Income earned by a business is subject to state income taxes, with relatively few exceptions for states with no income tax. For businesses that operate in only one state, the regime is relatively simple–that is, all state-taxable income is generally taxable to the state in which the business operates. Challenges arise once a business begins operating in multiple states, requiring the business to “apportion” or assign a portion of its taxable income to a particular state according to its tax laws. The states have various ways of calculating the amount of taxable income derived from their state. It is important to note that each state is permitted to utilize a different methodology of computing state income tax so long as a comparable tax would be paid in other jurisdictions if the other state adopted the same rules for taxation. Understanding and keeping up with each state’s rules and ongoing changes can be a monumental task. However, there are some underlying concepts that can help navigate these state compliance complexities.
C Corporations & Pass-Through Entities
C corps pay state income taxes at the corporate level while, historically, pass-through entities—inclusive of S corps and partnerships—do not. As the moniker indicates, pass-through entities “pass through” income to be taxed on the individual owner’s tax return. Notwithstanding, both entity types must calculate multistate apportionment, whether to calculate state income tax at the entity level, in the case of C corps, or to report on state K-1s a pass-through entity’s individual owner’s state-apportioned taxable income.
The passage of the Tax Cuts and Jobs Act (TCJA) limited federal deductions of state and local taxes to $10,000. A majority of states implemented elective taxation at the pass-through entity level as a “workaround” to the TCJA-imposed limitation. The rules vary among the states, but the basic premise is that a pass-through entity may elect to calculate a state tax liability at the entity level, pay it, and receive a deduction on the entity’s federal tax return, and the owner individuals receive either an income subtraction or a credit against their state income tax liability on their individual returns. Although these relatively new state income elective taxes change the historical premise that pass-through entities do not pay tax, ultimately, state income taxes are still calculated at the individual level based on the state-apportioned taxable income provided to them on their K-1s.
Nexus
One of the first steps in determining whether a business’s income may be subject to a particular state’s tax laws is to determine whether the business has established “nexus” with the state.
The Commerce Clause of the U.S. Constitution has been interpreted to restrict a state’s ability to tax an out-of-state business without “nexus” or, in other words, a “connection” to the state. For decades, nexus was determined by a physical presence within a taxing state, such as the presence of a business’s property or employees. The Interstate Income Act of 1959, otherwise known as Public Law (P.L.) 86-272, codified the limitation of a state’s ability to assess income taxes when business activity within a state is limited to the solicitation of sales and orders of tangible property. Many states provide guidance in their regulations regarding how P.L. 86-272 will be applied in practice, including which activities are considered protected and which activities create a taxable presence in the state.
The 1992 U.S. Supreme Court decision in Quill Corporation v. North Dakota affirmed the physical presence standard concerning use taxes to achieve nexus under the Constitution. However, in 2018, the Supreme Court decided South Dakota v. Wayfair, Inc. in favor of South Dakota’s requirements for sales tax collection and remittance obligations on remote sellers with more than $100,000 in sales or more than 200 transactions within the state. This decision overturned the physical presence standard in Quill and allowed states to employ an economic standard to establish nexus and impose a use tax. It should be noted that several states had already employed economic nexus standards since 1993 following the South Carolina Supreme Court’s decision in Geoffrey, Inc. v. South Carolina Tax Commission. The ruling allowed the state to tax royalties derived from Geoffrey Inc.’s parent, Toys R Us, despite Geoffrey Inc.’s lack of a physical presence in the state. The U.S. Supreme Court refused to hear the case, waiting decades until Wayfair to establish the constitutionality of economic nexus and validating the South Carolina Supreme Court’s decision.
While the decisions in Quill and Wayfair specifically relate to state sales and use taxes, they have emboldened states to consider—and a few to implement—economic-based nexus standards to collect income taxes. P.L. 86-272 remains in effect and should offer protection to sellers of tangible property who merely solicit sales in other states and fulfill orders from outside the state.
