4 red flags that can trigger a residency audit
Tax season may be over, but that doesn’t mean your clients’ chances of being audited at the state level disappear. There are circumstances, factors, and financial and life events that occur throughout the year that could become red flags that trigger state residency audits. If the taxpayer is a high-net-worth or high-income earner, the likelihood of being audited becomes even greater.
As states seek to fill revenue gaps and recover tax revenue losses, the risk of state residency and non-residency audits continues to grow. The risk has become so great that tax experts say that if you’re a high-net-worth or high-income individual and you move or create a similar type of red flag, there is a 100 percent chance that you’ll be audited by the state. With this in mind, here are four risk factors to monitor for your clients throughout the year.
1. Moving to low- or no-income tax states
As people continue to flee high-tax states like New York, California, Connecticut, New Jersey and Illinois, and are moving to low- or no-income tax states like Florida, Arizona, Wyoming, Texas and the territory of Puerto Rico, high-tax states are losing a significant amount of tax revenue. Millions of dollars are at stake, and as a result, this trend is prompting states to become more aggressive with domicile, residency and non-residency audits, and they are conducting these audits with a higher level of scrutiny.
If your client is in the highest income tax brackets and they move, consider an audit a certainty and help them be prepared. One tip is to minimize the number of demonstrable ties to the original state. This will show that the taxpayer has indeed moved and intends to stay in the new state. In addition, help your client collect as much data about their day-to-day whereabouts as possible so that they can prove that they did indeed move and are spending the majority of their time in the new state. When it comes to audits, the taxpayer is “guilty until proven innocent” and the burden of proof is on the taxpayer.
Collecting this data does not need to be as onerous as it once was. You’ve probably heard the same stories that we have about people trying to establish and prove their domicile and residency -- shoeboxes full of paper receipts, handwritten diaries, strategic credit card swipes, and even people posing for photos in front of their homes holding the day’s newspaper. Today, there are ways to automate location tracking and digitize the collection of data to show proof of domicile and residency. Many taxpayers don’t know about this technology, putting tax advisors in a strong position to bring something to their clients.
2. Purchasing and traveling between multiple permanent abodes
Some taxpayers own multiple homes in different states and travel back and forth between them. Retirees, snowbirds, consultants, professional athletes, or anyone who moves between permanent places of abode in two or more states should know that their chances for residency audited are higher - especially if they’ve previously been flagged.
This is where residency comes into play. In the first example, the first hurdle to clear is changing domicile, which, for high-net-worth or high-income people, will almost certainly trigger an audit. Once that audit is completed -- and hopefully won! -- the taxpayer then needs to be concerned about residency and non-residency audits, which can occur repeatedly and at any point after changing domicile.
Let’s use the example of a snowbird couple who changed their domicile from New York to Florida but still own a home in New York to which they frequently travel. They would need to be careful about how many days they spend in New York. If they go over 183 days, New York will consider them New York residents and will tax their income. New York may decide to audit them even if they don’t go over 183 days. As previously discussed, the taxpayer is guilty until proven innocent and must prove that they spent less than 183 days in New York. The snowbird couple must always be counting days, tracking their travels and collecting data points in case they get audited. It’s much easier to start doing this as soon as possible -- and to automate and digitize this activity -- versus waiting to be audited.
3. Moving shortly before selling a business
Taxpayers who move and then sell their business shortly after will raise a red flag, especially if they move from a high-tax state to a low- or no-tax state. The state which they left, which stands to lose out on the taxes of the sale of their business, will almost certainly audit them and ask them to prove that their move was legitimate.
One thing auditors will look for in this scenario is whether the owner is still showing involvement in the business. For example, maintaining consistent communication with new management long after the sale will be perceived as still being involved in the business. Auditors will also look to see if the owner continues to travel to and from the state in which the business was sold. Again, this highlights the importance of keeping accurate travel and location records, and having reliable data that can be used as proof in an audit.
In line with the trend of people moving to more tax-friendly states, there is also a trend of business owners relocating their businesses where property and income tax rates are low. This can also be tricky. Filing for a change of address will draw the attention of tax authorities and will (with high certainty) trigger state auditors to pursue an investigation to verify that business operations have actually changed.
It is also important to note that the actions of the executives of a business could put the organization at risk. Red flags raised by executives, especially if they are in association with the business as discussed above, will likely draw attention to the organization. This should be considered if the business is a partnership or larger business involving more people. A tax attorney or other expert who specializes in moving businesses from one state to another should be consulted prior to moving.
4. Moving shortly before selling a large amount of stock or other asset that results in a capital gain
Similar to the previous example of selling a business, it is not uncommon for people to move to a low- or no-tax state before selling a large amount of stock or other asset that results in a taxable capital gain. This will create a red flag and, for high-net-worth individuals, will likely trigger an audit. Say, for example, that your client bought stock while residing in New York State and then sells that stock while claiming to live in Florida. New York State will most likely come after the taxpayer in a quest to tax the capital gain on the asset.
As with the other risk factors discussed, the best way to minimize risk is to establish proof and legitimacy around the move. The taxpayer needs to show that they are not trying to cheat the system. It is recommended that they create a digital record of their location data leading up to the financial event, through the financial event and well after the event. Proof is the only thing that wins audits, and reliable data provides that proof.
Although tax season is behind us, your clients should know that the chance of being pursued at the state level for a residency audit is still likely at any time during the year. Knowing the high-risk factors discussed in this article and also in this highly detailed guide will make your clients more informed and better-prepared for domicile, residency and non-residency audits.
Auditors have many tools at their disposal to make their case. Many taxpayers are ill-equipped to fight these audits because they use paper-based or dated and flimsy forms of evidence. More importantly, they do not proactively collect evidence leading up to and through the financial and life events described above. This leaves them flat-footed and playing catch-up during the audit.
Today, there are ways to automate and digitize a taxpayer’s record of location and residency. This digital record can then be used as verifiable proof in an audit. Tax advisors are well-positioned to see the risk factors, warn their clients, and help them be prepared for potential audits.