Analyzing The Legality of California’s Exit Tax

What Is California’s Exit Tax?

California’s "exit tax" is the informal name given to a provision within California’s state income tax law (Revenue and Taxation Code Section 17951) that taxes the income of former California residents for up to 10 years after they’ve moved out of the state if they continue to have income from California sources. Also referred to as "Residency Based Income Taxation" or "RBIT", the exit tax applies to individuals with gross income over $200,000 in the year before they leave California.
The exit tax is assessed on all of an individual’s income that was reported on a California tax return in the year prior to the year in which they moved out of the state, reduced by a 5% reduction for each full year worked in a job away from the state for the next ten years after the move .
California requires state income tax returns to be filed for the year that you moved out of the state, despite you being a non-resident for the remainder of the year. This means you will owe California income tax for income earned while a California resident.
If you have California-source income after your residency in the state ended, you will need to continue to file a California income tax return for as long as you receive or earn income from California sources. However, for the first 10 years, you can reduce the amount you owe to California by 5% for each full year you performed services outside the state. It is important to note that a full year is generally defined as having performed services in two or more weeks before and after a leap year February 29, and not based on a calendar year.

The Legality of California’s Exit Tax

The legality of California’s exit tax has not been decided in the courts, but it is based on the straightforward, original law that imposed a tax on people who removed property from the state. In many ways, it is like a severance tax. Severance taxes apply to the removal of natural resources such as minerals and oil. The old law simply related to the transfer of any type of property out of California. The specific legal provision for this was California Revenue and Taxation Code Section 17740(a-1) which provided in relevant part:
"[W]henever, by attachment or levy under an writ of attachment, execution, lien, mortgage, or deed of trust, the rights or powers of a judgment debtor are sold, the transfer of the subject property out of California shall be subject to a California documentary transfer tax imposed at the highest rate provided in Section 11911, with respect to real property, private railcar property, or manufactured homes; or at the rate of four dollars and seventy cents ($4.70) for each five hundred dollars or fractional part thereof of the sale amount or other consideration, with respect to all other property."
This provision was enacted in 1967 and remained in effect until it was amended in 2017 to apply only to the transfer of real property out of California. In addition to moving real property out of California, the law also had broad application to the sale or transfer of personal property and intellectual property out of state. The URA tax is now only applicable to real property transfers out of California.
The longstanding authority of the URA tax is codified in Revenue and Taxation Code section 11911.

Constitutionality and Litigation Issues

Sparsely populated amidst the frenzy of first-tier tech cities, California has long been a coveted destination for individuals and businesses alike, with its expansive coastline, temperate climate, and high quality of life. But what happens when your dream state becomes your nightmare? And what happens when the cost of living – tantalizingly low only a decade ago – moves toward parity with the highest in the nation? Well, the only thing more certain than the costly exit tax California imposes on departing residents is the fact that the exit rate will continue to draw legal fire. Indeed, a number of states impose additional taxes on income earned after a move based on residency, but these exit taxes have garnered national attention because of their size and frequency. For the past five decades, states in the Northeastern U.S. have imposed exit taxes; most recently, Connecticut and New Jersey in response to recent departures of its wealthiest residents. Departing from typical taxation – where in-state residency will trigger a tax on all or some income – California’s approach takes a novel turn: the bulk of an individual’s income earned within the multi-state "period" is subject to tax. In its initial Congressional 1987 analysis of the issue, the Institute on Taxation and Economic Policy (ITEP) found that California was one of the states that treated moving taxpayers’ income as wholly earned while a resident and taxed that amount after their move. Nevertheless, a similar analysis in 2015 found that California had abandoned this total recapture approach, now calculating exit taxes based on the proportion of a year, or "period," during which a departing resident earned income within the state during the ten years preceding their departure. This "period" regulation created a so-called "window." Specifically, prior to 2013, California conducted an intra-testamentary analyzed of a departing California resident’s period in the state to determine the percentage income taxed under California’s tax code. If a person resided in California for 2 of the 10 years preceding the termination of their residency, the person would be taxed on 20% of their total income; 3 years, 30%; 4 years, 40%; and so forth, until a higher leaving resident was taxed 90% for a 9-year period. By switching to the new method, departing residents became taxed on a smaller window of time and began paying lower rates. Some view California’s ability to levy this exit tax as well within its authority to impose state taxes on a broad geographic basis. ITEP contends that such taxation violates the privileges and immunities clause. ITEP based its argument in part on the Supreme Court case of Supreme Court of New Hampshire v. Piper, 470 U.S. 756 (1985) wherein the Supreme Court held that a state cannot require a bona fide resident of another state to obtain a certificate of legal residence if a resident of the state is not required to do the same. Further, ITEP argued, "that California contradicts the spirit of the 14th Amendment by trying to fine individuals who move to other states, especially given that the state constitution explicitly prohibits a state income tax." Opponents are also quick to point out that the state’s exit taxes violate the Due Process Clause of the 14th Amendment, which maintains that individuals are due "equal protection of the laws." The specific argument is that the formula of the exit tax results in a disparate treatment between those rerouted back into California state tax laws and bona fide non-residents who are not subject to California tax on all or some of their income. Efforts to legally challenge this California Tax have prolonged since it was first adopted in 1988, when it was ratified by 62.6% of California’s voters. Amidst the recessionary pressures of a weak economy and the increasingly attractive retirement offers of other states, the exit tax remains grounded in California’s state constitution.

