Was a nonresident's payment for dismissing a wrongful-termination lawsuit taxable by California when the right had no California business situs?

Plain-English summary

California Chief Counsel Ruling 01-201181 concluded that a nonresident's payments for dismissing a wrongful-termination lawsuit were not taxable by California on the submitted facts.

FTB characterized the payments as income from an intangible: the former employee's right to continued employment.

That income was generally sourced to the former employee's residence when recognized, not to the place where the employee had worked or would have worked.

What the taxpayer asked

A former employer paid the nonresident under an agreement requiring dismissal of a lawsuit alleging wrongful termination.

The original request mentioned California personal income tax, State Disability Insurance, and other unspecified withholding items. The requester later narrowed the question to whether the amounts received for dismissing the lawsuit were subject to California income tax.

FTB answered only that narrowed income-tax question.

Why FTB treated the payment as intangible income

FTB relied on the State Board of Equalization's Appeal of McAneeley for the rule that income from termination of an employment contract is not compensation for services but income from an intangible.

For sourcing, FTB saw no difference between payment under a termination agreement and payment under an agreement to dismiss a wrongful-termination lawsuit.

In both cases, the relevant intangible was the right to continued employment.

California sourcing rule and exceptions

Under Revenue and Taxation Code section 17952, income from this intangible was generally sourced to the former employee's residence when the income was recognized.

FTB identified two possible exceptions:

• The intangible had acquired a business situs in California.
• The income accrued while the taxpayer was a California resident, even though it was received after the taxpayer became a nonresident.

The submitted facts showed neither exception. FTB therefore concluded that the amounts lacked a California source.

Holding

None of the amounts received under the dismissal agreement were taxable by California because they were not California-source income.

FTB expressly did not reach whether, or to what extent, the amounts constituted income generally.

What this means for you

Nonresident former employees

The label placed on a settlement does not by itself decide California sourcing. The nature of the right being surrendered, residence when income is recognized, prior accrual, and any California business situs all matter under this ruling.

Employers and payroll teams

Separate the California income-tax sourcing question from withholding, disability-insurance, and other payroll questions. This ruling answered only the income-tax issue.

Tax professionals

Document the taxpayer's residency timeline, when the claim accrued, the legal right exchanged for payment, and any facts that could create a California business situs.

Common questions

Q: Was the payment treated as compensation for California services?

A: No. FTB treated it as income from an intangible right to continued employment.

Q: Did the employee's former California work location control the source?

A: No. The general rule looked to the former employee's residence when the income was recognized.

Q: When could California still source this type of payment to the state?

A: If the intangible had a California business situs or the income accrued while the taxpayer was a California resident.

Q: Did FTB decide State Disability Insurance or other withholding issues?

A: No. The request was narrowed, and the ruling addressed only California income-tax sourcing.

Q: Did FTB decide whether the payment was income at all?

A: No. Because the amounts lacked a California source, FTB did not reach that broader question.

Key source language

• Conclusion: “We conclude that none of the amounts received are taxable by the State of California because they are not income from California sources.”
• Characterization: “In either case, the income is properly characterized as income from an intangible, the right to continued employment.”
• Application: “There are no facts alleged that suggest the agreement acquired a business situs in California or that the monies accrued before ** became a nonresident.”
• Scope limit: “Because we conclude that the amounts do not have a California source, we do not reach the question of whether or to what extent the amounts constitute income, generally.”

Citations and references

• Cal. Rev. & Tax. Code §§ 17554, 17952, and 21012(a)(1)
• Appeal of McAneeley (Cal. St. Bd. of Equal., Oct. 28, 1980)
• Appeal of Money (Cal. St. Bd. of Equal., Dec. 13, 1980)

Source

• Landing page: Chief Counsel Ruling index
• Official ruling: Chief Counsel Ruling 01-201181

Original ruling text

STATE OF CALIFORNIA
KATHLEEN CONNELL
FRANCHISE TAX BOARD
Chair
Legal Branch
CLAUDE PARRISH
PO Box 1720
Member
Rancho Cordova, CA 95741-1720
(916) 845-5316 Fax (916) 845-3648
B. TIMOTHY GAGE
Member

October 15, 2001
Chief Counsel Ruling
01-201181

Dear ****:

In your letter dated **, you requested a ruling as to whether California Personal Income Tax, State Disability Insurance and other unspecified items were wrongfully withheld on certain monies paid to ****, a nonresident, by his former employer under a contract by which he agreed to dismiss a lawsuit alleging wrongful termination of employment. You subsequently modified your request to address only the question of whether amounts * received as a consequence of that dismissal are subject to California income tax.

We conclude that none of the amounts received are taxable by the State of California because they are not income from California sources. 1

In your letter, you provided the following information. ******

**************.
***************.

***************.

Nonresidents are subject to California income tax on income from California sources. Income from a termination of employment contract does not constitute compensation for services rendered, but income from an intangible. (Appeal of McAneeley, California State Board of Equalization, October 28, 1980.) Thus, the source of such income is not where the services were provided or would have been provided had the employment relationship not been terminated, but generally at the residence of the former employee

1
Because we conclude that the amounts do not have a California source, we do not reach the question of whether or to what extent the amounts constitute income, generally.

Page 2

October 15, 2001
Page 2

at the time the income is recognized. (Revenue and Taxation Code § 17952.) There are two exceptions to this rule. If the intangible has acquired a business situs in California, the income has a source in this state. (Ibid.) Also, if the income accrued while the taxpayer was a resident of California, it may be taxable by California even though it is received when the taxpayer is a nonresident. (Revenue and Taxation Code
§ 17554, as limited by Appeal of Money, California State Board of Equalization, December 13, 1980.)

For sourcing purposes, we see no difference between income from a termination of employment contract and income from an agreement to dismiss a lawsuit alleging wrongful termination of employment. In either case, the income is properly characterized as income from an intangible, the right to continued employment. Here,
* received amounts from an agreement to terminate a lawsuit alleging wrongful termination of employment. There are no facts alleged that suggest the agreement acquired a business situs in California or that the monies accrued before * became a nonresident. Accordingly, the amounts do not have a source in California and are not subject to California income tax.

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the named taxpayer and are based upon and limited to the facts you have submitted. In the event of a change in relevant legislation, or judicial or administrative case law, a change in federal interpretation of federal law in cases where our opinion is based upon such an interpretation, or a change in the material facts or circumstances relating to your request upon which this opinion is based, this opinion may no longer be applicable. It is your responsibility to be aware of these changes, should they occur.

This letter is a legal ruling by the Franchise Tax Board's Chief Counsel within the meaning of Revenue and Taxation Code section 21012(a)(1). Please attach a copy of this letter and your request to the back of the appropriate return(s) (if any) when filed or in response to any notices or inquiries which might be issued.

Richard C. Gould
Tax Counsel III