Introduction to the California Exit Tax
California has a unique tax called the "exit tax" and the consequences of being subject to this tax can be quite costly for someone who is a former resident or for someone who is thinking about becoming a future resident in this state. A brief introduction to the California exit tax is provided in the information below.
What is the CA Exit Tax?
At the core, the California exit tax is a tax on the gains from the sale of California real property for a nonresident. The gain resulting from the sale of California real property is subject to California taxation, regardless of where the gain is recognized for federal income tax purposes. Essentially, this tax for a nonresident simply mirrors the standard capital gain tax that is applicable to a California resident .
What is the Purpose of the California Exit Tax?
The exit tax requirement was enacted in 1989 and was intended to ensure that the State of California would collect the required tax due from individuals for whom California was their last residence before moving out of California. The California exit tax would also apply to related entities such as partnerships, corporations, limited liability companies and trusts.
How does the California exit tax work?
A nonresident selling California real property must pay to California the tax amount estimated to be due within 30 days of the sale of the property. FTB Form 593-C, Impart of Sale Escrow Statement must accompany the payment of the estimated tax due. The amount due is based on the sales price reported on Form 593, sometimes referred to as the withholding form. The California exit tax rates applicable to corporations and individuals are the same. The applicable rate is 8.84 percent (the California franchise tax rate) applied to the sales price of the real property.
Who’s Subject to California Exit Tax?
Subject to certain exceptions discussed below, a "covered expatriate", as defined under the Internal Revenue Code (the "Code") is subject to the California exit tax. Individuals who are "covered expatriates" under sections 877(a)(1) or 877A(g) of the Code are defined under Section 18011 of the California Revenue and Taxation Code to be "exceedingly covered expatriates". An individual will be a "covered expatriate" under Section 877(a)(1) of the Code if he or she: (1) relinquished his or her citizenship and (2) met one of the following requirements in the 5-year period ending before such relinquishment: Similarly, an individual will be a covered expatriate under Section 877A(g) of the Code if he or she: Although straightforward, the determination of whether an individual qualifies as a "covered expatriate" under the above tests requires an accurate determination of whether an individual’s prior years filing positions meet the requirements of the tests. In some cases, an individual may need to file a final return and attach a "dual status return" or a "long-term resident" statement to end his or her U.S. residency status.
An individual is not a "covered expatriate" if he or she: California law grants broad powers to the Franchise Tax Board ("FTB") to define exceptions to the above "de minimis" amounts outlined in the Code. For example, the FTB has historically asserted that the "$600 exclusion" referred to in the Code is a reference to the "income exclusion" for Medicare wages, rather than the $600 exclusion for income taxes. As a result, individuals who determine their annual income tax liability under the prepaid method by using 100% of the income taxes withheld by their employer must file a California return, even if the amount withheld is far less than $600. The FTB has also reserved the right to impose additional limitations on use of the "$600 exception," such as the requirement that the individual file a final return with the FTB for the year in which residency is relinquished.
How Is the California Exit Tax Calculated?
The exit tax is calculated based upon the statewide net worth of the individual as of the date of their change of residence, which is determined through a formula set forth below.
Net worth means total assets minus total liabilities and the measure of net worth is the change of an individual’s net worth during any calendar year in which the individual is subject to the exit tax. The formula for calculating the amount subject to the tax is summarized as follows: Estimate of Net Worth as of the Final Date of Residency. The amount subject to the exit tax may be challenged if the taxpayer can prove that such estimate is incorrect. In such case, the taxpayer is entitled to a refund of any excess taxes paid but must submit a request for refund within three years of the due date of the return for the year in which the exit tax is required to be paid.
For purposes of calculating the exit tax, California adopts the general valuation principles pursuant to the Tax Court’s holding in Lootens v. Commissioner, 82 T.C. 835 (1984), and the Tax Court’s opinion in Estate of Hollis, 28 T.C. 816 (1957).
Assets are generally valued at their fair market value. However, use of fair market value assumes that the asset is readily marketable; if an asset is subject to a buy-sell agreement, the value for purposes of the exit tax will be based upon the price at which the asset could be sold based upon the terms of that agreement.
If the estate tax return has determined values, those values can be used if they are correct, but the statute does not require using such values in all cases. For the exit tax a spouse’s community interest in property cannot be valued on the basis of a one-half interest. Any fractional interest in a property engages uncertainty regarding its fair market value and the appropriate discount is based upon a consideration of the following factors: Taxpayers are allowed to deduct debts and other obligations from their net worth based upon the premise that the taxpayer must satisfy them or else risk bankruptcy. In this regard, any amount that a taxpayer is expressly released from liability by written agreement may be taken as a deduction from the net worth of the departing taxpayer.
The exit tax is also subject to a limitation calculated as follows: 50% of unrecovered capital investment dollars (i.e., basis) attributable to California real property for the years the taxpayer was a resident of California, multiplied by the fraction of the decedent’s lifetime that they were a California resident divided by the life expectancy under Section 13001(a) of the Probate Code.