Comparison of Exit Tax in Other States

The nature of California’s exit tax is not unique to the state and it’s important to understand how California’s exit tax stacks in comparison to exit taxes and laws in other states. Tax exile statutes are relatively uncommon and examples of other U.S. states that have similar exit taxes are few and far between.
Like California, Connecticut has a tax exile statute (Conn. Gen. Stat. § 12-711). However, unlike California’s exit tax, Connecticut’s exit tax targets only its personal income tax. Under Connecticut law, "the taxable income of a nonresident taxpayer for the taxable year in which the taxpayer expatriated shall be the taxpayer’s income derived from or connected with the sources specified in subsection (a) […] multiplied by the percentage of the taxpayer’s ownership interest in the entity for the entire taxable year. All other provisions applicable to the taxation of nonresident taxpayers in the state of Connecticut shall apply to the taxation of nonresident taxpayers under this section." Conn. Gen. Stat. § 12-711(a)(3). Only a few states even consider taxation of property attributable to an expatriated entity.
Massachusetts imposes an exit tax on an entity that conducts or has conducted business in the state , or is incorporated under Massachusetts law, as defined in its statute. The tax applies both to existing states as well as newly-formed entities should they elect to change their legal domicile or organizational structure.
Florida imposes a tax on a former Florida resident who was a bona fide resident of Florida. The state statute provides that "all estate tax, all income tax and all other taxes due the state shall be recoverable from any and all persons who sever their residency and cease to live in this state." § 215.32(2), Fla. Stat. (1991). However, there are no current legal challenges or litigation seeking to invalidate the Florida estate tax.
Rhode Island’s exit tax is a penalty tax that directly targets former residents of the state. Under Rhode Island law, the tax applies to any former indentured servant, apprentice, servant, hired hand or laborer who resides in a jurisdiction (including foreign jurisdictions) other than Rhode Island for 60 days or more, who has an income exceeding $475 annually. R.I.G.L. §44-30-47(b).

