For founders who have tirelessly nurtured their companies from inception to success, the prospect of a liquidity event brings both excitement and complexity. As this pivotal moment approaches, residency planning emerges as a crucial consideration.
The choice of where to establish one’s residency prior to a liquidity event can have far-reaching implications regarding income taxes and personal financial goals. As such, many factors need to be evaluated when contemplating residency planning, including but not limited to the following:
- Understanding the source of compensation vs. capital gains
- State tax rates, including no- or low-income tax states and city and local taxes
- Conformation to IRC. Sec. 1202
- Trust planning
Compensation vs. Capital Gains
Compensation income generally is taxed where an individual performs the services, whereas capital gain income is taxed to an individual’s state of residency at the time of the sale. When equity compensation is involved, the sourcing rules can become complex because many states have different sourcing rules depending on the type of equity being sold and whether the equity represents compensation income or capital gain income. Make sure you are considering the type of income when implementing state income tax planning techniques.
State Tax Rates
States without personal income taxes allow taxpayers to significantly reduce their overall tax liability. Currently, the states without an income tax include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. In addition, some states have flat tax rates, such as Pennsylvania and Illinois. These states allow for easier and faster tax calculations. Finally, some states, such as New Hampshire, only have a flat tax rate on interest and dividends.
It is important to note that some jurisdictions have city or other local tax rates that may require separate filings. For example, New York City taxes residents up to 3.876% on gross income, and Philadelphia has wage, business income and receipts, net profits, and school taxes. Before moving to lower your tax rate, check to see if local tax rates apply.
Conformation to IRC. Sec. 1202
A hot topic is always Qualified Small Business Stock (QSBS). Most taxpayers check their eligibility for the QSBS exclusion at the federal level but fail to confirm if their resident state conforms to the federal exclusion. For example, jurisdictions such as Connecticut, New York State and New York City allow the QSBS exclusion, but jurisdictions such as California, New Jersey, and Pennsylvania do not. Some jurisdictions conform to the federal exclusion but modify the tax benefit, and some states conform to the federal exclusion only as of a specific date. If you plan to sell QSBS, you should consider the rules of your resident state before the sale.
Each state has different rules regarding the income tax of trusts. For example, Wyoming currently does not have an income tax, and Delaware does not impose income tax on income accumulated in and capital gains realized by an irrevocable trust if none of the trust beneficiaries live in Delaware. Even if a taxpayer lives in a high-income tax state, one should consider utilizing trusts, which can result in state income tax savings. Additionally, taxpayers can utilize trusts to stack or multiply the QSBS exemption for an added benefit.