BY MARY BETH LOUGEN, EA, USTCP
Taxpayers who move in and out of the country should fully consider the state tax consequences of living and working in another jurisdiction. In this article, Mary Beth Lougen of American Expat Taxes explains the general considerations states use in determining whether a taxpayer is a domiciliary of that jurisdiction, and makes recommendations as to the steps practitioners can help their clients take to minimize risks of state tax liability
Living and working on an international assignment can advance a career and look great on a resume, as well as provide excitement and adventure in the employee’s personal life as they learn to live in and adapt to new cultures. However, it can be a very costly exercise in taxation for your client without proper foresight and planning. A taxpayer who fails to properly terminate state residency can incur thousands of dollars in income tax, penalties and interest years later. Even if a taxpayer thinks they have terminated their tax residency, the state may not agree.
Let’s start the discussion with the basics. Currently seven U.S. states do not have an income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Two others – New Hampshire and Tennessee – tax only the interest and dividend income of residents. The rest of the states and the District of Columbia have their own set of rules to determine who is a resident of their jurisdiction and thereby subject to taxation on world income. The rules lean towards inclusion as opposed to exclusion in the state “resident club,” and for some states it seems to be almost impossible for taxpayers to break their membership.
Domiciliary Versus Physical Residents
There are two different types of residency for state income tax: domiciliary and physical residents. Although every state has its own set of particulars, there are generalities that we can use for this conversation.
All states start with the premise that individuals who are “domiciled” in their state are residents for tax purposes. This means that taxpayers are responsible for filing state tax returns declaring their world income each year – even if they do not spend a single day in or have any income from that state. World income is all income received in the form of money, goods, property and services that is not exempt under the tax laws of the individual state, including income from sources outside the United States. In contrast, taxpayers who are deemed not domiciled or currently a resident in a state would report and pay tax only on certain state-sourced income.
The definition of state-sourced income for tax purposes varies by state, but practitioners can always count income from rentals, businesses, wages, and sales of real property interests to be subject to taxation for a state nonresident. Certain state-sourced income would not be taxed to a person who is not considered a resident – such as pension distributions, and interest, dividends and capital gains from personal portfolio investments.
It is very important to discern whether your client, the taxpayer, will be considered a domiciliary resident or a nonresident after he accepts a position in another country so the taxpayer can file the correct form and include only the income he is legally required to on his state tax return.
Domicile is generally defined for tax purposes as the place where a person voluntarily establishes herself and family with the present intention of making it her true and permanent home. It is the place where, whenever absent, the individual intends to return. A person can only have one domicile at a time, and once established a domicile is retained until the taxpayer acquires another one.
Physical residence is based on a set of rules that when met, cause the person to become a resident for state tax purposes. It is not uncommon for a person to be a resident in one state and domiciled in another. Physical residency determinations usually involve a “days of presence” and a “permanent place of abode” test, both of which vary by state. Each state has its own rules that determine residency and nonresidency under physical presence. Residence under physical presence is not a concept relevant to this article, since residency defined by physical presence alone would not create an ongoing issue for taxpayers who move abroad.
Domicile and residence are two different concepts that are often used interchangeably. Residence is the jurisdiction where a taxpayer physically lives at that moment in time. Domicile is the jurisdiction where the taxpayer intends to live, even if he or she does not currently live there. Current residence is not always the place where a taxpayer intends to live for the undetermined future. A taxpayer can be a resident of Canada, but be domiciled in California.
Maintaining a State Domicile
Now that we have laid the basics, let’s talk about what maintaining a state domicile means for someone on an overseas assignment. Essentially, it means that the taxpayer will be responsible for fulfilling any and all tax filing obligations imposed by his state of domicile on its residents, which includes the declaration of world income on the taxpayer’s state tax return. In addition to income tax, a person’s estate may fall under the state inheritance tax rules should they die while a domiciliary. Many states have estate taxes that kick in well below the federal threshold of $5.34 million for 2014 – in fact, New Jersey begins taxing at just $675,000.
The repercussions of maintaining a state domicile while living out of the country vary widely with the particular state involved. The best scenario for the taxpayer is to be domiciled in a state with no income tax, or in Tennessee or New Hampshire where only investment income is taxable for individuals. A worse case is for the taxpayer to be tied to a state that will tax their foreign income and provide no mechanism in the tax code to avoid double taxation of the income. Some states do not allow for exclusion of income under I.R.C. §911 or for credit for taxes paid to a foreign country or province.
Many U.S. states allow their residents to receive a credit for taxes paid to another state, or have reciprocal state tax agreements in place for people who live in one state and work in another. This treatment avoids double taxation of the income by one of two different methods.
