In the last post, we looked at the basics of California income tax and residency. Next, we’ll review some additional considerations—how this all ties into equity compensation and how residency laws interpret the growing trend of remote work.
Equity Compensation
While equity compensation often drives the question of whether moving from California would be advantageous from a tax perspective, for certain types of equity compensation, becoming a resident of another state may not actually be as helpful as you might imagine.
For restricted stock units (RSUs), California has a formula for determining how much of the income from your RSUs is California income. RSUs, including so-called double-trigger RSUs, are taxed as ordinary income from compensation when they vest. At vesting date, California taxes the portion of the income from RSUs that corresponds to the amount of time you lived in California between the grant date and vesting date.
For example, if you lived in California for two of the three years of a three-year vesting period on your RSUs, then two-thirds of the income from RSU vesting will be California income—even if you live out of state when the RSUs vest.
Non-statutory stock options (NSOs) work in a similar way. The gain on NSOs is taxed as ordinary income from compensation when they are exercised. At exercise, California taxes the portion of the income corresponding to the amount of time you lived in California between the grant date and exercise date.
Later when you sell the stock from the exercise of NSOs when you’re a non-resident, California will not tax the capital gain on any appreciation after the exercise date.
For example, let’s say you lived in California for three of four years between the grant date and the date you exercised your NSOs. You exercised 1,000 NSOs with a $0.50 strike price when the stock price was $20 per share. You will have a California compensation income of ($20.00/share - $0.50/share) x (1,000 shares) x (0.75) = $14,625.
The treatment of incentive stock options (ISOs) is more complicated but possibly more beneficial. Remember, the exercise of ISOs does not create taxable income under the regular income tax rules.
If you exercise your ISOs while you’re in California and plan to hold for the special holding period (two years from date of grant and one year from date of exercise) before selling the stock for long-term capital gains treatment for federal tax purposes, and then move out of the state, California will not tax the subsequent gain on the sale of the stock.
For those living in California with its top tax rate of 13.3%, leaving California before selling ISO shares can be potentially lucrative.
If you sell stock less than two years after the date of grant and one year from date of exercise in a so-called disqualifying disposition, the rules work the same as for NSOs. California will tax the portion of the gain for the time from the date of grant to the date of exercise that you lived in California.
For ISOs, there is an alternative minimum tax (AMT) consideration as well that you need to be aware of. When you exercise ISOs, the difference between the exercise price and the strike price is income for AMT purposes.
Since, in our ISO example above, you exercised ISOs while you lived in California, the gain will be alternative minimum taxable income in California, and you will owe tax on that income. You may be able to get some of that tax back through an AMT credit later when you sell the shares. How much AMT credit you may be able to use, if any, depends on the specifics of your tax situation.
The key takeaway here is that even with a valid change of residency from California, for two of the most common types of equity compensation, RSUs and NSOs, some of your income may still be taxable in California. With ISOs, a residency change may be more beneficial. Even so, you need to be aware of triggering AMT upon exercise of your stock options.
Remote Work
Many people are working remotely out of state during the pandemic and are now considering whether they are California residents, non-residents, or part-year residents. The key questions to ask are: Has your domicile changed? Was your stay in California temporary or transitory?
In many cases, the answers to these questions are no, and individuals will be considered to be residents. They were domiciled in California, but outside of California for temporary or transitory purposes due to the pandemic, or potentially part-year residents for the pre-pandemic portion of 2020 if they truly moved out of state and changed domicile.
These are fluid times, and California will look back over the next two or three years to see where you ultimately wound up deciding to live. For example, if you’re out of California for two years and sell stock but then move back, California may retrospectively decide that you were a resident of California the whole time—that you had not changed your domicile because you had always intended to return to California. This means that what you do going forward may be just as important in determining your residency status as what has happened to this point.
Remember, one part of the residency definition is domicile, which is the place where you intend to return. So later, if you return to California, the Franchise Tax Board may take the view that you have always been domiciled in California.
Also, be aware that superficial internet research can be misleading. There’s an internet myth that says if you’re in California for less than six months, then you can be considered a non-resident of California. However, the six-month presumption of non-resident status has qualifiers. The actual regulation says:
An individual whose presence in California does not exceed an aggregate of six months within the taxable year and who is domiciled without the state and maintains a permanent abode at the place of his domicile, will be considered as being in this state for temporary or transitory purposes providing he does not engage in any activity or conduct within this State other than that of a seasonal visitor, tourist or guest. 18 CCR §17014
So yes, being in California less than six months can qualify you for non-resident status, as long as you’re domiciled in another state. But that’s the question, isn’t it? Are you domiciled in California or not? So it’s back to the residency factors and your individual facts and circumstances to determine if you’re a California resident.
Leaving California to save income tax is possible, but it’s trickier than many people realize. You must genuinely move from California and sever your ties with the state. Even after you move, some portion of your income from equity compensation may be taxable in California anyway. All of this said, leaving may still be worth it in some cases. (But the weather sure is nice.)
To best understand how the regulations apply to you, talk to your financial advisor. You can also learn more in the following State of California Franchise Tax Board resources:
FTB Publication 1031, “2020 Guidelines for Determining Residency Status”
FTB Publication 1004, “Equity-Based Compensation Guidelines”
