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Income Tax and Sourcing

In the first of our state and local taxes (SALT) blog series, we took a look at the need for states to raise revenue through an increasing number of tax measures. We discussed how business entities are required to file taxes when they have established nexus, a direct or representational presence within a particular state or jurisdiction. Now we’ll take a closer look at corporate income tax nexus.

Most states impose some type of income-based tax, with the exception of Nebraska, Ohio (commercial activity tax – gross receipts tax), South Dakota, Texas (margin tax based on gross receipts), Washington and Wyoming. A state can only impose an income tax on an entity doing business in its state when nexus has been established. Seems simple enough, but what creates nexus can differ from state to state. Federal law protects businesses that are purely soliciting sales in a state for tangible personal property from being required to comply with a state’s income tax laws. However, it does not extend protection to an entity that is soliciting sales in the state for a service or providing a service in the state.

Economic Nexus

Over the last several years, states have been enacting economic nexus standards to pull entities into their state to create a filing requirement, thus creating state revenue. Generally, these economic standards are a certain dollar amount of property, payroll and/or sales in state. Even though an entity might have economic nexus with a state, public law protection can still be argued in some states if the entity is only soliciting sales of tangible personal property.

State nexus standards will have to be examined to determine if an argument can be made for public law protection. However, keep in mind—even if you are indeed protected by public law, many states impose a minimum income tax liability. In California, for example, you can claim public law protection, but you would still owe the $800 minimum fee.

Apportionment

Once it is determined that a filing requirement exists, you will need to determine how much of your income was earned as a result of doing business in a state. This calculation is based on your business apportionment factors by different states. Generally, the apportionment percentage is based on an entity’s property, payroll and sales in a state to its property, payroll and sales everywhere.

States weigh these factors differently; for example, some states may double weight the sales factor where others do not. Many states are also going to a single sales factor method for apportionment. The factors also vary by industry and service; in fact, services are further broken out by two methods: cost of performance (where work is performed) and market-based/economic benefit (where is customer located). Complicated, right? It gets better—states have begun migrating away from cost of performance by enacting market-based/economic benefit. That means the sale is based on where the customer is located and/or where the customer is receiving the benefit.

With a mixture of states still utilizing cost of performance and others switching to market based, there is a chance that a company may end up reporting more than 100% of its sales because the same sale could be reported to two different states.

For example, if State A is a cost of performance state and the work is performed in State A, all sales would be considered State A sales. But, the customer may actually be located in State B, and if State B utilizes market-based sourcing, the same sale would also be reportable to State B. In this situation a taxpayer can be paying on more than 100% of its income. The converse can also be true where a sale might not be reported to any state. This would occur in the following situation; if State A were a market-based state and the customer is located in State B, but State B is a cost of performance state. The sale would not be reported to either state and would be considered a “nowhere sale.”

These are only a few of the issues a taxpayer must consider when determining where they must file and under which method they must compute their apportionment. To learn more about today’s state and local tax issues, download our free e-book: State and Local Tax Issues That Affect Your Business. Contact Mary Jo Dolson, CPA or call 440-449-6800 to find out how Skoda Minotti’s State and Local Tax Services can help you grow your business.

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