This article will discuss whether a California resident can move to Texas to take advantage the Qualified Small Business Stock (QSBS) exemption on the sale of highly appreciated start-up stock and explain how to qualify, and compare the tax implications for California versus Texas residents. Let’s get to it.
Consider Jane, who holds $2 million in zero-basis stock and plans to sell in three months. As a California resident, she faces a challenge. The federal QSBS exemption under IRC Section 1202 could eliminate her federal capital gains tax if her stock qualifies, but California doesn’t recognize this exemption and imposes a state tax of up to 13.3% - potentially $266,000 on her gain. (California doesn't distinguish between income tax and capital gains tax. It's all considered income tax.)
Jane's strategy? Move to Texas, which has no state income tax, and establish residency before the sale. If successful, she could owe $0 in taxes: federal tax waived by QSBS, and no state tax in Texas. But it’s not as simple as it sounds.
Understanding QSBS: What It Is and How to Qualify
QSBS, outlined in IRC Section 1202, is a federal tax incentive that can exclude up to 100% of capital gains from selling stock in certain small businesses, making it a powerful tool for investors and founders. However, strict criteria must be met:
- C Corporation Stock: The stock must be issued by a U.S. C corporation, not an LLC or S corp.
- Small Business Threshold: At the time of stock issuance, the corporation’s gross assets must not exceed $50 million and must remain so until issuance.
- Active Business: At least 80% of the corporation’s assets must be used in a qualified trade or business (e.g., technology or manufacturing, not real estate or investments) for most of the holding period.
- Original Acquisition: The stock must be acquired directly from the company (not a secondary market) after August 10, 1993, through purchase, compensation, or specific exchanges.
- Five-Year Hold: The stock must be held for at least five years before the sale.
- Exclusion Cap: The gain exclusion is limited to the greater of $10 million or 10 times the adjusted basis. Jane’s $2 million gain with zero basis fits comfortably within this limit.
If Jane’s stock meets these requirements, she can exclude 100% of her federal capital gains tax (for stock acquired after September 27, 2010, when the full exclusion took effect). The catch? California ignores QSBS, while Texas’s lack of state income tax amplifies the federal benefit.
QSBS: California vs. Texas
Here’s how QSBS impacts Jane’s tax liability in each state:
-
California Resident:
- Federal Tax: With QSBS eligibility, Jane owes $0 in federal capital gains tax on her $2 million gain.
- State Tax: California does not honor the QSBS exemption, taxing her gain at up to 13.3%, or $266,000.
- Total Tax: Up to $266,000, driven by California’s state tax.
-
Texas Resident:
- Federal Tax: Identical to California—$0 federal tax if QSBS applies.
- State Tax: Texas has no state income tax, so no capital gains tax.
- Total Tax: $0, allowing Jane to keep her entire $2 million gain, assuming QSBS eligibility.
The contrast is clear: California could cost Jane $266,000, while Texas lets her sell her stock tax-free, making relocation an attractive option.
California’s Residency Rules: A Tough Hurdle
The California Franchise Tax Board (FTB) rigorously enforces residency rules to prevent tax avoidance. To determine if Jane’s move to Texas is legitimate, they’ll examine:
- Domicile: Where does Jane intend to permanently reside? Intent matters more than physical presence.
- Time Spent: How much time does she spend in Texas versus California?
- State Ties: Does she maintain significant connections to California, such as property, family, or business interests?
To establish Texas residency, Jane must fully commit:
- Texas Address: Secure a primary residence in Texas, not just a temporary address.
- Texas Documentation: Obtain a Texas driver’s license, register to vote, and update other official records.
- Sever California Ties: Sell or rent out California property, cancel local memberships, and minimize connections to the state.
Three Months to Establish Residency: A Tight Timeline
Under our scenario, Jane has three months to become a Texas resident before her stock sale. It’s feasible but challenging. She must act decisively, accumulating substantial evidence of her intent to make Texas her permanent home - think Texas utility bills, vehicle registration, and local community involvement.
The biggest risk is the “temporary move” rule. If Jane sells her stock as a Texas resident and returns to California soon after, the FTB may argue her Texas residency was a sham to avoid taxes. Such challenges are common, and the FTB often prevails in audits.
Potential Outcomes
Here’s what’s at stake:
- Texas Success: If Jane establishes Texas residency and her stock qualifies for QSBS, she pays $0 on her $2 million gain, keeping the full amount.
- California Failure: If the FTB determines she remained a California resident at the time of sale, she owes up to $266,000 in state capital gains tax.
- Alternative Strategy: If the timeline is too tight, Jane could roll her gains into another QSBS to defer taxes until her Texas residency is undisputed.
Key Considerations
Before making the move, Jane should note:
- FTB Audits: California is likely to audit high-value transactions like Jane’s. She needs meticulous documentation to prove her Texas residency.
- QSBS Verification: The stock must meet all QSBS criteria. A single misstep could disqualify the exemption, so professional review is critical.
- Expert Guidance: Navigating residency and QSBS rules requires specialized expertise. Jane should consult a tax advisor who is experienced with QSBS and residency requirements.
How the States Compare
Below is a table showing how each state complies with QSBS.
Conclusion
Relocating to Texas to avoid California’s capital gains tax is possible but demands careful planning and genuine commitment to Texas residency. The QSBS exemption can eliminate federal taxes, but California’s refusal to recognize it makes Texas’s no-tax environment a compelling draw.