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State Tax Residency Issues Editor: Editors note: Mr. McGowan is a member of the AICPA Tax Divisions State & Local Taxation Technical Resource Panel (TRP). Mr. Peterson chairs that TRP. For more information about this column, contact Mr. McGowan at jmcgowan@klcpas.com. Taxpayers should attempt to arrange their business and other economic activities to effectively minimize the income they apportion and allocate to states with high marginal tax rates. These efforts should entail determining the effect an individuals business activities has on compliance with the various tax laws in the states where the business activities occur. A key component in implementing such a strategy is identifying a taxpayers residence and tax domicile. For instance, as was recently noted, an administrative difficulty that arises [in payments on behalf of nonresident owners] is tracking the residency status of partners/members/shareholders. The owners mailing address may not provide a reliable basis from which to determine the state of residence; see Schneyman, Tax Clinic, Tax Payments by Passthrough Entities for Nonresident Owners, TTA, October 2003. This column explores the issues surrounding residency/nonresidency of an individuals business and pass-through entity holdings, as well as the ability of states to tax compensation and deferred income. Residency determinations are critical to individual income tax planning. A tax saving idea, such as shifting income from a high-rate state to a low- or no-rate state, must be weighed against a states ability to impose income taxes on all income of an individual considered to be a resident in the state. Conversely, a nonresident (generally defined as anyone who is not a resident) is taxed only on income earned within the taxing state. Residence in one state may not preclude another state from taxing the same income, if the nondomiciliary state finds that some (or all) of the income was earned from property located in, or activities taking place, within its borders. This emphasizes why residency is critical for planning and reporting business activities.
Determining Residency Most states use some common criteria to determine residency; see the exhibit below. But, in general, they usually employ four factors, either alone or in combination, as a test: (1) in-state domicile; (2) presence for other than a temporary or transitory purpose; (3) presence for a specified period; and (4) maintenance of a permanent in-state abode.
An income tax domicile is usually the same as a permanent home. A domicile, according to NYCRR 102.2(d)(1), for example, is the place which an individual intends to be his permanent homethe place to which he intends to return whenever he may be absent. If the domicile changes, the individual bears the burden of proving that a new one has been established; see Lawrence v. Mississippi State Tax Commn, 286 US 276 (1932). Many states use a physical presence test (normally based on days) to determine whether an individual is a resident in the state. Although New York law defines a resident as a person domiciled in the state, it contains exceptions for taxpayers who are out of the country for extended periods or who have two residences and spend less than 30 days of the tax year in New York; see NY Tax Law 605(b). A resident also includes any person not domiciled in the state who maintains a permanent abode there and spends more than 183 days of the tax year in New York, unless he or she is in active service in the U.S. armed forces. Thus, New York executives and employees domiciled elsewhere, but maintaining a New York presence for the requisite period, are taxable residents. As exemplified by New Yorks residency criteria, taxpayers need records to support a domicile or residency change. State residency determinations can be extremely fact-intensive; usually the taxpayer bears the burden of proof. Thus, proper documentation can avoid unnecessary tax liabilities. Records showing the time and purpose of visits to a state help to demonstrate residency or nonresidency, especially as many states use the number-of-days criterion in determining it. It is also important to find out how each state defines spending a day in or out of state. Thus, taxpayers not fully present in one state throughout the tax year, must carefully monitor how many days they spend in a state during the year and plan accordingly to avoid unnecessary visits that could establish residency. Nonresidents are generally liable for tax on their state-specific source income. This is usually defined as the items of income, gain, loss and deduction comprising an individuals Federal adjusted gross income (AGI) derived from in-state sources. For example, according to Indiana Code 6-3-2-2(a), AGI derived from sources within Indiana includes: (1) compensation for labor or services rendered in Indiana; (2) income from real or tangible personal property in Indiana; (3) income from doing business there; (4) income from conducting a trade or profession there; and (5) income from intangible property if the receipt from the intangible is attributable to Indiana.
Compensation Income Compensation for personal services is generally sourced to the state in which the employee performed the services. Similar to the Indiana rules discussed above, most states tax compensation, such as W-2 wages, for employee services performed in-state by a nonresident. They generally allocate this income to the state based on the proportion of the total number of working days employed in the state to the total number of working days employed both within and outside of the state. Under this method, income is apportioned based on a ratio, the numerator of which is the number of days worked in a state and the denominator of which is the total number of days worked in all states in which the taxpayer performed services during the tax year. The working-days concept is used by most states in sourcing income and is very prevalent in certain sectors, such as the airline and music industries, professional sports and management consulting. Reciprocal agreements: Before allocating income to a particular nonresident state, taxpayers should check whether that state has a reciprocal exemption agreement with their resident state. A reciprocal agreement would normally require the individual to remit tax to the state of his or her residence, rather than to the state to which the income is sourced (i.e., earned). Thus, individuals are exempt from tax on wages, salary and other compensation for personal services rendered in nonresident states with reciprocal agreements. In reciprocal agreement states, withholding and income tax filing will generally not be required in the individuals nonresident state, if the only income is from wages, salary and other compensation for personal services rendered in the nonresident state. In this case, an individual working in a reciprocal agreement state would report the wage income on his or her resident return as if earned in the state of residence. No reciprocal agreement: The remedy for nonreciprocal filing states is to have the taxpayer claim a credit for taxes paid to another state, and effectively assign tax to the state in which the income is sourced. The credit is normally limited to the resident state tax assessed on the out-of-state in-come. An individuals total state in-come tax burden increases in situations in which a higher-rate nonresident tax is not fully credited against the individuals resident lower-rate tax on the same income.
