January 20, 2014
A question I frequently get asked is whether an individual who lives in New York City but commutes to Stamford, CT, for work must file state tax returns in both states. The opposite situation–living in Connecticut and commuting to work in New York City–is also a common one.
I. State taxation is separate and independent from federal taxation.
Before answering the question of where to file, it helps to understand how state taxation and federal taxation interact. The federal income tax is levied by the U.S. federal government and governed by the internal revenue code. Unless an exception applies, every person working in the United States must file a U.S. federal income tax return.
Apart from the federal income tax, states also levy their separate state income taxes that are governed by state revenue laws. The two authorities to tax are separate and independent, even though states, in practice, model their tax systems after the federal one to make life easier for both the taxpayer and the tax collector.
II. A state tax return must be filed for each state that has the right to tax your income.
The general rule is that you should only file a tax return for each state that has the right to tax your income. So whether you must file a particular state tax return depends on whether that state has the right to tax you in the first place.
Whether or not a state has the right to tax you is governed by constitutional due process and each state’s revenue laws. Without getting into the details of any legal analysis, you should just know that the state that is asserting the right to tax your income must be able to demonstrate that your income is somehow connected to that state. The magic, non-legal word for that connection is “nexus”.
For nexus to exist, a state usually needs to show that (1) your activities or physical presence in that state gave rise to a portion of your income, (2) you own property in that state, or (3) you have chosen to make that state your “home state” for tax purposes.
III. A state has the right to tax your income derived from that state.
A state has the primary right to tax your income if your income is derived from that state. For example, if you work in New York City but live in Connecticut, then New York State has the primary right to tax your wage income. There are usually two ways to show that your income is derived from a particular state:
A. Activities within that state.
You derive your income from a state if the activities you engage in while present in that state gives rise to a portion of your income. For most salaried workers, the place you work will determine which state gives rise to your income. So if you work while physically present in New York State, you also derive income from that state.
B. Income-generating assets located within that state.
Another way you can derive income from a state is by using assets located within that state to generate your income. For example, if you rent an office in New York City and operate a copy machine in your office, then both the office building and the copy machine are physical assets that contribute to the income you generate in your business.
Intangible assets such as intellectual property and goodwill are harder to assign locations for. That is one of the reasons why many information-technology and financial companies are able to reduce their tax liabilities by locating intangible assets in low-tax jurisdictions.
IV. A state has the right to tax your income from wherever derived if you choose to make that state your home state for tax purposes.
A second basis for taxing your income is that you have chosen to make a state your home state for tax purposes. “Home state” is not a legal term you can cite to in any court. Instead, I have chosen the term to illustrate the principles behind the second basis of taxation.
The idea really is simple: the home state is the state that has the right to tax all of your income wherever derived. Being designated as your home state is significant for state taxation because the home state often is the only state that will tax your passive investment income, such as stock gains.
I like to think of a home state as a residual place to assign all of your untaxed income. If no state has asserted taxing right over an item of your income, then chances are, your home state should tax that item.
The goal and assumption of the multi-state tax system is that all of your income is taxed at least once by some state–that is also the reason we need the concept of a home state. This assumption will break down when we explore asymmetric taxation across state lines in a future article.
A. When two states both have the right to tax the same item of your income.
When there is a conflict between your home state and the state where you derive your income–let us call the latter your income state–the home state usually will recognize the income state’s primary right to tax.
For example, if your home state is Connecticut but your income state is New York, then Connecticut will forgive its state tax on your New York-derived income to the extent you have already paid New York’s state income tax. That forgiveness is achieved through a crediting system that we will explore in a later article.
B. Where is your home state for tax purposes?
I have been purposefully vague about how your home state for tax purposes is “chosen”. In most cases, your home state will be the state in which you live and reside–the state in which you own your home, have your driver’s license, and have your family members.
There is not a perfect overlap between your home state and your residence state, however, because many people live in out-of-state college dormitories with the intention of returning to their home states once they graduate.
The subjective intent about where you want to return may be clear to you, but tax law would not be enforceable if the tax collector had to guess what is in your head every time it assesses additional tax.
As a result, the states often look to the objective indicators of your intent–the state in which you own your permanent home and have your driver’s license, the state in which you spend most of your non-working time, etc.
To return to our question of which state tax returns you should file, the answer is that you should file a state tax return for every state that gave rise to your income during the tax year in question. You should also file a state return for your home state for tax purposes.
In the example of a person who lives in Connecticut and commutes to work in New York City, or vice versa, the person should file state income tax returns for both Connecticut State and New York State.