long or indefinite period, you were probably not in California for a temporary or transitory purpose. If you returned to California and have no specific plans to leave, you are probably not in California for a temporary or transitory purpose.
Maybe you are ill, and you are in California for an indefinite recuperation period. That is not temporary or transitory. You might own real estate in California. You might be sending your children to California schools. You might have a California driver’s license or auto registration. You might have business interests in California. In all these cases, you are probably not in the state for a temporary or transitory purpose, and you are likely a California resident.
The second part of the definition of resident has to do with domicile. Domicile is “the place in which an individual has voluntarily fixed the habitation of self and family, not for a mere special or limited purpose, but with the present intention of making the permanent home.” This is where you really live—where you consider to be home.
Franchise Tax Board regulations and a body of case law have defined domicile as “where an individual has his true, fixed, permanent home and principal establishment, and to which place he has, whenever he is absent, the intention of returning.”
An individual can only have one domicile at a time, and to change domiciles an individual must actually move to a new residence and intend to remain there permanently or indefinitely. Pretending to move—wink-wink, nudge-nudge—is not going to work.
Residency Audits
If you decide to move from California to a no-tax or low-tax state immediately before you sell a large amount of stock in a company that has just gone through an IPO or acquisition, be careful. California will look carefully at whether you are actually a resident of California at the time of the sale. The state conducts what are known as residency audits, and they can be very thorough.
The Franchise Tax Board looks at a variety of factors to determine whether you are a resident of California under the two-part definition above, including:
Amount of time you spend in California versus amount of time you spend outside of California (home state vs. California)
Location of your spouse/partner and children
Location of your principal residence
State that issued your driver’s license
State where your vehicles are registered
State where you maintain your professional licenses
State where you are registered to vote
Location of the banks where you maintain accounts (branches)
Origination point of financial transactions (charges on your credit cards)
Location of your doctors, dentists, attorneys, accountants
Location of your social ties, such as place of worship, social and country clubs, gyms, professional associations
Location of your real property and investments
Permanence of your work assignment in California
Many people mistakenly believe they can simply fool the Franchise Tax Board by buying a vacation home in Nevada and calling that property their primary residence. Or use a Nevada friend’s address. That isn’t going to work.
During a residency audit, the Franchise Tax Board looks carefully at where you actually spend most of your time and engage in life. For example, do most of your cellphone calls happen from Nevada or are they actually still originating from California? Auditors have even been known to review your social media to see where you are when you post.
The point is—you can’t fake it. You must actually move to change residency. And you must do it well in advance of receiving the large income influx you want taxed in another state.
These are the basics, which I hope show how much you really need to move out of California to “move out of California.”
In the next post, we’ll look at some additional considerations, such as how this all ties into equity compensation and how residency laws interpret this growing trend of remote work.
