State Exit Taxes And Other Innovative Way To Tax Former Or Departing Residents

Understanding Exit Taxes and State Residency Rules Before You Move

Before making the decision to move to a new state or establish a second home, it’s crucial to understand how your current state of residence will react. States that are experiencing net losses in population are increasingly developing innovative and aggressive strategies to retain tax revenue from departing residents. One of the most significant innovations in recent years is the implementation of an “exit tax,” which specifically targets individuals leaving the state. For example, California has proposed a wealth tax that would apply to residents and businesses with annual incomes exceeding $30 million ($15 million for married couples filing separately). Under this tax, individuals would be required to pay a 0.4% tax on their net worth exceeding the threshold amount, and they could remain liable for this tax for up to 10 years after leaving the state. This means that even individuals worth less than $30 million should be concerned, as once the tax is enacted, it would be relatively easy for the state to lower the threshold in the future.

How States Are Getting Aggressive with Taxes

States are not just stopping at exit taxes; they are also finding other creative ways to tax departing residents. In New Jersey, for instance, gains on the sale of real estate become immediately taxable if the seller is leaving the state, even if the gain would otherwise be exempt for a resident. The tax is estimated and collected at the closing of the sale. Additionally, some states have been successful in taxing deferred compensation that individuals earned while they were residents but did not receive until after they left the state. This includes stock compensation, such as options or shares, which may not be sold until after the individual has departed. Some states even require employers to withhold state taxes on deferred compensation payments, even if the recipient has already left the state. The recipient then has to decide whether to file a tax return to try to claim a refund. While no state has yet successfully taxed 401(k) distributions or pension annuities of former residents, some state legislators have discussed the possibility.

Residency Audits: How States Track Your Whereabouts

State tax departments are also becoming more aggressive in identifying and investigating individuals who claim to have moved out of state. Once someone stops filing a state income tax return or changes their filing status from resident to nonresident or part-time resident, certain automated programs are triggered, initiating a residency audit. States use various tools to gather information about an individual’s whereabouts, including cell phone usage, credit card charges, and toll road data, to determine how much time they still spend in the state. They also cross-reference other databases, such as driver’s licenses, vehicle registrations, real estate ownership, and business and professional licenses, to build a case. If the state gathers enough evidence suggesting that the individual has not truly moved, they will send a lengthy questionnaire requesting detailed information about the person’s travel, property ownership, business and personal activities, and more. A residency audit letter and questionnaire indicate that the state has already conducted significant research and is serious about challenging the individual’s new residency status.

The Dilemma of Domicile: How States Determine Your Tax Obligations

The concept of domicile plays a crucial role in determining tax obligations, as it refers to the state where an individual intends to maintain a permanent residence or abode indefinitely. This is a subjective test based on the facts and circumstances of the individual’s situation, and it can be challenging to prove a change in domicile. While some states use a bright-line rule, where spending more than 183 days in a calendar year in the state automatically makes you a full-time resident, others focus solely on domicile. Under the domicile standard, an individual could spend very few or even zero days in a state and still be considered a resident if the facts indicate that they intended to maintain their domicile there. This makes it essential to sever as many ties as possible with the old state, including changing your driver’s license, vehicle registrations, voter registration, and club memberships. Continuing to own a home or business in the old state can be particularly problematic, as it may override other evidence of a change in domicile.

Common Mistakes to Avoid When Establishing Residency Elsewhere

When attempting to establish residency in a new state, there are several common mistakes that individuals often make, which can lead to unnecessary complications and even penalties. One of the most significant errors is failing to fully sever ties with the old state. For example, keeping a home or business in the old state can create a significant contact that may override other evidence of a change in domicile. It’s generally safest not to own or even rent a home in the old state, and individuals should avoid being more than a passive investor in any business located there. Additionally, failing to change driver’s licenses, auto registrations, voter registrations, and club memberships can raise red flags. Many states will not consider a move permanent if memberships are merely switched to inactive, nonresident, or associate status instead of being resigned or transferred. Some states also require individuals to surrender professional licenses issued by the old state or obtain new ones in the new state.

Proactive Planning: Strategies to Ensure a Smooth Transition

To avoid the pitfalls of residency audits and ensure a smooth transition to a new state, it’s essential to engage in proactive planning. This begins with meticulous recordkeeping, including keeping logs or calendars that detail where you were each day of the year, as well as receipts and other documentation to support your claims. It’s also crucial to avoid inconsistencies in your actions, as these can trigger fraud penalties in addition to tax bills. For example, telling an insurance company that you are a resident of one state to secure lower premiums while claiming residency in another state for tax purposes is a recipe for disaster. Aggressive states are on the lookout for such inconsistencies, and they will not hesitate to act if they uncover evidence of fraud. Additionally, it’s important to consider the long-term implications of your decisions, as some states may even attempt to assert claims against your estate after you’ve passed away. By understanding the risks and taking proactive steps to establish your new residency, you can minimize the chance of disputes and ensure that your move is as seamless as possible. Finally, consulting with a tax professional or attorney who is well-versed in residency and tax laws can provide valuable guidance and help you navigate the complex landscape of state tax regulations.