State Individual Income Taxes: Basic Concepts and Planning Considerations

Article excerpt

Forty-three states and the District of Columbia presently have an individual income tax. Only Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not tax an individual's income. New Hampshire and Tennessee tax only interest and dividend income. In addition, over two dozen major cities, e.g., Baltimore, Cincinnati, Cleveland, Detroit, New York, and Philadelphia, impose an income tax on individuals. For individuals to minimize their income tax burden, serious consideration must be given to planning for these non-Federal assessments.

The state income tax environment has become increasingly complex and contentious over the last several years. Most states have stepped up their enforcement efforts to collect additional taxes from both resident and nonresident taxpayers. Through the extensive use of computers and information sharing with other states and the Federal government, state tax authorities are aggressively assessing deficiencies against noncomplying individual taxpayers, particularly nonresidents. In the search for more revenue, states are also expanding their tax bases through the liberal interpretation of tax statutes. As state governments continue to struggle with their fiscal problems, individuals must be prepared to deal with both greater complexity and increased liability exposure for state income taxes.

STATE JURISDICTION TO TAX AND "NEXUS"

The U.S. Constitution imposes certain limitations on a state's authority to impose taxes on individuals and other taxpayers. The Supreme Court held the Due Process Clause (14th Amendment requires a "definite link, same minimum connection, between a state and the person, property or transaction it seeks to tax" [Miller Bros. Co. v. State of Maryland, 47 U.S. 340, 345 (1954)]. The Court has also held the Commerce Clause (Article 1) imposes further restraints on state taxation by requiring a tax that is "applied to an activity with a substantial nexus with the taxing state, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State" [Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977)]. In the case of a state seeking to tax its own residents, the individual's physical presence within the state establishes nexus. The issues surrounding a state's authority to tax are generally those associated with a state's taxation of nonresidents.

The question of when sufficient nexus is established between a state and a nonresident is not always easy to resolve.

Nexus is a continuously evolving concept whose complexity is increasing with changes in technology and the manner in which economic activities are conducted. While some minimal physical presence of a nonresident within a state can satisfy the nexus requirement, a nonresident's business and other economic activities within the state can also establish the required "link" between the state and nonresident.

To illustrate the uncertainties surrounding the determination of state of residency, the State of New York's residency requirements are offered as an example.

RESIDENCY DETERMINATION--NEW YORK STYLE

New York has an aggressive enforcement campaign in place to identify resident taxpayers filing as nonresidents and reclassify them. State tax authorities have perceived a major noncompliance problem with individuals living and working in New York (for at least part of the year), but filing as residents of another state in which a home is maintained. An individual will be classified as a New York resident for state income tax purposes if either of two criteria is met:

1) The individual is domiciled in New York, maintains a permanent place of abode within the state, and is present within the state 30 days or more during the year; or

2) The individual is not domiciled in New York, but spends more than 183 days in the aggregate within the state during the year [New York Tax Law Sec. …