What Is an Exit Tax?
Exit taxes are taxes levied by a state on taxpayers who are moving out of that state, generally to recapture some of the tax benefit the taxpayer has received while a resident of that state. The theory is that the taxpayer has enjoyed the benefits of reduced state taxes for several years by virtue of living in the state, and after a certain period of time, on the basis of its laws in effect at the time of the taxpayer’s departure, that state taxes a portion of the savings to the taxpayer as a tax on the taxpayer’s income after it has left the state.
The first exit taxes were based on amounts received from the sale of stock that had been acquired during the years the taxpayer was a resident of the taxing state. The theory here of the taxing state was that a taxpayer will often time the receipt of a lump sum of cash to coincide with a move to another state. Thus , although the taxpayer was not residing in the state upon receipt of the large sums of cash, the taxing state would levy an exit tax on the amount of stock sales based on capital gains accrued as of the date the taxpayer had been a resident of the taxing state. The largest and most well-known exit tax is California’s, which is calculated as a % of capital gains accrued as of the day of exit. However, there are also exit taxes in 8 other states (Nevada, Kentucky, New Jersey, Ohio, Maine, Nebraska, Iowa and Mississippi).
Does the State of California Have an Exit Tax?
Recent legislative proposals to impose exit taxes in California have been met with criticism by some lawmakers who say the idea is both a bad policy and unlikely to succeed. Income taxes based on a taxpayer’s worldwide income can follow a taxpayer to a new state, as long as there is jurisdiction to tax at least some of the income in the new state.
California has no exit tax. Indeed, California tax law is very favorable for individuals who relocate from California. Under California Revenue and Taxation Code section 18032, an individual who moves out of California and becomes a full year resident of another state will be taxed by California only on California Source Income, i.e., income derived from or attributable to California within the meaning of California Revenue & Taxation Code sections 17951 and § 17952. Expats may effectively eliminate tax on California Source Income by moving their residences to a low or no tax jurisdiction, if they avoid committing the sins that can cause someone to have California Source Income, such as owning real estate or having business activity in California.
California no longer taxes individuals solely on the basis of residency. Prior to 2002, a taxpayer with green card or substantial presence residency could be liable for California tax on Massachusetts Source income. However, beginning in 2002, California no longer considers a green card holder or an individual with substantial presence as a California resident unless the individual either actually resides in California, CA Revenue & Taxation Code section 17014 & 17016.2(a)(3), or is domiciled in California and does not establish a domicile in another state, CA Revenue & Taxation Code section 17014 & 17016.2(b). Many green card holders or holders of substantial presence who do not actually reside in California are "locked in" for tax purposes to CA 2/20/99, Revenue and Taxation Code section 35116(b)(1).
As a practical matter, given the substantial state and local tax consequences of individuals relocating out of California, it is common for California residents who are considering relocation to have CPA advisers review the results of a planned move from California well in advance of the move.
Explaining California’s Wealth Tax Proposals
As the cost of living increases in California, so does the push for higher taxes on wealthy residents. Exiting the state, temporarily or permanently, may not be a solution if tax hikes continue to rise, and even the wealthiest Californians can be hit with hefty severance from their fortune or income due to high exit tax rates. Take the example of the well-to-do couple who moved to Texas to avoid paying state taxes. After two years of enjoying the benefits of being in a state that has no income tax, Texas bill came in the mail. It was a $158,000 tab for back taxes on the wife’s California stock options through her Silicon Valley job. Even in one of the most tax-friendly states in the country, the couple later had a $30,000 audit penalty lumped on top of the stiff penalty incurred when they underpaid their California taxes. The government found that they still owed taxes on the wife’s income from her remote job in California. The state taxman can still rule your purse strings long after you’re gone. Following the couple’s lead, many other high rollers from the Golden State are flocking to states like zero-income-tax Florida and popular cloudy Ohio. As the collective demand for talent soars, states are more willing to offer tax breaks like no income tax for 10 years to big businesses needing population boosts. Unfortunately, for the wealthy who are leaving the sunny coast for an easy life, legislature is now hammering away at alarmingly taxing forces to keep Californians from leaving without paying up. State lawmakers are advancing a wealth tax in the Governor’s race via SB 726, the California Wealth Tax Act. This state budget proposal may be a hefty 1% tax on net worths above $50 million (with a 1.5% tax rate for net worths above $1 billion). However, the proposal has already hit opposition and has not passed yet. California has also passed California Proposition 19, which was passed to increase property tax revenues by requiring a reassessment for tax purposes anytime real property transfers ownership. The specific provisions of the measure, however, has raised alarms about its possible "exit tax" implications – repealing the Proposition 58 parent-child exclusion for property transferred to heirs. California homeowners older than 55 who have lived in their home for more than five years may sell their home and transfer the tax value of their old property to their new property-including households who have lost a relative but haven’t sold the property yet. This can result in huge property tax savings for property owners who have owned their home for several decades. Prop. 19 will change tax-roll measures when real property ownership transfers from parents or grandparents to children or grandchildren, there shall be authorized a reappraisal; however, the property may be eligible for the base year value transfer, subject to certain conditions. In other words, when you leave your home, your heirs inherit the much higher tax basis of the property rather than your once lower tax basis, which means they get stuck with a substantially higher property tax obligation. This strike on the inheritance is enforced on visitation too. So even if you only live in the home a few days, your relatives take the property, and all the tax obligations come with it. This kind of forcible measure may force wealthy Estate Executors to rethink their strategies on how to pass down their properties to their heirs once they are gone as well. No retreat is assumed to satisfy the demands of the Californian tax collector.
