Best Practices: Taxes
Tax Americana
Daniel Gross
09/01/2004

In the 1990s, Victor Riley Jr., president and chief executive of KeyCorp, suddenly found himself adrift. When his company merged with Cleveland-based Society for Savings in 1994, Riley sold his home in New York and moved to the Midwest to help oversee the transition. Two years later,  mission accomplished, Riley sought to settle. “I was going to retire,” he recalls. “The question was, where do I go?”

The answer was close. In 1988, Riley had bought land near Cody, Wyo., as an investment. So while many of his peers flew south to the sunny coasts of Florida, the golf-averse Riley went west. Along with wide-open spaces unblemished by putting greens, he quickly found the Equality State had something else to recommend it—an attractive tax structure. Wyoming does not have a personal income tax. “So we figured that we would be able to run a ranch with money we would have ordinarily paid the state of New York,” Riley recounts. And because Wyoming derives most of its income from mineral taxes, the real estate taxes on the house Riley built on his 1,000-acre ranch, where cattle and sheep roam, “are very acceptable.”

Over the past few decades, other states, including Florida, Texas and Nevada, have used tax-based incentives to attract and retain affluent residents—even as chronic budget shortfalls have pressured many governors and legislators to raise taxes. As a result, the variation in the way the 50 states (and even cities within those states) tax different kinds of income has never been wider. For those of us with residences in multiple states, the question of where to establish residency can have large—and long-lasting—financial implications, particularly when it comes to income tax. Nine states have no personal income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. Conversely, avaricious states such as New York have a top tax rate of 6.85 percent (see box, below), which can quickly sap our income. (Click image to enlarge)



There is also a range of state taxes that, if not quite hidden, is less overt—taxes on dividends and interest, intangible property and estates. For example, Florida imposes an intangible personal property tax levied on assets such as stocks, bonds, mutual funds and loans. On January 1 of each year, residents must gauge the market value of these holdings and pay a tax on them—usually $1 per every $1,000 in value, with an exemption on the first $500,000 in assets. An individual who owns a portfolio worth $20 million would pay $19,500. Assets such as cash, IRAs, deferred compensation plans and employee retirement plans are exempt from the tax. In addition, both Tennessee and New Hampshire impose significant taxes on dividend income—6 percent and 5 percent, respectively. (Click image to enlarge)

Traditionally, the way most states handled estate taxes was comparatively simple: The federal government gave individuals a credit on their return for the amount of state taxes paid. “The trend, therefore, was for states to max out on the credit, and to couple the state tax with the federal tax,” explains Elda Di Re, a partner at Ernst & Young in New York. “And that made for a pretty uniform state estate tax.”

The variation in the way the 50 states tax different kinds of income has never been wider.
But even that arrangement is becoming more Byzantine. In 2001, Congress placed the federal estate tax on a path toward complete repeal in 2010. As of 2005, the credit for state estate taxes will disappear. The prospect of federal—and hence state—estate taxes fading away tripped alarms in many state capitals, where budgeters had come to rely on estate tax revenues to balance budgets. So in the past few years, many states have decoupled their estate tax from the federal tax. Among the 16 states that have done so, according to the Roseland, N.J.-based accounting firm Rothstein Kass, are Kansas, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, North Carolina, Oregon, Pennsylvania, Rhode Island, Vermont, Virginia, Washington and Wisconsin. Contrariwise, California, Florida and Nevada now have constitutional prohibitions against an independent state estate tax. “In 2005, someone with a $10 million estate will face over $1 million in state estate taxes in New York, whereas a person in California, Nevada or Florida will have none,” points out Diane E. Lederman, head of wealth planning at Neuberger Berman Trust. The trick, experts reveal, is to establish residency in states that have lower—or nonexistent—estate taxes.

Subjective Residency
Those of us who know we are going to experience a large liquidity event—the sale of a company or of family property, for example—might consider relocating to a new, lower-tax domicile state before the event. “I get people to become residents of Florida and Texas before a big gain,” says Greg Wilder of Grant Thornton, a financial advisory firm in Orlando, Fla.

