If you currently live in a what’s considered a high-tax state, you may have decided to look into changing state residency for tax purposes. And you probably have a lot of questions. Are the tax savings worth it? How does it work? What’s the difference between a domicile and a residence?
We’ll explore the tax implications of moving your domicile to another state, plus what you need to know and do to successfully make the move.
Tax considerations when establishing your state domicile
There are generally two big tax considerations for those who are considering leaving their current state and choosing a new one to reside in.
1. Income tax on world-wide versus source income
The state you are currently domiciled in can tax you on income you made world-wide. It doesn’t matter which state or country the source of income is located in. This makes the prospect of moving to a state with a lower tax rate — or even a “no tax” state like Florida — more attractive. However, when you become a non-resident of a state, it can still tax you on income you made from sources located in that state.
For example, earned income from stock options or restricted stock awards and from pass-through business income reported on state K-1s are common kinds of income that can be “sourced” to a nonresident state. When selling a business, choices about how to structure the sale can influence how the related income is sourced. While nonresident states generally can’t tax sales of stock, they generally can tax sales of tangible property located there, of interests in partnerships who operate there, and of gain from installment sales of both of these items. For this reason, understanding the sourcing rules that apply to income you would have after a domicile change is key to understanding the state tax impact of that change.
2. Estate tax
Some states have an estate tax exemption that’s much lower than the federal one. So when you pass away, your estate could avoid the federal estate tax but not your state’s. Or, your estate might already exceed the federal exemption, and now you’re looking to mitigate the state estate tax that will be due. Some states have much lower estate taxes than others, and some even have no estate tax, so it’s a good idea to review estate tax laws before choosing a new state to reside in.
Domicile vs residence
In the eyes of the law, a domicile is different from a residence. You can have multiple residences in multiple states, but you can only have one domicile. Your domicile is where you intend to remain permanently — your true, fixed and principal residence.
To establish your domicile, you must not only be physically present in that state but also have the intent to make that state your permanent home. This also means you must be able to prove that this intent is accurate and honest.
For example, if you have lived long-term in Minnesota and purchase a home in Florida, you cannot continue to spend the majority of your time at your Minnesota home and credibly claim that Florida is your new domicile. The courts would be able to correctly argue that your intent was not to make Florida your permanent home.
How to establish residency in another state
Many people are able to become statutory residents of a state by living at least 183 days a year in that state and having a place to live there year-round (i.e., three-season cabins don’t qualify). However, proving the intent required to become domiciled in a state involves taking things a step further. You have to do more than just update your mailing address, driver’s license and voter registration, and you have to do more than just log the time you spend in your new state versus other states.
To provide compelling proof of intent, the courts want to know which community you’re actually investing in. Going back to our example of Florida residency versus Minnesota residency, are the clubs and religious institutions you and your spouse are members of located in Florida? Are the home, cars, furniture and art you own in Florida bigger, nicer and newer than the ones you own in Minnesota? Are you still working for a business in Minnesota? Where does your family live? If you’re living in Florida but your kids are attending high school in Minnesota, the courts are not going to look favorably at your claim to Florida domicile.
Even purchasing a hunting license in Minnesota at the state-resident rate — or if the entries on your personal calendar for trips to Minnesota say that you are going “home” — can help the state build a case against you.
Is moving to a new state worth it?
Establishing a domicile in another state means truly wanting to permanently make a fulfilling life there.
While many people use the 183-day requirement as a bright-line test for state residency laws, it’s easier than you think to run afoul of it. Think of this situation: It’s getting close to Christmas, and a retired couple is close to spending more than 183 days/year in Minnesota already. But how can they miss Christmas with their grandchildren? They end up becoming “statutory residents” of Minnesota in order to spend time with their family. COVID-19 quarantines have also caused people to accidentally become “statutory residents” of Minnesota, even if they are simultaneously domiciled in a different state.
The most important part of looking into changing your state domicile is deciding whether it’s personally worth it to you. You may be able to save thousands of dollars in taxes, but it may come at a personal cost that, in the end, you decide isn’t worth it. You may be too invested in the community you grew up in and raised children in to leave. Said differently, you don’t want the tail to wag the dog.
Also, consider the taxes that you will still owe. Even if you move to a state with lower taxes, you might still have trailing income related to the state you’re leaving. If you’re an executive with deferred compensation, stock options, restricted stock units (RSUs) or other income that vests over time, your home state reserves the right to tax you on income from those items if the work you performed to receive that income was earned in that state. If you sell your business, even in installment sales, the state it’s located in may tax you on that income.
On the other hand, non-resident states cannot tax you on intangible income such as dividends, interest, stock sales and retirement income.
This means that part of quantifying the financial benefit of moving to a new state is understanding what income will be sourced to your old state, what won’t, and whether those end numbers are worth it to you.
You may benefit from laws aimed to keep you in your current state
Another consideration when quantifying the benefit of moving to a new state is whether your current state has laws that would make it beneficial for you to stay. Some states are enacting laws aimed to keep residents.
For example, the 2017 Tax Cuts and Jobs Act (TCJA) capped the personal itemized deduction for SALT at $10,000, which caused many individuals to feel the full burden of their state’s individual income tax rate. However, the TCJA did not limit the business deduction for SALT. As a result, some states are now letting owners of passthrough entities (PTEs) like S corporations, partnerships and limited liability companies elect to pay tax on the entity’s income instead of passing the income through to and taxing the owners. Because PTEs can fully deduct this tax (no $10,000 cap) at the federal level, this so-called “workaround” election effectively restores the same, uncapped itemized deduction for SALT that the owners enjoyed before the TCJA — making it less expensive for them to live in an otherwise “high-tax” state.
As of March 2021, eight states (Alabama, Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin) have enacted a workaround law. Because the IRS effectively blessed this strategy in November 2020, more states are sure to enact their own workaround laws in the near future. As a result, if you are a PTE owner, be sure to consider whether your state of residence offers a workaround election before deciding that a move to a lower-tax state is worth it for you and your family.
Lastly, make sure to talk to your tax advisor to have an in-depth discussion about pros and cons and exactly how you would benefit from moving. They can help you make the decision as well as develop a concrete plan that helps prove intent. As a top 20 national accounting and consulting firm, Wipfli can help. Contact us to learn more.
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