The State Tax Two-Step: COVID-19 and State Income Taxes

COVID-19 has upended the way we do almost everything, from working to shopping for essentials, to even where we go to sleep at night.  Many people with second homes removed from densely-populated urban areas have retreated from them to wait out the pandemic.  Doing so is probably smart from a health perspective, and certainly provides added peace of mind. There is one factor, though, that bears careful consideration:  state income taxes.  Both individuals and employers will want to carefully consider their potential liabilities in this area.

The Dual Taxation Trap

Typically, if you are physically resident in a state for 183 days or more during a given tax year, that state has a legal right to tax certain parts of your income.  With the COVID crisis dragging on past its fourth month, those with multiple residences will want to evaluate where they stand, how it might impact their tax status and what actions, if any, they want to take to protect themselves.  If a second state advances a claim that it can legally tax your income, that claim will be guided by the particular rules of that state.  Most states will give you some credit for taxes paid in other states, but only on work income from the latter state.  Other work income remains fully taxable, as does investment income.  More than likely, even if you have spent considerable time at your second home, you still have some maneuvering room to avoid dual taxation.  You may wish to change your plans, or it may make sense for you to acquiesce to additional taxation.

Changing Domiciles

On the other side of the coin, some people have been considering whether it makes sense to transfer their domicile – even temporarily – to their second home, especially if it is in a state that has lower tax rates than their current primary residence.  This might be a good long-term tax planning strategy, but it is unlikely to be effective in the short term.  While it only takes 183 days to give a state the right to tax your income, it takes considerably more than just time to reverse that right.  States like New York do not give up the ability to tax residents easily.  If you have been domiciled in New York, you will need to be prepared to show that you have deliberately and intentionally cut ties to New York and established them in the location of your second home.  Should you attempt to file in New York as a non-resident after a history of filing as a resident, expect the state to launch an audit within a year or two.  Having a driver’s license or registering to vote in your new state will not get them off your back, either.  Instead, the state will consider five primary factors:

  1. Size, nature and use of your New York residence
  2. Active business involvement in New York
  3. Time spent at each of your residences
  4. Location of items important to you (e.g., heirlooms or collections)
  5. Local family connections

In addition, the state will look at activity in the years before and after your attempted non-resident filing.  So, while you may wish to consider transferring your official domicile, it is unlikely to be effective way to achieve immediate tax savings.

Cautions for Employers

Nexus is an emerging concept that has caused headaches for many business owners in recent years.  Essentially, Nexus holds that any enterprise with business interests in a state may be subject to that state’s tax laws after it meets a certain threshold of contact or volume of business in the state.  Court rulings have established that, for sales tax purposes at least, a physical presence is not required.  Telecommuting employees have always posed a peculiar problem under Nexus.  Several states – including New York, New Jersey and Connecticut – having “convenience of the employer” rules or practical interpretations of tax law that subject telecommuting employees to state income taxes if their employer’s principal location or the employee’s assigned office is in that state.  The unanticipated rapid growth of telecommuting due to COVID-19 introduces significant confusion in this area and may introduce dual taxation liabilities for both employers and employees.

A Murky Future

State responses to COVID-19 and its accompanying economic fallout have varied greatly and have largely been implemented on a reactive basis.  It is possible that state legislatures will act to relieve the rules that may impose additional residency-based tax burdens.  It is also possible that, facing unprecedented budget shortfalls, they will leave in place any current rules favorable to them – and even seek to enforce rules that are often overlooked.  Your best defenses are to meet with your tax advisor to assess your situation and plot out your strategy for both the immediate and long term, and to carefully document anything that might impact which state(s) can claim the right to tax you and your business.  Your AKM CPA stands ready to assist you with a thorough tax analysis and plan so you can be better prepared for any eventuality.

Times are uncertain. You don’t have to be.
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