As with most issues involving tax codes, it is not quite that simple. In fact, the process is fraught with complications. “It has to be an actual change, and it has to occur prior to the income being earned,” instructs Art Rosen, a partner at the New York law firm of McDermott Will & Emery. As a rule of thumb, individuals who spend more than 183 days in a state are more likely to be considered residents. But such status is not automatic, and the judgment can frequently be subjective. “There’s a relative weighing of factors that goes into it,” says Douglas Joseph of the accounting firm Blum Shapiro, based in West Hartford, Conn. People who wish to change their domicile can also do many things that prove residency: register to vote, obtain a new driver’s license, redraft a will or join a country club in their new home state.

TOP VIEW
States such as Florida, Nevada and Wyoming rely on tax incentives, such as no personal income tax, to retain us as residents. However, there can also be a range of state taxes that are less overt: taxes on dividends and interest, intangible property and estates. For those of us with multiple residencies, sorting out these tax implications can have long-lasting financial consequences.
However, because states hate to see large sources of tax revenue leaving, they frequently subject relocation attempts to strict scrutiny. “I can almost guarantee that high-income taxpayers are going to be audited for residency,” cautions Di Re. State auditors are likely to examine everything from cell phone bills and voter registration to country club memberships and religious affiliations. Because the judgment is made on a subjective basis—there is no set of specific steps states publish that individuals can follow—it is important both to keep records that prove time spent in a state, and to ensure that we are not claiming residency in one state while spending most of our time—seeing all our doctors and serving on boards of nonprofit organizations—in another.

For those of us who are not tied down to a state for business or personal reasons, options are expanding. Two-thirds of the members of the PGA Tour live in Florida. “It’s partly the weather, but it’s also because of the tax situation,” notes Wilder. Lederman has pinpointed rapidly growing Nevada, which generally lacks the less overt taxes that some no-income-tax states have, as a more attractive destination. “Nevada is becoming more popular. It doesn’t have the income tax. And it’s similar to Florida in the sense that it won’t have an estate tax, and its property taxes tend to be pretty low,” she says.

Municipal Advantage
We can expect even more new tax wrinkles as states bid to play host to the wealthy. In an effort to encourage venture capital investing in a state better known for producing grains than capital gains, Kansas this year enacted an Angel Investor Tax Credit. The tax applies to investors who meet the Securities and Exchange Commission’s accreditation standards: individuals with more than $1 million in assets, or trusts with assets of more than $5 million. Accredited individuals who make cash investments in Kansas businesses that are fewer than five years old and have annual revenues of less than $5 million receive a credit against state taxes equal to half the investment.

California, Florida and Nevada now have constitutional prohibitions against an independent state estate tax.
In the past few years, some states have targeted wealthy residents as potential sources of state revenue. New Jersey, for example, is considering raising its income taxes, on individuals with more than $500,000 in taxable income, from 6.37 percent to 9 percent. But other states recognize that they can gain benefits by not taxing affluent individuals. “Wyoming is benefiting from the people of affluence who are retiring and building second homes here. It is part of the [state’s] economic development strategy,” says Ben Avery, portfolio manager at the Wyoming Business Council, the state’s economic development agency.

Wyoming also allows residents to receive full tax benefits when they buy municipal bonds from any state—offering investors wider choices. “You can pick and choose the kind of bonds you want from among 50 states, and I find that to be a tremendous advantage,” Riley boasts. In many other states, in order to get the full benefit of municipal bonds—whose interest can be exempt from federal, state and local taxes—residents must buy securities issued by their state of residence.

Since Riley has taken up residence in Wyoming, he has practically become the poster child for the Wyoming Business Council. He has started four Boys and Girls and Teen Clubs, and donated $1 million for the construction of a large hockey rink, the Victor Riley Arena, which doubles as a convention center. He is also a member of the Buffalo Bill Historical Center board of trustees and has joined the Northwest College board of trustees. The benefits he brings the state arguably outweigh any tax revenue it forgoes.

Illustration by Illo Credit.