DISCLAIMER: Nothing in this article is intended as specific legal, tax, or financial advice. Always consult with qualified legal, tax and financial counsel prior to implementing any strategy you are considering.
It provides a lower overall cost of living than much of the West Coast and still offers plenty of sunshine to enjoy the many outdoor activities available to those who seek an active lifestyle. It also has another key benefit for those looking to cut ties with the Golden State: NO STATE INCOME TAX FOR INDIVIDUALS. If you are one of the thousands of families and business owners looking to leave California for the Lone Star State, the first thing you need to know it is not as simple as just changing your residence or mailing address. The California Franchise Tax Board is one of the most sophisticated and aggressive tax collection agencies in the world. They need money to fund the State’s myriad social programs, infrastructure and public employee pensions so don’t expect them let go of their annual “profit share” without a fight.
Every person’s situation is different so it is important to have a qualified financial and tax professional review your circumstances. There are two basic rules you need to keep in mind if you wish to avoid California tax. The first rule is that a California resident pays California tax on their worldwide income.
For example, if you are a California resident and own part of a Nevada Limited Liability Company (LLC), you will pay California tax on your distributive share of the Nevada LLC’s income even if that LLC earned all of its income completely outside the state of California.
The second rule is that California will tax California-source income, regardless of where you live. Thus, if you live in Texas but own any income-producing California real estate, you will still have to pay California tax on the California real estate income.
California has an expansive definition of residency. An individual is treated as a California resident if they are in California for other than a temporary or transitory purpose, or if they are outside California for a temporary or transitory purpose but still maintain a domicile in California. The residency question is ultimately decided by whomever can build a stronger case for the state the person has the closest connection to during a taxable year.
Because the above definitions are largely subjective, the Franchise Tax Board looks to factors set forth in the 1985 California Supreme Court case Corbett v. Franchise Tax Board. These include (but are not limited to) the twenty nine residency factors in the list below known as the “Corbett Factors”.
The following factors may be used to build the case for residency based on the state in which the following occurred or are deemed to regularly occur:
1. Birth, marriage, raising family;
2. Preparation of tax returns;
3. Resident state income tax returns filed;
4. Payment and receipt of income;
5. Ownership and occupancy of custom built home;
6. Service as officer and employee of business corporation;
7. Holding of licenses for conduct of profession;
8. Ownership of family corporation;
9. Ownership and occupancy of vacation home;
10. Ownership of cemetery lots;
11. Church attendance;
12. Church donations;
13. Church membership and committee participation;
14. Family doctors and dentist;
15. Car registration;
16. Driver’s license of taxpayer;
17. Driver’s license of taxpayer’s spouse;
18. Voter registration and actual voting;
19. Charge accounts;
20. Predominant banking and financial accounts;
21. Location of accountant, lawyer, financial and other professional advisors;
22. Wills prepared and located;
23. Education of children;
24. Majority of time spent in that State;
25. Country club membership;
26. Intended state of residence;
27. Presence of, and visits by, other family members;
28. Social event attendance; and
29. Professional memberships.
Unfortunately, the Corbett factors are sometimes improperly relied on as a bulletproof defense against residency claims even in circumstances where the taxpayer actually spends most of their time in California. The reality is even these factors are subjective and considered collectively when the Franchise Tax Board makes its case that a person remains subject to CA taxation. For example, it won’t matter if you have your tax returns prepared in Texas, get a Texas driver’s license and buy a home in Austin if the CA Franchise Tax Board is still able to show you actively conduct business in California or if, in their opinion, you have not truly changed your permanent residence for other reasons.
The CA Franchise Tax Board is aggressive and resourceful in building a case against those they suspect are illegitimately claiming nonresident tax status or otherwise claiming they are not subject to CA taxation. They will do internet searches, review social media profiles, review credit card receipts and even have been known to send investigators in person to check out the change of residence claims. Having a Texas area code and updating your mailing address will do you no good if your credit card receipts show you are frequently donating to a San Francisco charity, getting coffee multiple times a month in Orange County or are known to be a regular at a breakfast spot in Danville.
The question of changing residency sometimes comes up in situations involving the sale of a business. Assume, for example, that a California resident owns a business they will sell for $20,000,000. Also assume the business is formed as a Delaware Corporation but holds most of its business assets and conducts operations in California.
Under these circumstances, the only legitimate way California taxes can potentially be saved by a change in the owner’s personal residency is if he or she were to sell the stock or assets of the corporation after a considerable period of time had passed since the change of residence to another state. Unfortunately, even if the owner does validly change residence to another state, if the assets of the corporation are sold instead of the company stock, there could still be California-source income from the sale. That California-source income will be taxed by California at the corporation level and/or could flow through the corporation and be taxed to the owner individually even if California agrees the owner changed his or her residency status.
Under the right circumstances, especially in the context of a major business sale, a change in residency can save substantial California taxes. However, it must be planned for and analyzed correctly far in advance.
In addition, you must be prepared to actually leave and stay out of California for the sale year and sometime thereafter since the State can still make an argument that someone who leaves for only a year or two to avoid tax from a major sale still kept their California “domicile”. Thus, someone planning to end their California residency should understand the rules, the steps required, and the practicalities of the entire process. The best practice is not to try and fool the system at all if the truth is you just want to avoid paying taxes but still basically live in (or mostly in) California. Following both the letter and the spirit of the law is always the best course of action even if it means a higher tax bill. Pursuing strategies to reduce or avoid California income tax as a non-resident is only advisable for those who are permanently changing their state of residence and leaving the State of California behind for good.
Adam Broughton, CFP® is the CEO and lead wealth manager for PBL Wealth Management, a boutique financial planning and wealth management firm in Austin, TX. He serves high performing company leaders, employees and medical professionals. Adam is a former California resident and made the transition to Texas in 2015.