California Residency Tax Planning
The Issue
With the rise of ecommerce, advanced telecommunications, and the new prevalence of remote work due to the COVID pandemic, more and more people are choosing the option of living in one state while working for an employer in another, sometimes without ever setting foot at the employer’s place of business. The possibilities for reducing state income taxes through this scenario haven’t been lost on founders, hi-tech C-suite, and other key employees in California. By moving across state borders and working for a California business (or even running it) through Zoom and other telecommunications, they become nonresidents, potentially free of California’s high income tax rates, while still being able to participate in California’s thriving economy.
Of course, this situation isn’t lost on California’s tax enforcement agencies either. Because remote work can attract audit scrutiny, nonresidents working for California firms need to be careful and understand the tax rules governing remote work, especially when it comes to highly compensated former residents.
California Tax Rules For Remote Employees: The Basics
Generally, if you work in California, whether you’re a resident or not, you have to pay income taxes on the wages you earn for those services. That’s due to the “source rule”: California taxes all taxable income with a source in California regardless of the taxpayer’s residency. In other words, nonresidents pay California income taxes on taxable California-source income. With respect to employees, the source of income from services compensated by W-2 wages is the location where the services are performed, not the location of the employer. This is true even if you are a nonresident, even if you don’t work out of a California branch or office, and even if the wages are paid to you outside of California and booked as payments to a nonresident worker.
You can imagine how important this income-sourcing rule is for California’s tax enforcement agency, the Franchise Tax Board, when it comes to highly compensated employees like CEOs, actors, and professional athletes. When James Harden (a nonresident) travels to California to play the Lakers at Staples Center, California gets a cut of his pay for that night in the form of state income taxes. The reason: as an employee of his NBA team, Harden performed his services in California on that particular night. It doesn’t matter which team he plays for or where he resides. The wages from that game are taxable California-source income because he performed his employee services while physically present in California, even though he is a nonresident. He may be entitled to a tax credit under the ”other state tax credit” system that exists among the states to prevent double taxation on the same income. But that’s a different issue (and since California has the highest income tax rates on the top bracket, he still has to pay income taxes to California on the difference between the credit amount and amount of incomes imposed on the California-source income).
But what if the employee is a nonresident who never sets foot in California to perform his services? Then the source rule works in the nonresident’s favor, even if the employer is California based. Remember, for employees, the income sourcing of wages is determined by where the employee’s work is actually performed, not the location of the employer. A nonresident programmer who monitors and upgrades satellite dish software for a Los Angeles-based media company, all while sitting comfortably in front of his computer in his Austin, Texas condo, doesn’t earn California-source income and doesn’t have to pay California income taxes, as long as the work is performed outside of California.
At the employer end, while California companies have to withhold state income taxes for resident employees wherever they perform their services, and generally for nonresident employees for services performed in-state, this is not the case for nonresident employees who perform all their services outside of California.
____________________________________
Highly compensated managers, executives and key personnel who work remotely may also have significant taxes at stake. So, they too need to make sure duty days and other residency language appears in their employment contracts
____________________________________
This is true, by the way, even if the employee is a highly compensated corporate officer, an independent director, or a non-principal LLC manager, as long as the taxpayer is a nonresident, and the compensation takes the form of W-2 wages, though there are special rules for sourcing director salary, and it is important not to confuse wages paid to principals in their officer capacity with profit distributions made to them in their ownership capacity (which is addressed in this article).
But Of Course, It’s Never That Simple
Such are the basics for sourcing and reporting personal income taxes with respect to nonresident employees. But, of course, California’s taxation of nonresidents is nothing if not complex. Personal income taxes have to be distinguished from employment (payroll) taxes, which fall under separate rules.
California’s employment taxes involve unemployment insurance, state disability insurance, and employment training taxes. They are applied to employee wages and are usually withheld by the employer. California’s Employment Development Department (EDD) administers these taxes, not the FTB.
The EDD uses a multi-step analysis to determine whether a nonresident’s wages are subject to employment taxes, and whether the worker should be classified as a California employee by the employer (as opposed to an independent contractor).
The first step is to determine whether the nonresident employee performs any services in California. If not, employment taxes do not apply. The analysis is over. If any services are performed while physically present in California, then onto the next step.
The next step is the “localization test.” If most of the services are performed in California, with only incidental services performed elsewhere, the services of an employee are subject to California employment taxes.
If the localization test doesn’t apply in any state (that is, neither California nor the nonresident’s home state), then the EDD moves to the “base of operations test.” Under this test, the employee’s services are still considered subject to California employment taxes if some services are performed in California and the individual’s base of operations is in California. What is a “base of operations”? The EDD defines it as the place of more or less permanent nature from which the employee customarily starts work and returns within the terms of the same contract.
Finally, if neither of the above tests apply in any state, an employee’s services are considered subject to California employment taxes if some services are performed in California and the place from which the employer exercises general direction and control over the employee’s services is in California. This might alternatively be called “the branch test.” If the worker takes directions from a California branch or office, the tax jurisdiction is in force. If the worker takes directions from a branch or office not in California, then the employment taxes don’t apply.
