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Are you a resident of this state?
On the surface, this is a simple question to answer. However, for tax purposes, it’s a lot more complex.
In an effort to increase revenue, states are using personal income tax residency audits to try and collect more taxes. These can be time-consuming and invasive audits to determine if an individual is a state resident and owes additional taxes. In this episode of “Unique Perspectives – The DGC Podcast,” our guest is Scott Thomas, a Senior Advisor at DGC. Scott takes you through the residency audit process and explains why a small detail might prevent significant tax liabilities.
You can listen to the episode by using the podcast player above or click here.
Why do we care if an individual is a resident?
A state typically taxes all of a resident’s worldwide income. However, the U.S. Constitution limits the taxation of non-residents to income sourced to or earned within that particular state. By redefining you as a resident, the state can make you pay more in taxes.
What usually triggers an audit of this type?
Residency disputes arise when taxpayers move into or out of a state, and the taxpayer disagrees with the government’s ruling on their residency status. Most often, the particular trigger is a move from a taxing state such as Massachusetts to a state with no personal income tax such as Florida. The former resident state would like to continue to tax the individual as a resident, giving the state the ability to tax the individual’s worldwide income. The taxpayer would obviously like to prevent that from happening.
How do I know if I am subject to one of these residency audits?
You will receive a letter from the state that says you are the subject of a domicile audit. That letter will have an attached document request and a questionnaire. It is an overwhelming list of documents and there are six pages of questions. If you receive one of these letters, you should reach out to your tax professional immediately.
How would a residency determination increase your tax?
If you have no income sourced to the state that you are leaving, establishing a residency change from a taxing state to a state with no personal income tax can eliminate personal state income tax in its entirety.
Let’s use a move from Massachusetts to Florida as an example. Because Florida is both a retirement destination and a state with no personal income tax, high net worth individuals headed to Florida from states with a personal income tax could face a significant financial impact. To quantify the amount at stake, a taxpayer can estimate the savings by multiplying the former residence state’s taxable income by the marginal rate in that state (5.1% in Massachusetts vs. 0% in Florida). This example assumes that the taxpayer moving to Florida does not continue to earn income from a Massachusetts source.
Now that we know what is at stake, how do I know if I am a resident?
Massachusetts and many other states in the U.S. define a resident as an individual that meets either one of two tests: The days test or the domicile test.
If you are in Massachusetts for more than 183 days during the year and have a permanent place of abode in the state, you have met the days test. A permanent place of abode includes a house, apartment rental, etc. This standard is straightforward and ordinarily is not the subject of a state audit.
The problem comes from the domicile standard. This is a subjective standard that relies on a determination of the individual’s intent. The courts have defined domicile using the following phrases:
To determine a taxpayer’s intent, we look at domicile factors which include actions taken by the individual that reflect the location of their true, fixed, and permanent home.
What factors will the state consider in determining if I changed my domicile? You have:
There are additional factors to consider. For example, purchasing a new home and selling your old home is much more important than voter registration or a driver’s license change. The state is supposed to value these five factors the most:
What if I move in the middle of the year?
Once you have established a change of residency, that change splits your tax year into two sections: A non-resident section and a resident section. You must pay tax on only Massachusetts earned income for the non-resident period but pay tax on all of your income for the residency period, regardless of where it was earned.
What was the exact day that you moved?
Here is where this process can become very complicated. For example, a recent wealthy retiree would like to move to Florida. The retiree:
After considering everything above, when did the retiree and the spouse officially change their residence? This is when a tax professional can help.
What should I do to prepare for a move and avoid a residency audit?
As we have outlined here, in terms of state income tax liability, small residency details can make the difference. DGC can help you gather the required documentation and take the necessary steps to demonstrate your intention to change your domicile to your new location. We can also help you use tools and apps that are designed to track your movements for state income tax purposes. If you do receive an audit letter, DGC can represent you and ensure you are well-positioned for the process. Please contact your client service team or Scott Thomas, JD, LLM at 781-937-5172 / email@example.com to receive more information about state residency status.
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