Credit for Taxes Paid
First, credit for taxes paid to another state allows an offset or reduction of taxes imposed in the taxpayer’s state of residency by the amount of taxes imposed by the state of source. As a general ordering rule when it comes to figuring out credits for taxes paid to another taxing jurisdiction, the jurisdiction of source has the right of first taxation, followed by the jurisdiction of
For example, Charlotte lives in southwestern New York near the Pennsylvania line. She works in Pennsylvania. Pennsylvania has the right to impose and receive tax on Charlotte’s wages since the money was earned there. Charlotte would file a Pennsylvania nonresident tax return and declare her wages. New York has the right to tax her world income because Charlotte is a resident, but will allow her to reduce the New York taxes payable on her wages by the amount of tax she will pay Pennsylvania on the income. Thus, Charlotte is not double taxed on her wages.
This is the same principal that is applied when calculating the foreign tax credit when a person is considered a resident for U.S. tax purposes, and lives or works in a foreign country. Some states allow a credit for taxes paid to other countries or foreign provinces. Other states allow a credit just to certain specific foreign countries. For example, New York has Form IT-112-C, Credit for Taxes Paid to a Province of Canada, which computes a credit against New York state tax. There are also rules to coordinate with the federal Form 1116, Foreign Tax Credit, to prevent “double dipping.” Practitioners need to research the regulations for the state in question for their clients.
Secondly, avoidance of double taxation is accomplished by reciprocal state tax agreements where wages earned in neighboring states are only taxed in the state of residence. This is a much simpler approach to the same end – elimination of double taxation.
Let’s move Charlotte to Waukegan, Ill., and have her commuting across the state line to work every day in Milwaukee, Wis. Wisconsin will neither require the withholding of Wisconsin state income tax, nor the filing of a Wisconsin tax return. Charlotte will have Illinois withholding throughout the year and file a resident Illinois return reporting her world income.
A similar principal exists inside the tax treaties the United States has with certain other countries. Tax treaties are reciprocal agreements between the governments of two countries that outline rules for the taxation of individuals and businesses resident in the other country. One of the goals of the tax treaties is the elimination of double taxation. Some treaty-based positions mirror state tax reciprocity provisions, there is a common treaty provision that taxes social security benefits from either treaty country only in one of the countries. For example, the United States/Canada tax treaty includes a provision like this—article XVIII(5) states that benefits received under the social security legislation of either country will be taxed only in the country of residence.1
So if Charlotte moves to Winnipeg, Manitoba, when she retires, her social security will only be taxed by Canada.
Varying State Tax Treatment of Foreign Income
Unfortunately for taxpayers, not every state has included one of these provisions in their tax code where the income in question is from sources outside the United States.
Alabama and California are two such states.2 To California’s credit though, they have a “safe harbor rule” for people who are domiciled in California, but are absent under an employment-related contract for an uninterrupted period of at least 546 days.3 Under safe harbor these taxpayers will be treated as California nonresidents. As long as the taxpayer and spouse do not have large amounts of intangible income ($200,000 or more from stocks, investments, etc.) or spend more than 45 days during any tax year in California during the contract period, they can file as nonresidents of California from the first day of the assignment. If at any time before the 546-day period is met, the taxpayers no longer meet the safe harbor requirements, they must amend any previously filed nonresident returns as residents and pay tax to California on world income for the entire period that falls outside the program.
For example, Marge is a domiciliary resident of California and accepts an assignment in London that is expected to last two years. She packs up and moves on Dec. 31, 2011. She can file her 2012 California tax return as a nonresident, taxed only on her Californiasource income, even though she has not yet been out of the state for the required 546 days. Her mother falls quite ill during the beginning of 2013 and Marge leaves her London assignment and returns to California to care for her. Now Marge must amend her 2012 tax return to a resident return and include her world income. California does not allow her to exclude her income using the Foreign Earned Income Exclusion, Form 2555, nor can she take a credit for taxes paid to the United Kingdom on her income.4
She will also file her 2013 taxes on Form 540, California Resident Income Tax Return, as a full-year resident. Her United Kingdom wages will be double taxed.
Even if a state provides a nonresident provision for domiciliary residents who are absent from the state, the above scenario of an assignment terminating early, for whatever reason, should be considered and factored in to the compensation package.
Advising Clients on Tax Ramifications of Foreign Moves
When a taxpayer begins to prepare for an overseas assignment, he should speak with a professional who can help him decipher the state domicile rules and what they mean to the client given his personal situation. Both income and estate tax should be discussed, as well as any other pertinent nuance in the state’s code of law.
If the state does not provide relief from taxation while the taxpayer is out of the country, the taxpayer needs to decide whether to terminate domicile. This
means cutting ties to the state in a real and substantive way. A common mistake many people make is that they try to garner the best overall deal they can from their old and new residences by keeping what is beneficial as a resident from each place – perhaps discounted hunting or fishing licenses, a property tax exemption on a former personal residence, or keeping in-state tuition options open for a child who is almost out of high school. These types of actions can give a state reason to reject claims of nonresidency and impose state taxation on world income. Taxpayers cannot have their cake and eat it, too, when it comes to state residency.
