California is known for having some of the most significant in-state taxes in the country with a 13.3% annual income tax rate.
However, did you know that you might still be taxed even after you leave the state?
Yep! Thanks to the California exit tax legislation, depending on how much money you get from in-state activities, such as investments in real estate or business operations, you could still be treated like a Californian on your next tax return!
Join us as we walk you through the California wealth and exit tax questions, such as “what is the exit tax in california,” how much it is, who it applies to, and a deeper dive into the CA wealth tax proposal and the Assembly Bill 2088.
The California exit tax is a one-time tax that must be paid by businesses and individuals who relocate outside of California. The tax is based on the value of the business or individual's assets, including property, stocks, and other investments.
It forms part of the larger California wealth tax, whereby the state imposes a tax based on its residents’ wealth.
Those who have lived in the state at any point in time in the past and who earn an annual income greater than $30 million are affected by the wealth tax and would have to pay an annual tax on their wealth for as long as 10 years after they have left the state.
The amount of the California exit tax is 0.4% of an individuals’ net worth over $30,000,000 in a tax year, no matter where it’s located—within CA, other states within the US, or overseas. This amount is halved to $15,000,000 if a married taxpayer files a separate return to their spouse.
The one caveat is that there is no California exit tax on real estate (but if the real estate is within state lines, it would still be taxed under California Revenue and Tax Code § 17591).
The exit tax applies to both businesses and individuals who leave California. This includes businesses that move their operations out of state as well as individuals who relocate to another state. It should be noted that the exit tax only applies if you're moving to another state, not within California.
The exit tax is intended to recoup some of the money that California has invested in these businesses and individuals.
For example, if a business owner has received tax breaks or other financial incentives from the state, the exit tax ensures that they will still contribute some money to California's economy even after they leave.
The primary reason for the enactment of the exit tax was to close a loophole that allowed people to avoid paying taxes on their capital gains.
Under federal law, capital gains are only taxed when they are realized. This means that if someone buys a stock for $1,000 and it goes up to $10,000, they don't have to pay taxes on that $9,000 until they sell the stock.
If that person lived in California and then moved to another state before selling the stock, they would never have to pay taxes on that $9,000 in capital gains.
To close this loophole, the Golden State enacted the California wealth and exit tax. Now, anyone who leaves the state is required to pay taxes on their unrealized capital gains.
It’s been criticized by many people, who argue that it is unfair and punitive. They point out that many people who are leaving California are doing so because they can no longer afford to live there.
By California taxing people who leave even more, they say the state is effectively pushing them out.
What's more, they argue that the exit tax will make it even harder for these businesses and individuals to get back on their feet financially once they're in their new location.
California is in the midst of a major overhaul of its tax code, which could expand the state’s ability to tax non-residents, even if they sever their connections with the state.
The bill that is causing quite a stir among business and property owners is called the Assembly Bill 2088 (AB 2088), which is, effectively, the California wealth tax proposal.
AB 2088 was introduced in Sacramento in August of 2020, and it proposes a California wealth tax for the first time in the state, affecting individuals who have lived in the state and who make an annual income greater than $30 million.
However, before we delve into the loopholes and exceptions to this ambitious, but potentially consequential, new bill, we must first understand how California’s tax code could impact you, even as a non-resident.
Whether you are a landowner or an entrepreneur with connections to the state, understanding the tax implications is crucial to mitigating the possibility of having to pay some pretty significant taxes.
First, California’s Franchise Tax Board (FTB) is in charge of setting the requirements for California citizenship, and plays a pivotal part in a California residency audit.
Factors that affect its determination include:
your largest residential property's location
Residence of your spouse and children
School districts where your children attend
Whether your account statements from your credit cards show your residence in California
Exemptions you may claim as a homeowner in California
Approximately how many days you spend in California each year
Whether your California residence is listed on a federal and local tax return
Where you vote
Where your vehicles are registered
Looking at these factors, you might think that removing yourself physically from the state would result in them no longer applying and saving you a fair amount of money.
There is some truth to this assumption, as the Franchise Tax Board actually cannot base your residence in California if you do not physically reside within your home in California for most of the year.
This is especially convenient for people who frequently travel or, perhaps, own other residential property outside of California.
Still, even if you change addresses, remove California on your tax returns, and move across the country, you could still be impacted by the California tax code when it comes to taxes.
The above factors listed by the FTB are to be used as a guideline; they are certainly not the only things to consider.
A common fallacy: people frequently believe that moving out of California will make them exempt from paying individual income taxes. This is not necessarily the case, and it would be wrong to assume relocation is a blanket solution.
