New Law Offers Tax Relief to Military Families

A new federal law may have a big impact on the state income tax bills of clients who are married to members of the Armed Services. Under the new law, these clients may be able to avoid paying income taxes in the state they are currently living in.

As a general rule, under most state laws, an individual who spends more than 180 to 183 days in a state is deemed to be a resident of that state. However, a member of the U.S. Armed Services (a “servicemember” in the language of the bill) does not automatically become a resident of the state where he or she is stationed.

Instead, the servicemember can remain a resident of his or her home state. This means the servicemember can continue to vote in the home state and be treated as a resident for other purposes.

Significantly, it also means that the servicemember’s military income is not subject to tax in the state where he or she is stationed. The Servicemembers Civil Relief Act specifically provides that compensation of a servicemember for military service shall not be deemed to be income for services performed or from sources within a tax jurisdiction of the United States if the servicemember is not a resident or domiciliary of the jurisdiction in which the servicemember is serving in compliance with military orders.

A new law that was enacted late last year extends similar relief to the spouses of servicemembers. The Military Spouses Civil Relief Act (P.L. 111-97) provides that a military spouse won’t be treated as having lost residence in one state or acquired residence in second state solely because he or she moves to the second state to accompany a servicemember spouse to a new duty station. Moreover, the law says that a military spouse’s earned income can’t be taxed by a state if the military spouse is living and working in the state solely to be with the servicemember spouse. Instead, the military spouse remains a resident of his or her original state for tax purposes.

Example: Jenna and Jordan, a married couple, are legal residents of Texas when Jordan enlists in the military and is sent to a duty station in California. Jenna moves with Jordan to California, where she finds a job with a software company. Result: Under the new law, Jenna’ s income from her job is not subject to tax in California. Instead, Jenna remains a “tax resident” of Texas (which, conveniently for Jenna, has no state income tax).
The new law applies retroactively to calendar year 2009. Consequently, military spouses whose 2009 earnings qualify for exemption from tax under the new law may be eligible for a refund.

REFUND OPPORTUNITY. According to the Federation of Tax Administrators, states plan to deal with 2009 withholdings by having eligible military spouses file a claim for refund directly with the state. So there will be no need for retroactive withholding adjustments. In fact, a number of states have issued preliminary guidance on how eligible spouses can claim refunds of 2009 withholdings. For example, California has indicated that eligible spouses can file for refunds using FTB Form 540NR, California Nonresident or Part-Year Resident Income Tax Return.

For 2010, eligible military spouses can claim exemption from income tax withholding in the duty station state. You can check with the state tax authorities and alert clients who are eligible military spouses to the proper procedures for submitting withholding exemption requests. Some states have indicated that eligible spouses should use existing exemption certificates, while other are revising their forms or developing special forms to be used for this purpose.

As a general rule, to qualify for the exemption, three basic conditions must be met:

The military spouse currently resides in a state different than the state of his or her domicile.
The military spouse resides in the state solely in order to live with the servicemember spouse.
The servicemember is present in the state in compliance with military orders.
However, the Federation of Tax Administrators makes it clear that each state will make its own interpretations of how and when the new law applies. The Federation says state regulations will differ on whether the military spouse and the servicemember have the same original domicile for the law to apply. For example, preliminary guidance from California indicates that a military spouse will be considered a nonresident for tax purposes if the servicemember and spouse have the same domicile outside California and the spouse is in California solely to be with the servicemember who is serving in compliance with military orders.

By contrast, both Maryland and New Jersey have indicated that a military spouse qualifies for exemption from state income tax if the servicemember is present in the state in compliance with military orders, the spouse is present in the state solely to be with the servicemember, and the spouse maintains a domicile in another state.

Key Point: The new law does not create an overall exemption from all state income taxes for military spouses. The exemption from tax by a duty station state applies only to wages or income from services performed in the state. It does not apply to non-service income, such as income from rental property. Moreover, a military spouse remains liable for income tax (if applicable) in his or her home state — including tax on income earned in the duty station state.
Under the Servicemembers Civil Relief Act, a servicemember declares a “legal residence” for purposes of withholding state income taxes from military pay. However, it remains to be seen whether states will require a residence declaration from military spouses or will require reporting of earnings to the military spouse’s state of residence. A task force of states is currently collaborating to establish common guidelines for implementing the new law.

Reach Out to Clients

So you can reach out to military spouses explaining the refund potential for 2009 and the withholding exemption opportunity for 2010, we have prepared a client letter that you can adapt as needed.