Cutting ties means terminating relationships in the original state and creating new ones at the taxpayer’s new home.
Here is a list of things your client needs to consider doing to prove he or she has the intent to terminate domicile. This is not an exhaustive list, nor does everything on this list need to be done to meet every state’s threshold.
- Sell the old home and buy a new one in the new country, or at minimum rent it to tenants who are not related for full rental value.
- Close old bank accounts and open new ones in the new area. A case can be made for keeping U.S. accounts and credit cards open, and it is not always feasible to close all U.S. accounts when someone moves abroad. There are many good reasons a person would need one, such as keeping credit active in the United States, buying and shipping gifts to friends and relatives in the States, and of course being able to pay U.S. tax obligations easily with U.S. dollars. But taxpayers should not use it as their main account.
- Investment accounts should be moved to a broker who can work with a client located in a foreign jurisdiction. U.S. Securities and Exchange Commission (SEC) rules require that brokers be licensed where their clients live.
- Give up the old driver license for a new one. The taxpayer will have to lose any sentimental attachment they have to that much younger and thinner picture on the old license. Many state codes require a person to attest that they are a resident of the state when they apply for a driver license, and nonresidents cannot be issued driver licenses.
- Switch doctors, dentists, and yes – even accountants – to professionals in the new home country, if feasible. However, it does not always make sense to stop using an experienced accountant and tax advisor who can handle expat issues.
- Switch any club or professional affiliations to nonresident status, and close any that do not allow nonresidents.
- Register to be an absentee voter, but do not vote in the state elections.
- Move household goods to the new domicile, including items of sentimental value.
- Change auto registrations and insurance.
- If it is possible, bring the pets along. Do not hire a friend to watch them until the assignment ends. Get new pet licenses in the new jurisdiction.
- Get established in the new town: join clubs and professional organizations.
- Keep excellent records showing what has been done to terminate domicile. It will be very hard to compile a comprehensive list a couple of years down the road if the state decides to argue the taxpayer’s nonresidency claims.
When you are working with a client who is about to move to a foreign country for an undetermined amount of time, breaking domicile can be difficult to do. But if the client commits to the process and breaks as many ties as they can, it can be done. With a solid plan, it is possible to break U.S. ties and establish a foreign domicile for all intents and purposes, even when the client’s state of domicile is one of the more difficult ones in which to terminate residency.
As a tax advisor, do your research! If you do not work in the world of expat taxation, speak to someone who is well versed in international tax. Confusion and misconceptions can occur when state guidance is written on a level most people will understand without being an expert, and you are dealing with an out-of-theordinary situation. Always take it back to legal code, no matter what people write in articles or blogs. If you cannot identify it in the tax code or other official source, it can not be cited as a defense position in an audit. Where the point is not clarified in code, look to other official sources such as decisions from a state tax court or tax commissioner, which can be used as precedence.
Case in point: the Virginia Department of Taxation’s website states, “If you are a Virginia resident who accepts employment in another country or moves outside the United States for other reasons (including military orders), the fact that you are living abroad does not mean that you are no longer considered a Virginia resident for tax purposes. Unless you have established residency in another state, you will still be considered a domiciliary resident of Virginia, and will be required to file Virginia income tax returns.”5
Many people believe that this statement means that taxpayers cannot terminate Virginia domicile with a move to a foreign country. At first read it would seem that way. The Virginia tax code provides the definition of domicile, but does not elaborate for foreign moves.6
However, a quick search on the Virginia Policy Library, Rulings of the Tax Commissioner page yielded several foreign assignments that resulted in termination of domicile. These types of rulings are essentially a textbook of how to terminate domicile for a particular state.
One ruling outlines a husband and wife who were residents of Virginia, and in tax year 2000 the husband accepted employment in a foreign country. The husband received a permanent permit to work in Country “A,” so they terminated their lease on their home in Virginia, sold their cars that were registered there, and registered their child in school in Country A.
In September 2002, the Country A employer terminated the husband’s employment. During August and September 2002, the taxpayers purchased and registered cars in Virginia, took out a new lease on a residence in December, and moved back to Virginia to live.
Pursuant to an audit, they were found to have never terminated their Virginia domicile and were ordered to file the 2000 through 2002 tax returns as residents. However, in response to a letter asking for reconsideration of the audit results, Tax Commissioner Kenneth W. Thorson conceded that it is difficult to ascertain intent and that, “In determining domicile, consideration may be given to the individual’s expressed intent, conduct, and all attendant circumstances including, but not limited to financial independence, profession or employment, income sources, residence of spouse, marital status, sites of real and tangible property, motor vehicle registration and licensing, and such other factors as may be reasonably deemed necessary to determine the
person’s domicile. A person’s true intention must be determined with reference to all of the facts and circumstances
of the particular case. A simple declaration is not sufficient to establish residency or domicile.”7
In the end, he determined that the taxpayers had in fact terminated domicile in 2000 and reinstated it in 2002 on the date they signed their new lease. The taxpayers were required to file a part-year tax return for Dec. 15-31, 2002, and resident returns going forward.
