As you probably have heard from the news coverage of the budget debates, New York, like most states, is in the midst of a financial shortfall. Due to the slow recovery from the economic downturn, state tax revenues have yet to return to their pre-2008 levels. As a result, New York, through its Department of Taxation and Finance, has become more aggressive in pursuing outstanding tax liabilities. One tactic that New York has used to produce tax revenue is the state residency audit. A state can impose its personal income tax on all income earned by a resident. Residency for state tax purposes, and hence residency audits, are determined by two factors: domicile and statutory residency. Domicile is where a taxpayer intends to maintain his permanent home in one state. Statutory residency is the physical presence of a taxpayer in a state for a specified number of days during the tax year. A taxpayer needs only one of these factors to be determined a resident for state income tax purposes. While the particulars of a residency audit are for another time, today’s discussion focuses on the aftermath of “losing” a residency audit, more specifically, the credit one is entitled for taxes paid to another jurisdiction.
Credit for taxes paid to another state is a mechanism that is used by states to alleviate the double tax dilemma. The double taxation problem arises when a taxpayer is determined to be a dual resident; both states impose personal income tax on the exact same income. Therefore, states permit a credit for taxes paid to another jurisdiction so as to minimize some of the ill effects of double taxation. Note the emphasis on some.
For example, New York Tax Law section 620 permits a taxpayer to take a credit for “any income tax imposed for the taxable year by another state . . . upon income both derived therefrom and subject to tax.” The regulations relating to this code section define income derived from another state as compensation for services performed in that other state, income from a trade or business carried on there, or from tangible personal property located in that jurisdiction. Therefore, a taxpayer that lives in New York and keeps a residence and works in Connecticut will be taxed in both states on his wages. New York, under section 620, permits a credit for the taxes paid to Connecticut because that is the source state where the taxpayer’s wages were earned. But here comes the some - the regulations exclude investment income and income from intangibles from the income available for the credit. Thus, using the same example above but substituting dividend income for wages, the taxpayer gets taxed twice – once in New York and again in Connecticut – and neither state allows a credit for the taxes paid on this income.
Not all jurisdictions have the New York-Connecticut problem. For example, New Jersey has a virtually all inclusive credit provision (N.J. Rev. Stat. Sec. 54A:4-1). Here, a taxpayer qualifies for the credit if income or wage tax is paid on the same income in the same year to both New Jersey and to another taxing jurisdiction outside the state. This includes income from investments and intangibles.
In recent years, Connecticut has taken steps to relieve the inequity of its credit statute. Connecticut’s new stance is predicated on an initiative set forth by Northeastern States Tax Officials Association (“NESTOA”). For years, NESTOA has been promoting the establishment of uniform standards and elimination of double taxation among its member states. Of its objectives, the three most relevant are:
- Taxpayer is considered a resident of only one state during a given period;
- Uniform criteria for establishing residency; and
- Uniform income sourcing rules should be implemented to eliminate double taxation.
Unfortunately, NESTOA is not binding on its member states, rather legislative action is required. Connecticut did amend its law to permit a credit for taxes paid to other jurisdictions on income from investments and/or intangibles, contingent upon the existence of similar legislation in the reciprocal state. To date, New York has yet to enact a similar credit mechanism. Therefore, a dual Connecticut-New York resident still cannot claim a credit for taxes paid to another state on investment and intangible income.
For now, the best defense to double taxation is to avoid any unnecessary exposure by limiting the number of days spent in a non-domicile state to less than 184 days – better yet, don’t even come close to that amount so there is no doubt. If one is already a dual resident, particularly of New York and Connecticut, the credit provisions will relieve some but not the entire double tax problem. As long as New York State continues to seek additional sources of revenue for its coffers, taxpayers can expect to see more residency audits and little change to its credit statute.
If you have any questions regarding the tax effects of state residency, please contact Manager of Tax Controversy and State and Local Tax Alan Goldenberg, at firstname.lastname@example.org or 212-897-6421, or contact your Friedman LLP tax professional.