State Income Tax

What Is State Income Tax?

State income tax is a direct tax levied by a state on your income. Income is what you earned in or from the state. In your state of residence, it may mean all your income earned anywhere. Like federal tax, state income tax is self-assessed, which means taxpayers file required state tax returns.

Understanding State Income Tax

Tax laws, rates, procedures, and forms vary widely from state to state. Filing deadlines also vary, but for individuals, state tax day usually falls on the same day as federal tax day, which is typically April 15. However, state filing deadlines were updated for the 2019 and 2020 tax years due to the COVID-19 crisis.

Taxpayers must file tax returns in each state and each year that they earn an income more than the state’s filing threshold. Many states conform to federal rules for income and deduction recognition. Some may even require a copy of the taxpayer’s federal income tax return to be filed with the state income tax return. 

As of the 2021 tax year, eight states have no income tax: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. New Hampshire taxes unearned income, such as interest and dividends, but it will end the practice as of Jan. 1, 2024.

Forty-one states and Washington, D.C., do have a state income tax. If you live in a state that levies an income tax, avoidance of it by working in a no-income-tax state is not possible. Your home state will continue to tax the income even though your earnings were made in a no-income-tax state.

Just like the Internal Revenue Service (IRS), states require taxpayers with income that is not subject to withholding, such as business or self-employment income, to estimate their annual tax liability and pay it in four quarterly installments. States will impose penalties and interest on taxpayers who fail to file and pay state income taxes on time and in full. Many taxpayers get a measure of relief knowing that states are barred from adjusting their state income taxes once the applicable statute of limitations has expired.

If you have income that is not subject to withholding, such as business or self-employment income, you must estimate your annual tax liability and pay it to the state in four quarterly installments.

Special Considerations

Working and living in different states

Most taxpayers live and work in a single state and file a resident state income tax return there. However, taxpayers who earn wages or income in one or more states other than where they live may be required to file state income tax returns in those states as well — unless, of course, a state is a no-income-tax state.

If, for example, you are an actor living in Jersey City, N.J., and you work on Broadway in New York City, do TV or movies in Los Angeles, and play a regional theater gig in Chicago, then you must pay taxes in the states of New Jersey, New York, California, and Illinois. Furthermore, your tax home is the general area of your main place of business. If you spend most of your time working on Broadway, then your tax home would be New York.

According to the IRS, to determine your main place of business, you must take into account the length of time you spend in the location, the degree of business activity occurring in the location, and the relative significance of the financial return from each location. However, the most important factor is the length of time that you spend in each location.

Returns in a state where you do not have a domicile will be filed as a nonresident or a part-year resident. Some states, often those that border each other, have entered into reciprocal agreements not to tax the same income. If no understanding is in force and your income will be taxed multiple times, then credits or deductions may be available as you file your state income tax return. If you telecommute, the rules can be even more complex. In such cases, it’s advisable to check with a tax expert before filing your taxes.

In an interesting situation, the state of New Hampshire sued the state of Massachusetts in October 2020 in response to a law enacted by Massachusetts earlier that year. Massachusetts adopted an emergency law that would allow the state to tax employees who previously commuted into the state but, as a result of closed offices during the COVID-19 crisis, were working remotely. This specifically impacted employees who were New Hampshire residents. New Hampshire does not tax wages, but Massachusetts has a 5% state income tax. In June 2021, the U.S. Supreme Court rejected New Hampshire’s challenge to the new Massachusetts law.

Depending upon the residency rules of the home state, expats may also still have a state filing requirement.

State income taxes on businesses

Some states impose an income tax on corporations, partnerships, and certain trusts and estates. These states frequently offer lower corporate rates and special exemptions to attract businesses to locate there. States cannot impose an income tax on a U.S. or foreign corporation unless it has a substantial connection, called a “nexus.”

Requirements for a nexus are different among states, but they generally include earning income in the state, owning or renting property there, employing people there, or having capital assets or property there. Even then, the income taxes imposed are apportioned and nondiscriminatory and require that other constitutional standards are met.