If you are planning to live, work, or invest offshore, you need to plan for your state taxes. This State Tax For Expats guide will help you eliminate your state’s taxes and keep you out of trouble with local tax authorities.
If you move offshore, and plan to return to your home state, then your state’s tax laws apply to all income you earn abroad. So, state tax for expats battles center around the issue of your intent to return… whether you moved out of your state and took up residency elsewhere, or if you remain a tax resident of that home state.
If your state’s tax laws remain attached to your income, then you need to know how your state treats foreign income. For example, some states have laws that match the federal government’s Foreign Earned Income Exclusion so you can earn up to $99,200 in wages while abroad and pay no federal or state tax.
Others have a variation of this law, while yet others, like California have no FEIE and thus attempt to tax ALL income you earn abroad. You must research your state’s laws before you devise a plan to move offshore. I’ll focus on California because that’s the state I’m most familiar with. If you are living in a tax free state like Texas or Florida, your state tax for expats analysis is simple – no problems.
As I said above, State Tax For Expats is focused on your intention. If you move abroad and intend to return to your home state, then its laws govern. If you move to another country, become a tax resident, and do not intend to return, then you should have no state tax obligations. While this sounds great, it is much more difficult to prove… especially if you are moving from a hungry and aggressive state like California. I also note that the burden of proof is on you to show that you intended to move out of your state and not return for the foreseeable future.
For example, if you are a contract worker in Iraq, on a 3 year agreement, and you keep a home and family in California, you remain a resident of California for tax purposes. No one will believe you intended to move to Iraq for the foreseeable future… you intended to work there for the term of your contract and then return to your home and family in California.
That is to say, your state will want its share if you leave sufficient contacts in that state. If your wife, school aged children, home which you have not rented out on a long term contract, bank accounts, driver’s license, are all in California, you are probably a tax resident of California. If your job is such that you obviously intend to return to California, then you are probably a tax resident of California.
Though, it is possible to be a tax resident of a foreign country and not a state in the U.S., while your wife and children are here. I have had three clients over the years in that situation. One was an attorney living and working for 15 years in the U.K., while his wife and kids remained in California. He would spend about 30 days a year in the state. Note that is one of the toughest state tax for expats situations, but it can be overcome. In this case, he qualifies as a resident of the U.K.
Of course, California found a way to get to at least some of his worldwide income. They passed a law that basically says the income of a family unit is attributable equally to each spouse. This law passed legal challenges in community property states and means that 50% of the U.K. lawyer’s income is attributable to his wife’s support (taking care of the children, etc.) and is thus California source income and taxable in the state.
That’s right, if you are living and working abroad, qualify for Foreign Earned Income Exclusion, are a tax resident of a foreign country, and remain married to someone living in a community property state, 50% of your income is taxable in that state. One solution is to get a divorce. Some suggest that prenuptial or transmutation agreements may also help.
Adding insult to injury, because California has no Foreign Earned Income Exclusion, state tax applies to all California source income. If the attorney were to earn $99,000, he would owe no Federal tax, but 50% of the income would be taxed by California at around 9%. This is why state tax for expats can be so confounding to the uninformed.
Capital gains is another issue you must consider when dealing with state tax for expats. Let’s say you move out of the United States to Panama. You move to Panama permanently, obtain residency, file taxes (if applicable), become part of a community there, cut all ties with your home state by selling your home, etc.
However, you leave your bank and brokerage accounts in the U.S. and your state has no idea that you left. They won’t get notice (Form W-2) from your job in Panama, but they will receive 1099s from your bank and brokerage accounts. And, these 1099s will reflect only the sales, and not the purchases in that trading account. This means the state will have a very distorted view of your income… all stock sales and no expenses/purchases.
California will take this information and prepare a return on your behalf, create a tax bill, and attempt to collect. The first you may hear about this is when they empty out your U.S. bank and brokerage accounts with a tax levy. Think I am exaggerating? I have represented too many clients to count over the years in this very situation. One was a day trader with a net loss on his brokerage account, but $1 million in sales for 2012. California taxed that $1 million and levied his account for the balance due. He was left to negotiate, beg, and file a claim for refund. He had to prove he was not a resident of California, which is an uphill battle… especially after the government has a hold of your cash.
When dealing with state tax for expats, you have two options: 1) move everything out of the reach of your state, or 2) move to a state with no income tax for a year before you go offshore. Option 1 will protect your assets, but option 2 will protect you AND avoid a confrontation.
Had my client moved his wife and child to Florida or Texas before going to work in London, he would have zero state taxes to pay. Assuming his income was $99,000 (it was closer to $800,000), he could have also moved them to any state with a matching Foreign Earned Income Exclusion with the same result.
Likewise, you can first relocate to a non-taxing state, file a partial year return with your state referencing the change, and then go offshore without the risk of California coming after you. This prevents the substitute for return issue, and makes an audit unlikely. People in the military have been doing this for years. Expats should take a page from the Navy’s playbook.
However, you must be sure to cut all ties with your original state and become a resident of Florida or Texas before going offshore. You should sell or rent out any real estate (I am a big believer that selling is better than renting), close any bank and brokerage accounts in California and open new ones in Texas or Florida, get rid of your CA driver’s license, and cut all ties with California.
As you can see, it is important to be proactive when dealing with the state tax for expats issue. Remember that these state tax problems can come back to bite you years after you move offshore, so dealing with them now will save you in taxes, interest, penalties, and fees to a CPA or Attorney.