Can I Leave California, sell my QSBS and Return?

Several states, including California and Pennsylvania, choose to ignore federal QSBS tax treatment.

Since so many start-ups come from Silicon Valley, one of the most common questions we’re asked is “Can I leave California, move to a tax-free state to sell my QSBS, and return?” 

California’s Tax Climate

California may be the least tax-friendly state in the nation. Taxable income above $57,824 (or double that amount for joint filers) is assessed at a rate of 9.3%, even though that amount barely covers rent in the Bay Area. Rates climb from there all the way to 13.3%, the highest marginal rate of any state. Always hungry for more, lawmakers have recently proposed wealth taxes, estate taxes, and retroactively raising the top tax rate to 16.4%.

On top of that, California is one of the few places where capital gains are taxed at the same rate as ordinary income. Even most European nations assess a lower rate on capital gains, recognizing the important role risk-taking plays in job and business creation. Several impose no capital gains tax at all, including Belgium, Luxembourg and Switzerland.

It’s, therefore, no surprise that so many entrepreneurs and start-up workers seek to escape California’s onerous taxes on QSBS. 

The FTB Might Be Waiting For You

The good news is that if you permanently and legitimately leave California, you can avoid the FTB. The state has no claim on the shares after you leave, even though you earned them while living in California.

If you plan to return, however, it’s a different story. People often move out of state for a year, sell their QSBS and return, hoping to avoid California taxes on the sale. In reality, it’s not that simple.

The typical “move” entails renting a house in Nevada and going through the motions of establishing residency there, such as re-registering their cars and voting in local elections. Many keep their California home and travel back and forth, limiting their stay to less than six months. Needless to say, the FTB has caught onto these fake moves, which are common and easy to spot.

How California Defines a Resident

You can still be subject to California taxes even if you never set foot in the state in a given year. For tax purposes, the definition of a resident includes "Every individual domiciled in [California] who is outside the state for a temporary or transitory purpose." Once you return, the FTB can argue your move was temporary and impose state taxes on your income during your absence.

To truly escape California’s reach when you sell your QSBS shares, there are two tests you must pass.

1) The “Closest Connections Test”

The first test is designed to ensure you are truly a resident of your new state when the shares are sold. This test is exhaustive and hard to fake.

Known as the “Bragg factors” (Bragg, Cal. St. Bd. of Equal., May 28, 2003), the factors below will be considered in their entirety:

1. The location of all of the taxpayer's residential real property and the approximate sizes and values of each of the residences; 

2. The state wherein the taxpayer's spouse and children reside;

3. The state wherein the taxpayer's children attend school; 

4. The state wherein the taxpayer claims the homeowner's property tax exemption on a residence; 

5. The taxpayer's telephone records (i.e., the origination point of taxpayer's telephone calls); 

6. The number of days the taxpayer spends in California versus the number of days the taxpayer spends in other states, and the general purpose of such days (i.e., vacation, business, etc.); 

7. The location where the taxpayer files his tax returns, both federal and state, and the state of residence claimed by the taxpayer on such returns;

8. The location of the taxpayer's bank and savings accounts;

9. The origination point of the taxpayer's checking account transactions and credit card transactions; 

10. The state wherein the taxpayer maintains memberships in social, religious, and professional organizations; 

11. The state wherein the taxpayer registers his automobiles; 

12. The state wherein the taxpayer maintains a driver's license; 

13. The state wherein the taxpayer maintains voter registration and the taxpayer's voting participation history; 

14. The state wherein the taxpayer obtains professional services, such as doctors, dentists, accountants, and attorneys;

15. The state wherein the taxpayer is employed; 

16. The state wherein the taxpayer maintains or owns business interests; 

17. The state wherein the taxpayer holds a professional license or licenses; 

18. The state wherein the taxpayer owns investment real property; 

19. The indications in affidavits from various individuals discussing the taxpayer's residency.

No single point is determinative. Instead, the factors will be reviewed within the context of your situation. If enough of these items point to California, you may continue to be considered a resident for tax purposes. 

As you can see, some of these points have become outdated, such as the location of bank and savings accounts. Therefore, this list has continued to evolve. Recent years have seen the addition of the following factors, both of which appear to carry considerable weight:

• Where you return after traveling;

• Where you keep your pets.

FTB auditors are notoriously thorough and persistent. They often interview friends and neighbors, review phone and credit card records, and visit the organizations you claim to join. Their mandate allows and encourages them to be intrusive, and the standard rules of evidence offer you no protection.

As a practical matter, what you do with your California home is particularly critical. If you keep your primary residence and return to it, this provides the FTB with a strong argument that you intended to return to California all along. This argument is especially difficult to refute if you allow the home to go unrented while you’re gone.

2) The “Identifiable Purpose” Test

The second test is necessary to prove your move was more than “temporary or transitory”. To pass, a reasonable third party should be able to readily determine why you moved. Was it to obtain a new job? Be closer to family? Move to a retirement community? 

Even if an obvious reason exists, you must allow enough time to pass before returning to California. How long? Although there is no formal case law on this matter, one relevant ruling might shed some light:

"[W]here an individual expects to be out of California for an indefinite period which is expected to last more than two years, such individual will be considered to be out of the state for an indefinite period of substantial duration" and, therefore, is no longer considered a resident of California. (Appeal of Crozier, Cal. St. Bd. of Equal., Apr. 23, 1992)

The safest way to pass this test is to take a job for at least two years. If you’re leaving for any other reason, make sure it can stand up to close scrutiny from an examiner.

Bottom Line

Satisfying these tests is not easy. One should not expect to get away with a fake move. If you’re not willing to go to these lengths, you’re better off following the rules and paying California taxes, as confiscatory as they may be.

Either way, be sure to work with a team of competent advisors to ensure you are receiving accurate and current advice.

Nothing in this article shall be construed as tax or legal advice. The content is provided for informational purposes only and, there can be no guarantee of its accuracy. Consult your personal advisors prior to acting on any of the information contained in this article.

About the Author

Michael Yoder, CFP® is principal at Yoder Wealth Management (www.YoderWM.com), which provides high-end financial planning and investment advice for individuals and families. You can find more information here.

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