Since the passage of Proposition 30, California now has both the highest personal income tax rates and the highest sales tax rate of any state in the Union. But wait, there’s more: the escalation you’ll see in your tax bill doesn’t just start in 2013! Rather, this increase in personal income tax rates for high-income taxpayers is retroactive back to January 1, 2012. Proposition 30 also provides for a sales tax increase from 7.25% to 7.5% from 2013 through 2016. Take a look at the following chart to see how the top income tax rates will increase in 2012 and 2013.
There is some good news, though. The tax experts here at Richard Welling have uncovered five ways to reduce or avoid entirely the impact of Prop. 30 for high-income earners. These remedies aren’t that complicated, so let’s get started.
The marginal tax rate under Proposition 30 varies depending on your California taxable income. The table below shows the old and new marginal tax rates at the various break points of taxable income:
Proposition 30 raises tax rates anywhere between 11% and 32% depending on your tax bracket and filing status. The biggest increase (a 32% hike in the state income tax rate) is born by single individuals earning between $500,001 and $1 million and head of household filers earning between $680,001 and $1 million.
Now that you know the pain you could suffer, let’s see what we can do about avoiding it.
Many business owners as well as others have the ability to control the amount of income they earn in any given year. Given the choice, it just may behoove you keep your income below the thresholds shown on the table above. Because the tax rates apply in a graduated manner as income reaches each threshold, the tax savings only becomes significant if large amounts of income are moved out of a tax threshold. Still, something is better than nothing, especially if you have the choice and if it doesn’t interfere with other financial imperatives that are not tax related.
Apart from managing your income, what else can you do to reduce your state income taxes? While we never advocate making investment decisions just for tax reasons, there are some advantages to limiting taxable investment income that can figure into your decisions. For example, the State cannot lay claim to certain types of tax-free bonds—US Treasurys or California municipal bonds. Municipal bonds floated by California issuers are more attractive now that Prop. 30 has passed. However, be very careful when selecting any individual California municipal bond issue. Our state has the second highest rate of municipality default and bankruptcy in the country. Stockton, San Bernardino, Atwater, Inglewood School District, Hercules and Mammoth Lakes, to name a few, all face severe fiscal challenges and have already defaulted or entered bankruptcy proceedings. We often work in conjunction with our client’s investment advisors in managing the taxation of their investment income.
The federal maximum long-term capital gains tax rate will rise from 15% to 20% for gains recognized after December 31, 2012. Further, the 3.8% tax to pay for The Patient Protection and Affordable Care Act—commonly called “Obamacare”—will be imposed on most post-2012 gains of America’s high-income taxpayers. We are advising some clients, who have the choice, to close the sale of substantially appreciated capital assets before the end of this year.
However—you probably already guessed—there’s an issue for California residents contemplating the implementation of this strategy. The California tax on 2012 gains could be as high as 13.3% (the top state income tax rate and remember: it’s retroactive back to 2012). Although the combined federal and California tax rate will be higher in 2013, the higher 2012 California capital gains tax may give California taxpayers a reason to rethink their overall capital gains strategy. There may be other ways to defer, perhaps indefinitely, these capital gains such as with tax-free exchange, installment sale or some other method. We urge you to consult with your tax professional if you find yourself facing such a capital gains issue.
It may surprise you to learn that the California corporate tax rate is 8.84%—less than the top individual state income tax rate. Let’s turn the state’s missed opportunity to your advantage. Depending on your situation, this lower corporate tax rate could make it beneficial for a California resident and shareholder/officer of a California corporation to reduce their salary in order to lessen their combined corporate and personal tax liability.
There’s another possible strategy as well. With the almost guaranteed individual federal tax increases coming, the “C Corporation” will become more attractive for many California businesses. If your company is already organized as a different entity (S-Corp, LLC, Partnership or some other organizational form), we recommend talking with your tax professional about the potential advantages of switching to, or creating a C-Corp.
We’ve heard this before from clients fed up with the tax-and-spend orientation of California’s legislature. So we thought this was the forum to put it on the table. Leaving our beautiful state—even with all its faults—is most certainly the nuclear option. California taxes its residents on their worldwide income. Whereas, non-residents pay taxes only on income they actually earned in California. If you’re mobile and can move your legal residence to a lower (or no tax) state such as Florida, Nevada or Texas, this might lower your overall tax burden.
This tax strategy morphs into a life-style move. Given the many other variables associated with such a decision, a California resident having a highly appreciated intangible asset, or tangible asset located outside of California could benefit tax-wise by moving their legal residence to another state. Beware, changing your legal state of residence involves substantially more than just changing the address on your tax returns. California does not willingly give up tax revenue from its “ex-patriots” without a fight. Changing your state of residence requires careful planning and advice from a tax consultant familiar with the applicable California tax rules.
You nonresident Californians are probably aching to know what your California tax liability is under Prop. 30. There’s a simple way to compute it:
CA tax liability = CA taxable income X (Tax on total taxable income / Total taxable income)
Here’s how it works: Say that Gloria is single and a California nonresident. Her total taxable income for 2012 is $2,000,000. Included in that total is a $250,000 gain on the sale of a California property. The remaining $1,750,000 of income is not California source income. Based on the new 2012 California tax tables, the computed California tax on $2,000,000 would be $243,103.
Gloria’s prorated California tax is $30,388 (250,000 X (243,103/2,000,000).
Even though Gloria’s California source income is only $250,000, her effective California tax rate on the $250,000 California gain is 12.2% (30,388/250,000). Assuming Gloria pays income tax in her state of residence, she may be able to claim a credit for the California taxes in her home state. However, since the California tax rate is higher than any other state, at most she will only get a partial credit.
Retroactive means the Prop. 30 California income tax increase became effective as of January 1, 2012. This means that you may need to make larger payments in the coming months to account for the full-year effect of the rate increase. Again, we urge you to consult your tax advisor to determine how much to pay before year-end, by January 15, 2013 or April 15, 2013. And don’t forget that the amount paid in California taxes during 2012 versus 2013 will impact your federal income tax planning.