Forty-three states and the District of Columbia presently have an individual income tax. Only Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not tax an individual's income. New Hampshire and Tennessee tax only interest and dividend income. In addition, over two dozen major cities, e.g., Baltimore, Cincinnati, Cleveland, Detroit, New York, and Philadelphia, impose an income tax on individuals. For individuals to minimize their income tax burden, serious consideration must be given to planning for these non-Federal assessments.

The state income tax environment has become increasingly complex and contentious over the last several years. Most states have stepped up their enforcement efforts to collect additional taxes from both resident and nonresident taxpayers. Through the extensive use of computers and information sharing with other states and the Federal government, state tax authorities are aggressively assessing deficiencies against noncomplying individual taxpayers, particularly nonresidents. In the search for more revenue, states are also expanding their tax bases through the liberal interpretation of tax statutes. As state governments continue to struggle with their fiscal problems, individuals must be prepared to deal with both greater complexity and increased liability exposure for state income taxes.

State Jurisdiction to Tax and "Nexus"

The U.S. Constitution imposes certain limitations on a state's authority to impose taxes on individuals and other taxpayers. The Supreme Court held the Due Process Clause (14th Amendment) requires a "definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax" Miller Bros. Co. v. State of Maryland, 347 U.S. 340, 345 (1954). The Court has also held the Commerce Clause (Article 1) imposes further restraints on state taxation by requiring a tax that is "applied to an activity with a substantial nexus with the taxing state, if fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State" Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977). In the case of a state seeking to tax its own residents, the individual's physical presence within the state establishes nexus. The issues surrounding a state's authority to tax are generally those associated with a state's taxation of nonresidents.

The question of when sufficient nexus is established between a state and a nonresident is not always easy to resolve. Nexus is a continously evolving concept whose complexity is increasing with changes in technology and the manner in which economic activities are conducted. While some minimal physical presence of a nonresident within a state can satisfy the nexus requirement, a nonresident's business and other economic activities within the state can also establish the required "link" between the state and nonresident.

To illustrate the uncertainties surrounding the determination of state of residency, the State of New York's residency requirements are offered as an example.

Residency Determiantion--New York Style

New York has an aggressive enforcement campaign in place to identify resident taxpayers filing as nonresidents and reclassify them. State tax authorities have perceived a major noncompliance problem with invididuals living and working in New York (for at least part of the year), but filing as residents of another state in which a home is maintained. An individual will be classified as a New York resident for state income tax purposes if either of two criteria is met: 1) The individual is domiclied in New York, maintains a permanent place of abode within the state, and is present within the state 30 days of more during the year; or 2) The individual is not domiciled in New York, but spends more than 183 days in the aggregate within the state during the year New York Tax Law Sec. 605(b)(1).

For purposes of any residency test, an individual's domicile is a question of fact based on taxpayer intent. An individual is condisered to be domiciled in a given state if the individual intends that state to be his or her permanent home. As individual can have multiple residences at any given time by only one domicile. The following factors have been found to provide evidence of an individual's intent regarding domicile in the State of New York and may be illustrative of the factors other states consider in determining an individuals domicile.

* Place of employment and extent of business activities;

* Disposition of property located at site of previous domicile;

* Nature of interest in abode (ownership vs. short-term rental);

* Location where routine medical services are obtained;

* Location of bank accounts;

* Site of voter's registration;

* Driver's license and automobile registration;

* Execution of will;

* Presence of family members;

* Site where children attend school;

* Telephone listings;

* Religious, community and social affiliations;

* Formal declaration of residency.

An individual's permanent place of abode is a dwelling suitable for year-round living with facilities found in a normal dwelling, e.g., facilities for sleeping, cooking, and bathing. A permanent place of abode can be either owned or rented, even if rented on a short-term basis. For example, former President George Bush maintained a Texas residency during his Washington tenure even though his only residence in Texas was a Houston hotel room he rented a few days a year. An individual who is domiciled in New York is assumed to be present within the state for the entire year unless documented otherwise. Furthermore, an individual's presence in New York for any portion of a day will count as an entire day.

As illustrated by New York's residency rules, an individual who maintains a residence and otherwise spends considerable time within a particular state must be prepared to overcome a substantial record keeping burden to avoid unwanted residency status.

Under the various state residency rules, an individual may be treated as a resident for income tax purposes in more than one state. Individuals should undertake deliberate, well documented, actions that will serve to provide evidence of their intent regarding the site of their domicile. States are continually upgrading their compliance programs to ensure that resident individuals are properly reporting and paying their tax liabilities.

Income Sourcing Rules

Once the nexus requirements has been established, the issue shifts to the determination of the amount of income subject to (sourced within) a particular state's tax jurisdiction. The sourcing of income by a state will determine the extent of an individual's exposure to that state's income tax.

