If you live in California, you probably feel that you are taxed to death. True, California has one of the highest tax rates in the country and the state will derive income from any and all sources that it can. This can get complicated if you conduct business across state lines.
In this chapter, I am going to address what sources of income are taxable in California, which extends beyond employment income. There is tax on tangible and intangible assets, income from S corps, partnerships and trusts, alimony, sale of stocks and the list goes on.
However, before considering the specific rules of taxation for each of the various sources of income, there is one overarching principle that can guide you in determining your tax liability regardless of your residency status: if any money you receive derives from a California source, chances are, you owe taxes on those earnings.
See FTB Pub 1100 Taxation of Nonresidents and Individuals Who Change Residency. If you are a resident of the state, income derived from any jurisdiction can be taxed. Id.
All of this is difficult to sort out. If you are confused and need some guidance, give me a call. I specialize in helping small business owners in California with their tax questions. That is one of the reasons why I created this series.
Determining Employment Within and Outside of California State Lines
Taxes stemming from employment (whether self-employment or otherwise) and benefits derived from employers are categories of taxes that a majority of individuals must grapple with come tax filing season.
This is especially true when it comes to non-residents needing to determine what their California tax liability is for transactions they have made through their business, trade or profession.
Under 18 CCR § 17951-4(a), when a non-resident operates a business or performs their trade or profession entirely outside of the state, any income derived from that work will not be taxable.
Nonetheless, this does not mean that such a non-resident cannot be taxed for other sources of income derived within the state. Intuitively, a nonresident running a business or performing services for their trade or profession entirely within the state will have to pay taxes for income derived from that work. Id.
However, when it comes to businesses, trades or professions carried out partially within and outside of the state of California, determining whether such work is taxable will be slightly more complicated.
Where the work performed by a non-resident in California is “separate, distinct and unconnected” to the work being performed out of the state to the extent that both the in-state and out-of-state activities could not be said to “be part of a unitary business, trade or profession,” then California will only tax the work that was performed in-state.
For example, if you were to have a guitar-manufacturing business in California and a golf retail business in Utah, only the guitar-manufacturing business would be taxed. On the other hand, if you are a screenplay writer living in Arizona and are hired to provide freelance screenplay writing services to a California business, you will be liable for taxes even if you did not perform your services in California. Such was the case of the taxpayer in the case of In the Matter of Blair S. Bindley, OTA Case No. 18032402 (May 30, 2019).
Income from S Corporations, Partnerships and Trusts
In most circumstances, income derived from California sources will be deemed taxable in the state. Conforming to this general principle, distributions from S corporations, partnerships and simple trusts that are based on California income sources are taxable for nonresidents.
Occasionally, California residents receiving distributions from an out-of-state entity will leave California at some point during a certain tax year. In such scenarios, the taxpayer will have to determine their tax liability through calculations that take into account their share of the organization and the company’s income in California and in other jurisdictions during the periods that the individual was and was not a resident.
For an example of how the tax liability would be calculated, refer to the FTB’s Residency and Sourcing Technical Manual, 23-25.
Benefits and Severance Pay
Companies may offer various benefits such as quarterly or end of year bonuses, sick leave, and vacation pay. Once more, when it comes to the taxation of such benefits, what matters is not your place of residency but rather, where the services for which the benefits are being given were performed. Thus, nonresidents receiving such benefits for their work performed in California will have to pay taxes on the benefits in the state.
Another benefit that taxpayers must take into account is moving benefits. In the state of California, any moving expenses paid for a move into the state for the purpose of employment within the state are taxable.
On the other hand, reimbursement costs for moves outside of the state are not taxable. On the topic of moving, taxpayers must also take into account any severance pay they received. Again, it will not matter that the taxpayer received severance pay after they moved out of the state. If the pay derives from work rendered in California, then it is still taxable.
Taxation of Intangible Property and Real Property
The rules regarding the taxation of stocks and bonds are completely different from the rules regarding taxation of partnership distributions or income on real property. Stocks, bonds and related financial instruments are considered intangible personal property. As such, the taxation of such instruments will be entirely dependent on where the holder of such instruments resides.
