Compensation and Benefits Bulletin
An expatriate assignment is an exciting undertaking, but with the move come many uncertainties, including taxes. Americans face a special challenge because we’re taxed on worldwide income, unlike our colleagues who are citizens of other countries and able to break tax residency when working abroad. Although the United States provides its citizens and residents working away from home with a number of concessions, including foreign earned income exclusions and foreign tax credits, these additional considerations can greatly complicate annual tax compliance. The highest tax rates apply at the federal income tax level, and that is the primary focus of planning, but don’t overlook state income tax considerations, which can also contribute to the financial success of an assignment.
Currently all but nine states impose a tax ranging from 0% to 12.3% on earned income. States impose tax when they have sufficient nexus, or connection, to activities that give rise to income. An employee is generally taxed in the state where services are rendered, so an employee working in Georgia is subject to Georgia income tax on his or her compensation income. States also tax income from other activity within their borders, such as gains from the sale of property or other business transactions. Most states tax their residents on worldwide income, allowing credits when double taxation occurs, so a South Carolina resident working in Georgia is also subject to South Carolina tax on Georgia wages. In the right circumstances, the taxation of a state resident moving to a foreign country can be significantly reduced, but it’s important to remember that each state differs and has its own set of rules, regulations, tax rates and criteria for imposing tax.
When sending an employee overseas, you need to understand two sets of rules: where the employee has residence and is domiciled. These two concepts differ greatly, yet many times they’re interchanged, which can be a costly mistake if the employee lives in a domiciliary state.
Domicile can create unexpected costs
Domicile is the jurisdiction where a taxpayer intends to live or return to, even if he or she currently lives elsewhere. It has an underpinning of permanence and is strongly based on the taxpayer’s intent. Generally a person can have only one domicile at a time, and one is retained until another is acquired. States that tax individuals on the basis of domicile often continue to impose tax even after a taxpayer relocates overseas, which can be an unexpected cost.
Residence is the place a taxpayer currently lives, regardless of any intent to remain there. It is possible, even common, for a person to have a residence in one state or country and a domicile in a different state or country. States that tax on the basis of residency are less likely to impose individual tax on worldwide income after an international relocation.
Assignees who reside in a state that taxes based on domicile will continue to be taxed on worldwide income during the assignment unless the state rules provide some type of relief, such as the following:
- Taxpayers can be considered nonresidents while they’re residing overseas (usually called a “bright line” or safe harbor test based on the number of days outside the country).
- Credits or deductions are available for taxes paid to a foreign country.
- Foreign earned income can be excluded under Internal Revenue Code Section 911 or an income tax treaty.
Three domiciliary states where employees will be taxed on worldwide income without concessions are Alabama, New Jersey and Pennsylvania (2014 forward).
For states that allow concessions, the rules vary by state and must be carefully analyzed. For example, California and Maine have similar rules for a safe harbor test based on time spent outside the state. However, California requires the absence from the state to be for employment purposes, whereas Maine doesn’t. Employees from either state who are on foreign assignment for three years should be able to break their residency, which means they will be taxed on only income earned in the state during their assignment, resulting in significant cost savings. Other states with safe harbor rules include Connecticut, Delaware, Idaho, Missouri, New York, Oklahoma, Oregon and West Virginia.
When evaluating state tax costs, consider the following additional complications.
- There is usually a better chance of breaking residency if the taxpayer’s family also relocates.
- The taxpayer has college-age dependent children who remain in the state to take advantage of resident tuition rates.
- The family has two incomes, and one spouse doesn’t relocate but continues to live in the family home.
- A family maintains a principal residence that isn’t converted to a rental property during the assignment and is frequently used by family members during the year.
- Part of the family repatriates before the safe harbor requirements are met.
State rules present tax savings opportunities for employees relocating overseas, but the rules differ in every state and require careful planning.
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