Considering most businesses now have an online presence, it is not presently clear whether an internet site constitutes a “physical presence” within a state. The Multistate Tax Commission (MTC) has made it its mission to establish consistent tax policy among the states. While its statements are not legally binding, many states have adopted its positions and interpretations in administering their tax regimes. The MTC has proposed that a business’s online interaction with its customers is equivalent to having a physical presence within a state, which may or may not fall under the protections of P.L. 86-272. For example, post-sale assistance and the use of internet cookies may not be protected, while online stores where customers can make direct purchases of tangible personal property would be protected if the website has limited functionality.
Careful consideration should be given to P.L. 86-272, relevant court cases, and each state’s rules when determining if a business has nexus within a state. A regular nexus study should be performed to identify in which states a business should file. The rules and interpretations can be complex and varied, making the determination of nexus often the most difficult step in complying with multistate taxation. Tax advisors with knowledge and experience in navigating these issues can be a valuable tool for multistate businesses.
Apportionment Formulas
Once nexus has been established, businesses must apportion taxable income according to each state’s rules. Every state determines its formula for apportionment. In 1957, the National Conference of Commissioners of Uniform State Laws (now known as the Uniform Law Commission) established the Uniform Division of Income for Tax Purposes Act (UDITPA) to assist states in formulating their income tax regimes. UDITPA bifurcates income between business income and nonbusiness income. Business income is apportioned utilizing several factors, whereas nonbusiness income, e.g., interest income, is allocated to a specific state where it is sourced.
There are three primary apportionment formulas in use:
- A three-factor formula utilizing a business’s payroll, property, and sales in the particular state with all factors given equal weight
- A three-factor formula that places greater weight to sales within the state
- A single sales factor formula that only factors sales within the state
Three-Factor Formula With Equal Weight
This is the traditional apportionment method as created under UDITPA. Under this apportionment formula, a business would calculate the percentage of its payroll, property, and sales derived from a state, add up the percentages, and then divide the sum by three to determine the percentage of the income taxable by the state. For example, if a business has 20% of its payroll, 30% of its property, and 40% of its sales in Kansas, the state will tax 30% of its taxable income.
Three-Factor Formula With Greater Weight to Sales
States using this apportionment formula—say Arizona, for example—place greater emphasis on sales derived from the state to apportion taxable income. A business with 20% of its payroll, 40% of its property, and 50% of its sales in Arizona would give a double portion or 100% to sales. The sum of the percentage is then divided by four to calculate an apportionment percentage of 40%.
Single Sales Factor Formula
This formula is the most straightforward. If a business has 20% of its sales in Illinois, for example, the state will tax 20% of its taxable income. States are heavily trending toward the single sales factor formula as internet sales become a more dominant means to achieve multistate sales. As the physical locations become less necessary and telework becomes more prevalent, states are adopting heavier sales factor formulas to more accurately reflect a business’s presence within their borders, adopting an “economic”-centric approach as opposed to the historical “physical presence” standard.
Sourcing tangible property sales is fairly straightforward, with states generally sourcing to the state of ultimate destination. It is much less clear how to source services and other intangible sales under state law. States have adopted two primary methods to determine state sourcing of these revenue streams. Some states source the sales of intangibles where the cost of performance takes place, often the payroll cost incurred to perform a service or earn an intangible revenue stream. A growing majority of states invoke market-based sourcing and determine the sourcing of the sale based on where the benefit is received. Depending on the state filing footprint and location of payroll, the combination of market-based sourcing and cost of performance rules often results in sourcing or more or less than 100% of total sales. Consultation with state and local tax professionals is advised for clients with material sales of services or intangibles.
Strategic placement of a business’s property and payroll between states can help reduce state income tax liabilities. There are many other nuances among the states, such as elective alternative ways to calculate apportionment that may be more advantageous for businesses or mandatory alternative formulas required for certain industries or circumstances. Teaming up with a trusted tax advisor can help determine advantageous elections and assist businesses in complying with the variety of state apportionment requirements.
Considering the number of states and their ever-changing tax laws, it can be difficult for businesses to keep up with not only maintaining compliance but also determining certain tax advantages that may be contained therein. The State & Local Tax team at Forvis Mazars can be a helpful resource for any business seeking to navigate such complexities.
If you have any questions or need assistance, please reach out to one of our professionals.