Title: Navigating the Gray Zones: State Income Taxation of Nonresident Individuals in 2025

Introduction: A New Era of Complexity

As state revenue departments grow increasingly aggressive in enforcing their jurisdiction over cross-border earners, nonresident individuals find themselves at the center of intensifying scrutiny. The days of clear-cut state taxation—residents taxed on all income, nonresidents taxed only on in-state income—are rapidly fading. In their place, a complex and uneven web of rules has emerged, riddled with gray areas that challenge both taxpayers and practitioners alike. From multi-state wage allocations to the sale of business interests, and from deferred compensation to the limitations of resident credits, state income taxation for nonresidents in 2025 has become a labyrinth with numerous traps.

Resident vs. Nonresident Taxation: The Foundational Divide

The foundational rule remains: resident individuals are subject to state income tax on all income from all sources, whereas nonresidents are only taxed on income that is derived from or connected with the taxing state. However, as work arrangements, compensation structures, and investment vehicles have evolved, so too have state tax policies. Remote and hybrid work models, in particular, have created significant compliance challenges, with many states now reevaluating how and where income is sourced. Compounding this are states seeking to capitalize on the gray zones—asserting taxing rights over transactions or services with tenuous in-state connections.

The “Convenience of the Employer” Rule and Its Expansion

One of the most contentious developments in recent years is the expansion and reinterpretation of the “convenience of the employer” rule. Traditionally used to determine wage sourcing for remote workers, this doctrine allows a state to tax income earned by a nonresident working out-of-state if the work is performed for the employee’s convenience rather than out of necessity. States such as New York, Connecticut, and Delaware have long enforced versions of this rule, but others, including New Jersey, Nebraska, and Alabama, have recently adopted similar provisions or retaliatory versions. These laws often result in double taxation, with both the state of residence and the state of the employer claiming taxing authority over the same wages. For example, a Delaware resident working remotely from Colorado for a Delaware-based employer might find that both Colorado and Delaware consider the same income taxable under their respective rules. In such cases, absent statutory relief or a resident credit mechanism, the taxpayer faces full taxation in both states.

Wage Allocation and the Remote Work Dilemma

Wage allocation for nonresident workers has become equally thorny. Most states still rely on physical presence tests to determine in-state workdays, using day-count formulas to apportion compensation. However, the practical application of this method is complicated by inconsistent definitions of what counts as a workday. Questions remain about how to treat weekends, holidays, partial workdays, and travel days. In the remote work era, these ambiguities have grown more pronounced, particularly when a taxpayer’s work is location-independent or spans multiple jurisdictions. Moreover, even states that follow physical presence rules may deny tax credits for taxes paid to states with conflicting sourcing approaches, leading to complex and often inequitable results.

Deferred Compensation and Stock Options: Sourcing Across Time

The treatment of deferred compensation and equity-based income raises additional concerns. Severance payments, bonuses, and stock options earned during periods of multistate employment are typically subject to apportionment, but states differ on the look-back periods and allocation methods. New York, for instance, uses a three-year average based on compensation in the year of termination and the three prior years. Minnesota requires taxpayers to look back across the entire span of employment. This can significantly affect sourcing, especially for long-tenured employees who relocate before receiving deferred compensation. For stock options, states use different metrics to calculate income attributable to in-state work: some use the period between grant and vesting; others, grant and exercise; and still others rely on multi-year averages. The lack of uniformity can result in disproportionate tax liability or disputes over the applicable sourcing period.

Business Sales and Investment Income: Evolving Rules for Pass-Through Entities

The sale of business interests introduces further complications. Traditionally, states did not tax nonresidents on gains from the sale of intangible property like stock or partnership interests. This rule aligned with constitutional principles limiting a state’s ability to tax out-of-state income. However, states like New York and Massachusetts have adopted aggressive positions targeting sales involving pass-through entities. If a nonresident sells an interest in a partnership or S corporation that operates within the state, the gain may be apportioned based on the business’s in-state activity, even if the seller was a passive investor. New York, for example, applies apportionment factors to gains realized through IRC §338(h)(10) elections, installment sales under §453(h), and even sales of partnership interests when the underlying entity owns New York real estate exceeding 50% of its asset base.

Massachusetts briefly pulled back from this approach in the 2022 VAS Holdings decision, where its Supreme Judicial Court held that a nonresident could not be taxed on gain from the sale of a non-unitary LLC interest. However, the state is now pursuing legislative changes to override that decision, signaling a policy shift toward taxing such gains regardless of whether the taxpayer has a unitary business connection. In the Welch case, the state went a step further by attempting to tax the gain on corporate stock sold by a nonresident founder, arguing the gain was compensatory due to the taxpayer’s involvement in the company. Although that ruling is under appellate review, it reflects a growing willingness by states to recharacterize capital gains as taxable income based on a taxpayer’s role in the business.

Resident Tax Credits: Narrow Protection and Double Tax Traps

For taxpayers facing multistate exposure, the resident credit for taxes paid to other states is often the only protection against double taxation. Unfortunately, the structure of these credits is narrow and inconsistent. Most states grant credits only for tax paid on income that, under their own rules, is considered sourced to the other state. In California, for instance, the credit applies only to income “derived from sources within” the other state using California’s sourcing rules. This means that even if another state taxes a transaction, California may not allow a credit if it would not have sourced the income similarly. In In the Matter of Buehler, the California OTA denied a credit for taxes paid to Massachusetts on the sale of an LLC interest, reasoning that the income was not sourced to Massachusetts under California’s sourcing rules. Although the OTA acknowledged the double taxation, it held that the credit statute was narrowly drawn and did not provide relief.

Similarly, carried interest remains a thorny issue. Because it is typically treated as intangible income, states like New York do not allow credits for taxes paid to other states unless the income is tied to a business, trade, or profession conducted there. Taxpayers receiving carried interest as part of a compensation package from a fund operating in another state may find themselves taxed by both jurisdictions, without relief. Courts have offered conflicting guidance on whether and when carried interest qualifies as sourced income, making it an ongoing area of risk.

Conclusion: Navigating the Gray Areas with Strategic Precision

As we enter 2025, the taxation of nonresident individuals remains deeply unsettled. The remote work revolution, aggressive state enforcement, and diverging statutory frameworks have combined to create a compliance environment fraught with uncertainty. Practitioners advising mobile professionals, executives, and investors must carefully navigate state-specific rules, analyze sourcing methodologies, and proactively structure compensation and transactions to mitigate risk. In many cases, the gray areas have become the rule, not the exception, requiring both a detailed understanding of state tax law and a strategic approach to income allocation, documentation, and planning.

© 2025 Jeanette Moffa. All Rights Reserved.