Basic Tax Math – Part 7 – State Taxation, Domicile and Your License

The place most travelers and tax practitioners stumble when dealing with multistate taxation, is separating the concepts of permanent residence / domicile and a tax residence. The two are entirely different yet frequently referred to synonymously because they are often at the same place.

A permanent residence is a legal concept, often referred to as one’s domicile. If you want to know someone’s permanent residence, just ask to see their driver’s license, car registration and voter registration. Each of these connections tie an individual to a state, and more particularly, a community within the state. The permanent residence, domiciliary state has the right to tax an individual’s global income regardless of where they earn it and how many days they spend within the state.

This concept of permanent residence and domicile spills into  the understanding of “residency” as it is applied to professional practice licenses. If a registered nurse holds a compact license, their primary license which grants the right to practice in other compact states is based on their permanent residence and domicile.  In granting this license,  it is expected that the nurse will continue to reside  in the state.  This is the reason so many state tax agencies and professional practice boards  share information with one another.  The licensing agency  checks a tax return as a way to confirm a taxpayer’s continued  residence in the state and right to hold a residence license – the state tax agency will use the roster of professional practice licenses  as an hunting/discovery tool tool to ensure that those  benefiting from residency in the state  are paying their share of taxes.

The cross-referencing of professional practice licenses and state tax returns started many years ago with California leading the way. Gradually,  it spread to almost every state in the nation.  About six years ago we did a survey  of every  nursing board  and state tax agency in the nation, asking whether they actively cross referenced data the for their own purposes. The answer was unanimous – they can and will when necessary.

This is why it is imperative for a multistate traveling professional  to file their state returns with the proper residency status. Every tax return leaves a cookie trail. When it comes to the states , the last thing you want is a series of annual returns that have no domiciliary consistency. Otherwise, the cookie trail can meander into the state taxation abyss where eager trolls endowed with the power to assess tax delinquencies await to harvest tax dollars from those that wander.

Basic Tax Math – Part 6 – State Taxation

While dealing with federal taxes is hard enough, anyone who works in more than one state has a greater challenge juggling all the different state tax returns.

How are taxes computed when you work in more than one state?  Well on paper,  it’s pretty simple, however, it is a great source of confusion for most.

The rules run like this : your home state will tax your global income  regardless of where you earned it and regardless of whether you earned any income in your home state. It doesn’t even matter if you were gone for an entire year and never set foot in your home state- the fact that you maintain a legal domicile in your home state is sufficient basis for that state to tax your global income .

At the same time,  when you work in  another state and labor on its soil,  that state has the right to tax all of your income earned within its borders.

Now.  Are you being taxed twice on the same income?  Yes.  But, there is relief.  Your home state is obligated to give you a credit for the tax that you pay to the work state on the same income . Many states will call this,  “credit for taxes paid to other states”.

To illustrate:  say you live in a state that has a 5% tax . You work a temporary assignment in a state that has a 2% tax. Since the tax you pay to the work state is less than the tax you would pay to your home state on the same income, you will have to make up the 3% difference.

Let’s look at this illustration in reverse : say you live in a state with a 2% tax and work temporarily in a state that has a 5% tax. Since you pay more to the work state than you would in the home state, there is nothing due to the home state, since the credit brings the tax liability for that income to zero.

I will explore other nuances of multistate taxation in later posts.

Basic Tax Math – Part 5 – How Withholding is Calculated

As mentioned in Part 4, the amount withheld for income taxes is based on the data you provide on Form W4 and the state equivalent – if any. How is the actual amount determined from this data?

The withholding “formulas” start with the rate of earnings for each individual paycheck extrapolated to an annual amount. Assume you are paid bi-weekly, which is 26 checks per year. If you make $2K in the biweekly pay period, the withholding formula starts with the assumption that you make $52,000 a year. Based on $52K a year, the formula then calculates the amount of tax that someone who is say “Single with 2 exemptions” (as you note on your W4 form) would be liable for on that amount of annual income. It then divides that amount by 26 to get the amount to be withheld from your paycheck.

