It is safe to say most “employee equity” situations take place in the state of California. Sure, startups are popping up everywhere, and some tech companies are starting in, or relocating to, other states, but California has the highest number of equity compensation paying companies. One of the reasons why this is significant is that California also has the highest state income tax out of the 50 states.
With California topping out at 13.3%, many residents are asking questions like this: How can I minimize my California tax hit when my company IPOs or I have a large windfall?
Or this: If I leave California with all of my stock options, do I avoid paying California taxes?
Below is an extensive guide to the topic of California taxation of your equity.
There are a few key considerations to understand first.
What it actually means to “leave” California.
Difference between Ordinary income and Capital Gain income.
Allocation Ratio: the ratio that California uses to tax a percentage of income/equity based on your residency status.
First, we need to define what it means to “leave” California or become a non-resident. Different states have different rules, and it doesn’t come down just to the number of days.
California has a good incentive to ensure they collect every dollar they deserve. California (at 13.3%) is a lot more aggressive than a state with a 3% income tax. As Charlie Munger said, “Show me the incentive and I will show you the outcome.” They have incentives to track down tax dollars, and their actions reflect that.
California does not simply care about the number of days you lived outside of the state. It primarily cares about you actively becoming a non-resident of California, and you actively becoming a resident of another state. What does this mean? Based on a 1985 court case, there are 29 different factors to consider, below are a few:
Driver's license
Car registration
Voter’s registration
Mailing address
Number of days present
Location of physical goods
Location of home/apartment or other real estate
Location of spouse and children
To “actively” leave not only means to move physically, but to update all of your documents and affairs to essentially “break up” with California and establish residency elsewhere by setting up those same items in your new state.
Additionally, if you “leave” California, it is important that you don’t have any plans to return in the near future. For example, if you leave California for Nevada for 365 days while keeping all of your things in storage in California, sell all of your employer stock while in Nevada, then return - you likely don’t have too strong of a case when dealing with California’s Franchise Tax Board. We urge anyone considering leaving California to avoid state taxes to work with a knowledgeable tax professional.
Next, we need to draw a line between two primary types of income as it relates to equity compensation: Ordinary Income and Capital Gain Income.
Ordinary Income is recognized during the following:
Vesting of Restricted Stock Units (RSUs)
Exercising Non-qualified Stock Options (NSOs)
Selling Incentive Stock Options (ISOs) before meeting the requirements for a Qualifying Disposition (holding for > 1 year after exercise and > 2 years after grant).
Vesting (or Early Exercising) of Restricted Stock Awards (RSAs)
Capital Gain Income:
Appreciation after the vesting of RSUs
Appreciation after exercising NSOs
Gains from a sale of ISOs (that meet the requirements for a Qualifying Disposition)
Appreciation after the vesting/early exercising of RSAs
Capital gain income is very straightforward, so we’ll start with that.
If you sell equity with capital gains, then those capital gains will only be taxed by the state that you were a resident of at the time of sale. We’ll revisit this in some examples below.
Ordinary income is a bit more complex. This is where the concept of the Allocation Ratio comes into play. Essentially, California will tax these based on the percentage of time you were a resident.
Allocation Ratio: # of days worked in California divided by the total # of workdays for the period.
Note: The total # of days worked for the period can either be the length of time from grant to vest (RSUs), grant to exercise (Options), or grant to “termination date” (if you leave your employer), whichever comes first.
A few examples are below covering all types of employee equity, starting with the most common:
RSUs Single-Trigger: I have 1,000 Restricted Stock Units that were granted to me two years ago. Given the 4-year vest (250 shares per year), the shares are 50% vested (500 of 1,000), and all of the vested shares were fully taxable to California given my CA residency. I recently moved to Texas, where I will live when the next 500 shares vest over the next two years. Even though the next 500 shares will vest and become my “property” while I am a resident of Texas (no state income tax), California has a claim to a percentage of each vest from the original 1,000 share grant as the Allocation Ratio will be applied. The first vest of 250 shares while in Texas (vest 3 of 4) will have a higher Allocation Ratio (67%) than the 4th and final vest (50%).
The Allocation Ratio comes into play for all of the RSU grants received while a California resident. Any RSU grants (not vests) that I received after leaving California are not subject to the Allocation Ratio.
RSUs Double-Trigger: I have 1,000 shares that have “time vested” but did not truly vest (hit my paycheck and brokerage account) until my company IPO’d. Between my grant date and the IPO (5 years), I lived in California for 3 years (60%) and in Texas for the last 2 years (40%). Even though all 1,000 shares truly vested and became my “property” while I was a resident of Texas (no state income tax), California has claim to 60% of the income (3 out of 5 years).
The Allocation Ratio comes into play for all of the RSU grants received while a California resident. Any RSU grants (not vests) that I received after leaving California are not subject to the Allocation Ratio.
What if I decided to return to California? The allocation ratio does not come into play if I’m entering California. If I was in California for 3 years, in Texas for 2, and returned to California right before the IPO - 100% of the income will be attributed to California. If the “other state” (Texas in this example) taxed the income as well, then California would offer a tax credit to ensure I’m not double taxed on that income.
Capital Gains: If I decide to hold the RSUs beyond their vest, any future appreciation will be taxed to my state of residence at the time of sale. This appreciation will be taxed as a short-term or long-term capital gain.
NSOs: As a reminder, the “spread” when exercising Non-Qualified Stock Options is considered ordinary income and typically shows up on your W-2. (The spread is the difference between the strike price and the FMV on the date of exercise.)
