Hi, BobKamman,

Thank you for your reply.

I have been searching for an official citation but haven't found one yet.

The reason the fourth item in the list does not apply is because a W-2 employee is not engaged in a trade or business in California or anywhere else for that matter. The Texas S corporation (and the California S corporation) are engaged in a trade or business in California, but they are paying out all the K-1 income from the LLC as wages to the individual nonresident employee shareholder, so even though the S corporations must file a California income tax return, their taxable income is zero.

Here is an excerpt from a non-official source. I would love to find an official source for this.

...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.

https://www.palmspringstaxandtrustlawyers.com/nonresidents-working-remotely-for-california-businesse...

This article indicates that the employer does have to withhold taxes in this case, but the LLC might have to withhold taxes on the distribution the S corporation. I am still not sure about this.