California income of a non-resident

[mhlester]

Hello tax experts,

A client is thinking of moving to Texas from California and establishing permanent residency there. He wants to know if he will be taxed on certain income in California after he becomes a Texas resident for income tax purposes. Here are the facts as I understand them.

A Texas S corporation (T), which is a partner in a California LLC taxed as a partnership (C), receives non-passive income from C whose employees and partners perform talent management services in California. C files a California income tax return and issues T a K-1 as a non-resident partner. T files a California tax return to report the K-1 income from C and pays an equal amount to the Texas resident owner/employee of T (O/E) as wages reported on a W-2. O/E performs no services in California. Does O/E have California income to report on a nonresident California income tax return?

Same facts, except T is a California S corporation.

[George4Tacks]

I think you are possibly using "he" moving to Texas as the S-Corp is moving to Texas. The taxpayer moving does not change the fact that the S-Corp is still a CALIFORNIA S-Corp.

Too many single letters for me, or maybe not enough. I think T would owe tax in CALIFORNIA from any income received, especially if it from C deriving income from CALIFORNIA. 

[Strongsilence-CPA]

2024 FTB Publication 1031 Guidelines for Determining Resident Status

[mhlester]

Hi, George4Tacks,

Thank you for your reply.

You are right... this question is hard to ask.

I will try to clarify.

The individual moves from California to Texas.

He creates a new Texas S corporation to acquire his old California S corporation's interest in a California LLC taxed as a partnership.

The LLC has California income that it reports on the Texas S corporation's K-1.

The Texas S corporation zero's out its K-1 income by paying the same amount of wages to the employee/shareholder, now a Texas resident.

Thus, the Texas S corporation has no income to be taxed in California.

The individual performed no services in California related to this income.

So, under the rules, as I understand them, even though the income is sourced in California at the LLC and Texas S corporation levels, he, as a W-2 employee, because he did not perform services in California, is not taxed on that income in California.

It seems like the result would be the same if it was a California S corporation that zeroed out its income by paying it all out as wages to the Texas resident employee/shareholder.

I am just looking to see if I have this right.

Also, a new question comes to mind... will the LLC be required to withhold tax on distributions to the Texas S corporation as a non-resident partner? I think so.

[George4Tacks · Accepted solution]

The California S-Corp has filed for dissolution and has (or will do) a final tax return. It somehow "sells" it's k-1interest to the new Texas S-Corp?  

Is all the work don't virtually? Does your person EVER physically going to CA to earn the W-2 income.  

My gut tells me California is going to look for a CA return from the Texas S-Corp for the LLC income reported as CA income. 

The Partnership may have to do withholding. https://www.ftb.ca.gov/forms/misc/1017.html#:~:text=A%20withholding%20agent%20is%20required,an%20app....

I think this is above my paygrade and experience. CA is vicious in terms of seeking out anything that hints of avoiding CA taxes. 

[qbteachmt]

"The Texas S corporation zero's out its K-1 income by paying the same amount of wages to the employee/shareholder, now a Texas resident."

"Thus, the Texas S corporation has no income to be taxed in California."

Doesn't seem right as stated.

I think you mean, the CA-sourced LLC-sourced income will be offset by the Texas S Corp wages, just like any other Texas S Corp expense activity will offset the other Texas S Corp income, to end with a net. You are mixing perspectives. Either you're looking solely at CA-sourced income and expense, or you're looking at the Texas S Corp's bigger picture.

You can't just wipe out a sourced income by having other unrelated expenses to account for it. You still had the sourced income; that's what the K-1 is reporting. You might net 0 for the Texas S Corp, but there was reported income. If you had sourced expense against that sourced income, as the CA LLC will have, that would be different. You explained there is no CA activity done by the Texas S Corp, though.

[BobKamman]

How do you propose to get around the fourth item on this list from the FTB?

https://www.ftb.ca.gov/file/personal/residency-status/part-year-and-nonresident.html# 

As a nonresident, you pay tax on your taxable income from California sources.

Sourced income includes, but is not limited to:

• Services performed in California
• Rent from real property located in California
• The sale or transfer of real California property
• Income from a California business, trade or profession

[mhlester]

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.

[BobKamman]

California law seems to require withholding of tax on distributions to nonresident beneficiaries, including your Texas S-Corp.  "A partnership is required to withhold funds for income or franchise taxes when it makes a distribution of income to a domestic (U.S.) nonresident partner (R&TC Section 18662)." (Form 565 instructions.)  I'm also puzzled by Lines 12 and 13 of the Form 565, which seem to allow only guaranteed payments to partners, and those would be taxed as California source.  (The Texas S-Corp would still be required to file a California return, right?  But which form?)  

I have family members in a similar situation as your client, but I let their California CPA sort this out and pay for the related liability insurance.  My general rule is "if it sounds too good to be true, it probably isn't." Corollary is "don't expect a good answer from online randos."