Your clients may be part of a continuing trend of people moving to low- or no-income tax and they may be coming to you more for related tax advice.
The first thing to make clear is that if they’re moving from a high-tax state like California, Illinois, Connecticut, New Jersey or New York, there is a good chance will be audited, as these states are using non-residency audits as a tool to recover lost tax revenue. This is especially true for high-net-worth individuals.
As migration patterns to lower-tax states intensify, residency audits -- particularly domicile change and statutory residency audits -- are becoming more frequent and aggressive and create problems for taxpayers. Our research shows that in New York state, for example, the average number of non-residency audits per year is over 3,000, with data showing that 52 percent of taxpayers lose their cases.
These audits result in New York State collecting $144,270 on average from the losing taxpayers, with many being forced to pay millions of dollars. During the five-year period from 2013 to 2017, New York State collected approximately $1 billion from taxpayers in residency audits.
Then there’s the process. Both, domicile and residency tax audits are highly intrusive, as auditors seek to understand where taxpayers are actually living their lives and they take months and even years to resolve. Moreover, just because you’ve had one residency tax audit, it doesn’t mean that you won’t have another in the future.
Lastly, fighting these audits can be tricky. When it comes to these types of audits, the burden of proof for residency and time spent in different states lies with the taxpayer. So, it’s not the state but the taxpayer that needs to prove their case.
5 Things to Know About Low-Tax States
With this in mind, here are some important things to be aware of and keep top of mind as you advise clients that have recently moved or are considering a move from a high-tax state to one with low or no taxes. These factors can have an impact on how to file taxes to prevent double-taxation and how to prepare in case of an audit.
1. How Does the SALT Cap Affect the Taxpayer?
The migration trend is being compounded by President Trump’s Tax reforms, which include a $10,000 cap on state and local tax (SALT) deductions that has resulted in taxpayers being able to deduct considerably less in state income, local income, and personal property taxes than they might have previously done.
Although the reforms have reduced federal tax rates for high income individuals, in many cases these same reforms are in turn causing these individuals to pay a higher combined total tax on their income. This is primarily affecting individuals in states like California, New York, and New Jersey where the income tax rates and property taxes are sky-high. As a result, many high earners, and retiring or retired individuals are fleeing to low- or no-tax states like Florida, Arizona, Wyoming, Texas, etc.
As tax jurisdictions lose or risk losing more on tax revenue, they will increasingly pursue residency audits against individuals claiming to have moved out, i.e., changed their domicile or are no longer statutory residents. The higher the taxpayer income, the higher the likelihood of a residency audit.
2. Where is the Taxpayer’s Primary Residence Located?
The first thing auditors will want to verify is that your client isn’t still domiciled in the location from where they claim to have moved. In a domicile audit, a tax auditor will try to determine where the taxpayer’s ‘home’ or domicile is.
Auditors will want to know the relative size and worth of your client’s home in their new state and compare it to that of the home in their previous state. It’s a good sign if your client’s home in the new state is bigger and of higher value than the home in the previous state.
The state will also look at information such as: credit card bills, travel schedules, cell phone records, social media feeds, and where the taxpayer’s primary vet, dentist, and doctor are located to establish that the new home is truly where they are living the majority of their life. Making sure your client has this information ready and that it shows what you are trying to prove will serve them well in case of an audit.
3. Where are the Taxpayer’s Business and Family Ties?
If the taxpayer has claimed they’ve sold their business, auditors will look at whether they’ve kept in constant communication with new management, customers, etc. which can hurt their case in asserting a change of domicile. Individuals need to be prepared to hand over phone records, email records, and other correspondence regarding current or past business ties. In addition, auditors will also investigate where the immediate relatives of the taxpayer live, and will flag them if, say, they’re suddenly claiming their wife and kids are now living in a different state.
4. Where are the Taxpayer’s ‘Near and Dear’ Possessions?
Things ‘near and dear’ are those of sentimental value and their location has an impact on where the auditors determine a taxpayer’s home or domicile to be. These items are often family heirlooms, antiques, fine art, books, photo albums, etc. Increasingly, where the taxpayer keeps their pets has become a smoking gun. Also, auditors will usually ask for bills of lading showing their location has been transferred as well as insurance policies and other records to determine their current location.
5. Where Does the Taxpayer Spend Time and the 183-Day Rule?
According to legal experts in this field, of all the factors covered here, the most important one in domicile and residency audits is the ‘time’ factor. Auditors will look at how many days during the year in question your client spent in their new ‘home’ location and compare that with the number of days they spent in their old ‘home’ jurisdiction.
According to leading audit defense attorneys, a good rule of thumb for your clients to be safe when trying to prove a successful change of domicile is to spend two days in the new location for every one day spent in the previous location. Once your client successfully proves a change of domicile, auditors will then investigate if the taxpayer remained a statutory resident in the jurisdiction he or she claims to have left. This is often informally referred to as the 183-day rule.
According to the rules in almost all relevant states, if taxpayers spend more than 183 days in a state where they maintain a permanent residence (i.e. a place they can freely access and stay when they visit), then they’re rightfully deemed a resident of that state for tax purposes and will have every single dollar of income for that year taxed as if they’d never left. This is the reason why 183 days is the number taxpayers carefully observe if they have homes in different states.
So, if your client is indeed moving between multiple states, they should be diligent about counting their days spent in a particular state to ensure they don’t overstay their welcome. This includes understanding how each state defines ‘a day spent’ in that state. In New York, for example, ‘a minute is a day.’
It’s important to note that once your client has successfully established a change in their domicile, the state can’t relegate it through another audit. That is, unless your client’s facts and circumstances change meaningfully enough subsequently. However, your client will very much continue to be subject to recurring residency audits, especially if their income continues to be high enough and they haven’t cut ties with that state, such as continuing to maintain a home there.
As state auditors become better-equipped with technology to try to prove their cases (including subpoenaing telephone companies like AT&T, Verizon, etc.), it’s important for advisors to keep their clients informed of tools at their disposal. Emerging technology is enabling better-tracking of travels, making the process of logging time spent in different states easier and giving taxpayers the ability to create an audit-ready digital record. Advisors and taxpayers alike should start to leverage these technologies to be prepared for and to defend against state residency audits.
As stated earlier, the burden of proof is on the taxpayer and this notion is captured nicely in a quote from Tim Noonan, Partner, Hodgson Russ, regarding New York State audits: “The auditors will generally start the audit with the assumption that the taxpayer spent 365 days in New York.” What proof, what hard data will your client have to whittle that 365 number down below 183?
We’re living in a time where receipts and credit card swipes may not be enough. Auditors are using today’s technology and tools, shouldn’t you and your clients be doing the same?
About Anupam Singhal
Anupam is co-founder of Monaeo, a personal & enterprise location tracking & audit defense system designed to minimize taxes and increase compliance.