Unexpected Tax Bill: California Nonresident Owes Income Tax on NSOs and RSUs

By: Jeff Glickman, SALT Partner

At a glance 

• The main takeaway: California’s Office of Tax Appeals ruled that a nonresident owed state income tax on income generated from exercising non-qualified stock options and vesting in restricted stock units.
• Assess the impact: It’s crucial for individuals who receive various forms of deferred income to understand how that income will be taxed at the state level.
• Take the next step: Aprio’s State and Local Tax (SALT) team can advise you on your state tax obligations for various types of income earned and help to reduce your risk of unexpected state tax liabilities.

Schedule a free consultation today to learn more!  

Throughout their careers, employees can receive various forms of compensation. Some of these are treated as income in the year they are received, while others may be deferred to a future year. Examples of deferred income may include:

• Contributions to a pre-tax 401K plan or receiving an employer 401K match
• Receipt of a pension following retirement from a company

In either of these cases, the employee is deferring, or the company is deferring the employee’s receipt of income from a current year to a future year, ultimately impacting how the employee treats that income for tax purposes. From a federal perspective, this creates a deferral of tax obligations associated with this income. However, from a state perspective, this may not just involve a deferral.

Understanding state deferred income

If an employee works in State A and contributes compensation to a 401K, that contribution amount is not taxed (i.e., State A does not receive tax revenue) even though the compensation was received. If the employee retires, moves to State B, and starts withdrawing income from the 401K plan, State A could argue that a portion of this income should be taxable to State A since it relates to compensation earned while the employee was working in State A. If that employee worked in different states throughout his career, determining that allocation could be a nightmare.

Fortunately for retirees, there is a federal law that simplifies the reporting and taxation of retirement income for state income tax purposes.[1] This law prohibits states, other than the individual’s resident state, from taxing certain retirement income, such as income from 401Ks and similar plans, as well as qualifying pension income. This law is what allows retirees to escape state taxation on their retirement income by moving to a no-tax state like Florida or Nevada.

Tax implications of NSOs and RSUs across state lines

However, not all compensation or income falls within the protection of that federal law. For example, if an employee receives a non-qualified stock option (NSO) or a restricted stock unit (RSU), the receipt of that NSO or RSU may not be income in the year of receipt, but it would generate taxable income in a future year when the NSO is exercised or when the RSU vests. 

So, what happens when an employee is working in one state when the NSO or RSU is received, but lives in another state when the income is recognized? 

Executive’s NSOs and RSUs draws the attention of California’s Office of Tax Appeals

The taxpayer represented in this California Office of Tax Appeals (OTA) opinion worked as an executive for Monster Beverage Company.[2] He predominantly worked from the company’s California headquarters from 2007 to 2013 until he moved to Hawaii in December 2013. He continued to work for the company while living in Hawaii.

At various times during his California employment, the taxpayer received both NSOs and RSUs. In September 2014, while still a resident of Hawaii, the taxpayer exercised his NSOs and became vested in his RSUs. The taxpayer reported that income on his 2014 federal tax return, but none of the income was reported to California. The State of California assessed the taxpayer for tax on a portion of the income based on the ratio of California working days to total working days for the period when the NSO/RSU was granted to the date they were exercised/vested. The taxpayer appealed the assessment.

California’s ruling on NSOs and RSUs explained

Under California law, nonresidents are taxed on income derived from California sources, including compensation for personal services if California is the location where the services were actually performed.[3] Except for certain enumerated situations not applicable in this situation, California rules require that “total compensation for personal services must be apportioned between this State and other States and foreign countries in such a manner as to allocate to California that portion of the total compensation which is reasonably attributable to personal services performed in this State.”[4]

In ruling against the taxpayer, the OTA concluded that the income received by the taxpayer from the exercise of his NSOs and the vesting of his RSUs was compensation for personal services performed by the taxpayer and that the state’s use of a working days ratio was a standard and reasonable methodology.

Individuals who receive various forms of deferred compensation need to understand how that compensation will be taxed at the state level, as it is not always the case that the income will be taxed solely in your state of residence. 

The bottom line

Aprio’s SALT team has experience advising individuals regarding their state tax obligations for various types of income earned during working/retirement years and how their state of residence can impact their total state tax burden. Our tax advisors can work with you to minimize your state income taxes and minimize your risk of incurring unexpected state tax liabilities and penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter. 

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[1] 4 U.S. Code § 114. While not necessary, California enacted a statute mirroring this federal law.  See Cal. Rev. & Tax Code § 17952.5.

[2] In the Matter of the Appeal of C. Hall and M. Hall, OTA Case No. 2209113257 (Dec. 13, 2024).

[3] Cal. Rev. & Tax Code § 17951; Cal. Code Regs. Tit. 18, § 17951-2.

[4] Cal. Code Regs. Tit. 18, § 17951-5(b).