As Baby Boomers ease into retirement, they are becoming a very mobile generation. Many are migrating to other states, not just in search of a sunnier climate — but also for tax planning considerations. We’ve just seen federal income tax rates drop to historic lows, with ordinary rates peaking at 37% and capital gain rates at 20%. But there is an important understory — your deductions for state and local taxes are now limited to $10,000 per year. Tax refugees If your state income tax rate is 10%, but you can deduct the state tax on your federal return, your effective […]
As Baby Boomers ease into retirement, they are becoming a very mobile generation. Many are migrating to other states, not just in search of a sunnier climate — but also for tax planning considerations.
We’ve just seen federal income tax rates drop to historic lows, with ordinary rates peaking at 37% and capital gain rates at 20%.
But there is an important understory — your deductions for state and local taxes are now limited to $10,000 per year.
Tax refugees
If your state income tax rate is 10%, but you can deduct the state tax on your federal return, your effective state tax rate is 6.3%. Now, it’s a firm 10%, which represents a tax rate increase of 58.7% over the 6.3%.
Meanwhile, many states have been struggling for tax revenue and have raised their income tax rates. Top-rate honors go to California, with a high rate of 13.3%. Hawaii is second at 11%. Then comes Oregon at 9.9% and Minnesota at 9.85%.
The tax laws triggered a migration out of high-tax states into no-income-tax states such as Washington, Texas and Florida.
But things can change quickly. Washington’s legislature is working on an income tax on capital gains. Contacts in Washington tell me it is likely to happen. Plus, they fear it will soon be followed by a general income tax.
Estate taxes
As important as income taxes are, you also have to think about your estate taxes. Seventeen states and the District of Columbia impose estate or inheritance taxes at your death.
The highest rate is Washington’s 20%, with several states coming in second at 16%.
I recently had a client ask about moving from Oregon to Washington to save taxes. Although he would save a lot of income tax each year, he would have to live 10 years for the income tax savings to offset his larger Washington estate tax.
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We also have to consider sales taxes, since our collector cars are tangible personal property that is commonly subject to sales and use taxes.
The highest sales tax rate in the country is 10.5% in parts of California. Many states exceed 9%.
Where to go?
It isn’t realistic to analyze every one of the 50 states, so the best idea is to focus on states where you are willing to live. Then it becomes a three-step analysis — what works for your business, what works for you and what works for your cars.
You may have to make a compromise.
States have been targeting business taxation recently. The new tax act’s reduction of the corporate tax rate to 21% seems to have made the states think there is money left on the table — ripe for the plucking.
Taxing your business
Most states tax businesses based upon the portion of their income that is deemed allocable to the particular state.
Traditionally, the income allocations were made using a three-factor test that averaged sales, payroll and property.
Generally, an in-state business would likely pay more tax than an out-of-state business. Say the in-state business made only 10% of its sales in the state, but had 90% of its property and 90% of its payroll in the state. The average of the three is about 63%, so the business would pay tax on 63% of its net company-wide income.
If the same business were based out of state, its in-state property and payroll would likely be near zero. The average of the three factors would then be under 4%, and it would pay tax to the state on only 4% of its company-wide income.
Some states have favored in-state businesses by shifting away from the three-factor approach and using only a single sales factor.
In our example, each company would be taxed on 4% of its company-wide income, putting in-state and out-of-sate companies on a par. That can be a very good deal for a company such as Nike, which is headquartered in Oregon. Oregon uses a single-sales-factor approach. Nike’s Oregon sales are miniscule, so very little of Nike’s income is taxed in Oregon. But a higher-than-average percentage of its property and payroll are in Oregon, which shifts income away from states that use the three-factor approach.
If your company is an LLC or S Corporation, then its income is taxed directly to you. That makes it all taxable in your state of residence, but you still pay tax in the states in which your company is deemed to have generated income using the same allocation approaches.
Your home state generally gives you a credit for taxes paid to other states — to avoid double taxation.
You have to be very careful here, as the states tax in a patchwork fashion. There is no requirement that exactly 100% of your business income be taxed by the states as a group. Based upon the different approaches, you can end up with, say, only 80% of your income taxed at the state level. However, there is no legal reason why it can’t end up being 120%.
Taxing you
Once you’ve nailed down where your business will be located, you can look at the options for where you can live. Obviously, if you’re retired, you can skip the first step.
Income taxes are typically the most important factor to consider. Moving to a state with no income tax is the Holy Grail, but that is not always possible.
Moving to a state with a lower tax rate can be valuable.
For example, our firm works with several longtime Oregonians who have second homes in Arizona. For them, spending more of their time in Arizona — and less in Oregon — can enable them to become Arizona residents and Oregon second-homers. That change doesn’t eliminate their state income taxes, but it cuts them about in half. And if they can move their business to Arizona, in whole or in part, the savings can be more dramatic.
Taxing your cars
Last is the question of where your cars will live.
Many states are friendly to new residents. For example, Washington allows new residents to bring their cars into the state without any sales or use tax. The exception is that you must have owned the car for at least 90 days before moving into Washington. This prevents you from saving tax by buying a new car in anticipation of the move.
But other states are less hospitable. For example, Louisiana allows you to avoid tax only to the extent that you paid sales tax elsewhere.
Montana
It is possible to title and register your cars in a state other than your state of residency. The states of greatest interest are Montana and Oregon.
Montana has become famous as an out-of-state car registration tax haven. Under Montana law, you can form a Montana-organized LLC, transfer your cars to the Montana LLC, and then title and register them in Montana. There is no sales tax, and registration fees are very low.
That sounds great, but once your Montana-registered car enters your home state, your home state’s law will require that you title and register it there. Although the Montana registration is completely legal under Montana law, it is simply illegal for you to drive the car in your home state without registering it there and paying tax.
Of course, many people just cheat.
If you are thinking of doing the same, bear in mind that many states have caught on to the Montana approach.
Multi-state residency
Montana can be useful if you and your cars don’t live together.
For example, if you live in California, a Montana LLC owns your cars, and your cars stay in a third state — then you should be okay.
California can’t tax the cars until they come into California. The third state likely won’t require registration there because most states only require their residents to register their cars there.
You do have to check the law of the third state to see if the presence of the cars might be the hook that requires registration and tax.
Oregon
Oregon can be useful because of an unusual provision in its law. You can register your car in Oregon — no matter where you live — so long as the car lives in Oregon.
It has to be stored in Oregon, and it has to return to Oregon every time you finish driving it. If you are willing to store your cars in Oregon, this is an appealing approach, as there is no sales tax and registration fees are very low.
Location is the key
The question boils down to where your cars are going to be kept. If they are kept in your home state, they have to be titled and registered there.
Note that I wrote “kept” — not “driven.” Bringing the car into your home state triggers the obligation to pay use tax, even if you never drive the car — and even if you never actually register it in your state.
If it is feasible to keep your cars in some other state, and not drive them in your home state, then it’s worth taking a look at Montana or Oregon registration.
If storing them in Oregon makes geographic sense for you, then the Oregon registration is the best bet. If they have to stay in some other state, then consider using a Montana LLC. ♦
John Draneas is an attorney in Oregon. He can be reached through www.draneaslaw.com. His comments are general in nature and are not intended to substitute for consultation with an attorney.