Legal Opinions for State Residents

A resident considering an impending exit from California may seek legal advice to mitigate the financial consequences of the exit tax. For key deadlines, see California’s Statewide Sticker Shock, in which the author examines the California exit tax.
A real property owner may be subject to the 13.3% exit tax. This tax is a California capital gains withholding requirement for real property transfers of $1 million or more. The tax is not actually a tax but rather an advance withholding that is applied against the transferee’s California tax liability. Alternatively, the seller may be entitled to a refund. However, a real property owner can avoid the advance withholding requirement by filing a Pre-Closing Certificate (CT-400) that sets out eligibility for various exemptions, including the $1 million exemption for residences. Another potential way out is a properly timed sale of real property in which the proceeds are directly reinvested in another California residence; if this in-and-out transaction is executed correctly, no exit tax will be incurred.
Before leaving the state, a resident (whether individual or business) should undertake a residency test to determine how long and under what circumstances he or she was or remains a California resident. The residency test is not a straightforward, definitive inquiry and involves both a technical review of historical facts and qualitative assessments of intent. It is important to carefully assess whether personal and business activities are sufficiently demonstrative of California residency to withstand scrutiny.
Finally, whether an exit tax applies may not be the end of the matter: within seven years of departure, a new California resident may be subject to a "California claw-back" of sales, use, and other taxes on property brought into California and retained for use in California. A resident who has claimed the maximum exclusion of $250,000 for single owners or $500,000 for married owners on the first $250,000 or $500,000 of gain from the sale of a principal residence ordinarily will not be subject to claw-back.
If an exit tax does apply, the taxpayer should examine filing requirements for the year of the exit and for the following seven years. For a resident with multiple property holdings and gains without exclusions available, there is a risk that the exit tax will be greater than the limited exclusion. A careful review will be necessary to determine whether the California claw-back regime applies at all and, if so, whether it can be avoided through proper structuring and timing of resident and business activities, or through the use of taxpayers’ rights to appeal the residency determination or to seek a rescission of the exit tax.

Exit Tax Law in California Moving Forward

The exit tax law in California is poised for several changes in the near future. On August 23, 2016, AB 2159 was introduced to amend the exit tax. It would revise the way the sales price is determined. Similar legislation has failed twice before in its initial stages in 2008 and 2015. Other proposals are expected.
The most recent attempt, AB 1897 (the legislation that resulted in the tax ruling against Johnson), is of greatest interest to California taxpayers. This bill would expand the "net capital gains election" provision from publically traded companies to privately held companies, and it would repeal the exceptions to the market-based sourcing provision. In other words, it would remove the loophole that allows a company that sells into this state but does not have nexus in the state to still avoid the exit tax on those sales. However, the bill died in inactive file in August 2016. Whether a new version will be proposed in the 2017 session is unclear.
Morrison & Foerster even suggests that the future of the exit tax is in question, as the recent management of A.P. Green Refractories, Inc., as successor in interest to thirty-two different corporate entities, filed a tax refund claim on August 31, 2016. The claim challenged that exit tax on the grounds that the statute is unconstitutional, violates the Commerce Clause, violates the Due Process Clause, and that the California Franchise Tax Board (FTB) is equitably estopped from attempting to collect the exit tax. The claim does not specify the refund amount. Further, the FTB has not determined whether a similar retroactive refund claim will be considered against the tax refund statute .
Taxpayers, all the way back to the 2005 enactment of the statute, have believed that the statute violates both the Due Process and Commerce clauses of the United States Constitution. The IRS has already taken the position that this statute cannot be used to retroactively assess an exit tax against a company that relocated during the period of the statute’s applicability because the statute was not in compliance with the Commerce clause. The Morrison & Foerster blog goes on to say that the FTB rejected this position and assessed a tax on a taxpayer who relocated to Africa and closed its remaining manufacturing operations in California. The taxpayer then sued the state and lost on the grounds that the statute’s retroactivity did not violate the prohibition against ex post facto laws. However, on October 5, 2015, the California Court of Appeal reversed the lower court’s determination and ruled that the state improperly sought retroactive collection of taxes from the taxpayer who relocated. The state took the position that the taxpayer violated the exit tax statute, but the court found otherwise. As a result, the state could not make a retroactive assessment under the statute against the taxpayer.
It is clear that there are hurdles ahead before any retroactive exit tax can be assessed. The changes proposed by the Morrison & Foerster blog raise even more questions. As indicated, the issue is far from resolved and further developments can be expected. For now, businesses should remember to stay current on exit tax issues.