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Here’s What Businesses Should Know Before Leaving California

July 11, 2022, 8:45 AM

Businesses have long chosen to headquarter 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 navigate moving elsewhere, small businesses are often left wondering: What does it take to leave California? This article walks through five key steps to move your business out of the Golden State.

Informing the Franchise Tax Board and IRS

In general, moving operations out of California protects your business income from California income taxes. However, the California Franchise Tax Board may be able to tax at least some of that income if the business is registered in California, its income is derived from in-state sales or services, or the legal entity is a pass-through entity for tax purposes (e.g., a partnership) and the resulting pass-through income is recognized by one of the business’s owners based in California.

Moving operations is 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 engag[e] in any transaction for the purpose of financial … gain” in California.”

Next, memorialize that the business is no longer subject to California tax. To terminate your tax status as a California business, you must file any outstanding California tax returns; pay all outstanding balances, fees, and interest; and then file your business’s final California tax return. Make sure to check the “final return” box and write “final” at the top of the first page. Remember that this won’t bypass California taxes on California-generated income or any income for pass-through business owners residing in California.

Make sure to inform the IRS of your new address, as failure to do so can result in missed correspondence. You can inform the IRS by including your new address on your business’s next tax return. If it’s early in 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 California business is relatively easy—when you’re ready, terminate its legal existence in California and “cease” in-state operations. The closing process largely depends on the entity’s form. Sole proprietorships and general partnerships don’t need to register with the California secretary of state upon formation, so they don’t need to file anything with the SOS to close. Corporations, limited partnerships, limited-liability partnerships, and limited-liability companies do register with the SOS upon formation, so they must file forms of dissolution (corporations) or cancellation (LLCs and partnerships). Do this by filing a closing form with the SOS within 12 months of filing your business’s final-year tax return. If you’ve suspended your business, you first need to revive it before you can dissolve it. Do so by filing an application for revival.

Moving a business out of California for legal purposes is a little harder. The three primary methods are converting the California entity into an entity organized under the laws of your new home state; merging the California entity into a new entity organized under the laws of your new home state; and, less common, 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 forming an entity in the new home state and filing a certificate of merger with the new state’s SOS. Transferring assets involves the most work because it requires the preparation of documents to memorialize the transfer of each asset.

Before converting, merging, or transferring assets, make sure counsel confirms that doing so won’t unintentionally breach, terminate, or negatively affect current agreements. Some of your contracts may include anti-assignment or change of control provisions that will be triggered, including vendor and customer contracts, as well as loan and lease agreements. This concern mainly applies to transfers of business assets to a new entity and is especially problematic during our current high-inflation environment—you could end up renegotiating with vendors for the same services or supplies at a higher price. Often, state statutes cause anti-assignment provisions not to apply to conversion and certain types of mergers. California has such statutes in place, but make sure to confirm with counsel that they apply to your situation.

Registering as a Foreign Entity in California

Whether you convert, merge, or transfer your assets to a new entity, if you plan to continue conducting business in California, you should consider whether to register as a foreign entity there (or to use the proper word, qualify). Many fret over this strategic business decision, and with good reason. California’s rules regarding foreign qualification are ambiguous, and registering can prompt unnecessary attention from the California Franchise Tax Board.

Ambiguity. Generally, a business must register if it “transact[s] intrastate business” in California. The phrase “transact intrastate business” is defined as “entering into repeated and successive transactions” in California. There are fact-specific questions to consider based on the business’s in-state activities and unsurprising statutory exclusions (e.g., owning shares in another company that transacts intrastate business). But after a deep dive, you’re often still left without much clarity.

Penalties. Failure to register results in a $20 daily penalty. Equally important, until the business pays its penalties plus an additional $250, it cannot effectively sue others for claims based in California state courts. Also, each person knowingly involved is exposed to a misdemeanor charge carrying a penalty of up to $600.

The greatest penalty derives from a business’s noncompliance with California’s tax rules, not its registration rules. As noted above, a business engaging in California transactions may continue to be taxable in California. Not only does this result in California taxation, but nonfiling and nonpayment can also result in penalties (e.g., $2,000 annual failure-to-file penalty) plus interest on unpaid taxes accruing at 5% per month (up to 25%).

Flagging the franchise board. In deciding whether to register, a key concern of many businesses is that registration increases the likelihood of attention from the California Franchise Tax Board. Registration automatically requires a business to file a California tax return. Even if the business would not otherwise owe California income tax, registering triggers a filing requirement, an $800 minimum tax liability, and unwanted monitoring.

Filing Licenses and Permits

Nearly 75% of U.S. businesses are sole proprietorships. Even though they don’t need to register with the SOS, they’re 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, professional licenses, sales tax licenses, and home-based business licenses. Even if your business is exempt, licenses can often provide access to funding and limit owners’ personal liability. Upon your business’s closure, make sure to cancel all of your business’s state and local licenses and permits. Failure to do so can result in a trail of paperwork, communications, and additional fees.

Knowing the Hiring Laws in the New State

Employment law is a beast of its own, so be ready for changes in rules 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 top destinations for former California businesses—generally enforce employment non-competes if the restrictions are reasonable in time, geography, and scope of activity. You should check the new rules your business will have to follow.

Moving a business is hard. But it may be harder to ignore potential gains from lower taxes, cheaper living, and a more permissive regulatory environment. The realities are enough to give any business owner pause. If you choose to leave, be ready to take these steps.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Sergio Broholm is an associate in the Corporate group at Shartsis Friese. He focuses on mergers and acquisitions, emerging companies, and general contractual and transactional matters.

Jack Frisbie is a law student at USC (’23). Since working as a Treasury 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’s Office of Tax Policy. He consults for businesses on strategy, partnerships, and marketing.

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