The Indiana Department of Revenue recently released Indiana Information Bulletin No. IT28 that, among other things, states that California is no longer a “reverse-credit” state effective for the 2017 tax year.
In the past, Indiana has had reverse credit agreements with the following states: Arizona, California, Oregon and Washington D.C. Indiana residents who earn income in these “reverse-credit” states are required to include the income from that state on their Indiana income tax return and then file a nonresident return for the state where the income was earned and claim a credit for the taxes paid to Indiana on that same income. This is opposite (or reverse) of the way income earned in states without a reverse credit agreement is taxed. Indiana residents who earn income in states without reverse credit agreements are allowed a credit on their Indiana income tax return for the taxes paid to other states on the income earned outside of Indiana.
The announcement that California will no longer be a “reverse-credit” state is good news to Indiana owners of pass-through entities doing business in California, namely those that are included in California composite tax returns. California has one of the highest individual income tax rates in the country (maximum tax rate of 12.3%). With California a “reverse-credit” state, Indiana residents included in a California composite return pay the highest marginal tax rate on their California source income while receiving no credit for that tax on their Indiana income tax return, effectively paying a state income tax rate of 16.6% on their California source income. Starting in 2017, Indiana residents included in a California composite return will receive a credit equal to the Indiana income tax rate multiplied by the income taxed by both Indiana and California, reducing the effective state tax rate on their California source income to 9%.
Indiana taxpayers with significant amounts of California source income will still want to evaluate whether it is advantageous for them to elect out of a California composite return and file a California non-resident return. This allows them to pay California income tax at the graduated rates, however this increases their tax filing burden.