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California’s Proposed Wealth Tax’s Impacts on High-Net-Worth Residents

01.27.21

With an economy larger than most countries, California boasts more millionaire households than any other state in the U.S. These households comprise a robust tax base for the state: Wealthy California residents already pay some of the steepest income taxes in the country, including a top marginal tax rate of 13.3%. Now, two proposals from state assembly members aim to increase those taxes considerably to raise money for state services, which are being strained more than ever due to the COVID-19 pandemic.

The first proposal is to increase in the top marginal income tax rate from its already lofty heights to 16.8%. The other is to introduce a net wealth tax of 0.4% on individuals with assets greater than $30 million, which would apply to an estimated 30,400 Californians. While the former proposal is not trivial, it has a much better shot at passing than the latter proposal, which is truly unprecedented. Wealth taxes have been imposed in various European Union states, but never in the United States.

Ultimately, both proposals failed to advance last year. However, it is safe to bet that we have not heard the last of either. Coming out of a decade that saw record gains for the top 20% of earners — a situation that has only been amplified by COVID — taxing the wealthy will continue to be a popular idea among California legislators. High-net-worth individuals should understand those proposals to avoid being caught unaware should either of them pass. To that end, here are some of the top considerations for individuals that could be affected by the proposed income tax hike.

Even if you leave California, the wealth tax could follow.

The proposed tax hikes come at a time when California is witnessing a mass exodus of businesses from the state toward greener pastures. This includes two of the Bay Area’s biggest employers, Oracle and Tesla, which have announced their intention to move their headquarters to Texas, which has no personal state income tax. Included among these businesses’ rationales for leaving Silicon Valley, the traditional seat of innovation in the United States, has been ever-expanding tax schemes. Should either of these proposals pass, it could accelerate this exodus by making lower tax states look even more attractive to business owners, executives and others with high salaries.

It seems California is catching onto the potential consequences of these taxes, however. The wealth tax proposal includes a provision that would make individuals who leave California subject to the tax for up to 10 years after they leave the state. Depending on how you interpret the language regarding this “10-year tail,” as many are calling it, the wealth tax could apply not only to wealth that was created in California, but wealth that a former California resident builds after they leave and sever ties with the state. Moreover, the bill would make anyone who spends more than 60 days in the state per calendar subject to the tax. (Typically, one has to spend more than 180 days in the state to be subject to income tax.)

If these provisions become law along with a wealth tax, you can bet California’s tax collectors, who are known for aggressive enforcing any taxes they believe the state is owed, would keep a watchful eye on wealthy individuals who choose to leave the state. The upshot is wealthy individuals who may be planning to leave California, if the taxes become too burdensome, should not assume relocation will exempt them from these taxes.

The wealth tax contains a carve-out for real estate.

While quite wide-ranging in many respects, the wealth tax is moderated somewhat by the fact that real property held directly by the taxpayer does not enter into the calculation of an individual’s net wealth for purposes of the tax. This category likely includes one’s personal residence, while obviously excluding indirectly-held real estate such as that held through real estate investment trusts. Additionally, if the real property is held indirectly through a corporation, partnership or other legal entity, it would be considered a component of the individual’s net worth. Given the value of land in California, this provision could soften (slightly) the blow of a 0.4% wealth tax and, for some individuals, possibly even mean the difference between being subject to the tax and being exempted from it.

A wealth tax would transform tax preparation.

While directly-held real estate is excluded from calculation of the individual’s net worth, pretty much everything else is included. This means publicly-traded stocks, bonds, options and futures are considered part of one’s net worth, as well as stock in an S Corporation, interest in a partnership, interest in a hedge fund or equity fund, cash deposits, art and collectibles, and pension funds. As it stands, every California taxpayer would be required to file a breakdown of their assets and liabilities each year on their tax returns (although realistically there would probably be an exclusion carved out for these whose net worth is unlikely to be anything substantial). Additionally, note that California would be interested in every resident’s worldwide net worth, not just that which can be tied directly to California.

The process of calculating one’s worldwide net worth for purposes of computing one’s wealth tax amount would represent a complete transformation of the way taxpayers and accountants in the U.S. have been accustomed to filing tax returns. The increased administrative burden would likely be considerable. Determining the value of items like art and collectibles would likelyrequire valuations on a regular basis, and even then there would often still be disagreement between the owner of the asset and the Franchise Tax Board regarding its value.

That is why we recommend individuals who believe they might be subject to this wealth tax, were it to pass, get in the habit now of completing a personal balance sheet on a regular basis. When faced with uncertainty of this type, knowledge is the best defense you can have. Knowing the answer now to the question “might I be subject to this wealth tax?” could influence your tax planning strategies for years to come.

Reach out to BPM’s Private Client Services Group or contact BPM Tax Director Meredith Johnson for additional support.