Leaving California Before a Severance Payment: New OTA Decision Draws a Line Between Severance and RSUs
California's rules for taxing compensation received after an individual leaves the state can be surprisingly complex. A recent California Office of Tax Appeals ("OTA") decision illustrates why the answer may depend not simply on when a payment is received—or even how it appears on a Form W-2—but on the legal character of the payment and what the taxpayer received the payment for.
In Appeal of J. Otting and Y. Otting, 2026-OTA-403P, the OTA considered whether compensation received by a former California resident after relocating to Nevada remained taxable by California. The amounts at issue included severance payments, employer-paid medical benefits, and restricted stock units ("RSUs").
The distinction proved significant.
The OTA concluded that the severance and medical-premium payments were not California-source income under the circumstances presented, while compensation attributable to RSUs remained California-source income because the RSUs related to services the taxpayer had performed while working in California.
The decision, which has been designated pending precedential, is potentially important for executives, founders, and other highly compensated individuals who leave California while retaining rights to severance, equity compensation, bonuses, deferred compensation, or other employment-related payments.
The Dispute
The taxpayers were former California residents who relocated to Nevada. After the move, the husband received substantial payments associated with the termination of his former employment, including severance and medical-premium benefits. He also received compensation attributable to RSUs.
The California Franchise Tax Board ("FTB") asserted additional California tax, resulting in a proposed assessment of approximately $1.8 million.
The dispute therefore presented an increasingly common question: When an employee works in California but receives compensation after becoming a resident of another state, how much of that compensation can California continue to tax?
There is no single sourcing rule that answers that question for every type of payment.
Severance Was Treated Differently From Compensation for Prior Services
One of the most important aspects of the OTA's decision is its treatment of severance.
The OTA relied on longstanding California authority distinguishing payments made for the termination or cancellation of an employment contract from compensation paid for services actually performed in California.
Under that authority, a contractual right to receive severance may constitute an intangible right. For a nonresident, income from an intangible generally follows the taxpayer's domicile unless the intangible has acquired a business situs in California or another exception applies.
Because the taxpayers had moved to Nevada, the OTA concluded on the facts before it that the severance payments were not California-source income.
The medical-premium payments associated with the severance arrangement received similar treatment.
That conclusion is particularly noteworthy because it differs from the broader position the FTB has more recently articulated regarding severance associated with California employment.
The OTA Addressed the FTB's More Recent Position on Severance
The decision also highlights an apparent tension between existing California authority and the FTB's administrative position.
The OTA discussed revisions made to the FTB's Multistate Audit Technique Manual in 2022. The revised guidance generally takes the position that benefits directly related to California employment—including severance pay—may constitute California-source income.
But an administrative manual is not the same thing as controlling legal authority.
In Otting, the OTA concluded that earlier precedential authority governing payments for termination of an employment contract controlled the issue presented. The fact that the taxpayer's former employment occurred in California did not, by itself, convert the subsequent severance payments into California-source compensation.
That distinction may become important in future FTB audits involving executives who relocate before receiving substantial separation payments.
Why Were the RSUs Different?
The taxpayer did not receive the same result with respect to his RSUs.
The OTA concluded that the RSU income was attributable to services the taxpayer had actually performed while working in California. As a result, the income retained a sufficient connection to California to constitute California-source income.
This distinction illustrates a fundamental principle of nonresident compensation sourcing.
The relevant question is not necessarily:
Where did the taxpayer live when the money was received?
Instead, the analysis may require asking:
What did the taxpayer do, relinquish, or become entitled to in exchange for the payment?
For an RSU earned through services performed in California, moving to Nevada before the income is ultimately recognized does not necessarily eliminate California's ability to tax the portion attributable to California services.
For a severance payment made in exchange for terminating contractual employment rights, however, the sourcing analysis may be materially different.
Not Everything Reported on a W-2 Has the Same California Sourcing Rule
This is one of the most useful practical lessons from Otting.
