How to Determine State Source Income for Tax Purposes

State taxes aren’t just about where you live—they also depend on where your income is earned. Each state has its own rules for determining taxable income, which can be confusing if you work in multiple states, move during the year, or have business operations across state lines.

Understanding how states determine source income is essential to avoid unexpected tax bills or double taxation.

Residency and Domicile

Where you live and where you are taxed are not always the same. Residency is often based on the number of days spent in a state, while domicile is about intent—where you consider your permanent home. Some states, like California and New York, apply a 183-day rule, meaning if you spend more than half the year there, you are considered a resident for tax purposes. Others, such as Texas and Florida, do not have a state income tax, making residency status less relevant.

Domicile is more subjective and depends on factors such as where you maintain a primary home, register to vote, hold a driver’s license, and have family or business ties. Courts and tax agencies examine these indicators to determine if you have truly changed domicile. If you move from New Jersey to Florida but keep a home in New Jersey, continue using a New Jersey bank, and return frequently, New Jersey may still consider you domiciled there and subject to its income tax.

Physical Nexus for Income

States impose income tax not only based on residency but also on whether a taxpayer has a sufficient connection—known as nexus—to the state. This typically arises when earning wages, operating a business, or providing services within a state’s borders. If you work remotely for an out-of-state employer but occasionally travel to the company’s office in another state, that state may claim a right to tax a portion of your earnings. Some states, like New York, enforce a “convenience of the employer” rule, taxing remote workers if their job could theoretically be performed at the employer’s in-state location.

For businesses, physical presence creates nexus when an office, warehouse, or employees operate within a state. Even temporary activities—such as sending employees for client meetings or trade shows—can trigger tax obligations. California has aggressive enforcement, considering economic activity within its jurisdiction as sufficient grounds for taxation. Public Law 86-272 provides some protection, limiting states from taxing businesses whose only presence is soliciting sales of tangible personal property, but this does not apply to service-based income.

Independent contractors and gig workers must also consider where services are performed. If a consultant based in Illinois travels to Indiana for a client project, Indiana may require income tax filings. Some states have reciprocity agreements, such as those between Maryland, Virginia, and Washington D.C., allowing residents to pay tax only in their home state despite working across borders.

Allocation for Part-Year Residents

When someone moves from one state to another during the year, they must determine how much of their income is taxable in each state. Most states require part-year residents to file a return that divides their earnings between the time spent in each location. Some states use a direct tracing method, taxing income based on when and where it was earned, while others apply a proportional approach based on the number of days spent as a resident.

For wages, states typically rely on payroll records to determine earnings before and after the move. If an individual relocates from Georgia to North Carolina in July but continues working for the same employer, their W-2 should reflect state withholdings for both states. However, if an employer does not automatically adjust withholdings, the taxpayer may need to manually allocate the income on their tax return. Stock options or bonuses can complicate allocation if they were earned over multiple years or tied to work performed in different states.

Investment income and retirement distributions are generally sourced to the taxpayer’s state of residency at the time of receipt. A person who sells a home after moving may need to report capital gains in the new state, even if the property was located elsewhere. Rental income remains taxable in the state where the property is situated, regardless of residency changes. New York and California have strict enforcement policies and may audit returns to ensure proper income allocation, especially for high earners.

Apportionment for Multi-State Entities

Businesses operating in multiple states must determine how to divide their taxable income among jurisdictions, a process known as apportionment. Most states follow a formulaic approach, typically using a three-factor formula based on sales, payroll, and property. However, many states have shifted to a single-sales factor model, taxing businesses primarily on revenue generated within their borders. This benefits companies with significant physical assets and employees in high-tax states but minimal in-state sales, as it reduces their tax burden in those jurisdictions.

The Uniform Division of Income for Tax Purposes Act (UDITPA), adopted in some form by many states, provides a standardized method for apportionment. Under this model, a company’s taxable income is divided based on the proportion of total sales, payroll, and property located in a state. For example, if a corporation earns $10 million nationwide, with 30% of its sales, 20% of its payroll, and 25% of its property in a particular state, its taxable base in that state would be determined by averaging these percentages. However, states that use a single-sales factor would ignore payroll and property, taxing only the portion of sales occurring within their boundaries.

Out-of-State Employment Earnings

Earning income in a state where you do not reside can create tax obligations that many employees overlook. States generally tax wages based on where the work is physically performed, meaning nonresidents who commute or temporarily work in another state may owe taxes there. Some states, like Pennsylvania and New Jersey, have reciprocity agreements that allow residents to pay taxes only in their home state, but many do not, requiring careful tax planning to avoid unexpected liabilities.

For remote workers, tax treatment varies depending on state laws and employer location. Some states, such as New York and Delaware, apply the “convenience of the employer” rule, taxing employees based on where their company is located rather than where they physically work. This can result in double taxation if the employee’s home state does not offer a credit for taxes paid elsewhere. Conversely, states like Arkansas and Connecticut have adopted more employee-friendly policies, taxing remote workers only if they physically perform services within the state.