March 13 (Bloomberg) -- With professional golfers and hedge fund managers talking about moving to lower-tax enclaves, states are stepping up audits on top earners who flee.
Several states including California and Maryland raised taxes on high earners last year, and Congress boosted federal levies on them. Families who look to change their domicile to a state with no income taxes such as Florida or Nevada open themselves up to years of scrutiny and possible litigation as local governments search for revenue.
“I look at some of these domicile audits almost as an archeological dig and a full physical including MRIs and CAT scans,” said David Scott Sloan, a partner who advises high net worth families at Boston-based Holland & Knight LLP. “What we’re seeing at least in Massachusetts is the tax authorities are not going quietly into the night.”
States are using automated programs to track down residents who say they have moved and may be keeping two residences, and officials are seeking to tax earnings on stock awards beyond their borders. In Minnesota, Governor Mark Dayton proposed a so-called snowbird tax that would lower the number of days a person spends in the state before having to file a return.
Some families are considering moving from high-tax states such as California and New York to a lower -- or-no tax -- state because tax rates are climbing, said Jim Steiner, president of Abbot Downing, a unit of Wells Fargo & Co. whose new clients generally have at least $50 million in investable assets.
Congress raised the top rate this year to 39.6 percent from 35 percent for taxable income above $400,000 for singles and $450,000 for married couples. Those same top earners saw the rates on long-term capital gains and dividends jump to as much as 23.8 percent from 15 percent.
Golf champion Phil Mickelson drew attention in January after saying he would make some “drastic changes” because of higher taxes. Voters in California, where he lives, approved an increase in the top state income tax rate to 13.3 percent from 10.3 percent.
Hedge fund manager John Paulson of New York is exploring a move to Puerto Rico, Bloomberg News reported this week, citing four people who spoke with him. Puerto Rican law lets new residents pay no local or U.S. federal taxes on capital gains.
Top earners who change domicile have to prove they have changed their life if they are audited by their former state.
The audit and appeal process can take years, said Phil Olsen, a partner at Burns & Levinson LLP in Boston who litigates state and local tax cases. Olsen has 14 such cases pending now, nine of which are in litigation and five in the audit process. Families often reach a settlement and pay some taxes before agreeing to a date when they are no longer considered a resident, he said.
“It feels to clients like states are making you pay an exit tax,” similar to how the U.S. government assesses those above a certain income level who give up their citizenship only at the state level it’s not statutory, said Sloan, chairman of the private wealth group at Holland & Knight.
Taxpayers filing a part-year-resident tax return or one that indicates they are no longer residents can trigger an audit, Sloan said.
“That typically puts the first red flag up,” he said.
A new trend is the attempt by states to capture more revenue from equity awards even of people who have moved out, said Cara Griffith, legal editor of Tax Analysts’ weekly publication dedicated to state and local taxation.
Federal law prohibits states from taxing certain retirement income of non-residents such as distributions from 401(k) and individual retirement accounts. Other equity-based compensation including restricted stock units or stock options don’t have those limitations, said Griffith.
“States are starting to look at how they can tax that money,” if it was earned while people were working within their borders, she said. “States are getting aggressive across the board. Anywhere they think they can get money they’re going to grab it.”
Revenue departments in states also have gotten better at using technology to tap information in Internal Revenue Service databases as well as credit reports to E-Z Pass records to track down former residents, Griffith said.
Audits done by the Massachusetts Department of Revenue more than doubled in 2012 to 45,887 from the prior year with assessments on taxpayers totaling $79 million, according to the state’s bureau of desk audits. The jump was largely due to automated programs, spokeswoman Ann Dufresne said.
New York state’s tax department uses tools for audits including analytics, third-party data and IRS referrals, spokesman Geoffrey Gloak said. “The department uses its business analytics to review every return and identify those that have the greatest likelihood of compliance issues,” he said.
In Minnesota, Dayton proposed a snowbird tax to require those in the state more than 60 days rather than 183 to file a return.
“He feels that if individuals live in the state for part of the year, they should help pay for the services that they enjoy,” spokeswoman Katharine Tinucci said in an e-mail.
Sloan gives high net worth clients who move a checklist of actions such as obtaining a new driver’s license, cancelling memberships to local organizations in the prior state and transferring investments so they are based in the new locale.
“You have to change your life,” Sloan said. “You can’t just say I’m spending 183 days here and not 183 days there.”
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