Potential Effects of the California Exit Tax
The exit tax could have significant financial and legal consequences for both individuals and businesses. If an individual or business is subject to the exit tax, the sale of their interest will be subject to a withholding tax of up to 10.3%, meaning the buyer must withhold this amount from the sale proceeds and pay it directly to California. For example, if an individual selling their interest owes a tax of 10% on a capital gain of $100 (i.e., $10), and they do not sell their interest until at least 10 years after establishing residency in another state, then they would pay an effective tax rate of between 0.3% and 10.3% on the entire $100. If the seller sells the interest before at least 10 years have passed since they established residency in the other state, then the tax rate would range from 0.3% to 1%, depending on how long they have been a resident of the other state, their effective California tax rate, and other factors.
In addition to the exit tax, if you are also considering a sale of the interest to an individual or business in California, then the seller should also determine whether, and to what extent, they will be subject to California income tax on the sale. For instance, if the seller is not a California resident, but they sell a 5% limited partnership interest in a California LP to a California resident, and the LP has real property in California, then the seller will likely be subject to California income tax, so the sale of their interest could be subject to both the California exit tax assessment and California state income tax.
If that same seller, however, sold their limited partnership interest after establishing residency outside of California for 10 years, and they continued to reside outside of California, then the exit tax may not apply. In such a circumstance, the LP could avoid California withholding requirements on the gain from such a sale transaction.
How to Reduce Exit Tax Liability
California taxpayers should consider several strategies to reduce their exit tax exposure as much as possible. First of all, the taxpayer should work with both legal counsel and financial advisors to minimize their exit tax liability. In particular, the taxpayer should analyze how the exit tax would apply to their potential gain/loss and determine whether there are any exemptions or exclusions that could reduce their exposure. Once again, planning begins early. Of course, in addition to the exit tax, the taxpayer should also consider how the exit or relocation will impact their federal tax situation.
As California taxpayers relocate out of California, they also should take the opportunity to structure their assets and their affairs to minimize their post-tax-exit tax liability . Depending on travel schedules, tied to their business (e.g., if the business has operations in multiple states or overseas), and other factors, the taxpayer may prepare and file a part-year 5401040NR and/or their federal tax return from their new state of residency.
Finally, if the taxpayer has appreciated assets (e.g., stocks, collectibles, heirlooms), they should consider whether it would make sense to sell any of those assets that have/continue to appreciate (even if the appreciation is being held "captive"). Selling of these appreciated assets at gain would result in the taxpayer reporting the capital gain and paying taxes during their year of exit, and the gain would not be taxed by their new state if it does not impose an exit tax.
Current Developments and Legal Challenges
In 2016, the California exit tax law was challenged in court in the case of Franchise Tax Board v. Harris (N.D. Cal., C 15-03504 TEH). A federal court ruled that the law was unconstitutional as it applied to non-residents because it treated them differently than resident investors.
In the wake of this decision, there have been calls to reform the law to treat non-residents the same as residents. Several proposals have been made, including a provision in the California State Budget for 2017 that would have repealed the law, and, in May 2017, Senate Bill 623, which would create compliance requirements for taxpayers and appoint an advisory committee to study and report on the issue of whether a business should be subject to California’s taxing jurisdiction in certain circumstances.
At this time, California does not appear to have informed affected taxpayers about how to comply with the law. The California State Budget for 2017 did not include any provisions related to the law. Senate Bill 623 has only passed the Senate Governance and Finance Committee. Because litigation may resume at any time, however, taxpayers may want to analyze their potential exposure under the law with respect to any sales or exchanges they are contemplating.
Conclusion: Planning Your California Exit
While the Exit Tax law has been on the books since 1993, it is a little known piece of legislation that is not often considered in tax planning, either by individuals or their advisors. Due to the uncertainty surrounding some of the questions addressed by the statute and the necessity of determining which government agency is empowered to collect the Exit Tax, it is highly recommended that anyone making the decision to leave for other states also factor the Exit Tax and its related rules into their exit strategy planning.
The Exit Tax is a poorly defined statutory creature that was adopted in response to the California Supreme Court’s employment decisions in the Campbell Soup Company case (1979) and the Sutherland Lumber-Southwest, Inc. (1994), both income sourcing cases. In these cases, the Supreme Court found that the state’s Franchise Tax Board could not require individuals to pay California taxes to the extent that the individuals had not physically been in the state the requisite days needed to be a "resident . " The outcome of the cases was that the results of those cases should be considered to determine how the application of California’s exit tax would be determined.
The legislation places the burden of providing proof that the requisite days have been met and that an individual is no longer a resident, as well as the burden of proof for the character of the income, on the tax payer. This is a problem because each government department involved in the collection of this tax has a different set of rules and only the California Franchise Tax Board can provide a final and binding determination.
The state should provide this type of guidance for California residents, but also for California non-residents who are dealing with California source income. Situations can arise where, although a taxpayer may not be a resident, he or she would not be able to conclusively prove their residency status, and thus be "presumed" to be a resident. This could leave many taxpayers vulnerable to a hefty tax bill. The exit tax is an issue that needs to be reviewed, analyzed, and included in any plan to relocate from California.