A state will generally tax its residents on their entire income, regardless of the state in which the income is sourced. Since some of that income may also be sourced and taxed within another state, the resident state generally allows a tax credit for any income taxes paid to other nonresident states. The credit is normally limited to the amount of the resident state tax assessed on the out-of-state income. An individual's total state income tax burden increases as a result of nonresident taxes to the extent such taxes are not fully allowed as a credit against the individual's resident state taxes on the same income.

In addition to the possibility of multiple taxation on out-of-state income, a resident may also incur higher compliance costs as a result of any nonresident tax returns required. Several states have addressed the compliance burden imposed on non-residents by entering into reciprocal agreements with other state whereby a resident of one signee state is not required to file a nonresident tax return of another signee state.

The sourcing of a nonresident's income is generally accomplished with an apportionment and allocation system. "Apportionment" refers to the process of apportioning business net income among the states in which the business operates. "Allocation" refers to the process of allocating non-business net income to the state in which the income is deemed earned. To determine the apportionment and allocation of income, most states have either adopted the Uniform Division of Income for Tax Purposes Act (UDITPA) or enacted similar income sourcing legislation. Some general comments regarding the sourcing rules under UDITPA are provided below.

Uniform Division of Income for Tax Purposes Act

UDITPA provides general guidelines for sourcing of income derived from both business and non-business activities. UDITPA was promulgated to provide greater uniformity in state taxation of income, to minimize the possibility income would be taxed by more than one state, and to reduce the number of disputes between the state tax authorities. The document often falls short of its goals, however, primarily because states seek to tax their residents on income earned from all sources, within or without the state of residency, and because various state have adopted altered versions of UDITPA. A particular state's sourcing rules may therefore vary from the general rules outlined below.

Business Income. "Business income" refers to "income arising from transactions and activity in the regular course of the taxpayer's trade or business." The correct classification of income as either business or non-business is a question of fact determined by the context in which the income is earned. For example, interest income earned on a bank account consisting of working capital funds is included in business net income. Business net income is typically apportioned, i.e., sourced, among the states in which the business operates using a formula based on sales volume, payroll, and/or property utilization within such states.

A state is generally precluded by Federal law from imposing an income tax on a nonresident individual's sales income derived within the state if I) the individual's only business activity within the state is the solicitation of orders, II) the orders are sent outside the state for acceptance or rejection, and III) approved orders are filled by shipment from outside the state 15 U.S.C. Sec. 381.

Non-business Income. Any income not classified as business income will be non-business income. The category includes any non-business rents, royalties, capital gains, interest, and dividends. The allocation of non-business net income generally turns on the location of the income producing property. For instance, real property rent and royalty income is allocated to the state in which the property is located. Likewise, tangible property rental income is generally allocated pro rata to the states based on the location of the property's utilization by the lessee. Royalty income from patents and copyrights is also generally allocated to the states according to the location of the property's utilization. Capital gains and losses on real property are allocated to the state in which the property is located, and capital gains and losses on personal property are generally allocated to the state in which the property is located at the time of sale. Dividend and interest income is generally allocated to the recipient's state of residency. Finally, compensation for the performance of services is generally allocated to the state where the services are physically performed. The ease in which individuals can run into nonresident state income tax compliance problems as a result of performing services within more than one state is illustrated below.

Compensation of Nonresidents--Philadelphia Style

Philadelphia, which imposes a 4.3% flat tax on all compensation income earned in the city, recently sent out approximately 4,500 tax notices to professional athletes that had played in sporting events in the city but had not filed nonresident tax returns. City attorneys indicated they expected to collect between seven and ten million dollars in taxes, penalties and interest in the first year of this program.

The above example highlights the problem for individuals who perform services within several different taxing jurisdictions, e.g., as athletes, actors, doctors, attorneys, accountants, engineers, and other consultants. These professionals are generally the high income earners state and local tax authorities seek out for noncompliance. Professionals performing services within several states may want to incorporate these associate state tax burdens into their fee structure.

Pension Benefits

The sourcing of pension benefits collected by former residents is another contentious state income tax issue. Individuals, after several years of employment and residency within an income tax state, e.g., California or New York, often retire and move to a no, or low, income tax state, e.g., Nevada or Florida. These individuals then collect pension benefits taxed very little, if at all, by their new resident states. Several states, including California and New York, assert that such pension benefits relate partially, if not entirely, to the individual's former employment within their taxing jurisdiction. Such relationship establishes a "sufficient nexus" to tax the pension benefits.

