With the ease and growth of e-commerce as well as the incredible efficiency of many supply chains, companies of all sorts are finding it attractive to do business across state lines. But this could raise tax issues in other states. The resulting liability may substantially threaten profitability. Complicating matters, the rules aren’t the same as they used to be.
For many years, business owners had to ask themselves one question when it came to facing taxation in another state: Do we have “nexus?” Essentially, this word indicates a business presence in a given state that’s substantial enough to trigger that state’s tax rules and obligations.
Precisely what activates nexus in a given state depends on that state’s chosen criteria. Triggers can vary but common criteria include:
- Employing workers in the state;
- Owning (or in some cases, leasing) property there;
- Marketing your products or services in the state;
- Maintaining a substantial amount of inventory there;
- Using a local telephone number.
Then again, one generally can’t say that nexus has a hair trigger. A minimal amount of business activity in a given state probably won’t create tax liability there.
For example, an HVAC company that makes a few tech calls a year across state lines probably wouldn’t be taxed in that state. Or let’s say you ask a salesperson to travel to another state to establish relationships or gauge interest. As long as he or she doesn’t close any sales and you have no other activity in the state, you likely won’t have nexus.
As with many tax issues, the totality of facts and circumstances will determine whether you have nexus in a state. So it’s important to make assumptions either way.
For a long time, nexus ruled and was the primary focus of companies considering whether and how they’d be taxed across state lines. But in recent years, there’s been a new twist. Many states have established “market-based sourcing” for determining the tax liability of service companies that operate within their borders.
Under this approach, if the benefits of a service occur and will be used in another state, that state will tax the revenue gained from said service. Service revenue generally is defined as revenue from intangible assets — not the sales of tangible personal property. Thus, in market-based sourcing states, the destination state of a service is the relevant taxation factor rather than the state in which the income-producing activity is performed (also known as the “cost of performance” method).
Essentially, these states are looking to claim a percentage of any service revenue arising from residents — customers — within their borders. But there is a tradeoff: Market-based sourcing states sacrifice some in-state tax revenue because of lower apportionment figures. (Apportionment is a formula-based approach to allocating companies’ taxable revenue.) But these states evidently feel that, even with the loss of some in-state tax revenue, they’ll see a net gain as their pool of taxable sales increases.
Not every state has adopted market- based sourcing. As of this writing, there are 20 states using it. But consider that as of 2008, there was less than half that amount. Market-based sourcing states span the country geographically and include populous states such as New York, California, and Illinois.
If your company is considering operating in another state, you’ll need to consider more than logistics and market viability. The tax impact could be significant and its specifics will vary widely depending on just how the state in question approaches taxation.
For starters, strongly consider conducting a nexus study. This is a systematic approach to identifying the out-of-state taxes to which your business activities may expose you. Bear in mind that the results of a nexus study may not be negative. You may find that your company’s overall tax liability is lower in a neighboring state. In such cases, it may be advantageous to create nexus in that state by, say, setting up a small office there. If all goes well, you may be able to allocate some income to that state and lower your tax bill.
Naturally, if you’re a service company, you’ll also need to identify whether the state in question is a market-based sourcing location. If it is, learn the state’s particular rules to get a clear picture of the potential tax impact.
When the subject of multistate taxation comes up, many businesses understandably focus on whether they’ll be taxed in another state. But another important question to ask is, what kind of taxes are we talking about? There are a variety you could face.
Sales and use taxes. This can be a particularly tricky area for certain companies. Sales taxes are imposed on retail transactions involving tangible personal property. Meanwhile, use tax is imposed on consumers of tangible personal property that’s used, consumed or stored in the state in question. Generally, the two are mutually exclusive.
Corporate income taxes. Some states calculate the percentage of a company’s income subject to tax using a three-factor formula involving sales, property and attributable payroll. Other states may use a single-factor formula based on only sales. If your business is structured other than as a corporation, the tax treatment will differ.
Franchise taxes. In cases where this applies, it’s important to study the rules carefully. Typically, a franchise tax isn’t based on income. Rather, it’s generally calculated using a formula involving the net worth of or capital held by the entity.
This has been a general discussion and is not intended as advice. Taxation can be complex so it is advisable to consult a qualified professional on tax matters.
Norman Grill is a certified public accountant and managing partner of Grill & Partners LLC, CPAs and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien. He can be reached at 203- 254-3880.