Written by John Yoak, Manager of Specialized Tax Services at BDO USA, LLP
The states are becoming increasingly aggressive with respect to how they tax businesses operating in the multistate environment. As such, businesses that currently operate within, or have plans to expand into multiple states should be aware of how those activities may impact them from a state income tax perspective. When examining this impact, it is important for multistate businesses to understand that a state may only impose a tax on a business that has nexus with the state. For this purpose, “nexus” describes the degree of business activity that must be present before a state has the right to impose a tax. The measurement of the relationship that is necessary is defined by state statute, case law, and the Due Process Clause and the Commerce Clause of the U.S. Constitution.
Each state is free to define its own nexus standard as long as the standard does not exceed certain constitutional limitations, which are contained in decisions of the United States Supreme Court. In this context, the Due Process Clause has been interpreted to permit taxation only when the taxpayer has established certain “minimum contacts” with the state, which can only be determined through an analysis of the quality and quantity of the taxpayer’s contacts with the state, and to require that the tax fairly reflects the taxpayer’s activities in the state. Similarly, the Commerce Clause has been interpreted to permit taxation only when the taxpayer has established “substantial nexus” with the state, such that the tax does not unreasonably burden or impair the free flow of interstate or foreign commerce.
For corporate income tax purposes, many states historically took – and some continue to take – the position that a taxpayer must have a physical presence within the state in order to establish nexus. However, over the past 25 to 30 years, changes in the business environment have caused the states to reconsider how they look at nexus for corporate income tax purposes. In the late 1980s and early 1990s, creating intangible property holding companies was a popular nexus isolation strategy. To address what was a growing concern, several states began asserting nexus and taxing intangible property holding companies to the extent they licensed intangible property for use within the state. Holding that neither the Due Process Clause nor the Commerce Clause of the U.S. Constitution required a physical presence to establish nexus for corporate income tax purposes, state courts deemed these “economic nexus” standards constitutional.
With the increasing ease of conducting business via the Internet, the states are once again reconsidering how they look at nexus. Several states, including Alabama, California, Colorado, Connecticut, Michigan, New York, and Tennessee have revised their corporate income tax nexus standards to include “factor-based nexus thresholds.” Under these standards, the states assert nexus and impose tax on out-of-state taxpayers if their in-state business activities exceed certain dollar or relative percentage amounts. For example, beginning in 2015, business entities organized outside of Alabama have “substantial nexus” and are subject to Alabama corporate income tax if they exceed any of the following thresholds during the tax period: $50,000 of property in Alabama; $50,000 of payroll in Alabama; $500,000 of sales in Alabama; or 25% of total property, total payroll, or total sales in Alabama.
It is important to note that taxpayers must use each state’s specific revenue assignment rules when determining whether their in-state business activities exceed the applicable threshold. For sellers of tangible personal property, generally there is consistency among the states for “sourcing” sales of tangible goods. Specifically, the states generally agree that, with certain exceptions, sales of tangible goods are sourced or assigned to the destination state (i.e., the customer’s location). However, with respect to sales of services or licenses of intangibles, the applicable rules vary by state. For the purpose of determining where sales of “other than tangible personal property” should be assigned, some states require taxpayers to consider where they incur the costs of performing the income producing activity, whereas other states require taxpayers to use a market-based approach. To make this process even more challenging for taxpayers, the states that require a market-based approach often define what constitutes the “market” differently. Some states consider the market to be where the customer is physically located, while other states consider the market to be where the customer receives the benefit of the service, while other states determine the market by applying a hierarchy of rules that consider a number of factors, including where a corporate customer is domiciled, where the contract for services is managed, where the customer placed the order, the customer’s billing address, or some other method of “reasonable approximation.”
Lastly, it is important to note that states may apply different revenue assignment rules to transactions that appear to be quite similar. For example, in Florida, gross receipts for the performance of personal services are attributable to Florida if the taxpayer performs the services in Florida. Gross receipts from the performance of services relating to a single item of income that are performed partly within and partly without Florida are attributable to Florida only if a greater portion of the services were performed in this state, based on costs of performance. However, where services are performed partly within and partly without Florida, the services performed in each state may constitute a separate income producing activity, even though the customer is billed a lump sum amount. In such cases, the gross receipts for the performance of services attributable to Florida are measured by the ratio that the time spent performing such services in Florida bears to the total time spent in performing such services everywhere. Same service, three rules.
The concepts of nexus and revenue assignment must be considered by someone knowledgeable of the multistate tax environment. Taxpayers may unknowingly structure transactions in such a way that results in the gross receipts derived from those transactions to be assigned to multiple states (e.g., performing services from a jurisdiction that assigns revenue based on costs for the benefit of a customer located in a jurisdiction that assigns revenue using a market-based approach), however, the opposite is also true. By planning and conducting a thorough analysis of these issues, taxpayers can help ensure proper tax compliance and may also discover an opportunity to minimize their state tax liability.
John Yoak, Manager, 714-668-7318
Tony Manners, Managing Director, 404-979-7274
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