State Income Tax Implications for Washington Residents
Washington doesn’t have an income tax, but that doesn’t mean that businesses and business owners shouldn’t be thinking about potential state income tax issues.
September 12, 2019
By David Volkert, State and Local Tax Supervisor
In general, state income taxes are a residency-based system. For example, a resident of ‘State A’ has 100% of their income subject to ‘State A’s’ income tax. If that resident of ‘State A’ earns income in ‘State B’, ‘State B’ will subject the income earned in ‘State B’ to ‘State B’s’ tax.
Some of you may have picked up on a potential issue with this system - that’s two states subjecting the same income to tax. In order to prevent state double taxation there is a tax credit system where (typically) ‘State A’ would give you credit for the tax you paid to ‘State B‘ against the tax you owe to ‘State A.’ Under this system, the only time you would pay more tax by working in ‘State B’ is if ‘State B’ had a higher income tax rate than ‘State A.’
Because Washington lacks an income tax, working a job in another state and commuting home to Washington would have a substantial impact on your income tax bill. 0% to any rate is a substantial tax increase! But where this disparity is even more apparent is if you are a partner/owner in a multi-state partnership or other flow-through type entity.
Like within the Federal income tax system, these flow-through entities are not directly subject to income tax, rather their owners are subject to income tax on the portion of income earned in that state. Mere ownership of these flow-through entities will subject you to tax in these other states. This wouldn’t be the end of the world if you lived in a state with an income tax; you would be trading tax in one state for tax in another state. But Washington has no income tax to claim credit against.
How are the taxes collected?
Furthermore, states have a variety of regimes designed to ensure the state actually collects taxes from out-of-state flow-through entity owners. Some regimes are largely voluntary, such as a composite tax filing - where the owner can elect to have the flow-through entity pay the owner’s tax on their behalf. Others require the flow-through entity to withhold from the owner a portion of their income, like wage withholding, and are more mandatory.
Consider the Impact
All of this means that whenever you consider expanding to a new state, you should consider the impact that state income tax will have on your business model.