If you work overtime, the annual wage base used in the formula is increased and so is the required withholding for that level/rate of income. Conversely, if you work less than full time in a payroll cycle, the withholding will be based on a lower annual rate of earnings as determined by that isolated pay period rather than the amount needed had you worked a full week of wages all year.

With this in mind, you can imagine what happens when a tax payer works multiple jobs with different rates and hours. Working a part time job results in less withholding by percentages on those paychecks than a job with full time hours. Since your tax is based on an annual “pot” of earnings, all of the withholding must aim for the withholding that will cover total wages for the year. It may be necessary to request withholding at the “single” rate despite the fact that you may are married. The W4 form doesn’t declare your marital status, it just allows you to set your withholding at a higher rate by using a different filing status, exemptions and specified additional amounts with each check.

Basic Tax Math – Part 4 – Why Do They Tax $X Out of My Check?

The short answer is ………. you told them too!

Seriously

Now don’t get the bright idea that you can tell them to withhold nothing (called declaring exempt) and wait till the end of the year and pay it at once either. That amount they take out – the “withholding” that we discussed in the earlier posts – is an estimated tax payment based on your income. Remember, it is not the TAX, it is your ESTIMATED payment.

You cannot change withholding for SS and Medicare as that is a flat rate and technically not an income tax – it is an employment tax. However, the Federal and state withholding is yours to determine. Remember that W4 for you had to fill out declaring your marital status and the number of exemptions you are claiming? That document determines your Federal withholding AND most of the states use it.

Some states like CA and AZ have their own form. AZ doesn’t go by marriage and exemptions –  it wants you to tell them the percentage of your gross to withhold. CA follows the Federal marriage and exemption format but with its own twist and there are a few others that require their own form.

In the next post we will discuss how to fill the form out.

Basic Tax Math – Part 3 – What is “Withholding”

When you receive a paycheck, you will see amounts “withheld” from your wages for Federal and State income tax and for Social Security / Medicare. Sometimes these are coded with acronyms like FIT, Fed W/H, S W/H, FICA, Med etc. Regardless of the label, it is an amount withheld from your wages for  estimated tax payments.

If it was not withheld, you would have to write a check to the IRS, Social Security and the State Tax Commission with each paycheck. Withholding makes it simple but is removes the pain of having to actually write the check and appreciate how painful it really is.

Withholding for Social Security and Medicare is set at 6.2% and 1.45% – This withholding is the actual employment tax, so there is never an excess amount taken from your pay unless you have more than one job and make something over 120K between the jobs.

The Federal and State Withholding are ESTIMATED payments based on the W4 form that you complete with your employer. Most states use the Federal W4 form to determine their withholding, but some like AZ and CA have their own.

Since WITHHOLDING is an estimated payment and not the actual tax, one can overpay their tax obligation during the year. When that happens, the taxpayer receives a REFUND when they file their return. If the withholding is too LOW for the income, the taxpayer will OWE on their tax return.

When someone works overtime or gets a bonus, the withholding % is higher than the regular pay due to reasons that I will discuss in later blog posts. When someone says that they are TAXED more when they work overtime or receive a bonus, they show that they misunderstand the system. The WITHHOLDING is more. WITHHOLDING is not the TAX. It just estimates the TAX due for the income earned on the paycheck. The actual TAX is determined when you file your annual tax return.

Basic Tax Math – Part 2 – Marketing Big Refunds

No – I don’t do this for clients

Nor do I make convincing commercials like this

I once drove by a tax preparation office in the suburbs of a large city giving away free leather jackets to those that walked in with their tax documents. The entire mass of humanity in their office were donned in brown leather jackets ….. They were all promised BIG refunds for wearing the uniform..

