Sam Brotman, JD, LLM, MBA January 8, 2021 17 min read

An Update on California's Proposals to Tax the Rich

During the summer of 2020, California’s political machinery continued to whine and hum. As its populace sheltered in place with COVID-19, two tax bills were introduced on the state’s Assembly floor.  

One bill would establish a wealth tax targeting high-net-worth individuals. The second was a bill set to increase the personal income tax rates of pretty much the same group of very wealthy Californians. 

Targeting the rich is the way to create a more equitable tax system, says the bill’s advocates. Taxing the state’s highest income earners will provide a bridge for the population’s rising income inequality. In addition, the new revenue will be slated for public goods and services, thus improving economic opportunity. 

Opponents of the two bills see them as another way for California to stifle growth, forcing millionaires to leave the state. This concern ABOUT the richest residents avoiding the wealth tax by moving to a different state holds some truth, but only a kernel.

In 2004, New Jersey imposed a millionaire’s tax which raised its income tax rate on the wealthiest of its constituents by 2.6 percentage points to 8.97. According to an article in the National Tax Journal, June 2011, “Tax-induced migration is estimated to be higher among people of retirement age, people living on investment income rather than wages, and people who work (and pay tax) entirely in-state.” 

Neither bill was passed by California’s deadline to vote on 2020 legislation, but it is likely that both bills will be debated again when California’s Legislature reconvenes for a new session. Because the new Legislature will increase taxes, in order to pass they require a super-majority which is a two-thirds vote, instead of a simple majority.

Wealth Tax

Most taxes in the United States are levied on income, payroll, property, sales, and capital gains. California’s proposed wealth tax would be the first of its kind in the United States. 

Rob Bonta’s (D-Oakland) proposed Assembly Bill No. 2088 would apply to individual net worth. This includes wealth that is earned, inherited or obtained through gifts and estates. If passed, the bill would affect about 30,400 Californians and raise $7,500,000,000 in tax revenue for the state

Wealth taxes may be new in the United States, but they are not new around the globe. However, according to an article in the Wall Street Journal, December 2020, “taxing someone who spends only 60 days in the state in any single year—and extending that tax over an ensuing decade—would be something new under the sun.”

Assembly Bill No. 2088

Assembly Bill 2088 would impose an annual tax rate of 0.4 percent of California residents’ net worth that is in excess of $30 million or in excess of $15 million in the case of a married taxpayer filing separately. According to the bill, “net worth” is calculated from 18 different categories of assets: 

  • Stock in any publicly and privately traded C-corporation
  • Stock in any S-corporation
  • Interests in any partnership
  • Interests in any private equity or hedge fund
  • Interests in any other non-corporate businesses
  • Bonds and interest-bearing savings accounts
  • Cash and deposits
  • Farm assets
  • Interest in mutual funds or index funds
  • Put and call options
  • Futures contracts
  • Art and collectibles
  • Financial assets held offshore
  • Pension funds
  • Other assets, excluding real property
  • Debts other than mortgages or other liabilities secured
  • by Real property
  • Real property
  • Mortgages and other liabilities secured by real property.

Under AB 2088, directly held real property, mortgages, and other liabilities secured by directly held property will not be considered in calculating net worth but must be listed for the “avoidance of doubt.” Although a taxpayer’s directly held property will not count towards net worth, property held indirectly, as through a corporation, partnership, limited liability company, trust, or other such legal form will be included in net worth.

The Wealth Tax calls for the calculation of net worth in the same manner as calculation of the Federal Estate Tax. Net worth will be the value of assets on December 31 of each year.

The bill calls for the California Franchise Tax Board (“FTB”) to adopt regulations to prevent any tax avoidance or evasion. Accordingly, if the primary purpose of a transfer or material change is to reduce the value of a taxpayer’s net worth, it will be disregarded for tax purposes. The bill is vague in how this will be decided.

