When it comes to your taxes, "location, location, location" may not be everything, but it sure can make a difference. In Oregon, single filers pay a whopping 11% on top of their federal taxes for incomes exceeding $250,000 a year (if your income is over $125,000, you only need to pay $10.8%). Just across the Columbia River in Washington state, however, residents and businesses pay exactly zero in state income taxes (Washington also has no corporate income tax, whereas Oregon's rate is 7.9%). This means both individuals and businesses crossing the river could save significant amounts, although some Washingtonians like William Gates Sr. are campaigning for a state income tax.

The uncertain economic climate is making those cost differentials even bigger. For example, recent tax hikes in New York state to plug a budget deficit have brought New York City's combined local and state income tax top rate to roughly 12.5%. California's chronic budget woes have contributed to a top rate of 10.55%. Meanwhile, states like Pennsylvania (with a 3.07% flat income tax) and Nevada (with no income tax) enjoy considerable advantages (even though they also suffer budget woes).

So in tough times, it may seem alluring to relocate your domicile, your business, or both. But enjoying the benefits of a lower tax state means more than just picking up and moving across state lines. Generally speaking, income is taxed where it is earned by both people and businesses. So if you move your company's headquarters to a low tax state, you might continue to be taxed in your current state if you retain most of your operations there. If you move your family to a low tax state, meanwhile, you'll usually end up filing both where you live and where you work. The system avoids double taxation by giving you a credit on your resident state taxes for what you pay to your state of employment.

So what happens if it is difficult to associate income with any particular state, as is sometimes the case with interest, dividends, royalties or capital gains? This is an area where the state of residency can make a real difference in tax liability.
Most states' tax laws say revenue is not subject to apportionment; it is instead allocated to a company's home state if it is classified as "non-business income." Thus, if a business's home state has low taxes, it can reap a significant benefit from such income. It is important to remember, however, that with income from tangible property, the tax liability cannot be avoided simply by selling the property out of state; rather, taxes must be apportioned among the states to which it has a "substantial nexus."

A similar principle allows individuals who sell stock or other intangible assets to benefit from lower taxes in the state where they reside-which can be helpful in the case of capital gains taxes (more on the issue of residency shortly). At one time, public sector pensions posed a special problem. Even though they were intangible, they had a significant relationship to the state paying them. But federal law now provides that such pensions are taxed only in the state of residency.

Many taxpayers can also take advantage of tax reciprocity agreements. These are deals hatched between adjacent states that permit out-of-state workers to file returns and pay taxes only in their states of residence so they don't have to deal with the hassle of also filing to the state of employment (and ultimately paying most of the taxes there). Such agreements exist between areas with a large number of non-resident workers, between Washington, D.C., and Virginia, for instance, or between Pennsylvania and New Jersey, and allow workers to pay lower income taxes simply by moving their residence while keeping the same job. But tax reciprocity agreements remain the exception to the rule.  

Some Complications
As usual, however, the tax code contains some traps for the unwary.

Residency issues present some of the most common headaches. While most states automatically consider you a resident if you are present in the state for more than half a year, they will also consider you a state resident if your conduct demonstrates an intent to consider it your permanent home, or in tax jargon, your "domicile."

"There are cases where people have spent more than half of their time in Florida, but nevertheless have been found to be domiciled in New York," says Peter Faber, an attorney with the New York office of McDermott Will & Emery LLP. "Since Florida doesn't have an income tax, the taxpayer can take a significant hit."

Legally, there is nothing wrong with changing domiciles for tax reasons, but taxpayers often need to overcome two hurdles before reaping the tax benefits. First, the burden rests on taxpayers to prove that they have not been resident in a state for more than 183 days and to demonstrate their intent to change their domicile. They must keep careful travel records and collect objective evidence (such as changed voting registration and driver's licenses) of their intent to change domiciles.
Continued business operations in your old state, for instance, might constitute evidence that you haven't really left it behind.