I have 1,000 Non-Qualified Stock Options granted to me. Between my grant date and my decision to exercise (5 years), I lived in California for 3 years (60%) and in Texas for the last 2 years (40%). Even though all 1,000 shares became my “property” via exercising while I was a resident of Texas (no state income tax), California has claim to 60% of the income (3 out of 5 years). Key Point: I was still an employee of the company while living in Texas.
The Allocation Ratio comes into play for all of the NSO grants received while a California resident. Any NSO grants (not vests) that I received after leaving California are not subject to the Allocation Ratio.
If I left my employer at the same time I left California, and still exercised two years later while a resident of Texas, then the Allocation Ratio does not come into play as California will have claim to 100% of the income. Generally, the Allocation Ratio for NSOs factors in the total time from Grant through Exercise (not vest). The exception to this rule is if 100% of your “Service Time” with the company took place in California. Many companies terminate/expire your ability to exercise options after you leave the company, so this is not a common scenario. However, several companies do still allow employees to exercise NSOs years after ending the employment relationship.
What if I decided to return to California? The allocation ratio does not come into play. If I was in California for 3 years, in Texas for 2, and returned to California right before exercising - 100% of the income will be attributed to California. If the “other state” (Texas in this example) taxed the income as well, then California would offer a tax credit to ensure I’m not double taxed on that income.
Capital Gains: If I decide to hold the NSOs beyond the exercise date, any future appreciation will be taxed to my state of residence at the time of sale. This appreciation will be taxed as a short-term or long-term capital gain.
ISOs: As a reminder, the “spread” when exercising Incentive Stock Options is not considered ordinary income and is only considered income for AMT purposes.
If a sale of ISOs is not a Qualifying Disposition, then the sale is treated like a sale of NSOs. A Qualifying Disposition of ISOs means that the sale (disposition) took place more than 2 years from the grant date and more than 1 year from the exercise date. For treatment of NSOs, please see NSO information above.
For a Qualifying Disposition of previously exercised ISOs, 100% of the gain is treated as a long-term capital gain. Capital gains are only taxed by the state of residence at the time of disposition and are not subject to the Allocation Ratio. If sold while a resident of California, the tax could be as high as 13.3%. If sold as a resident of Texas, the tax rate would be 0.0%.
Note: Most states do not have their own AMT tax, but California does. In the event an out of state ISO exercise of California granted ISOs, California would subject the “spread” to the Allocation Ratio as it relates to CA AMT. Generally, a taxpayer has to be pretty deep into AMT to be subject to California AMT, but it does happen.
RSAs: Restricted Stock Awards are most commonly given out to employees of very early-stage companies. The “spread” when RSAs vest is considered ordinary income and typically shows up on your W-2. Unlike NSOs, there isn’t really an “exercise” when it comes to RSAs - they vest when they vest, and that is when income is recognized. They are similar to RSUs in the sense that you can’t control when the income is recognized. One twist however is that you’re able to do an early exercise with an 83b election - you elect to treat some/all of your RSAs as income within 30 days of the grant date instead of when RSAs actually vest; this is not available for RSUs.
As it relates to leaving California with RSAs, here is an example:
I have 1,000 RSA shares that have been granted to me, vesting evenly over 4 years. Between my grant date and my full vest (4 years), I lived in California for 3 years (75%) and in Texas for the last 1 year (25%).
The first 3 years of vesting is simple, as I was taxed at vesting while I was a CA resident. For the 4th year, 75% of that last vest is taxed by California. Even though all 250 shares (25%) became my “property” via vesting while I was a resident of Texas (no state income tax), California has claim to 75% of the income (3 out of 4 years).
The Allocation Ratio comes into play for all of the RSA grants received while a California resident. Any RSA grants (not vests) that I received after leaving California are not subject to the Allocation Ratio.
What if I decided to return to California? The allocation ratio does not come into play. If I was in California for 3 years, in Texas for 1, and returned to California right before a vest - 100% of the income will be attributed to California. If the “other state” (Texas in this example) taxed the income as well, then California would offer a tax credit to ensure you’re not double taxed on that income.
Capital Gains: If I decide to hold the RSAs beyond the vest date, any future appreciation will be taxed to my state of residence at the time of sale. This appreciation will be taxed as a short-term or long-term capital gain.
ESPP: Similar to ISOs, ESPPs have Qualifying Dispositions and Disqualifying Dispositions. ESPPs also have two income components, similar to NSOs - Ordinary Income and Capital Gain. To qualify for a Qualifying Disposition, you must sell your shares at least 1 year from the purchase date and at least 2 years from the ESPP offering date.
In a sense, the “discount” you receive when acquiring the shares is counted as ordinary income at the time of sale. This discount, in a Qualifying Disposition, is the difference between the “Offering Price” and the “Purchase Price” - many times this is the 15% discount. In a Disqualifying Disposition the Ordinary Income component can be much larger. The specifics of this really depend on price movement as the tax rules can be quite complex.
If the eventual sale takes place outside of California, that portion of income is subject to the modified version of the Allocation Ratio. The modified version only focuses on the time between the beginning and end of the purchase period for ESPPs. Generally, this period only lasts for 6 months.
Similar to other capital gains, any growth on the ESPP shares above the FMV at the acquisition date are taxed to the state of residence at the time of sale.
We understand that this topic can be very confusing, though we hope you found this guide helpful, and that your understanding of California’s taxation of equity compensation is better after reading this. If you have any additional questions around this topic, feel free to poke around the blog, send us an email, or schedule a time to chat.