Should you move to a new state for tax savings before selling your startup?

Peyton Carr Contributor

Peyton Carr is a financial adviser to founders, entrepreneurs and their families, helping them with planning and investing. He is a managing director of Keystone Global Partners.

What you need to know about moving to save on taxes

Paying less in taxes isn’t as simple as packing up, skipping town, and resurfacing with a new address in a tax-friendlier state.

As tempting as it may be, you can’t keep a foothold in Silicon Valley while dipping your toe in the Gulf Coast — and still save on taxes. The kids may be unable to stay in their Manhattan private school while you relocate to Miami.

As tempting as it may be, you can’t keep a foothold in Silicon Valley while dipping your toe in the Gulf Coast — and still save on taxes.

Living in both states won’t save you here; when it comes to taxes, you must be all-in at your new address, or you’ll likely owe taxes at your old address. Unfortunately, some may not realize this until after they have spent a lot of time, money, and emotional investment.

Every state has its own rules for determining your residency for tax purposes, and you will not be able to fly under the radar if you’re a high-net-worth individual or top earner. High-tax states like New York or California pay especially close attention to those in the highest tax bracket. If you stop paying taxes at the state level, chances are the state will notice and challenge your new residency claim.

In other words, your move is likely to trigger an audit.

In particular, California’s Franchise Tax Board is known to be vigilant in monitoring individuals who attempt to terminate their California residence, making it all the more crucial to thoroughly plan and document your move.

Additionally, it’s important to consider the complexities of community property laws, which may impact your tax exposure if you have a spouse residing in California, even if you move to a lower-tax state. Proper legal and tax advice is essential to navigate these complexities and ensure a smooth transition.

Many people mistakenly think that splitting time between states and claiming the more favorable tax jurisdiction is easy. But when you have the means to travel and maintain more than one home, this doesn’t mean you get to choose the domicile that works most favorably for you when tax time comes. Simply spending 183 days of the year outside your high-tax state isn’t likely going to shrink your tax obligation.

Even after leaving high-tax states like New York or California, it’s important to be aware of potential tax obligations tied to passive income sources within those states. For example, if you continue to have passive income from partnerships, investment properties, or other sources within New York or California, you’ll need to file a nonresident return and pay taxes on that income in those states.

Additionally, having passive income sources in your former state can increase the likelihood of a residency audit. As a result, it’s important to carefully consider whether retaining those investments producing state-specific income aligns with your overall financial and tax planning goals.

Preparing to move

If you’re considering a move to a lower-tax state, it’s crucial to plan ahead and be prepared. The more time you give yourself before your company’s exit, the better off you’ll be. We recommend making a clean break from your high-tax state several years in advance to ensure a smooth transition. It’s also wise to assume that you may be subject to a state tax audit, so keep meticulous records and be prepared.

Saying you were away isn’t enough; an audit will look for logs and calendars that track your whereabouts and activities throughout the year. And if you’re thinking of fudging it or estimating where you were and what you were doing at a later date, think again. Technology can track your exact location at practically any given time. For example, credit card purchases and phone records have been the “gotcha” in far too many audits for taxpayers to claim ignorance.

Fortunately, technology can come to the rescue when it comes to keeping track of your whereabouts for tax purposes. There are day-tracking apps that can record and organize your location data, making it easier to prove your residency in the event of an audit. It’s important to note that the burden of proof is on you — the states typically take the position that you were there every day you can’t prove you were somewhere else.

Hence, the value of good contemporaneous record-keeping, with or without an app, is vital. For founders, using these apps can simplify the process and provide peace of mind as they accurately document their residency status.

With the help of your tax advisor, it’s up to you to be familiar with the subjective domicile test for your primary state — the measure of your true, primary residence. Remember, the state will review various items to determine where your “intent” to live is and whether your move is considered permanent or temporary. Some examples that are considered include:

Where you are registered to vote.
Where your vehicles are registered.
Establishment of bank accounts.
Location of clubs, gyms, and other organizations where you hold membership.
If you own a home in California or have keys to an apartment in New York.
Where you spend your weekends and holidays.
Where your spouse and children live.
Location of your place of work.
Where you own a business or most often conduct business.
Location of your doctors’ offices.

Your actions and how you present yourself should be consistent with a permanent and not a temporary move. Have you told your friends and neighbors that you’re moving? Did you set up a forwarding address at the post office?

Have you taken steps to register to vote or find a new dentist? Not everything is a dealbreaker, but anything that can be considered inconsistent with a permanent move can potentially count against you.

Common mistakes to avoid when moving for tax purposes

Even with the best intentions, some founders find themselves in hot water trying to save on state tax by moving. The possibility of a residency audit means you must be diligent about checking off all the right boxes; there are no safe shortcuts or workarounds.

Here are examples of common mistakes to avoid:

Owning a home in New York or California while renting in Florida.
Exaggerating travel day estimates, which can be easily discovered via technology and financial records.
Owning a business in New York or California and living in Florida, claiming to work from home when you’re actually in the office often.
Suddenly traveling more often just to say you spend more days out of the state without actually moving your home base.
Claiming you live in Florida when your spouse and children live in New York or California.
Putting off selling your home in your old state without renting it out.
Moving too close to selling your company or equity without fully establishing your new residency.

Simply put, moving states to save on taxes is a legitimate strategy, but you must be committed to moving forward and demonstrate that you intend to make it a permanent move to a new domicile.

How close to a transaction can you move?

There is no cut-and-dried answer to this question. In high-tax states like California and New York, where domicile is being disputed, an important factor will be your intent behind the move and proving that this is a permanent move rather than temporary. For example, you will not have a good case if you move down to Florida from New York a week before your company is sold.

It’s also important to consider certain technical rules when it comes to timing your move relative to a transaction. For instance, if there’s a signed contract to sell your company with no major contingencies left to clear between the signing and closing dates, the effective date for the transaction is likely the signing date, not the closing date — regardless of the time lag between the two dates.

Additionally, some states, such as New York and California, have specific rules regarding stock option exercises. These rules may treat option exercises as being sourced back to the state where you were living when the options were earned. So, if you earned options while living and working in New York, you may still owe New York state tax when you exercise those options, even if you’ve since moved to a lower-tax state like Florida.

Contrarily, If you planned in advance, established a domicile in Florida, moved your company headquarters down to Florida, sold your New York home, bought a new home in Florida, then sold your company two years later, you’d likely have a much better chance at proving your intent.

Long-term benefits of moving to save on taxes

Even if you are unable to relocate and time your move before selling your company, it’s important to recognize the significant impact that a long-term move to a tax-exempt state can have on the compounding of your wealth over time.

By residing in a state without income tax and avoiding the tax drag on your investment portfolio, you have the opportunity to maximize your financial growth. Even if you end up paying taxes in your high-tax state due to the timing of your move and company exit, it may still be worthwhile to evaluate whether a future relocation for long-term tax optimization makes sense.

When moving is not an option

For founders who realize a move is not in the cards, there are some other advanced planning strategies for state tax optimization that I mention here that can include using one or more trusts. Additionally, anyone expecting an exit larger than $10 million should be planning ahead and at least consider the options available for some advanced exit planning.

The bottom line

Deciding whether to move to a lower-tax state is a complex decision and should be approached with a strategic mindset. It’s essential to carefully weigh the pros and cons, which can be both quantitative and qualitative, before making a final decision. In some cases, relocating can be a smart move, but it’s crucial to consider all the factors involved.

If you’re already considering a move down the line, syncing it with a potential future exit could be a wise decision. However, it’s important to keep in mind that moving states to save on taxes associated with an exit requires careful planning and preparation well in advance.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.