Reverse credits: In most situations, the resident state allows a credit for taxes paid to the nonresident state. However, states are not required to afford credits for taxes paid to another state. In these situations, taxpayers must be alert to states that provide credits in reverse to each other. Under this circumstance, a credit is taken on the nonresident return for the resident state taxes paid on the same income. This credit normally cannot exceed the rate on which the nonresident state taxes the same income.
Deferred Compensation The taxability of deferred compensation (e.g., nonqualified stock options and retirement distributions) is another area of scrutiny when determining which income will be sourced to a state. The determination involves whether the resident state at the time the individual earns the deferred compensation, has the authority to tax such income if, at the time of receipt, the individual resides in a different state. These situations typically arise when individuals, after several years of being employed in and residing in a high-income tax state (e.g., California or New York), retire and change residency to a no- or low-income-tax state (e.g., Florida) and start collecting retirement income. These individuals face little to no taxation of these benefits by their new resident states. P.L. 104-95 prohibits state taxation of the qualified retirement income of any individual who is not a resident of the state where earned when the payments are made. The statute also ad-dresses city income taxes, which are also barred. While the Federal statute refers to the protected arrangements as retirement income, that phrase is defined in relation to payments from enumerated qualified plans, rather than from employment income received after retirement. Qualified retirement income does not refer solely to income received after retirement, but includes payments made from specifically defined qualified deferred-compensation arrangements. The Federal statute also includes payments under nonqualified deferred-compensation plans that meet certain requirements. For certain deferred-compensation arrangements not meeting the P.L. 104-95 criteria, some states will attempt to use the source theory to tax the income in the state in which the deferred compensation was earned. Taxpayers should check for planning opportunities for such items as incentive stock options, which are generally considered compensation income subject to tax in the state where earned. However, there might be opportunities to reduce state taxes on such income if the recipient is no longer a resident of the state when the options are sold.
Tangible Property Income Rents or royalties from real or personal property earned by individuals may be considered nonbusiness income, which is allocated to the state in which the property is located. Thus, the income source of real or tangible personal property is generally determined by physical location. Real property normally presents little difficulty; however, tangible personal property may create uncertainties. For example, in California, it is unclear whether rents on property stored there but leased for use in another state, are California-source. Also, if tangible personal property is removed from California immediately before it is sold, tax avoidance issues may arise.
Business Income If a taxpayer derives Schedule C sole proprietorship or passthrough entity business income from both in-state and out-of-state sources, the portion taxable in a particular state is generally derived by multiplying the states apportionment factorsusually sales, property and/or payrollby the taxpayers share of business income. For nonresident partners/shareholders, the obligation to file returns and pay taxes in every state in which the passthrough entity does business, can create enormous administrative, enforcement and compliance burdens. Composite returns: Many states permit a passthrough entitys nonresident partners/shareholders to file a composite return. The majority of states that permit such returns do so only if the included partners/shareholders: (1) are nonresidents for the full tax year and (2) do not have any other in-state source income. In some states, entities with nonresident members will be required to file either (1) a composite return for individual nonresidents or (2) an agreement that each will file a return, pay all taxes timely and be subject to that states personal jurisdiction. Withholding: A number of states also impose withholding on nonresident partners/shareholders. In such states, a nonresident partner/shareholder may be able to execute an agreement to assume all liability for filing returns and paying taxes, which relieves the passthrough entity from withholding taxes for them. Otherwise, states generally require passthrough entities doing business in the state to withhold income tax at the highest rate on state-sourced income paid to nonresident members. In most circumstances, these nonresident withholdings/composite tax payments can be claimed as a credit when the taxpayer files his or her resident income tax return. Failure to file: Generally, a nonresident partners/shareholders failure to file a return keeps the statute of limitations (SOL) open indefinitely. In Durovic, 487 F2d 36 (7th Cir. 1973), cert. den., the Seventh Circuit rejected the argument that a passthrough entitys properly filed return is sufficient to toll the SOL for its individual members. Another potential adverse consequence of failing to file a return is being barred from claiming passive loss and net operating loss carryforwards in subsequent years. Although many state laws are unclear as to whether failure to file will preclude a nonfiler from claiming certain tax benefit carryforwards in later years, the mere fact of many states disallowance of such carryforwards provides sufficient incentive for taxpayers to file returns claiming losses. Although this column focuses on individual income taxes, it is important to note that any state income tax imposed at the passthrough-entity level (e.g., the Michigan Single Business Tax) will generally create double taxation for nonresident partners/shareholders. This arises when such owners must report their entire distributive share of passthrough entity income without credit for taxes paid at the entity level.
Nonbusiness Income Any income not classified as business income is deemed nonbusiness income, and typically includes rents and royalties, as well as capital gains, interest and dividends. Capital gains and losses on real property are allocated to the state in which the property is located; gains/losses on personal property are generally allocated to the state in which the property was located on the date of sale. Dividend and interest income, not otherwise classified as business income, is generally allocated to the recipients state of residence. When a taxpayers status changes from resident to nonresident (usually a part-year residence classification), an allocation is often made for income and deductions before and after the date of change in residency.
Conclusion Taxpayers who work and/or reside in more than one state must continually monitor business and other economic activities and keep good documentation and tax records. They must weigh these activities against the state tax laws in their residence/domicile to minimize effectively the amount of income apportioned and allocated to states with high marginal tax rates. The issue of state tax residency is far from simple. But, proper planning now may save tax dollars later. |
