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How To Avoid a Residency Tax Audit

Last update on: Sep 20 2022
estate planning

Here’s a long-term financial consequence of the pandemic no one talks about…

An increase in disputes over which states can tax a person’s income.

The pandemic made some state tax departments more aggressive as they became more concerned about losing tax revenue previously paid by remote workers and retirees who moved out of state.

A recent case in New York was favorable to the taxpayer and could save some taxpayers a lot of money, but it’s safer to make plans that don’t rely on the case.

Most states impose their income taxes on all the income of two types of people: domiciles and residents. (The same rules generally apply to estate taxes.)

Other people pay taxes only on income earned in the state. Some neighboring states have agreements about which income of residents of the other states they will and won’t tax.

Most states also allow tax credits or deductions for taxes paid to other states.

A domicile is a person who intended to maintain a permanent residence or place of abode in the state indefinitely.

The state looks at the facts and circumstances to determine your intent. Because the test is subjective, you can be away from a state for years and still be considered a domicile.

Later, I’ll discuss how to prove that you changed a domicile. A resident usually is determined by a clear rule.

Many states follow the New York rule: a resident is a person who maintained a permanent place of abode in the state for substantially all the year and spent more than 183 days in the state during the calendar year.

When counting days, any part of a day spent in New York counts as a day in New York, unless you’re merely passing through such as by connecting or boarding flights at one of the airports.

You don’t have to stay overnight or be there for 24 hours to have spent a day in the state for tax purposes.

In the latest case, the taxpayer clearly spent more than 183 days in New York. His principal residence was in New Jersey, but he went to Manhattan most days to work at the office. He also purchased a vacation home in the Adirondacks region of New York.

The state tax department maintained this home was a permanent place of abode and, coupled with the number of days spent in New York, made him taxable as a resident on all his income. But the appeals court disagreed.

The regulations say that a mere camp or cottage that is suitable and used only for vacations is not a permanent place of abode.

The court pointed out that the taxpayer used the house for only two to three weeks each year.

He and his family didn’t keep personal effects there. He also didn’t commute to work from there, and commuting would be impractical because the house was about a four-hour drive from his office.

The court ruled he did not maintain a permanent place of abode in New York. The case means it is possible to have a place to live in a state, spend more than 183 days during the year in the state and not be considered a resident.

But the circumstances are unique, and you probably don’t want to rely on them. Aggressive state tax departments frequently conduct residency audits. A residency audit begins long before the taxpayer is contacted.

States look for individuals who used to file resident tax returns and now file as part-time residents or not at all.

A state might search public records for indications the person owns or rents property in the state or has other significant contacts with the state.

After establishing a presumption that the person is a domicile or resident, the state often requires the person to complete a detailed questionnaire.

If you’ve moved, or are planning to move, prepare for a potential residency audit while you’re moving, and even before starting the move.

Proving you aren’t a resident is fairly easy, since most states follow some variation of the New York rule.

A good step is not to maintain anything that might be considered a permanent place of abode, whether it is owned or rented. When you visit, stay at a hotel, short-term rental, or with friends.

The next step is to establish that you spent fewer than 183 days in the state during the calendar year. Be sure you know how the state defines a day spent in the state.

For example, some states don’t count travel days, while New York and some others count any part of a day in which you were in the state as a full day.

Maintain logs or calendars that list where you were each day of the year.

Also, keep receipts and other documents that prove what’s in the logs or calendars. Be aware of how technology tracks you and leaves a record of your locations during the year. The aggressive states often review cell phone records and other technology trails.

To prove you aren’t a domicile, you must show that you severed all or most ties with the old state and made major changes in your lifestyle.

Your life needs to be centered around the new state. The domicile review starts with the 183-day rule, but that’s only the beginning.

Remember that under the domicile standard, you can spend only a few (or even zero) days in a state and still be considered a domicile when other facts don’t show you intended to leave permanently.

The biggest mistakes are to continue owning a home or business in the old state. Even downsizing and maintaining a smaller home in the old state is risky.

As much as you can, sever all other contacts with the old state.

The more contacts you maintain, the greater the likelihood that you’ll be viewed as a domicile. Your driver’s license, auto registrations, voter registration and church and club memberships all should be changed.

Many states won’t consider the move permanent if memberships are switched to inactive, nonresident, or associate status instead of being resigned or transferred.

They’ll argue the change is temporary and you easily can switch back to full or resident membership. Some states expect you to give up professional licenses in their states or at least obtain counterparts in the new state.

It also is not a good idea to leave valuable property such as jewelry, furs and art in the old state.

Many states consider leaving valuable items, even in storage, to be a significant contact that indicates you’re a domicile.

A common mistake is to maintain a boat or vehicle registration in the old state because the property taxes or registration fees are lower.

Another frequent mistake is for someone to tell the state he is a passive investor in a business but assert active investor status on the federal income tax return.

Another bad ploy: Tell an insurance company you are resident in one state because premiums are lower for its residents but tell the state you are resident elsewhere for tax purposes.

In other words, be sure all your actions are consistent with each other and with the idea that you moved your permanent home. Inconsistent actions could trigger fraud penalties in addition to a tax bill.

Perhaps worst of all, a state can spring this trap after you have passed. When you no longer are around to testify and help gather evidence, the states can swoop in and assert their claims for both income and estate taxes against your estate.

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