Nonresident employees working for a California business typically avoid California employment taxes under the first and second tests, because most of their work or their base of operations is out of state. However, where the first two tests are inconclusive, they can get caught up in the direction and control test.
As you can see, these tests can be factually challenging and ambiguous. The result is employers often don’t apply them correctly, and nonresidents working remotely for California companies find themselves in a tax dispute with California or their employer.
Employees Versus Independent Contractors: The “Never Set Foot” Rule
Note, this entire analysis assumes the nonresident is an employee, and not an independent contractor (that is, the taxpayer receives W-2 wages versus 1099 payments). For nonresident independent contractors, different rules apply. Specifically, the issue is not where the independent contractor performed the services, but in what state the benefit was received. Accordingly, even if nonresident independent contractors never set foot in California, if they perform services for a California-based customer, they have an economic nexus with the state and are likely doing business in California for income tax purposes. That determination falls under a totally different set of stringent, often complex rules, which typically result in the net revenue from a sale of products or services to a California customer being subject to California income taxes (though there are special exemptions for sales of products, as opposed to services).
This often comes as a shock to nonresident independent contractors who receive an audit notice from the FTB for services performed entirely outside of California, and who thought the “never set foot” defense applies to them. It doesn’t. It only applies to employees. Moreover, the status of the vendor as independent contractor matters not only to nonresident sole proprietors, but any out-of-state business entity with sales to California customers. For more details about the economic nexus rules for independent contractors, see “Internet-Based Companies and ‘Doing Business’ in California: Be Careful What Your Website Says About You.”
The “Duty Days” Issue
Returning to our remote employee, so far so good if he hasn’t set foot in California. But what if a difficult glitch arises requiring the programmer to fly to Los Angeles to fix the system on site? Then everything changes. The source rule kicks in against the employee. In that case, just like Harden playing at Staples Center, or Paul Newman (who was a resident of Connecticut) making a movie in Hollywood, California taxes the income from those in-state services. What the FTB does then is to use an allocation formula based on “duty days” – the days the employee is present in California and working – in proportion to total work days.
The reason I mention Newman, by the way, is that he prevailed in a landmark case against the FTB for his performance in The Sting. Newman was able to show that the duty days formula should be based on what his contract actually required for working in and out of California, rather than the FTB’s own calculation of duty days. Paul L. and Joanne W. Newman v. FTB (1989) 208 Cal. App. 3d 972. That’s why it’s very important to have a written employment contract that clearly states what obligations an employee has to work in California and what constitutes such work. In fact, the union contracts of professional athletes and actors usually meticulously define and limit duty days, because so much potential state income taxes are at stake. Highly compensated managers, executives and key personnel who work remotely may also have significant taxes at stake. So, they too need to make sure duty days and other residency language appears in their employment contracts. And as a practical matter, it’s very rare for any remote worker not to have to make some visits to California to perform work while physically present in the state. The more time spent in state, the more taxes at issue, and the more pressing the need for dealing with duty days in the employment agreement.
Note also that it’s easy for James Harden to prove how many days he worked in California and how many days he worked outside of California. You just have to look up the NBA schedule. It’s not that easy for a programmer or other nonresident workers who perform services from their living room computers, and also make trips to California. Therefore, scrupulous record-keeping and detailed employment contracts are a necessity to prevail in an audit.
The Vesting Equity Compensation Plan Issue
If a vesting equity compensation plan are part of the remote worker’s compensation package, the tax implications of duty days increase astronomically. That’s because the number of duty days may determine what portion of the stock or other equity interest vesting is allocated to work in California, and if the options are non-qualified or their characterization as compensation isn’t limited by a section 83(b) election at the federal level, then they will be taxed as wage income. A portion of that compensation will be prorated to California, as a result of the duty days spent here. Needless to say, if the options are related to a startup that hits the jackpot in an IPO or a merger and acquisition, the value of the options and hence the income tax potentially due to California may be enormous. The taxation of equity compensation plans is inherently complex. The duty days concept adds an extra layer of complexity. Therefore, any remote worker with vesting stock options needs to have their compensation package carefully analyzed and managed for this vulnerability by tax counsel who understands California-sourcing rules. This applies to other forms of vesting compensation, such as restricted stock units, golden handcuffs, nonqualified deferred compensation, and phantom-stock incentive plans.
To add insult to injury, some of these nonqualified plans may not become taxable for many years. This is particularly true of deferred compensation plans. At that point, the taxpayer may no longer be associated with their California employer and many not have access to the employer’s records. If the nonresident didn’t keep track of his work in and outside of California during the vesting period, it may be difficult to convince an auditor not to allocate a maximum amount of income to California (as the FTB tried to do in the Newman case). The burden is on the taxpayer.
___________________________________________________________________________
Long-term nonresidents who begin remote employment with a California business don’t usually need extensive planning or input from a tax attorney
___________________________________________________________________________
Who Needs Remote Work Planning (And Who Doesn’t)?
For founders and key employees who are currently residents, taking advantage of remote work tax benefits requires that they first change residency. After that, the planning will focus on managing any retained contacts in California and entering into an employment agreement or remote work agreement consistent with nonresidency. A comprehensive, integrated attorney-drafted plan is usually a good idea, particularly where the former resident retains significant connections with California, such as a vacation home, business investments, and hard assets such as expensive vehicles, yachts, and aircraft.
