Does your company do business in multiple states? What does this mean from a tax perspective and how do you determine which states require tax returns? The answer to this question is different for each state, however, most states follow similar principles. By understanding these fundamental concepts, you can better prepare your business to meet state tax obligations and potentially develop a plan to create state tax savings. Please click below for more information.
If you have a company that conducts business in multiple states, you have likely faced the daunting task of researching state tax filing requirements and how to calculate income sourced to each state. This task becomes increasingly complicated with each additional state as every state has different rules regarding these factors. In this article, we will review the general concepts used by states to determine filing requirements and income apportionment.
A company must file a state income tax return for each state in which it has nexus. What is nexus? Nexus is the technical term used to define when a company is “doing business” in a given area or jurisdiction. A company is considered to have nexus in a state when it has a physical or economic presence. While the exact definition of nexus is different for each state, presence is determined based on the sales, employees, and/or property attributed to each state.
Apportionment is the process of allocating income or loss to each state. For tax purposes, apportionment is determined based on a ratio of sales, payroll, and property sourced to a particular state as compared to the overall total as reported on the federal return. This can become confusing because each state may have a different method of calculating their apportionment percentage based on one or more of the three factors (sales, payroll, and property). For instance, if a state includes all three factors evenly in their calculation, the state is using the three-factor apportionment formula. Conversely, if a state puts more weight on sales in the apportionment calculation, it is considered to be using the modified three-factor formula. Third, if a state uses only sales in calculating the apportionment percentage, then it is using the single-sales factor method. States have recently begun to change their apportionment calculations by putting more weight on the sales factor and many states have plans to move to the single-factor sales method. In 2013, California changed from the three-factor formula to the single-sales factor method.
Determining State-Sourced Sales: Market-Based vs. Cost of Performance
How do we determine the sales total to use in the apportionment calculation? States use one of two methods in calculating state-sourced sales: market-based and cost of performance. When market-based sourcing is used, the sales revenue is allocated to the state where the product or service is purchased. When cost of performance sourcing is used, revenue is allocated to the state where the product or service is originating from.
Because of the differences in apportionment calculations from state to state, companies may end up allocating more than or less than 100% of federal net income to the states. By understanding and taking advantage of these tax rules, businesses may have the opportunity for state tax savings.
Individuals with ownership in pass-through entities (i.e. Limited Liability Partnerships/S-Corporations/LLCs) may have the opportunity to elect to file a composite return in their non-resident states. A composite return is a tax return filed on behalf of electing owners which pays all tax on the income earned by the pass-through entity. Income tax is paid at the highest state tax rate; however, it relieves individual owners from the responsibility of filing personal tax returns for states in which a composite return is filed. This benefits the owners by greatly simplifying their individual income tax returns.
Multi-state business filings are a complicated topic with significant tax implications. If you are considering operating in multiple states, please contact your L&B professional at 858-558-9200.