Whether the current performance of services within a state provides a sufficient nexus to tax future pension benefits collected by a nonresident is an issue that has attracted much attention in the press. The issue is likely to culminate in some Federally legislated policy on state taxation of a nonresident's retirement income. In fact, several bills have been introduced in Congress over the last few years that would entirely or partially prohibit a state from taxing a nonresident's, including former resident's pension benefits. States could presumably respond to such a legislative prohibition by currently taxing all compensation, whether or not deferred for Federal tax purposes, earned within the state.

Pass-Through Entities

State taxation of partnership and S corporation income is an area certain to increase compliance problems for individuals. Compliance considerations become particularly complex when an individual has an ownership interest in a partnership or S corporation that has business activities in more than one state. State income tax treatment of multistate partnerships and S corporations is anything but uniform. As a rule of thumb, states exempt a partnership or S corporation from taxation and, instead, tax the partners or shareholders on the entity's income. However, the following discussion illustrates several exceptions.

Partnership Income. Most states treat a partnership as an entity exempt from income taxation. Exceptions include Michigan and New Hampshire which assess a business tax on all partnerships. Tennessee taxes some partnerships on their interest and dividend income. Other states, e.g., California and Wisconsin, treat some limited partnerships and/or publicly traded partnerships as corporations for income tax purposes. Furthermore, some states, e.g., Maryland, impose an income tax on a partnership with respect to the sum of the nonresident partners' distributive share of partnership income.

If a state taxes a partnership's entire income at the entity level, the partners, both resident and nonresident, are generally relieved from reporting and paying tax to that state with respect to their distributive share of the partnership's income. Any state income tax imposed at the partnership level will generally create double tax problems for nonresident partners. Such partners are required to report and pay tax within their resident states on their entire distributive share of partnership income without any offsetting credit allowed for the income taxes paid by the partnership.

In the usual case where a partnership is exempt from state income tax, the partners, resident and nonresident, are responsible for reporting and paying state income tax on their distributive share of partnership income. Each partnership is generally required to file an information return for each state in which partnership income is apportioned and allocated. Additionally, the tax information provided each partner should indicate not only the partner's distributive share of partnership income, deduction, gain, and loss, but also the apportionment and allocation of those amounts to the various states in which the partnership operates.

A state will generally require its residents to report and pay tax on their entire distributive share of a partnership's income, while a nonresident is generally required to report and pay tax only on the portion of the nonresident partner's distributive share which is apportioned and allocated within the state. Partners of multistate partnerships must therefore examine the compliance requirements for each state in which partnership income is sourced. In some cases, an individual may be required to file a nonresident return for a state solely because of an interest in a multistate partnership.

Some partnerships have eliminated this problem for their partners by reaching agreements with states to file composite returns for their nonresident partners. Although the nonresident partners have to pay a tax, they do not have to file a return. This type of arrangement is not available in every state.

To combat compliance problems associated with nonresident partners, several states, e.g., California and Minnesota, have enacted legislation that requires, in certain situations, a partnership to either withhold a nonresident partner's state taxes from distributions or otherwise pay a nonresident partner's state taxes. In most cases, partnership withholding may be averted by filing a nonresident partner's consent to comply with the state's tax laws.

S Corporation Income. Complying with state income tax laws regarding multistate S corporation income is an even more perplexing matter. State laws covering tax treatment of S corporation income vary widely from state to state. As in the case of partnerships, a shareholder of a multistate S corporation must wade through the maze of tax laws for each state in which income of the S corporation is apportioned and allocated and, as a rule, report and pay tax to such states.

While most states recognize the Federal S corporation election, many of these entities do incur state level income taxes. For instance, even those states that recognize the S corporation election will generally impose a corporate-level tax on both built-in-gains and excessive passive investment income similar to the Federal tax treatment of such income. In addition, several states, e.g., Connecticut, Louisiana, Michigan, New Hampshire, New Jersey, and Tennessee, simply ignore the S corporation election entirely. In those states, an S corporation must generally report and pay tax as a regular C corporation. Subsequent distributions of profits from the entity will be treated by such states as taxable dividend income to the shareholders.

Additional income taxes may be imposed on an S corporation that has nonresident shareholders. A few states, e.g., Delaware and Vermont, impose a corporate-level income tax on the sum of the nonresident shareholder's distributive share of S corporation income. Other states will impose a similar tax unless the nonresident shareholders file a consent with the state agreeing to report and pay tax. Failure by a nonresident shareholder to report and pay tax with respect to some states will also result in an S corporation income tax. California requires the consent of nonresident shareholders to be taxed on S corporation income sourced within the state and the corporation to pay estimated taxes on behalf of the nonresidents.

A state generally will require residents to report their entire pro rata share of S corporation income on their resident state return. Some states, e.g., Alabama, Oklahoma, and South Carolina, however, only require their residents to report their share of S corporation income that is sourced within the state. Multistate S corporation shareholders generally must report and pay tax to any other state in which the S corporation income is apportioned and allocated.