In contrast, long-term nonresidents who begin remote employment with a California business don’t usually need extensive planning or input from a tax attorney. Rather, a knowledgeable CPA is often sufficient to determine their California reporting requirements, if any. The exception occurs where the nonresident remote worker is required to make trips to California to perform some of their employment duties. If the duty days add up to a significant amount of time, and the nonresident employee begins accumulating the kinds of contacts in California which typically accompany lengthy stays (such as renting living accommodations, keeping a vehicle, using a permanent office, etc.), then some additional planning may be in order for highly compensated individuals.
Employer Withholding And The Unintelligible Form DE-4
Note that this doesn’t mean longstanding nonresidents who begin employment with a California company won’t get into reporting disputes with their employer. Even large sophisticated companies like Facebook, Google, and PayPal seem unable to comprehend the W-2 sourcing and withholding rules. They tend to withhold first and ask questions later, often treating nonresident employees as if they were working in California full-time.
Part of the problem is reluctance by California employers to get involved in the overwhelming complexities of residency tax determinations. And part of it is the poorly drafted withholding exemption form provided by the EDD. California doesn’t use an IRS Form W-4 to determine or exempt withholding for California tax purposes. The EDD has its own form, a DE-4 “Employee’s Withholding Allowance Certificate.” The DE-4 is notoriously poorly drafted. Taken at face value it suggests that hardly anyone can avoid California income tax withholding, including nonresident employees who owe no California income taxes because they performed zero work in California. Rather than trying to parse the DE-4, California companies with nonresident workers tend to throw up their hands and withhold, leaving the problem for the nonresident employee to sort out with the FTB. The EDD tests for employment taxes and employee classification, discussed above, hardly help to clarify matters.
There is little purpose to arguing with the employer over this, unless you are a key employee with negotiating power. The EDD has put everybody in a no-win situation as a result of its incoherent withholding exemption form. Nonresident principals who receive W-2 wages can, of course, stop the withholding except where required by law. For principals and key employees, the withholding situation should all be memorialized in an employment contract with remote work and duty-days provisions.
If the California employer does withhold when it shouldn’t, it’s not the end of the world. California-source income is determined by law, not by employers’ withholding practices. What it does mean, however, is that the nonresident worker will have to file a nonresident return (Form 540NR) for the year at issue, and request a refund from the FTB for any income taxes withheld for compensation for work performed outside of California.
The tax professional to assist in filing for the refund is a knowledgeable CPA. A tax attorney is usually overkill, unless extremely large amounts of withheld income taxes are at stake.
In the normal course, filing a 540NR to obtain a refund doesn’t raise much audit risk for longstanding nonresident employees. However, it may do so for employees who are spending significant time in California, particularly if they own a second home here. Those residency-related facts have to be disclosed on Schedule CA of the 540NR, which may pique the interest of an FTB examiner. But again, unless very large amounts of income are at stake, this is something best handled by a CPA.
Summary, Caveats
To summarize, working remotely for a California firm as a nonresident has the potential for significant tax savings. But there are important caveats.
First, the entire favorable tax treatment of working remotely is based on the assumption that the employee is truly a legal nonresident. For employees who move from California to a lower tax state like Nevada, Texas, or Florida, it’s important they follow residency rules and meet the legal standard for changing California residency status. If they don’t make the necessary changes to disentangle themselves from California contacts and manage those they keep (such as working for a California company remotely), they may find themselves in an unpleasant residency tax audit with a large tax liability at stake.
Second, in contrast, long-term nonresidents who start remote work with a California company don’t usually need extensive planning, at least not with a tax attorney. They don’t face significant audit risk, unless they start spending an inordinate amount of time in California, begin accumulating significant California contacts, and receive large compensation packages. Generally, they only need the guidance of a knowledgeable CPA for tax reporting purposes, which may involve multistate returns and a refund request if the employer withheld or otherwise reported improperly.
Third, the favorable tax treatment of remote work depends on employee status. Independent contractors providing services or products to California customers fall under totally different rules involving thresholds for doing business in California.
Fourth, in a perfect world, the nonresident employee should have a written employment agreement or remote work agreement, which spells out the services to be performed out of state and in state, if any. In this way you, not the FTB, are in control of the duty-days allocation. In addition, the employment contract should reflect the employee’s nonresident status, deal with withholding, and handle other residency-related matters such as the office or branch the employee is assigned to, and provide for remote work. Generally, only principals and key employees need to or are in a position to obtain the appropriate language.
Finally, if any work is required on site (and it almost always will be at some point), the employee will need to keep good records of their work both in and out of state. This will allow the nonresident to make the most of the duty-days formula allocation. That allocation is all the more important if the nonresident’s compensation package includes vesting equity compensation. If that’s the case, how duty days are defined or limited may make a tremendous difference in the amount of California taxes owed when the options are exercised or otherwise become taxable.
________________________
Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.
________________________
No information contained in this post should be construed as legal advice from Justia Inc. or the individual author, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.