By Brian Ellenbecker, CFP®, EA®, CPWA®, CIMA®, CLTC®
This article is the second in a two-part series. Part 1 focused on how to establish residency for state tax purposes. Part 2 focuses on the tax impact of spending time in multiple states during the year.
For those that spend time living in more than one start during the year, determining which state is entitled to collect tax can be a tricky area of tax law. Whether you moved to a new state during the year, spend several months per year in two or more states, or have been working remotely in a different location, knowing which state or states you will owe tax to is complicated.
To add to the complexity, each state has their own rules regarding in which circumstances a person is obligated to pay tax. These rules can vary dramatically from state-to-state and oftentimes get complicated. Business owners have their own set of rules to follow. It is important to consult with your tax advisor for tax planning advice specific to your situation.
Domicile, Tax Residency, Nexus and Dual Residency
It’s important to first understand some key terms that dictate in what state(s) a person may owe tax.
A "domicile" is a person's true, fixed, and permanent home where they intend to remain permanently and indefinitely and to which they have the intention of returning, whenever absent. It is often referred to as "legal residence." A person may be physically present, working or living in one place but maintain a domicile in another. A person has only one domicile at any point in time.
Most states claim the right to tax an individual’s income if they are believed to be a resident and domiciled in that state. Usually, they also impose tax on 100 percent of a resident’s income from all sources, including portfolio income.
The term "nexus" applies to businesses. It describes a business that has a tax presence in a particular state. A nexus is a connection between the taxing authority and an entity that must pay the tax. Nexus can also describe the amount and degree of business activity that must be present before a state can tax an entity's income in its jurisdiction.
Nexus is typically created if an entity derives income from sources within the state, owns or leases property there, has employees there who are engaged in activities that exceed "mere solicitation," or has capital assets or property located there.
If someone is considered a dual resident, they could end up paying tax in more than one state. Individuals who could be caught in the trap of dual residency and dual taxation are:
- retirees with a second home in another state
- taxpayers who live in one state but have business activities or interests in another state
- individuals who have relocated to another state but return after a number of years,
- individuals who temporarily relocate to another state or overseas for a job assignment
- individuals who have severed all ties with a state but fail to establish residency or domicile in another state
Working in Another State
Due to the onset of COVID, the number of people working in different locations has increased dramatically. Remote workers—especially those who have been hopping to different states—could be on the hook for additional taxes when they file their returns in spring. Whether someone is working from their vacation home in a different state, renting a place in their dream location or were simply looking for a change of scenery, the more time spent away from home base, the greater the likelihood of having new state tax obligations.
The rules vary by state, sometimes dramatically. The general rule is if employment income is earned while physically located in a state, you typically must pay tax in that state. You will also need to pay closer attention to your state tax withholding. Make sure you are having enough withheld and that it’s going to the proper state. Employers have state income tax withholding requirements, although when withholding must start varies by state.
Many exceptions exist to the above premise, however. Some states require you to file a return after working just one day, like New York. Some offer at least a few accommodating provisions before taxing someone or requiring withholding to be paid. Sixteen states offer reciprocity, which may allow you to avoid paying tax to a second state altogether
Wisconsin currently has reciprocity agreements with four states: Illinois, Indiana, Kentucky, and Michigan. These agreements provide that residents of these states working in Wisconsin will be taxed on income earned as an employee by their home state and not by Wisconsin. Conversely, Wisconsin will tax Wisconsin residents working in one of these states; and the other state will not tax the income earned as an employee by Wisconsin residents who are employed in that state. Reciprocity applies only to income earned as an employee. It does NOT apply to other types of income, such as investment income (interest, dividends, capital gains), rental income, and retirement account distributions.
Moving to a Different State
Another common scenario involves moving to a new state during the year. This could be related to a job relocation, retirement, or moving to a warmer climate. Whatever the reason, your state tax situation will likely be more complicated in the transition year.
You’ll have to file two part-year state tax returns if you moved across state lines during the tax year. Some states consider you a full year resident if you lived in the state for 183 days or more. One return will go to your former state, and one will go to your new state. You would generally divide your income and deductions between the two returns in this case, but some states require that you report your entire income on their returns, even if you resided there for less than the full year. This process can vary considerably by state. Check each state's tax return for an apportionment schedule to find out how you should go about allocating income and deductions. The schedule should explain how to divide your income depending on that state's rules.
Many states also offer credits for taxes paid to other states
Owning a Business in a Different State
If your business is organized as a C corporation, it must pay income tax in most states. Tax rates and rules will vary by state. Some states also have a franchise or similar tax. This tax is usually based on some measure of the value of the corporation, rather than income. Some states access both income and franchise taxes.
If your business is formed as an S corporation, an LLC, or a partnership, the business itself will typically not need to pay income tax. Because these are pass-through entities, the income is passed to the owners, partners and/or shareholders who report it on their personal income tax return. For income from S corporations, LLCs, and partnerships, you generally should look to your state’s personal income tax rules for guidance.
A significant number of states impose a franchise, privilege, or similar tax on S Corporations, LLCs, or both. If your business has nexus in a particular state, it could be subject to franchise, privilege or similar taxes. Check with the state your business is located in to see if the business itself owes any of these types of taxes.
If you sell your business (or any other valuable asset), shortly after moving to a new state, careful planning is required. In the case of the sale of a business located in the old state, you likely will not be able to move the gain to the new state—especially if it’s a lower tax state. Consulting with a tax advisor well before making any such move is critical to achieving the best tax outcome.
Work with Your Tax Advisor
Dual state filing is complex. To ensure you don’t pay any more tax then necessary, get the proper credits and prepare returns in the correct order, seek out advice from your tax advisor. Your tax advisor will help determine what, if any, tax liability may be owed to a state you temporarily spent time in this past year.