The first audit I ever represented for a client was one where the taxpayer was audited to produce evidence against a tax preparer that was under investigation for fraud. The CID (IRS Criminal Investigation Division) was following a gentleman that had an office within a few minutes of a large hospital that used many travel nurses. He marketed himself as a professional that understood travel healthcare providers and could guarantee a BIG refund. And get BIG refunds he did …… for himself. The preparer would provide the client a return with one set of numbers to sign off on, but would file another return with inflated deductions. He would pocket the difference by having his fee deducted from the refund – his fee was equal to the difference in the two returns plus a normal fee. All of the clients got what they expected – he got more. CID raided his offices while he was in Las Vegas. I found out by calling local businesses to see if his operation was legit.

When I walked through the original return with the client, she did not know where many of the numbers came from. “He made them up I guess”. The return the client was provided already had a significant refund as a hook. But the IRS transcript of the return that was filed did not match the copy the client had for their records.

Whenever you are promised a BIG refund, its no different from being promised the doubling of a stock that a broker is promoting. Its all a gimmick. A real tax professional knows that a refund means you paid in too much tax withholding for the income you earned. Not due to some sort of magic or adding mythological relatives to your list of dependents. A true tax professional is looking for the lowest tax liability both with the return they are preparing and the future returns they may do for the client. I constantly tell clients to manage their tax, not their refund. Consistently big refunds are usually a sign of poor financial management. The best refund is no refund. The best return is nothing due, nothing refunded.

Whenever a prospective client asks: “Can you give me a big refund?” I should be asking, “Can you tell me why you have more tax withholding than you need?” Of course, this is when we encounter the shroud of mystery thrown around taxes. Some really believe it is magic…..

Basic Tax Math – Part 1

I have two adopted boys. We have been a family for over two years now. My oldest is 13 years old at the date of this writing. He has learned English very quickly even though he is still struggling with some nuances of our weird language. One year ago he told me he wanted to learn how to do taxes thinking it would be fun to sit at a computer all day and play video games, after all that’s all I do, right?. In fact, he pestered me about it a month after his initial request. So I eventually sat down with him, made a fictitious W2, provided him the one page 1040EZ form and the 23 page instruction booklet that tells you how to complete a one-page 1040EZ form.

When he looked at the big instruction booklet, he wasn’t very interested in all of that reading.  So I threw it in the trash.  With a return this simple, all you need to do is read the instructions on the form itself.  He then took the W2  that I gave him and other than explaining some of the harder English words,  he went through each line of the return and completed it.  As you can expect, he was very proud of himself and  made mother know he could now do dad’s job and play video games all day.

The next morning while he was eating breakfast , he looked up from his cereal bowl and asked me in his thick European accent, “Dad?” …. “Yes son” … “When I have to do my first tax return ,will you do it for me?” …. “Yes, but you did perfectly fine  by yourself yesterday” … “I still want you to do it – its too complicated.”

Now,  he is only 13 years old,  but he  already manages his own checking account,  debit card,  investment account, and even his own eBay account.  He’s a serious saver as well.  I wanted him to learn this stuff early and even had him read a lengthy book  on how to buy stocks.  Something my grandfather did with me at the same age. Pretty good, I’d say.

I think this is something lacking today.  We don’t teach this stuff at home and our schools are too busy ushering the herd through the system.  When I was in 10th grade,  my United States history teacher offered  to teach each of us who had jobs how to file a tax return.  Four of us took her up on the offer. We brought in our w2s  and she walked us through the entire tax return in less than 10 minutes.  She gave a harder,  full class assignment to the rest where we had an extra 30 minutes  to ourselves after finishing the returns.  I was surprised how easy it was and we all talked about what we would do with our refunds.

Now granted, those are very simple returns that require very little  knowledge of the tax laws .  However,  I find that many people do not  understand the mechanics by which  taxes are withheld, paid ,and reconciled. As my son says, “its too complicated!” It really shouldn’t be. My next couple of entries will address this. Enjoy!

My two sons, oldest on the left

 

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