Does California Taxes Pay for Other States’ Income?

California has some of the highest state taxes in the U.S., leading many residents to question whether their tax dollars support other states. This concern stems from California’s large economic output and its role as a major federal revenue contributor. However, state income taxes are not simply redistributed across state lines.

To determine whether California taxpayers are financially supporting other states, it’s essential to examine residency rules, how income earned elsewhere is taxed, and whether credits mitigate double taxation.

Residency and Domicile

California taxes individuals based on residency, which is determined by where a person has the strongest ties rather than just physical presence. The Franchise Tax Board (FTB) evaluates factors such as home ownership, employment, family residence, and financial accounts. Even if someone spends extended periods outside California, they may still be considered a resident if they maintain significant connections.

Domicile, while related, refers to a person’s permanent home—the place they intend to return to after temporary absences. A person domiciled in California but living elsewhere may not be a resident for tax purposes. However, maintaining a California driver’s license, voter registration, or property ownership can still subject them to state taxation.

California has some of the strictest residency rules in the country. Moving to a state like Nevada or Texas, which has no income tax, does not automatically exempt someone from California taxes. If they own property, have dependents in California schools, or frequently return for business, the state may still classify them as a resident. The “close connection” test evaluates whether enough ties have been severed to establish nonresidency.

Sourcing Income From Other States

California taxes residents on all income, regardless of where it is earned. However, income sourced to another state may also be taxed by that state, raising the risk of double taxation.

For wages and salaries, taxation depends on where the work is performed. If a California resident works in another state, that state may impose its own tax, but California still taxes the income. This often requires filing multiple state tax returns.

Business income is treated differently depending on the entity’s structure. Sole proprietors and partners in pass-through entities, such as S corporations and LLCs, must allocate income based on where business activities occur. California uses a market-based sourcing rule for service-based businesses, meaning revenue is taxed based on the customer’s location rather than where the service is performed. This creates complex tax situations for consultants, freelancers, and online service providers with clients in multiple states.

Investment income, such as dividends, interest, and capital gains, is taxable in California regardless of where the investment is held. However, rental income from properties in other states is sourced to that state, requiring compliance with its tax laws. Some states, like New York, impose nonresident withholding on rental income, requiring out-of-state owners to pay taxes upfront.

Credits for Taxes Paid Elsewhere

California residents earning income in other states may face double taxation. To mitigate this, California offers the “Other State Tax Credit” (OSTC), which offsets taxes paid to other states.

The OSTC applies only to income taxed by both California and another state. It does not apply to taxes paid on income that California does not tax, such as earnings from states with no income tax. The credit is limited to the lesser of the actual tax paid to the other state or the amount of California tax attributable to that income. For example, if a taxpayer owes $5,000 in another state but California would have taxed the same income at $4,000, the credit is capped at $4,000, leaving the taxpayer responsible for the remaining $1,000.

Only state-level income taxes qualify for the credit. Local taxes, franchise taxes, and other business-related levies do not. This is particularly relevant for individuals earning income in states like New York, which imposes both state and city income taxes. In such cases, only the state portion qualifies for the credit.

Claiming the OSTC requires filing Form 540 and completing Schedule S, which details income earned in other states and the corresponding taxes paid. Taxpayers must provide supporting documentation, such as copies of other state tax returns and proof of payment. Errors in allocation or miscalculating the credit can lead to audits or denied claims, making accuracy essential.

Allocation vs. Apportionment

Determining how income is divided among multiple states depends on whether it is allocated or apportioned. Allocation applies to non-business income, such as royalties, rents, and capital gains, which are assigned to a single state based on specific rules. Apportionment is used for business income and distributes taxable earnings across multiple states using a formula that considers factors like sales, payroll, and property.

California follows a single-sales factor apportionment method for most businesses, meaning the percentage of total revenue derived from California customers determines how much of a company’s income is taxable in the state. This differs from traditional three-factor formulas used by some states, which also consider in-state payroll and property. By focusing solely on sales, California’s method can significantly impact businesses that generate substantial revenue from California customers but have minimal physical presence in the state.

For individuals with pass-through business income, apportionment can be particularly complex. If a partnership or S corporation operates in multiple states, each owner’s share of income must be apportioned based on the entity’s activities. This can lead to tax liabilities in states where the individual has little or no physical presence, requiring careful planning to ensure compliance while minimizing unnecessary tax burdens.