The business has long chosen to be headquartered in California over other states. But since 2018, many large corporations have moved their headquarters out of state, including Tesla, Oracle and Nestle. The change is undoubtedly driven, at least in part, by the state’s expensive cost of living, high taxes and complex regulatory environment.
While large corporations have the legal resources to handle relocation, small businesses often wonder: What does it take to leave California? This article looks at five key steps to moving your business out of the Golden State.
Notifying the Franchise Tax Office and the IRS
Generally, moving operations outside of California shields your business income from California income taxes. However, the California Franchise Tax Board may be able to tax at least a portion of that income if the business is incorporated in California, its income is derived from sales or services in the state, or the entity is a taxable entity (e.gpartnership) and the resulting pass-through income is recognized by one of the owners of the California-based business.
Relocation operations are necessary to “leave” the state for income tax purposes, but more is required. Technically, the business will remain subject to California income tax if it continues to “actively engage[e] in any transaction for financial . . . gain” in California.”
Then remember that the business is no longer taxable in California. To terminate your California business tax status, you must file all outstanding California tax returns; pay all outstanding balances, fees and interest; and then file your final California business tax return. Be sure to check the “final return” box and write “final” at the top of the first page. Remember, this will not bypass California taxes on income generated in California or any income for California resident business owners.
Be sure to inform the IRS of your new address, as failure to do so may result in missed correspondence. You can inform the IRS by including your new address on your business’s next tax return. If it’s at the beginning of the tax year, inform the IRS at the same time you file your California tax returns by filing IRS Form 8822-B.
Converting, merging or transferring your business
Closing a business in California is relatively easy—when you’re ready, cease its legal existence in California and “cease” operations in the state. The closure process largely depends on the shape of the object. Sole proprietors and general partnerships do not need to register with the California Secretary of State upon incorporation, so they do not need to file anything with SOS to close. Corporations, limited partnerships, limited liability companies, and limited liability companies register with SOS upon incorporation, so they must file dissolution (corporations) or dissolution (LLCs and partnerships) forms. Do this by submitting a closure form to SOS within 12 months of submitting your business tax return for the last year. If you have suspended your business, you must first revive it before you can terminate it. Do so by submitting a refund request.
Moving a business outside of California for legal purposes is a bit more difficult. The three main methods are converting the California entity into an entity organized under the laws of your new state; merging the California entity into a new entity organized under the laws of your new state; and, less commonly, transferring business assets to a new entity organized under the laws of your new home state.
Conversion is often the simplest, but is limited to certain business forms. LLCs, LPs and GPs can convert to a foreign business entity – corporations cannot. A merger requires a bit more paperwork, including creating a legal entity in the new home state and filing a certificate of merger with the new state’s SOS. Transfer of assets involves the most work as it requires the preparation of documents to perpetuate the transfer of each asset.
Before converting, merging or transferring assets, ensure that the adviser confirms that doing so will not inadvertently breach, terminate or adversely affect existing agreements. Some of your contracts may contain anti-assignment or change-of-control provisions that will be triggered, including contracts with suppliers and customers, as well as loan and lease agreements. This concern mainly relates to the transfer of business assets to a new entity and is particularly problematic during our current high inflation environment – you may have to renegotiate with suppliers for the same services or supplies at a higher price. State laws often make anti-transfer provisions not apply to conversions and certain types of mergers. California has such laws, but be sure to confirm with your attorney that they apply to your situation.
Registering as a California Alien
Whether you’re converting, merging, or transferring your assets to a new entity, if you plan to continue doing business in California, you should consider registering as a foreign corporation there (or, to use the correct word, qualify). Many are concerned about this strategic business decision, and with good reason. California’s rules regarding foreign qualification are ambiguous and registration may attract undue attention from the California Franchise Tax Board.
Ambiguity. In general, a business must register if it “does business[s] intrastate business” in California. The phrase “conducting intrastate business” is defined as “engaging in repeated and successive transactions” in California. There are fact-specific issues to consider based on the business’ activities in the state and unexpected statutory exceptions (eg, ownership of shares in another company doing business within the state). But after a deep dive, you’re often still left without much clarity.
Penalties. Failure to register results in a fine of $20 per day. Equally important, until a business pays its penalties plus an additional $250, it cannot effectively sue others for claims based in California state courts. In addition, any person knowingly involved is subject to a misdemeanor charge carrying a penalty of up to $600.
The largest penalty stems from a business’s failure to comply with California tax rules, not registration rules. As noted above, a business that transacts in California may continue to be taxable in California. Not only does this result in California taxation, but failure to file and pay can also result in penalties (eg $2,000 annual penalty for failure to file) plus interest on unpaid taxes accruing at 5% per month (up to 25%).
Franchise Board Marking. When deciding whether to register, a primary concern for many businesses is that registration increases the likelihood of being noticed by the California Franchise Tax Board. Registration automatically requires the business to file a California tax return. Even if the business does not otherwise owe California income tax, registration triggers a filing requirement, a minimum tax liability of $800 and unwanted monitoring.
Submission of licenses and permits
Nearly 75% of businesses in the US are sole traders. Although they are not required to register with SOS, they are subject to most of the same licensing and permitting requirements as other businesses. These include building permits, zoning and land use permits, health permits, public safety permits, occupational licenses, sales tax licenses, and home business licenses. Even if your business is exempt, licenses can often provide access to financing and limit owners’ personal liability. When closing your business, be sure to cancel all state and local licenses and permits of your business. Failure to do so may result in a trail of documents, messages and additional fees.
Know the hiring laws in the new state
Employment law is a beast in itself, so be prepared for rule changes wherever you go. California generally voids employment non-compete agreements and non-compete clauses in other employment-related agreements. On the other hand, Texas and Nevada—two of the most popular destinations for former California businesses—generally impose non-competes if the restrictions are reasonable in time, geography and scope of activity. You should check the new rules that your business will have to follow.
Relocating a business is hard. But the potential gains from lower taxes, cheaper living and a more permissive regulatory environment may be harder to ignore. The reality is enough to give any business owner pause. If you decide to leave, be prepared to take these steps.
This article does not necessarily reflect the views of The Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Information about the author
Sergio Broholm is an associate in the Corporate Group at Sharzis Frize. He focuses on mergers and acquisitions, emerging companies and general contractual and transactional matters.
Jack Frisby is a law student at USC (’23) and a summer associate at Kirkland & Ellis. Since working as a financial analyst at Belk, he has focused on business law and strategy.
Jeremy Babener is the founder of Structured Consulting and previously served in the US Treasury Department’s Office of Tax Policy. He advises businesses on strategies, partnerships and marketing.
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