California looks at two major factors when determining whether an individual’s income is taxable and how that then applies to the California exit tax proposal 2020:
Let’s look at these two in more detail and how they apply to the “leaving California tax”, as it’s sometimes known...
According to the California Revenue and Tax Code § 17591, any financial ties you have to California follow you to your new state of residence.
In other words, if you have invested in or own real estate within California, you still need to pay in-state tax on that real estate, even if you technically reside in another state.
This tax code applies even at the time of sale of that real estate, because it falls under the category of “California-source income”—income derived from sources within California state lines.
FTB Publication 1031 elaborates further on the types of real estate and property investments that are subject to California nonresident taxes:
For individuals with spouses who are California residents, the spouse’s income is considered community property and is, therefore, split equally by the couple.
The community property share of that income is taxable to each spouse, even if one of the spouses lives outside of California and has never lived in the state before.
Any gain (or loss) from selling real estate located in the state of California is taxable under California’s tax code.
This applies even if the owner is a non-resident who has never lived within the state. The location of the property controls whether the tax applies.
Another situation to be wary of is owning or operating a business within California state lines as a non-resident.
Many business owners falsely believe that because they live outside of California or conduct part of their business operations out-of-state that this exempts them from California taxes.
Under the Constitution, a business’s income may be taxed by the percentage of business activity conducted within a given state.
As applied to California, if a business’s manufacturing facilities are located in Nevada but its workforce, such as remote and/or in-person workers, and corporate offices are in Los Angeles, then that business has demonstrated a sufficient “nexus” or connection with California.
Thus, it is subject to the state’s taxes, and the exit tax in California applies.
If a business demonstrates a sufficient connection or “nexus” to the state of California, it may be subject to the state’s taxes, regardless of whether some of its operations or employees live out of state.
Still, this does not necessarily mean that the California taxes will apply to that business’s total income, especially if only a fraction of the business’s total revenue is derived from California sources.
Say, for example, a business earns $10 million in annual income with 40% from California consumers and 60% from Nevada consumers. California will only be able to tax $4 million of the total $10 million income, because that is the proportion of California-sourced income.
FTB Publication 1031 elaborates further on the types of business activities that are subject to California non-resident taxes:
Salary and wages: To non-residents, wages and salaries for services performed in California are taxable, regardless of the location of the employer or employee.
Income from business: Income from a business, trade, or profession conducted in the state may be taxed on non-residents.
In terms of whether the California exit tax 2020 proposal bill will actually stand the test of litigation, the likelihood of courts nullifying the law, should it be enacted, is high.
The exit tax clearly violates the constitutional right to travel, because it burdens individuals from:
To provide some context to why courts will likely find the tax unconstitutional, it is important to first understand the levels of “scrutiny” or critical inspection of the law that will be applied.
Since the law affects a fundamental constitutional right—the right to travel—strict scrutiny will apply here.
Under strict scrutiny, the burden is on the legislature to show that the law was enacted to further a “compelling government interest” and the law is “narrowly tailored” to achieve that interest.
In other words, the question revolves around whether the law is essential or necessary and whether there are alternative, less-intrusive methods of attaining the same result.
The state of California will likely argue that the “compelling” interest is to mitigate economic inequality and the disparity between classes. This is certainly an important and necessary issue to address.
However, coming up with an argument to show that the exit tax is “narrowly tailored” in that no other alternatives for achieving the purpose are available will be an uphill battle.
Overall, because the bill will impact a fundamental constitutional right and there are likely many other ways to go about addressing the compelling interest it aims to address, the likelihood of the exit tax withstanding strict scrutiny is slim.
Nevertheless, litigating the issue will take time, and it’s important to prepare for any impact the bill may have upon being enacted.
The first step to approaching this California tax for leaving state is to consult a licensed tax attorney and explore your options.
Depending on your situation, taxes may apply to you in ways you might never anticipate.
Further, having a professional explain to you what parts of your income, business operations and activities, and wealth are taxable under California law will help to ensure that you do not suffer from unfortunate surprises on your next tax statement.
The AB 2088 Bill is responsible for the California wealth tax over 10 years ruling, whereby if you leave California, the State can tax you for up to 10 years.
As part of this California 10 year tax, the exit tax is 0.4% of an individuals’ net worth over $30,000,000 in a tax year, which is halved if you have a spouse filing a separate tax return.
However, this all depends on your residency status, which can be a complicated matter. Get in touch with our team if you need help with residency or anything to do with the California exit tax.
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