In the years immediately following the pandemic, high-net-worth individuals have participated in a mass exodus from high tax states to low tax states. Individuals have also discovered newfound freedom from geographical restrictions through remote work, and have established permanent domicile in one state and perform work while traveling to various other states. From white sands and palm beaches in Florida, to desert landscapes in Nevada, to diverse frontier land and iconic cities in Texas, high-net-worth individuals have moved in droves to find a haven among states with lower overall taxes and often better conditions for owning and operating closely held businesses. With both permanent relocation and the flexibility of remote work on the rise, individuals on the move now have complex tax obligations that must be considered carefully. This article explores essential factors in determining state residency, matters for establishing domicile, the steps required to establish or change one’s residency, and the implications of such decisions in today’s tax landscape.
Why Does Residency Matter for High-Net-Wealth Individuals?
Forty-two states impose an income tax on individuals in some form, but rates vary considerably by state. High-net-worth individuals, specifically, may find unfavorable exposure with several states having income tax brackets that amass within narrow income bands, leaving high earners subject to maximum rates at just a fraction of their total income. For example, the State of Virginia’s fourth and highest tax bracket reaches its cap at $17,000 total taxable income with a tax rate of $720 plus 5.75% of the amount in excess of $17,000 as opposed to a 2% income tax levy for income up to $3,000.
Additionally, some states impose wealth-related taxes that may disproportionately impact individuals with substantial income or assets. For example, Massachusetts’s flat income tax rate is notably average at 5%. However, in 2022 “Massachusetts voters approved a 4% surtax on taxable income over $1,000,000,” creating an effective tax rate of 9% for millionaires and their estates, trusts and unincorporated associations.
The imposition of individual income tax at the state level, determining residency, and proper allocation of income are significant because the residents of a state are generally subject to income taxation on their worldwide income regardless of where that income originated. By comparison, a nonresident would only be subject to taxation on the portion of income derived only from that state. When considering a change to residency, one might evaluate positions in which taxation on worldwide income as a state resident would be most favorable. Additionally, those individuals with anticipated inheritance or sizable estates may consider which state would impose additional state-level taxes on estates above the exemption threshold, or on inheritance.
How is Residency Determined?
Residency for state income tax purposes is determined through two methods: the domicile test and the statutory presence test. It is imperative to note that domicile and residency are not synonymous. Domicile represents “an individual’s fixed or permanent home” in which the taxpayer lives, even if for a brief period, with no intention toward relocation. Both physical presence and intent are significant factors in fulfilling the test of domicile. Additionally, domicile remains until a change is proven, with the burden of such proof lying with the taxpayer to reflect the termination of domicile in the prior location and start of domicile in the new location. Domicile may be considered with the following factors: location of primary residence, physical presence in one state relative to others, intent to remain or return, location of immediate family or maintenance of significant social and community ties or business relationships, and official documentation.
In the case of Matter of Gray v. Tax Appeals Tribunal, the taxpayer claimed to have changed their domicile from New York to Florida. The taxpayer sold their residence in New York, purchased a residence in Florida, and made sequential changes to legal documents including various registrations, such as registration to vote and driver’s license registration, to represent their domicile in Florida. The New York State Department of Taxation challenged the status of domicile for this taxpayer and the court ultimately ruled in favor of the taxpayer, citing that both physical presence in Florida and intent remained valid.
The statutory presence test generally applies if the taxpayer does not intend to permanently relocate but spends considerable time in states other than that of which domicile is maintained. While some states have a rigid test that qualifies based on a set number of days spent in the state within a single year, others may have more complex approaches. For example, the State of California has set a “facts and circumstances” evaluation process for most cases, with limited cases utilizing a 546-day safe harbor threshold. Some states, such as Montana, do not impose a statutory presence test, however, and defer only to domicile for income tax purposes.
A taxpayer would most likely file a resident income tax return in the state in which they maintain domicile, should that state impose an individual income tax. A taxpayer who maintains domicile in one state but meets the statutory presence test factors for another state, may be required to file a state individual income tax return in that state in which statutory presence is exhibited.
What are the Implications of Resident Versus Nonresident Status?
Allocation of income varies based upon the type of income, whether earned or unearned, and becomes more complex when considering income from passthroughs. Unearned income including income from interest, dividends and capital gains is considered worldwide income, as referenced earlier in this article, and is subject to taxation in a taxpayer’s state of residency. On the other hand, earned income, including W-2 wages or tips, commissions, and money made from self-employment are reportable and subject to income taxation in the state in which the income is earned. If the state in which the income is earned imposes an individual income tax, there may be a related compliance requirement and tax liability. Passthrough entities and self-employment income may be allocable or apportionable to several different states, possibly creating nonresident filing requirements and state income tax liability. High-net-worth individuals who live primarily off their portfolio income may find low- or no-income tax states more favorable to establish domicile as such income is generally not taxable in any other state.
Key Takeaways
Today’s tax landscape is ever-evolving, and adding in consideration for state income taxation only increases complexity for many high-net-worth taxpayers. Establishing and maintaining state residency has become a critical factor in optimizing tax planning strategies and financial goals for many individuals. With states continuing to refine rules surrounding residency and related enforcement efforts, understanding the nuances of domicile, statutory presence, and income allocation is crucial. Strategic planning, maintaining adequate documentation, and engaging effective professional guidance can aid individuals in navigating these complexities and avoiding costly tax consequences.
Sydney Phillips is a Manager in the Tax Department at LBMC, focusing on real estate and closely held businesses with operations in multiple states. You may reach Sydney at Sydney.Phillips@LBMC.com and at (423)755-0739.
