California Differences - Employee Stock Options
California conforms to the same treatment as the federal return but has its own AMT and nonrefundable AMT credit carryover computation based upon the California Alternative Minimum Tax computation. It is conceivable that the AMT could apply to either the federal or CA and not the other depending upon all the factors affecting the make-up of the tax return.
California does not conform to the IRC Sec 83(i) election (see above), so for CA purposes the income is recognized on the option’s exercise date or on delivery of the fully vested stock.
The California Franchise Tax Board has issued guidance (California Tax News, May 2001) explaining how the state taxes stock option income when taxpayers change their state of residence to or from California. It also addresses the incentive stock option (ISO) alternative minimum tax adjustment
TAXABILITY OF STOCK OPTIONS TO CA NONRESIDENTS – OVERVIEW
When an individual was a CA resident when the option was granted and is a nonresident when the option is exercised. . .
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Nonqualified Options (NQSO) – Always treated as CA source income and taxable to CA.
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Qualified Options (ISOs):
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Qualified Disposition – If the disposition meets the requirements of a “qualified” ISO disposition then the gain is NOT taxable to CA.
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Nonqualified Disposition – Where the disposition does not meet the requirements of a “qualified” ISO disposition then the disposition is treated as a NQSO and thus the gain IS taxable to CA.
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CA Non-Qualified Stock Options
A non-qualified stock option (NSOs) is a plan that allows employees to buy their company's shares at a preset price. There are specific rules that apply to NSOs.
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Change of residency to California - When a taxpayer is granted an NQSO while a nonresident of California and later exercises it while a California resident, the difference between the fair market value of the stock on the date of exercise and the option price is subject to California tax. The state recognizes income at the point of exercise because the taxpayer acquires stock with a value greater than the exercise price. The income is subject to California tax because the taxpayer is a California resident when the income is recognized.
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Change of residency from California - When a taxpayer is granted an NQSO while a California resident and later exercises it while a nonresident, the Franchise Tax Board will properly characterize the income from its exercise as compensation for services with a source in-state where the taxpayer performed the services. Nonresident taxpayers who performed services both within and outside of California must allocate to California that portion of total compensation reasonably attributed to services performed in California (California Regulation §17951-5). One reasonable method is an allocation based on time. The period of time includes the total amount of time from the date of grant to the date of exercise (or the date employment ended, if earlier). The basis for this position is that the state properly characterizes the income upon exercise as compensation for services during the time the stock increased in value.
Income taxable by CA = total stock option income × allocation ratio.
The allocation ratio is California workdays from date of grant to date of exercise ÷ total workdays from date of grant to date of exercise
If a taxpayer performs services for the corporation entirely within California, but exercises the option after terminating employment and becoming a nonresident, the difference between the fair market value of the stock on the date of exercise and the option price has a source in California even though the underlying value of the stock may have increased after the taxpayer became a nonresident.
CA Incentive Stock Options
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Change of residency to California - When a taxpayer exercises an ISO while a nonresident of California and later sells the stock in a qualifying disposition (the holding period requirements under IRC §422 are met) while a California resident, California taxes the difference between the amount realized on the sale and the option price because the taxpayer is a California resident when the stock is sold.
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Change of residency from California - When a taxpayer exercises an ISO while a California resident or while a nonresident and then disposes of the stock in a disqualifying disposition (the holding period requirements under IRC §422 are not met) while a nonresident, the income from the disqualifying disposition is functionally equivalent to income from the exercise of an NQSO and the FTB will properly characterize it as wages. The wage income is equal to the difference between the fair market value (FMV) of the shares on the date of exercise (or the sale price, if lower) and the amount paid for the shares. If the FMV of the shares on the date of sale is greater than the FMV of the shares on the date of exercise, the FTB will treat the further increase in value as capital gain income. (Proposed Treasury Regulation §1.422A-1(b)(3))
Example 1 - ISO Change of residency from California: Mr. Smith, a resident of California, worked for X Company. He performed all his services in California during his entire career. On April 1, 2019, Mr. Smith's company granted him an option to purchase stock under its incentive stock option plan. On April 1, 2022, while still living and working in California, Mr. Smith exercised his option to purchase 30,000 shares of his company's stock. The option price on April 1, 2019, was $10 per share. The FMV on April 1, 2022, was $50 per share. On December 30, 2019, Mr. Smith retired and permanently moved to Florida. On March 15, 2023, he sold the 30,000 shares for $35 per share. The FTB will characterize income from the disqualifying disposition of ISOs as wages. Because Mr. Smith performed all his services in California between the grant date and the date of exercise of the option, 100% of the income is treated as wages from a California source as follows:
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• FMV of stock, date of sale: $1,050,000 (30,000 shares @ $35* per share)
• Less: Option price, date of grants: $300,000 (30,000 shares @ $10 per share)
• Equals: Wage income, California source: $750,000.
*The FTB used the sale price of $35 to compute the wage income because it is less than the exercise price of $50.
Example 2 - ISO Change of residency from California: Assume the same facts as Example 1, except Mr. Smith sold the stock on March 15, 2024, when the FMV of the stock was $60 per share. The FTB will determine the amount of income treated as wages from a California source as follows:
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• FMV of stock, date of exercise: $1,500,000 (30,000 shares @ $50 per share)
• Less: Option price, date of grant: $300,000 (30,000 shares @ $10 per share)
• Equals: Wage income, California source $1,200,000.
The FTB characterized the increase in the FMV of the stock from the exercise price of $50 to the sale price of $60 as capital gain income. The capital gain income has a source in Florida, Mr. Smith's state of residence when he sold the stock.
• FMV of stock, date of sale: $1,800,000 (30,000 shares @ $60 per share)• Less: FMV of stock, date of exercise: $1,500,000 (30,000 sh @ $50 per sh)
• Equals: Capital gain, Florida source $300,000.
• Incentive
stock option alternative minimum tax adjustment - For
federal and California AMT, the taxpayer must include, as an adjustment in
figuring alternative minimum taxable income, the amount by which the FMV of the
stock exceeds the option price in the year the stock is substantially vested
(the taxpayer's rights in the stock are transferable or no longer subject to
substantial risk of forfeiture). The FTB requires no adjustment if the taxpayer
disposes of the stock in the same year of exercise.
Deffered Intercompany Stock Account (DISA)
On July 30, 2025, the Franchise Tax Board (FTB) issuedLegal Ruling 2025-1, which relates to the treatment of a Deferred Intercompany Stock Account (DISA) in certain nonrecognition transactions. The Legal Ruling has important implications for taxpayers in combined reporting groups in which there is a DISA with respect to a member corporation's stock, and the stock is transferred in a nonrecognition transaction under Internal Revenue Code of 1986, as amended, section 355.
Taxpayers in the situation described in the Legal Ruling have faced uncertainty as to whether the DISA would cause income recognition. As described in the Legal Ruling, these taxpayers may use available basis to reduce or eliminate the DISA when the stock is distributed in certain nonrecognition transactions.