A departing executive may receive several different types of payments in the same year, potentially including:
salary through the termination date;
an annual or performance bonus;
severance;
accrued vacation or other benefits;
RSUs or other equity compensation;
deferred compensation;
payments under a noncompetition or release agreement;
employer-paid medical benefits; and
settlement consideration.
Some or all of those amounts may appear on the same Form W-2.
That does not necessarily mean they should all be sourced to California in the same manner.
The tax analysis should generally begin with the legal and economic character of each payment. The employment agreement, equity award documents, separation agreement, release, settlement agreement, compensation plan, vesting schedule, and the taxpayer's work history may all become important.
Severance Agreements May Require Careful Tax Analysis
The decision also underscores why the drafting of a separation agreement can matter.
A payment described generically as "severance" may, in substance, compensate an employee for several different things. For example, an agreement might provide consideration for terminating employment rights, compensate the employee for previously performed services, accelerate an existing bonus, settle disputed compensation, release legal claims, or modify rights under an equity plan.
Those payments should not automatically be assumed to have identical sourcing consequences merely because they are contained in the same separation agreement.
Taxpayers contemplating a departure from California may therefore benefit from reviewing the underlying agreements before the payment occurs, particularly when significant severance, equity compensation, deferred compensation, or settlement proceeds are involved.
The documentation should accurately reflect the parties' actual legal rights and economic arrangement. Tax characterization generally cannot be manufactured after the fact simply by attaching a favorable label to a payment.
California Residency and California-Source Income Are Separate Questions
Another important point is that establishing nonresident status does not necessarily end California's taxing jurisdiction.
A taxpayer who genuinely becomes a Nevada, Texas, Washington, Florida, or other non-California resident may still owe California tax on California-source income.
Accordingly, there can be two distinct inquiries:
Residency: Was the individual a California resident when the income was received?
Sourcing: Even if the individual was a nonresident, was the particular income nevertheless derived from a California source?
A taxpayer may prevail on the first question and still owe California tax under the second.
For executives with equity awards and deferred compensation, this distinction can be particularly significant because payments may occur months or years after the individual leaves California.
What Taxpayers Leaving California Should Consider
Individuals expecting significant post-departure compensation should consider identifying and separately analyzing each category of compensation before filing their California nonresident return.
Relevant documentation may include employment and separation agreements, RSU and stock-option award documents, vesting schedules, payroll records, bonus plans, work calendars, records showing where services were performed, correspondence concerning the reason for a payment, and documents establishing the taxpayer's change of residency.
The greater the amount involved, the more important it may be to establish the sourcing analysis contemporaneously rather than attempting to reconstruct it after an FTB audit begins.
The Broader Significance of Otting
Otting does not stand for the proposition that moving out of California automatically converts severance or other employment compensation into non-California income.
Nor does it establish that all severance received by a former California employee is exempt from California taxation.
Instead, the decision demonstrates something more important: California sourcing is payment-specific.
The legal nature of the taxpayer's right to receive a payment may determine its source. Severance paid for the termination of contractual rights can present a materially different sourcing question from RSUs or other compensation earned through services performed in California.
For taxpayers receiving substantial compensation after leaving California, that distinction can translate into a significant difference in California tax liability.
Tax Controversy and California Residency Matters
California residency and income-sourcing disputes are highly fact-specific. Taxpayers facing an FTB examination or proposed assessment involving severance, equity compensation, deferred compensation, business income, or other post-departure payments should evaluate both their residency position and the sourcing of each material category of income.
Early review can also be valuable before a transaction or payment occurs, particularly where an executive is negotiating a separation agreement or planning a move from California.
Disclaimer
This article is provided for general informational purposes only and does not constitute legal, tax, accounting, or other professional advice. The discussion is based on the authorities and information available as of the date of publication. Appeal of J. Otting and Y. Otting, 2026-OTA-403P, has been designated pending precedential, and its status should be confirmed before relying on the decision as precedential authority. Tax consequences depend on the particular facts, governing agreements, applicable law, and the taxpayer's circumstances. Readers should consult qualified legal and tax advisers regarding their specific situation.