The Familial and Financial Implications of Leaving California
To fully understand California’s exit tax, you must understand how the state taxes its residents when that person decides to leave the state. A state resident can be taxed on income that they earned while a resident of the state, as well as any earnings Center Holdings, LLC may have while they are living in the state. If you move out of California, you will be subject to capital gains taxes as though you still live in California on any earnings you made while living in the state. Because your California income taxes are based on the calendar year, you can stay in the state until December 31 and move out of the state at the beginning of the new year.
California residents are subject to California property taxes. According to section 2.1 of Article XIII of the California Constitution, for taxes levied for the 1986-87 fiscal year and thereafter, all property taxes on a parcel of real Property shall be based on the base year value of the real property plus an annual inflation factor, not to exceed 2% unless the property is "newly constructed." What this means is that each year the county will review your property tax bill and increase the amount you pay based on inflation, with 2% being the maximum increase. Even with this increase, it will be a fraction of what you would be paying if you hadn’t moved from California. If you continue to earn income in California after you move, you are required the pay taxes on that income to California.
How to Plan for a Move Away from California
Fortunately, there is a transition period in place so that you can avoid exit taxes. In order to avoid an exit tax, the taxpayer must sever all informally and legally established connections to California. The taxpayer must show a lack of legal and financial connections to the State and no plans to return to the State. There are some ways to prepare for an exit tax.
Quite possibly the easiest way to prepare is to sever as many ties and legal connections to California as possible well before the actual date of the move. Establishing physical presence, or "presence" in the state that one is moving to, should be as early as possible.
A taxpayer may wish to engage in "changing residence" , prior to the actual move, by showing an intent for a new residence in the new state before moving there. The new residence and home should be established before moving. This can involve things like changing information on social media platforms, opening up new bank accounts while closing both California and new state bank accounts, and moving most of your furniture to the new home before actually moving.
Finally, it is often in the taxpayer’s best interest to consult a tax professional in the new state and a tax professional who specializes in California taxes around the same time as the move, to properly plan out the separation from California with at least one year advance notice.
Experts Weigh in on California Tax Policy
"In order to develop effective policies that can sustain a state’s revenues and encourage individuals to remain in their jurisdiction of residence, elected officials should heed the advice of economists and experts in state and local tax policy," states Professor Elizabeth Garrett, an expert on tax policy and a former University of Southern California law professor, in her 2006 article that appeared in the USC Law Review. "Their analysis suggests that states should: (1) maintain a broadly based personal income tax with low rates and low exemptions; (2) adopt a flat-rate-based personal income tax; (3) favor a progressive personal income tax over a progressive tax with special rates on capital gains; (4) avoid taxing capital gains as ordinary income; (5) avoid taxing income from all sources at the same rate; (6) avoid taxing capital gains at a higher rate than ordinary income; (7) avoid taxing capital gains at a higher marginal rate than taxpayers at the top of the wage rate distribution; and (8) avoid means testing tax credits," writes Professor Garrett.
Opinions on the viability and application of the California exit tax, as it is called by its proponents, are varied among experts. According to John W. Van de Kamp Jr., member at Manatt Phelps and Phillips, a national law firm headquartered in Los Angeles that specializes in government relations in the state, there is no chance of passage to the exit tax.
"None. I’m telling you it’s just posturing. that’s all it is. The Governor will never allow it, and when he is gone, come back and ask me if you want me to pay a dollar. It’s just rhetoric," he says.
"If you mean the top 1 percent, they currently pay roughly 47 percent of all the PIT [personal income tax] collected. It is far from regressive," says John Lutz, Chairman of the Tax Department at Jeffer Mangels Butler & Mitchell LLP, a Los Angeles-based full-service law firm.
"The concern I have is that the top 50 percent pays only 97 percent of all the income taxes paid. The lower half of the wage earners pay 3 percent. We are looking down the barrel at the same situation we faced early in the 1980s, which contributed to the property tax revolt in California. Even county officials protested the somewhat regressive measures, such as the passage of Proposition 13," notes Mr. Lutz.
While an exit tax may not be in store for the time being, other tax increases are suggested by experts to balance the deficit. For instance, the Griffith Park bond proposal put on the Los Angeles ballot and a potential tax on beverages in the city are examples of taxing mechanisms suggested by experts.
These examples are supported by tax policy leaders, as stated by the U.S. Chamber Institute for Legal Reform Director of Policy, Eric Sanchez, and senior state tax policy leader in New York, David Magdaleno.
"It will be a difficult proposition to find the votes in the legislature for a value-added tax or an increase in the income tax, or a special additional sales tax," says Mr. Sanchez. "The guts it takes to do that are hard to find in both parties, with Democrats having a super majority and Republicans having the clout to defeat any tax increase."
"There will be some tax increases, but not too many because the economy still hasn’t fully recovered from the financial crisis, and the impact of the 2012 federal income tax reform legislation, which included an increase in the taxes on dividends and long-term capital gains, hurt California," states Mr. Magdaleno. "I am not a fan of the millionaire tax. We are nearing the need to reduce taxes for most taxpayers, not increase them."
Exit Taxes and the Future of California
As the discussion surrounding exit taxes gains momentum, the future of California’s regulatory landscape remains uncertain. Speculation has arisen regarding possible legislative action on the issue, with some lawmakers advocating for a more structured framework to govern such taxes, while others argue for a more flexible approach that would consider the unique circumstances of each taxpayer. This division highlights a need for clarity and consistency in the implementation of such measures .
One proposal under consideration is a gradual phase-in approach, allowing taxpayers to prepare for the potential imposition of an exit tax. Such an approach could provide predictability for both residents and businesses, but it remains to be seen whether lawmakers will pursue this path. Regardless of the method implemented, residents are sure to follow proposed legislation closely and engage in the public discourse.