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.

Benefits
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.

Second, state tax liability based on residency is almost always a state legal issue alone. Without any federal involvement, residency decisions are left in the hands of state courts, which some lawyers believe are subject to an inherent conflict of interest in favor of the state that pays their salaries. The result can be double taxation and exposure to extra levies-such as New York City's 3.5% income surtax-only payable by legal residents.

Another issue that may prove to be problematic in the years ahead involves taxpayers operating a partnership or LLC in states where they aren't residents.

This issue would come up where there is divided residency: the partnership "resides" in one state, while one of the partners lives in another. In such cases, the partner needs to file two tax returns, one in the state where the partnership resides (and thus, where he receives income) and one where he himself resides. Again, in the simplest situation the partner would then claim a tax credit on his home state return for taxes paid to the state where the partnership is situated.

However, this scenario assumes two things. One is that the partnership's state imposes an income tax on the partnership (treating a partnership, in essence, as it would an individual). But some states don't. Instead, they tax receipts rather than income. There could be cases in which the partnership state imposes a gross receipts tax or franchise tax but the partner's home state imposes an income tax. It is then arguable that since the partnership hasn't paid any income tax, it would be inappropriate for the partner to claim a credit on his home-state income taxes.

There could also be complications if the partnership state imposes income tax on the entity level. In other words, instead of Partner Smith earning $100,000 from the partnership and reporting that income on his tax return in the partnership state, the partnership reports the income and pays the tax. Again, arguably Partner Smith could not claim a credit in his home state because he hasn't paid income tax himself, only the partnership (of which he is a part owner) has.

The problem ends up in the home state of the partner, which might not award him a credit. So he might be effectively (if not strictly) double taxed.

Business owners thinking about relocating also need to know whether the states they operate in use a "single sales factor" test or the "triple factor" test to apportion business tax liabilities. The triple factor test, which is still the law in more than half the jurisdictions, apportions a business's tax liability according to a formula based on its in-state sales, property holdings and payroll. The idea is that these three factors in tandem better represent a company's in-state presence than sales alone.

But states like Texas, Oregon and Pennsylvania use only one-factor sales. This is usually adopted to simplify corporate bookkeeping. But it can be a double-edged sword. If companies can concentrate their operations in single-factor states, they will pay lower taxes in the multi-factor states. If their operations are located more in multi-factor states, however, they will pay higher taxes there.

Another issue faced by businesses in the state tax arena is the increased interest of the states' departments of revenue in challenging companies' classification of income as "non-business" (in some cases, they are abolishing the non-business income category altogether). In most of the states that retain the distinction between business and non-business income, revenue will be subject to apportionment if it is earned in the regular course of trade or business or earned using property integral to regular business. While the first element is the source of some disputes, it is the second that has generated more litigation, as states increasingly claim that interest or dividends should be apportioned if the intangible property generating the interest or dividends was itself earned in the regular course of business.

"Sorting out business from non-business income can become extremely technical and complicated, especially since the method can vary from state to state," says Marvin Kirsner, a corporate tax attorney with Greenberg Traurig LLP. "It's something to consider when a company is seeking to expand or relocate."

Given these challenges, it is of course incumbent on both individuals and businesses to do their homework before deciding to move.