We would like to think that states give their residents a full tax credit for taxes paid to other state jurisdictions so that individuals won’t be subject to double taxation. Although this is often the case—for example, a state gives its resident a credit for taxes paid to a neighboring state on wages earned there—it isn’t always the case. States don’t like to talk about double taxation, yet state and local tax (SALT) practitioners know that there is no constitutional prohibition against it; thus, significant numbers of taxpayers are subject to some degree of double taxation.

We also know that of the 41 states (plus the District of Columbia) that impose a personal income tax, there are 41 different taxing regimes—even more if we include local jurisdictions that impose some type of income tax. On top of that, individuals and their businesses have been crossing jurisdictional boundaries with increasing frequency over the past few decades, which has dramatically increased the prevalence of individuals paying tax to more than one jurisdiction and seeking a credit in their home state. The result? Resident credit issues abound.

Many states do not simply give a dollar-for-dollar resident credit for taxes paid to another jurisdiction; instead, they limit the allowable credits based on their own tax rates and income sourcing rules. As a result, residents who work, conduct business or are otherwise subject to tax in multiple jurisdictions can get whipsawed. 

In the past year, widespread pandemic-related changes in the places where taxpayers work and live, have highlighted several longstanding resident credit issues related to statutory residency and interpretations of “convenience of the employer.” Against this backdrop, we wanted to take a fresh look at state resident credit provisions and when they are most likely to create the potential for double taxation. The starting point is, of course, the resident credit statutes themselves.

I. State Resident Credit Statutes: How Generous Are They?

State-level personal income taxes are imposed on residents’ worldwide income, and also imposed on nonresidents’ income from sources within the state. All 41 states that impose personal income taxes allow some form of a resident credit that offsets the tax due to their home state based on taxes paid to another state. But states take different approaches to calculating their resident credits and those differences can determine how much double taxation is eliminated.  Let’s unpack these approaches.

A. Credit Limited to Sourced Income: The Dual Residency Problem

As noted, resident credits allow an individual taxpayer to offset the tax due to their home state on their worldwide income taxes paid to another state.  Most states require that the income taxed by the other state be actually sourced to the other state for a credit to be given. For example, New York’s resident credit statute states in relevant part:

“A resident shall be allowed a credit against the tax otherwise due . . .  for any income tax imposed on such individual for the taxable year by another state of the United States, a political subdivision of such state, the District of Columbia or a province of Canada, upon income both derived therefrom and subject to tax under this article.”  [N.Y. Tax Law § 620(a) (emphasis added)].

Similarly, Connecticut’s resident credit statute provides:

“Any resident . . . of this state shall be allowed a credit against the tax otherwise due under this chapter in the amount of any income tax imposed on such resident . . . for the taxable year by another state of the United States or a political subdivision thereof or the District of Columbia on income derived from sources therein and which is also subject to tax under this chapter.” [Conn. Gen. Stat. § 12-704(a)(1) (emphasis added)].

California’s resident credit statute likewise provides that:

“The credit shall be allowed only for taxes paid to the other state . . .  on income derived from sources within that state which is taxable under its laws irrespective of the residence or domicile of the recipient.” [Cal. Rev. and Tax Code § 18001(a)(1) (emphasis added)].

Provisions like these, which limit the resident credit to sourced income, mean that income without a source (e.g., dividends, interest, capital gains) cannot be included in the calculation of the resident credit. In most cases, that’s not a problem, because states do not typically tax nonresidents on unsourced or intangible income. But what about the dual resident?  Consider, for example, someone whose primary and principal home (i.e., their domicile) is New York. But during COVID, he went to stay at his weekend house in Connecticut, intending to return to New York in fall 2021. If he spent more than 183 full or partial days during the calendar year in Connecticut in 2020 or 2021, he would be a “statutory resident” of Connecticut as well as domiciled in New York and thus taxable in both states on his worldwide income. To the extent that he had investment income from intangible assets (e.g., stocks and bonds), neither New York nor Connecticut would give a credit for taxes paid to the other jurisdiction on that income, resulting in potentially significant double-taxed income. The double taxation that results from this scenario has been repeatedly upheld by the New York courts, as discussed more fully by our colleagues here.    

A few states do not limit their resident credit to sourced income. Instead, these states simply require that the income not be sourced to their state. In New Jersey, for example, the resident credit is only limited to the extent that (i) the income is not from New Jersey sources and (ii) the income is actually taxed by the other jurisdiction. This means that New Jersey allows a resident credit for tax paid to another jurisdiction on intangible income. Michigan, Montana and Oregon offer similarly structured resident credits.

B. Different Sourcing Methods: The Convenience Rule Problem

Limiting a state’s resident credit to income sourced to that jurisdiction wouldn’t be such a problem if states had the same methods for determining whether income is derived from sources within the state—of course, they do not!  Note that in the examples of the more limited resident credit provisions of California, Connecticut and New York, the credit is only available for income derived from sources in the other state. Whether income is derived from sources in the state is determined under the rules of the state offering the credit. In other words, if New York would tax nonresidents on that income, they will provide a New York resident a credit for taxes paid on that income to another state.