Planning Opportunities. Even when the intent is genuine, sometimes there are insurmountable obstacles that just can’t be overcome with diligent severing of ties from the original state. If a client moves abroad on a temporary visa, it is doubtful that they will be able to terminate current state domicile. With a timestamp on the length of time they can remain in the new home country, they cannot establish a new domicile in the true sense of the word and would likely lose a challenge by the state.
Another forward-thinking consideration is that when the foreign assignment has ended and the taxpayers move back to the States, they should settle in a different state. If they move back into their old house in their former community, the state can deny that domicile was terminated because moving back clearly demonstrates intent to return. This could result in the state assessing taxes on world income for all the years the taxpayers were out of the country. Obviously, this could be a massive financial blow.
Having Cake and Eating It, Too. In the previous example the taxpayers made very clear steps to terminate their residency and it worked in their favor. Others who are not so careful do not necessarily fare so well.
In another Virginia agency decision, a husband and wife who moved to State “A” in 2005 spent more than 183 days per year there and qualified for State A’s homestead exemption. They kept their driver licenses and four vehicles registered in Virginia, because the cost of insurance in State A was very high. They changed their voter registrations to State A. They also owned a home in Virginia, which they were in process of transferring to their son through a qualified personal residence trust (QPRT).8
Under audit and reconsideration they were held to be domiciled in Virginia during the period in question. Although they had performed actions consistent with establishing State A domicile, they had failed to terminate their Virginia domicile by keeping their driver licenses and cars registered in the state, along with the existence of the trust, which afforded them use of the home for a period of time.
In another agency decision, a taxpayer who resided and worked abroad claimed he was not a domiciliary resident of Virginia. However, he purchased a home in Virginia, registered some cars there, obtained a Virginia driver license and voter registration, and indicated he lived in Virginia on the application for in-state tuition rates for his children. Not only was he deemed to be domiciled in Virginia every year from the point he registered to vote, but he was assessed a 100 percent penalty for fraud with intent to evade tax.9 “The Department considers the fact that a taxpayer seeks to gain the benefits of lower costs available to Virginia residents to be strong intent of a taxpayer’s desire to be a domiciliary resident of Virginia,” according to a subsequent agency
Proper planning can make the all the difference in the world to a client who accepts an international assignment, and can prevent a rude awakening from a
state tax perspective after it is too late to change the facts.
- Do your research! Just reading blogs doesn’t count.
- Speak to someone who works in international taxation.
- Make sure your client understands the choices of terminating domicile or keeping it—they need to know the ramifications of both.
- If your clients choose to terminate domicile, they should cut ties in every way that is reasonable and makes sense.
- If you see your clients playing the game of getting economic benefit from both sides of the border, advise them that they are playing with fire and explain the risk involved.
- If your clients keep their domicile, help them understand what it will cost in the way of taxes and tax preparation fees, so they can speak with their employer about a tax equalization package that includes state tax considerations.
- If the state provides nonresident treatment of domiciliaries, make sure the clients understand the rules and what will happen if they do not meet the requirements to take advantage of the provision.
For U.S. citizens who accept international assignments, advance planning on a state level is very important. Unfortunately many of our clients come to us after the fact, and there is no “un-doing” bad planning–only the challenge to make the best possible case within the regulations and rules of whichever state with which we are dealing.
1 Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, U.S.-Can. (1980) (as amended by 2007 Protocol).
2 Ala. Dept. of Rev., Admin. Law Div., Nos. INC. 96-234 (Sept. 13, 1996) and INC. 85-147 (Sept. 24, 1985) (Alabama does not allow exclusion of foreign earned income under I.R.C. §911); Alabama Form 40 Instructions; California Instructions for Schedule CA (540); California Instructions for Schedule S (540).
3 Cal. Franch. Tax Bd., Pub. 1031 (2010).
5 Va. Dept. of Taxn., Residency Status, http://www.tax.virginia.gov/site.cfm?alias=ResidencyStatus.
6 Va. Code Ann. §58.1-302.
7 Virginia Ruling of the Commissioner PD 05-120.
8 Virginia Ruling of the Commissioner PD 10-249.
9 Virginia Ruling of the Commissioner PD 02-149.
10 Virginia Ruling of the Commissioner PD 10-249 (summarizing a key finding in Virginia Ruling of the Commissioner PD 02-149).