For example, if the corporation for which the taxpayer holds stock is incorporated in California but the taxpayer is a resident of Washington, the income derived from the sale of that stock will be subject to the state laws of Washington.
On the other hand, if that same stockholder moved to California and subsequently sold their stock in the same California corporation, income derived from the sale will be subject to California taxation not due to the corporation’s state of incorporation but rather because of the stockholder’s state of residence.
In terms of taxes owed for interest accrued in bank accounts, the state of California will deem interest accrued while the taxpayer was a resident of the state to be taxable. Therefore, when determining where you must pay taxes for income derived from intangible property, always remember that your place of residency at the time the income was derived will be the deciding factor.
On the other hand, when it comes to real property, the taxing jurisdiction will be the place in which the land is located. For installment sales of property, a sale in which the seller will receive at least one payment after the tax year in which the property was sold, capital gains income would be taxable but the interest income would not be if the seller is a non-resident.
By extension, an individual who sells real property located outside of California while being a California resident but subsequently moves out of state would not have to pay taxes on income (either capital or interest) derived from the sale.
Other Income Sources
Estates and trusts are another source of income that nonresidents must look out for when determining whether they owe any taxes in California. While the laws surrounding trusts are nuanced, there are two principles that nonresidents must know from a tax perspective:
- If a distribution of trust income is derived from a California source, then that income will be deemed taxable
- Unless such property gains a business situs, any intangible property owned by the trust or estate will be deemed taxable in the state where the beneficiary lives.
Therefore, nonresidents deriving income from estates or trusts must be aware of the sources from which that income is coming and whether any intangible property held in that estate or trust has established a business situs.
If you are a recipient of alimony and are a resident of California, the alimony will be considered taxable. However, if you are receiving alimony as a nonresident, such payments will not be considered taxable. Regardless of whether the residency status of the alimony payer, if the payer has a filing requirement in California, they can deduct the payments.
When it comes to stocks, the rules regarding taxation will depend on whether the stock is a statutory stock (employee or incentive stock purchase plans) or nonstatutory (stocks that do not fall into the aforementioned category). The law surrounding taxation of stocks is complicated but there are a few key points to consider.
Generally, stock options are taxed at the date that they are exercised. Nonresidents must be aware that nonstatutory stocks are taxed based on the proportion of services rendered in the state. Where the stock option compensation can be attributed entirely to work within the state of California, the tax will be determined based on the difference between the fair market value of the shares at the time of the sale and the option price.
Where a nonresident has performed services in and out of the state, it is necessary to determine how much of the compensation is attributable to the services performed in California. For examples of how the exercise of nonstatutory stock options would be calculated for nonresidents, see Residency and Sourcing Technical Manual, 45-46.
Restricted stock options become taxable at the time that they vest. For residents, the tax calculation is based on the fair market value at the time the stocks vested minus the purchase price.
For non-residents, the income derived from the stocks that is attributable to the services performed in the state must first be determined and the calculation for the difference between the fair market value and purchase price should be calculated for the period in which the services were performed in California. For example, refer to Residency and Sourcing Technical Manual, 52-53.
A common concern for many taxpayers is income derived from employee stock purchase plans. Stock options sold under these plans are taxable income.
The calculation of the taxable income from these sales will depend once more on the income being derived from services performed in California (for nonresidents) and whether the stock option was sold when the holding period requirement was met (qualified disposition) or if it was not met (non qualified disposition).
For examples of how taxes would be assessed for these various scenarios, refer to the examples in Residency and Sourcing Technical Manual, 54-55.
In summary, any income you derived from a California source is subject to taxation and the lines blur when dealing with multi-state transactions. Just keep in mind that sources that you would not expect to be taxed, like severance, are.
It is better to err on the side of caution than to have the Franchise Tax Board (FTB) come after you to collect. It is not a pleasant process and extensive enough that I have written an entire separate book about the FTB.
For the purposes of assessing your state tax liabilities … If you are stymied by what income you can expect to be taxed on, reach out to me. I have helped small business owners and other taxpayers throughout the state of California figure out their tax liabilities from multiple income sources. It is much better to know up front what you owe than be surprised down the road with collection letters or audit notices.