For publicly traded assets, the value of the asset will be the fair market value. For non-publicly traded assets, “the best available methodology and information shall be used to estimate a current value at the end of the tax year.” The bill’s vagueness continues in regard to valuation of non-publicly traded assets and gives large discretion to the FTB in how it will enforce the valuation.

Cash Liquidity Constrainments

One concern that opponents of the Wealth Tax have is that many of the people who will be subject to the tax do not have the cash on hand to pay, because their money is tied up in securities and ownership of businesses.

These people are described as liquidity constrained. The Legislature presumes that any taxpayer subject to the Wealth Tax is not a liquidity-constrained taxpayer if the taxpayer’s hard-to-value assets are less than 80 percent of the taxpayer’s total net worth.

Liquidity-constrained taxpayers with ownership interests in hard-to-value assets and business entities, such as startup businesses, may contract with the state for tax deferral with a valuation of the asset to come in the future.

Taxpayers can get a credit for pro rata share of any property taxes paid on an asset. Any amount of net worth wealth tax on those assets paid to another jurisdiction shall be credited against the Wealth Tax. However, the value of credits shall not exceed the total tax owed under the Wealth Tax.

Divided Days of Residency

Under AB 2088, a taxpayer is a resident of California for a given year if they are an income taxpayer for said year. Residents who only live in California for part of the year are subject to the Wealth Tax, and their net worth will be multiplied by the percentage of days in the year such taxpayer was present in California.

A temporary resident is someone who is not a part-year resident but spends more than 60 days in California. Like part-year residents, temporary residents’ net worth is multiplied by the percentage of days spent in California, e.g., if the resident spends 60 days in California, their net worth will be multiplied by 16.4 percent.

The most controversial part of the bill is the portion committed to the “wealth tax resident.” This is any taxpayer with extreme wealth sourced to California.

Under this portion, the taxpayer’s wealth is subject to the Wealth Tax for up to 10 years even if the taxpayer leaves the state of California. “The portion of taxpayer’s wealth subject to the tax imposed shall be multiplied by a fraction, the numerator of which shall be years of residence in California over the last 10 years, and the denominator of which shall be 10.”

For example, a resident who has been a resident of California for the past 10 years will pay 100 percent of the 0.4 percent Wealth Tax. But if taxpayer named John Doe leaves for a state like Texas, John Doe will still pay 90 percent of the 0.4 percent Wealth Tax in year one, 80 percent in year two, and so on.

A new resident of California will start at 10 percent of the 0.4 percent rate for the first year, and then increase 10 percent each year until they reach the full 100 percent. If the taxpayer leaves in the middle of a given year, that year will be a fraction between zero and one, which will be included in the numerator.

The penalty for failure to comply with these rules is the greater of $1,000,000 $1 million? or 20 percent of the tax shown on the return for the taxable year.

Income Tax May Go Up

This summer, California also considered a bill that would increase taxes on high income Californians. California already has the highest income tax rates in the nation, and this would only increase those rates.

In the case of Assembly Bill No. 1253, wealth taxes would be increased on high-income Californians by 1 percent (13.3 to 14.3 percent) on income over $1,181,484; 3 percent (13.3 to 16.3 percent)
on income over $2,362,968; and 3.5 percent (13.3 to 16.8 percent) on income over $5,907,420. The odd dollar amounts are $1 million;
$2 million; and $5 million plus inflation adjustments respectively.

Relitigating is Likely

Although these bills did not pass, it is likely that they will be
relitigated in California Legislature’s next session and this can serve as an outline of the mechanics of the two bills. There are still many questions that remain.

The bills were left vague in order to allow the California FTB to have flexibility to enact these regulations. Additionally, the text of the bills may change when reintroduced to the legislation.

With the New Year just beginning and Sacramento still struggling with the continued spread of COVID-19 and its ramifications, the recent wildfires and affordable housing, it may take some time yet for California’s legislators to address the proposed wealth tax once more. But it more than likely will.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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