A reciprocal agreement is:
An agreement between two states that determines which state can tax compensation income.
An agreement between two states that limits taxation of income for residents of the other state to unearned income only.
An agreement between two states that determines the residency status of a taxpayer.
An agreement between two states that says each will tax the income of a resident of the other state.
The correct answer and explanation is:
The correct answer is: An agreement between two states that determines which state can tax compensation income.
A reciprocal agreement is a tax arrangement between two states where each state agrees not to tax the income earned by its residents in the other state. These agreements are designed to simplify the tax filing process for individuals who live in one state but work in another. Typically, the agreement allows the employee to pay taxes in their state of residence rather than the state where they are employed. This helps to avoid the complex situation where a taxpayer would be required to file income tax returns in both states, potentially leading to double taxation.
In practice, these agreements often apply to compensation income, such as wages and salaries. Without a reciprocal agreement, individuals might be required to pay income taxes in both states: the state where they live and the state where they work. Reciprocal agreements prevent this by specifying which state has the right to tax the compensation income. For example, if someone lives in State A and works in State B, State A would have the authority to tax their income if there is a reciprocal agreement in place, even though the individual works in State B.
It’s important to note that these agreements generally apply only to compensation income and not to other types of income such as interest, dividends, or rental income, which may still be taxed by both states. Additionally, reciprocal agreements do not generally determine residency status, nor do they limit taxation to unearned income. Instead, they focus on simplifying the taxation process for individuals working across state lines.