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Impact of Residency
A taxpayer’s legal state of residency retains the power to tax all the taxpayer’s income and property. Conversely, if a taxpayer has income or property in states where they are not a resident, the nonresident state may tax only the activity conducted in — or property located within — the nonresident state’s borders. The distinction between what a resident and nonresident state can tax is especially significant for affluent taxpayers, as investment income and assets are normally only subject to tax in the taxpayer’s state of residency.
Massachusetts is a high tax jurisdiction compared to many popular retirement-destination states. Massachusetts taxes most income at rates of 5% or 9% and taxes estates at a rate that can be as high as 16% of the value of the property transferred. This is in contrast to jurisdictions such as New Hampshire, Texas, and Florida, all of which have no — or limited — state income tax and no state estate tax. The difference in nominal rates between low tax states and Massachusetts is high enough for wealthy taxpayers to frequently consider tax-motivated changes in residency. If executed correctly, there can be a significant reduction in taxes.
Residency Is Not a Switch That Can Be Flipped
Residency in Massachusetts is established in one of two ways for income tax purposes: A taxpayer can either be “domiciled” within the state or, alternatively, can establish residency by having a permanent place of abode within the Commonwealth and by being physically present in state for more than 183 days during a given calendar year. Taxpayers frequently believe that they will not be considered residents if they are present in Massachusetts for less than 183 days during a year, but this is not necessarily the case. Indeed, when a taxpayer is present in Massachusetts for almost six months of every tax year, it substantially undercuts the argument that they have changed their domicile, as it is usually the case that they will also naturally have substantial family, social, and other arrangements with Massachusetts sources. For decedents, there is no 183-day test, and an estate will be considered a Massachusetts resident estate if the taxpayer’s domicile was in Massachusetts at the time of death.
The issue with taxpayers seeking to change their residency to a lower-tax jurisdiction is that establishing a termination of Massachusetts domicile is a fairly high hurdle to overcome. A taxpayer needs to show an intent to abandon their domicile in Massachusetts, establish a domicile in a new location, and come up with sufficient proof to establish that the new domicile is intended to be on a permanent or indefinite basis with no clear intention for the taxpayer to return to Massachusetts. Taxpayers need to not only move out of state on a permanent basis to change domicile but also sever most of their ties to Massachusetts. The ties that need to be cut aren’t limited to civic filings such as voter registration and driver’s licenses. Taxpayers also need to reduce or eliminate Massachusetts-based relationships – including employment relationships, economic relationships, service providers, and social entanglements – and establish them in their new state of residency. It can be especially difficult for so-called snowbirds to show an intent to change their domicile to Florida when they retain ownership of the family home in Massachusetts and return for six months of every year in the spring or summer.
The Massachusetts Department of Revenue audits taxpayers claiming nonresidency status on income and estate tax returns regularly. These are difficult audits for many reasons, the first and foremost of which is that the taxpayer has the legal burden to prove that they terminated their domicile in Massachusetts. The Massachusetts DOR uses the fact that the taxpayer has the burden to prove their intent to change their domicile against them, asking for an excessive number of documents in the event of an audit. For this reason, taxpayers considering a change in residency should consider getting legal advice before committing to major decisions such as purchasing a second home or changing their driver’s licenses.
Burden Continues for Nonresident Taxpayers
Taxpayers who are able to successfully change their residency out of Massachusetts are not necessarily out of the woods. As noted above, a nonresident taxpayer still must report and pay income tax to Massachusetts to the extent income items are derived from Massachusetts sources. Massachusetts-source income includes employment income earned when the taxpayer was physically performing services within the state — including when the work is performed remotely from a Massachusetts location — and income derived from property located within Massachusetts. Income derived from businesses operating in Massachusetts will be considered Massachusetts-source income, as would be gains realized from the sale of any real or personal property located in the state.
Determining the state of source for an item of income can occasionally be complicated. For instance, if a nonresident taxpayer recognizes income from a deferred compensation agreement or other equity-based grant that vested over a period of time, and a portion of the vesting occurred when the taxpayer was present in Massachusetts, the income will be partially sourced to Massachusetts. Special rules also apply with respect to the sales of business concerns that have substantial operations in the Commonwealth. These rules are frequently not understood by accountants who only practice in one jurisdiction and, as such, legal counsel should be consulted if there are large or atypical transactions.
Massachusetts can also impose estate tax on nonresidents based on the value of the decedent’s taxable estate in Massachusetts. This can result in liability for taxpayers who relocate to Florida, but for nostalgic purposes have retained ownership of an asset in Massachusetts, such as the family home on Cape Cod or Martha’s Vineyard. In this case, the Massachusetts nonresident estate tax is first computed as if the taxpayer were a resident of the Commonwealth of Massachusetts and is then multiplied by a ratio of Massachusetts-based property versus the taxpayer’s property in all jurisdictions. If a large percentage of the taxpayer’s total net worth is in Massachusetts real estate, this can result in a large tax bill. The formula also provides that the effect of the $2,000,000 Massachusetts estate tax exemption is applied against the worldwide gross estate value, meaning that even if the taxpayer has less than $2,000,000 in total Massachusetts property, they may still have a tax liability. Fortunately for taxpayers seeking to hold onto real estate in Massachusetts, legal counsel has tools available that can reduce or eliminate the nonresident tax burden.