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Reduce Your State Tax to Zero with an Inversion

Americans who read the news even poorly know large corporations use tax inversions to avoid massive amounts of taxes due the U.S. government legally. What most Americans don’t know is they can use the same strategies on a smaller scale to never pay state income tax again. My guess is fewer than ten accounting firms in the U.S. utilize these strategies to protect their clients from state taxes. Today I will show you how to use the tax inversion without the help of an accountant.

A tax inversion happens when a major corporation buys a smaller company in a low or lower tax country or municipality. The acquiring company then moves its headquarters to the acquired company’s country. We will not get into the minutia of corporate tax law as it is not the focus of this post. We will use techniques of large corporations where they are applicable to small businesses, landlords, and retired taxpayers living or working entirely within the U.S.

Individuals living and working in a single state will not find value in this discussion. Each state has its own set of tax laws to reduce income taxes a lot, but what we are interested in today is driving the state income tax to zero for business owners and landlords with a few simple moves. Your circumstances will determine how you structure your finances to avoid state income tax.

Small Business

High tax states like California, New York and Wisconsin place a massive burden on business owners of those states. Competing against rivals in low-tax or no-tax states is difficult to impossible.

To facilitate these strategies you will require a corporation (regular or S) or a LLC treated any way you want for tax purposes. Corporations and LLCs are entities and considered persons in the eyes of the law. This sets up some unusual opportunities.

In tax inversions by large public corporation the inversion is handled between divisions within the same company. For small business owners it would work better to have separate entities.

The best way to explain this is with an illustration. We will use my accounting practice, called TPAS here, as an example. Wisconsin is a high tax state and it is darn cold in the winter. We will use a simple example of a company with $1 million in profit for easy figuring.

Your friendly accountant is paying the dirty bastards, ah, I mean the state government, ~$75,000 per year in state taxes on his $1 million in profits. TPAS is located in Wisconsin. All clients are either in Wisconsin or send their stuff to Wisconsin for processing. Therefore, all work is being performed in Wisconsin, subjecting all profits to Wisconsin income tax. The goal: move those profits to a no income tax state.

The owner of TPAS prefers living in Texas. It is warmer and he gets to keep more of his income. The owner of TPAS-WI can’t move his business to Texas without losing most of his clients. As his advisor I tell him he should move to Texas (make Texas your domicile), but keep TPAS right where it is. His company’s profits will flow through to him personally, but because the business is in Wisconsin, Wisconsin income tax is still due.

Our friendly business owner has family back in Wisconsin and he is more than welcome to visit as often as he likes. But I recommend he start another business in Texas, an LLC: TPAS-TX. TPAS-WI will no longer e-file tax returns. Instead, they will farm out the e-filing to TPAS-TX for a fee. This is a high margin product that will in effect transfer a large amount of profit to TPAS-TX. For argument, we will assume TPAS-WI prepares 15,000 tax returns a year and pays TPAS-TX $50 each to e-file and process the acknowledgements from the IRS. TPAS-WI now has $750,000 less profit and TPAS-TX has the same amount of additional profit.

Now a process call “earnings stripping” is applied. TPAS-TX will loan TPAS-WI $3,125,000 for working capital at an 8% interest rate. The interest is $250,000 per annum and deductible by TPAS-WI and reported as income by TPAS-TX.

We have now successfully stripped 100% of the Wisconsin profit and applied it to TPAS-TX. I assume we have two LLCs treated as S-corporations here. The profits from both LLCs will flow to the federal tax return exactly as in the past; the tax will remain the same. However, there is no profit to report to Wisconsin, only Texas, therefore there is no tax owed Wisconsin. Since Texas has no income tax, state income taxes were eliminated.

Art by Tabatha Davis

Art by Tabatha Davis

It is a bit more complicated in real life, but you should now understand the basic mechanics of the structure. The biggest issue is the domicile of the owner/s. The state where the owner lives will be the state that is paid income tax on ALL profits; a credit is given for state taxes paid to other states.

My artistic talent is less than hoped for so I had Tabatha Davis draw the illustrations for me; she is an accountant in my office. There can be more moving parts (and probably will be) in a real life situation. Large companies already do this, but the little guy really needs to as well. The illustrations help visualize the process of getting money from a high-tax state to a low-tax state.


I have several clients who would benefit from this so I hope they are reading. In this scenario we will assume the taxpayer lived in New York City once upon a time and now lives in a state with a lower tax rate. While living in NYC she purchased investment property.

You will only need one LLC for the income properties this time. The LLC can be and should be a disregarded entity. This means you will report your rent income and expenses on your personal tax return for the property as you always have. (You never put real estate inside an S-corporation or an LLC treated as an S-corporation for tax purposes.)

The process is simple. The LLC does NOT have a mortgage with the bank and you as guarantor as most people structure investment properties. Instead, you get the loan, secured by the property, and you lend the money to the LLC. The interest rate charged the LLC can be higher than the bank mortgage rate to you as long as a reasonable rate is used.

Here is what happens. We will assume you have a $1.5 million property with a $1 million mortgage. The interest rate from the bank is say 5%. You charge the LLC 8% on your loan to it. This is called a wrap-around mortgage and common in the real estate industry.


Art by Tabatha Davis

Because real estate has unique tax laws to start with, your property has only $30,000 in profit after depreciation and other expenses. This is still enough profit for property held in NYC by someone living elsewhere to pay a hefty tax. Because the additional mortgage interest is $30,000, the LLC has no profit to report to NYC or NY. You still need to file a return, but that is the end of it.

The $30,000 additional interest to you over the bank mortgage interest is taxed at the tax rate where you live. You can keep the LLC perpetually in debt to you to maximize the ongoing deduction. The federal tax return will report interest income where there were rental profits before; the tax is the same for most taxpayers.

There is a tendency for people to want to charge a bookkeeping fee or management fee to the LLC with income properties. It is a bad idea since this turns rental profits into earned income subject to self-employment or payroll taxes. There is no need to get fancy with income properties. Mortgage interest should easily handle the shifting of income to your low-tax domicile taxing authority without any further need to reduce the tax at the property location.

Retired People

Ten or so years ago a retired wealthy client walked into my office who wanted to reduce his state income tax. He had a home in Wisconsin and was moving here from Illinois. I encouraged him to get a home in Texas and make Texas his domicile. He bought a small home in Texas as his primary residence, owned a second home in Wisconsin and Florida. By avoiding Wisconsin income taxes the Texas home was paid for with one year of tax savings.

Moral of the story: It is okay to visit or even own a home in a high tax state, but never make it your domicile.


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