Tax & Estate Planning Talking with clients about state and local taxes

State and local tax considerations can shape decisions involving income, investments, business interests, property and wealth transfers. Yet the conversation between advisor and client about state and local taxes often begins too narrowly, with a comparison of income tax rates. Some advisors may not be having these conversations at all — which could be a missed opportunity. 

You can add value by helping clients see the whole picture, identify where state tax exposure may arise and bring tax and legal professionals into the discussion before a transaction or move is underway. Our state tax planning guide can help you start more effective conversations with clients. This article gives you a quick overview of how to use the guide.

Start with states where the client is connected

A useful first step is to map the client’s connections to different states. Where is the client domiciled? Do they maintain more than one residence? Work remotely for an out-of-state employer? Own real estate or a business elsewhere? These facts matter because residents are generally taxed on all income, wherever earned, while nonresidents generally pay tax on income sourced to that state.

Business owners may have additional exposure. Employees, property or sufficient business activity can create a nexus, a sufficient connection to a state for tax purposes. Apportionment rules then determine how much of a business’s income is taxable in each state. The owner’s residence is only one part of the analysis.

Trusts add another layer. Grantor-trust income is generally reported by the grantor and taxed based on the grantor’s residence. A non-grantor trust may be taxed based on factors such as where the settlor lived when the trust became irrevocable, where the trustee resides or administers the trust, where the trust earns income and, depending on applicable state law and the beneficiaries’ rights or distributions, where beneficiaries reside. State and local taxes should be a consideration when a client is establishing a trust.

Look beyond the headline tax rate

Income tax rates are important, but they do not represent the entire state tax burden. Some states also impose surtaxes on high incomes. Others impose estate or inheritance taxes, sometimes with exemptions well below the federal exemption. Property, sales, transfer and business taxes can materially change the comparison between two states.

That is why a client considering a move should compare the full tax stack at the destination, not just the income tax rate. The right comparison depends on the client’s income, assets, business activity, property ownership and estate plan goals.

Consider upcoming decisions

State tax planning is most useful when it begins well before a liquidity event or a change of residency. For a business sale or large stock transaction, possible strategies may include moving before the transaction, spreading gain across years through installment or staged sales, or making gifts of shares to family members or trusts in lower tax states. These steps generally need to be considered before a binding agreement is in place.

For pass-through business owners, another discussion point is whether the state allows a pass-through entity tax election (PTET). In states that do, the business may elect to pay the state income taxes at the entity level rather than having the owner pay the tax directly. This may allow the tax to be deducted federally without being subject to the individual state and local tax deduction limit.

Trust and estate planning may also create opportunities. Even if you don’t offer these services in-house, you can encourage clients to review with their estate attorney or CPA whether a trustee change, strategic distribution, lifetime gifts or state-specific estate planning could reduce state tax. 

Flag important state and local tax considerations

Several issues deserve special attention, and you can help flag them for clients. For example:

• State tax treatment may differ from federal treatment, so a federal result should never be assumed to apply automatically.  
• Deferred compensation, vesting equity compensation and remote-work rules may keep income taxable in a client’s former state of residence. 
• Retitling a home to a trust, entity or family member may trigger reassessment at current market value and increase the property-tax bill. 
• When it comes to taxes, relocation also requires more than a new address. A complete domicile change may need to be supported by housing, licenses, voter registration, schools, doctors, clubs, places of worship and a reliable record of where a client spends their time. The facts should consistently point to the new state. 

Ask questions that uncover planning needs

You do not need to provide tax or legal advice to have a productive conversation. Your questions can help reveal where specialized analysis is needed: Is a sale likely within three years? Is there deferred compensation or unvested equity? Where are the business’s customers and employees? Are there irrevocable trusts, and where do trustees and beneficiaries live? Does the client own out-of-state real estate? Where does the client expect to retire?

Before a move, sale or trust change, ask the client’s CPA for a written analysis that brings together the relevant federal, state and local tax considerations. That integrated view can help the client weigh trade-offs and make decisions before the available options narrow.