In most states, the credit for taxes paid to nonresident states with respect to S corporation income wil be limited to those taxes which are paid directly by the shareholder. An income tax paid directly by the S corporation will generally not be allowed as a credit against a shareholder's state income tax liability.

Income Tax Bases

The states generally use some part of the Federal taxable income formula for a starting point in calculating state taxable income. In most cases, the starting point is either Federal adjusted gross income or Federal taxable income. Each state has its own adjustments to that amount in determining state taxable income. Two states, Rhode Island and Vermont, use a resident's Federal income tax liability as their tax base, and a third, North Dakota, has an optional tax calculation that uses that amount. As noted earlier, two other states, New Hampshire and Tennessee, limit their tax base to interest and dividend income. Exhibit 1 illustrates the various tax bases used by the states in calculating taxable income.

Two common adjustments made by states in arriving at state taxable income relate to interest income from government securities. First, Federal law precludes states from taxing interest income derived from Federal obligations 31 U.S.C. Sec. 742. Second, while the Federal tax system exempts interest on obligations issued by states or their political subdivisions and instrumentalities, the states themselves will generally tax such interest income exception to this rule is that each state exempts from taxation interest income derived from its own obligations, and most states also exempt from tax interest on other governmental obligations issued from within the state.

Several states, e.g., Alabama, Iowa, Missouri, Montana, North Dakota, Oklahoma, Oregon, and Utah, permit a deduction for Federal income taxes paid in determining state taxable income. The deduction is generally limited to the amount of Federal tax attributable to income apportioned and allocated within the state only. In addition, some states permit individuals to deduct some amount for employment taxes paid in determining state taxable income.

An individual's Federal itemized deductions are generally fully deductible in the computation of state taxable income. Some states may limit or disallow certain itemized deductions, however. Most states allow a standard deduction in lieu of itemized deductions. State standard deduction amounts vary greatly from Federal amounts and, in some cases, may be stated as a percentage of state adjusted gross income, with a maximum dollar limitation. Other states do not allow either itemized deductions or standard deductions due to the particular manner in which state taxable income is computed.

State income taxation of capital gains and losses generally parallels that of Federal tax treatment. That is, a net capital gain is fully taxed and a net capital loss is deductible only to the extent of $3,000 annually (with an unlimited carry forward of excess losses). A few states, e.g., New Jersey and Pennsylvania, do not allow for any deduction, either currently or as a carryover, for a net capital loss. Finally, some states, e.g., Massachusetts and South Carolina, provide preferential tax treatment for long-term capital gains.

Tax Rate Structures

State tax rate structures also vary greatly from state to state. Excluding those states which compute tax liability as a percentage of the taxpayer's Federal tax liability, five states have a marginal tax rate of 10% or more. In most cases, the states have progressive tax rate structures. A few states apply a flat or proportional tax rate, however. Some states have a different rate structure for nonresidents, while others use a gross-up method of tax calculation for nonresidents that reduces the benefit of any progressive rate structure. The accompanying chart illustrates the maximum marginal rate for each state and whether each state's rates are progressive or flat.

Planning Considerations

State income tax planning for individual taxpayers should begin with a review of all the taxpayer's economic activities, including those activities conducted through partnerships and S corporations, to identify and correct noncompliance problems. The accounting fees associated with maintaining full compliance are insignificant when compared to costs associated with coming into compliance under the dures of an audit in addition to the penalties and interest assessed for non- compliance.

Nexus and residency issues should be reviewed frequently. In some cases nexus is very easy to establish. Individuals are well advised to conduct their business and other economic activities with caution so that undesired nexus can be avoided. In addition, many states have aggressive enforcement campaigns in place to reclassify nonresident taxpayers as residents. Individuals may need to take action to maintain their intended state of residency or to avoid the unintended establishment of residency in other states. Such actions may include ensuring documents such as voter's registration, driver's license and automobile registration, as well as telephone listings, reflect the intended state of residency. Having the terms of a will drafted under the laws of that state is also a prudent step.

Once an individual's business and other economic activities have been identified and nexus issues resolved, opportunities may exist for reducing the individual's total state income tax burden. Of principal concern is the credibility of nonresident taxes against the individual's resident state tax liability. Double tax traps exist in the context of noncreditable taxes such as those paid by an S corporation to a state which does not recognize the S corporation election. Effort should be made to arrange an individual's business and other economic activities to minimize the amount of income apportionedXand allocated to states with high marginal tax rates. Only by continually monitoring both an individual's activities and state tax laws, can compliance be assured and state income tax savings be achieved.