Understanding and Optimizing for State Taxation

State taxation rules can differ substantially in some areas. Make sure you understand your state's specific tax laws for the strategies you implement.

Strategy Overview

State taxation can be challenging. Not only is there a wide variety of how states opt to tax income (for more details see State & Local Tax), but many states also opt in, out, or create their own rules regarding some federal tax programs (e.g. AMT; QSBS). The strategic opportunity (or perhaps warning in this circumstance) is that it's critical to understand your specific states rules regarding any tax strategy you plan to pursue.

Tax Details

With equity compensation like stock options and restricted stock, federal tax implications are complex enough. Misery loves company, however, and many states have their own set of complex rules to further complicate things. For example (1) some states have their own versions of AMT, and (2) a number of states "opt out" of certain IRS tax programs. While not a comprehensive list, we detail, below, some of the more commonly known ways state taxation can vary from federal. But as with many things taxation, it's complex and circumstance-dependent, and we recommend you consult a professional when developing your strategy and filing your taxes.

Alternative Minimum Tax (AMT)

As of 2023, six states have their own version of an alternative minimum tax (for more details see The Tax Foundation: States With a Minimum Tax). If you anticipate triggering federal AMT (most likely via exercising ISOs with a material bargain element), it's likely that you will also trigger your state's individual minimum tax as well.

Qualified Small Business Stock (QSBS)

The QSBS tax exclusion is unique, allowing a taxpayer to exclude up to $10 million in gains from taxation when they qualify. However, as of 2023 seven states (most notably California) opt out of the QSBS tax exclusion program (i.e. the gains from QSBS stock would be taxable for state income tax purposes if you live in the state). For more details see QSBS Expert: State Treatment of QSBS

If you anticipate a large gain that qualifies for QSBS, but your state is one that does not conform, there are a handful of tax strategies you may consider (e.g. Relocating to a new state; ING Trusts)

Opportunity Zones

Opportunity Zones are a unique federal tax program that provide tax benefits if realized capital gains are reinvested in a qualified geographic area. However, as of 2023 four states (most notably California) opt out of the beneficial tax treatment for Opportunity Zones.

529 Plans & Health Savings Accounts (HSA)

529 plans and HSAs are not part of the scope of this knowledge base. That said, to provide additional examples of ways state taxation rules may differ from federal rules:

• 529 plans. The IRS updated 529 rules in 2018 to allow withdrawals of up to $10,000 per year to pay for qualified K-12 educational expenses. However, some states don't conform to the 2018 update, penalizing withdraws for K-12 educational expenses.

• HSA plans. HSA's are sometimes referred to as "triple tax free" due to (1) contributions being made pre-tax, (2) earnings of invested balances being tax-free, and (3) withdrawals to pay for qualified medical expenses being tax-free. However, some states don't conform to federal rules, thereby (1) making the contribution to the plan be after-tax (vs. pre), and (2) taxing the earnings of invested balances.

Key Benefits

• Optimize total federal and state tax burden through planning. If you don't know the rules, you can't plan accordingly. But by understanding how your state taxes certain strategies, you can better determine the optimal plan for your specific situation.

• Some tax strategies may exist if your state's rules are onerous. While not a guaranteed home run, there may be some tax planning strategies to consider if your state tax burden is anticipated to be particularly onerous.

Key Considerations/Flags

• State residence determines what state taxes will apply. Changing residence has major tax implications that must be considered.

• Optimizing state taxes may require changes to account locations, grant structures, residence, sale timing, and more. Consult a tax professional experienced with state tax planning.

• There are limits and risks to over-optimization. Any plan needs to balance to costs to establish and maintain, the time required to cost and maintain, and the risk that tax laws may change over time.

Strategy: When to Consider This and When to Avoid It

🟢 When to Consider This Strategy:

• If you live in California (arguably the state with the most opt-outs), it's important to understand how the state's taxation rules will impact your strategy

• If you are pursuing a strategy that will likely trigger AMT, claim a QSBS exclusion, or utilize Opportunity Zones -> understanding the rules your specific state utilizes is important for planning

🔴 When to Not Use This Strategy:

• While not a guarantee, if you do not anticipate triggering AMT, claiming a QSBS exclusion, or utilizing an Opportunity Zone -> then its unlikely that you will be surprised by your state's taxation treatment.

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