In several situations, however, state sourcing rules differ so that our home state might not tax income in the same way as the other state where we paid tax. For instance, states generally tax nonresidents’ wages based on their ratio of in-state workdays versus total workdays in the year.  Yet the meaning of “in-state workday” can vary. Most states treat only days physically worked within its borders as in-state; however, five states—Connecticut, Delaware, Nebraska, New York, and Pennsylvania (collectively the “convenience states”)—impose a convenience of the employer rule. Under this rule, in-state workdays can be expanded to include a nonresident’s days worked from her out-of-state residence if she is working remotely for their own convenience and not for the employer’s necessity. This can create mismatches when a nonresident works in a convenience state and lives in a physical presence state. Consider this example:

James works in New York and lives in Vermont. In 2021, James has 200 total workdays including 150 days (75%) worked from his New York office and 50 days (25%) worked remotely from his home in Vermont for his own convenience. 

As a New York nonresident, James will have to pay tax to New York on 100% of his wages thanks to the convenience rule. Vermont, however, could limit his resident credit to 75% of his wage because, from Vermont’s perspective, only 75% of his wages were sourced to New York.  Consequently, 25% of James’ wages could be double taxed. Note that had James lived in New Jersey, he would be able to get a full credit under the state’s more permissive resident credit regime, although the New Jersey legislature may be rethinking that approach.

The proliferation of telecommuting during the coronavirus pandemic has further compounded the complexity in this area because the convenience rule is predicated on distinguishing between telecommuting for convenience versus necessity. Many practitioners, including us, believe states like New York are wrong to take the position that employees telecommuting during the pandemic—amidst state-mandated office closures and other extenuating circumstances—are subject to the convenience rule.  But even now that stay-at-home orders are being lifted, telecommuting for some or all of the work-week is becoming the new normal. Consequently, employers and employees can be caught unaware that telecommuting can result in double taxation.  

Beyond sourcing rules for employee wages, there are numerous areas where conflicting state rules for sourcing income can result in double taxation. Apportionment rules for guaranteed payments from partnerships or flow-through income (from partnerships and S corporations, deemed sales of S corporation assets and allocation of income from the exercise of stock options) are just a few areas where state sourcing rules often differ and can create problems in the resident credit arena.

C. Who Paid the Tax? The Pass-through Entity Tax Problem

Many resident tax credit statutes implicitly or explicitly limit the credit to taxes paid to the other jurisdiction by the taxpayer claiming the credit. In most cases, where the resident is paying tax as a nonresident in another jurisdiction, this limitation is not a problem. Yet recently, as pass-through entity (PTE) tax regimes have proliferated in response to the SALT deduction limitation imposed by the Tax Cuts and Jobs Act of 2017, more state taxes are being paid by the flow-through entity rather than its owners, so that the entity can claim a business expense deduction of the taxes paid on its federal tax return that the owners might not be able to deduct had the state taxes been paid by the individual owners. Typically, states that have established PTE taxes also then allow the PTE’s owners a resident credit for taxes paid by the PTE to other state jurisdictions, or at least for substantially similar PTE taxes. States without a PTE tax, however, are often not quite so generous.

New York is a case in point. Prior to the passage of its PTE tax in 2021, New York took the position—by statute with respect to S corporations and, somewhat more questionably, in its return instructions for partnerships—that taxes paid by the PTE were not eligible for an individual’s resident credit, even for taxes paid to neighboring Connecticut and New Jersey. But as part of its PTE legislation, New York now permits a resident credit for a “substantially similar” tax paid by the PTE to another state jurisdiction [see N.Y. Tax Law § 620(b)(1)]. It’s unclear how that phrase will be defined and whether it will encompass taxes such as New Hampshire’s business taxes or Tennessee’s franchise and excise taxes.

Some states, even if they do not have a PTE tax or impose only a minimum tax on flow-through entities, have specific statutory language permitting a resident credit for PTE taxes. For example, California permits a resident credit for taxes paid by a partnership or S corporation to another state, even though it has yet to pass a PTE tax.  But many states without PTE taxes are simply silent as to whether they will allow an individual resident owner a credit for PTE taxes paid elsewhere, leaving practitioners to infer from the language of the resident credit provision itself whether a credit would be available. Fortunately, more states have passed PTE taxes in the wake of the SALT deduction cap, making the resident credit more likely. But the availability of resident credits to the owners remains a key determinate of whether an entity should elect into a particular PTE tax regime.

II. Other Nuances: Jurisdictional Limits and Tax Rates

There are still other limitations on resident credits. For example, most states don’t offer a credit for taxes paid to foreign jurisdictions—although New York and other states permit credits for taxes imposed by Canadian provinces—and local jurisdictions. Most, if not all, states limit the amount of the credit to the tax paid to the resident state on the same income. In other words, if a resident of Pennsylvania, paying tax at a rate of 3.07%, claims a credit for taxes paid to California at 13.3%, the credit from Pennsylvania will be limited to the amount of tax based on its tax rate. This doesn’t result in double taxation, but taxation of a Pennsylvania resident at California rates on income sourced there.

Conclusion     

These days, an individual’s state tax burden is rarely limited to his home state’s taxes. Although most people recognize they are potentially taxable in any state where they work, conduct business, or otherwise earn income, it’s less widely understood that they might end up paying tax on that income to more than one jurisdiction without any offsetting credits. Unless Congress steps in and harmonizes state tax rules—an unlikely scenario—taxpayers and practitioners should beware of situations where they could become whipsawed by conflicting and overlapping tax regimes in their home state and another state seeking to tax income from in-state sources.