The dream of many business owners is to have multiple locations across the country. But, as businesses expand across state lines, managing various state taxes becomes increasingly complex.
To ensure compliance while optimizing tax positions, multi-state tax due diligence and state apportionment are essential. Conducting due diligence in a multi-state context involves reviewing company tax obligations across various jurisdictions to identify potential liabilities and uncover tax-saving opportunities.
Let’s explore some key considerations and strategies for effectively managing multi-state tax obligations.
Identify Nexus
Nexus is the connection between a business and a state that subjects the business to state tax obligations. It can be created through physical presence, employing personnel or significant sales within a state. Remote work can also establish nexus.
Many states have economic nexus laws based on sales volume or transaction count — making it essential to stay updated on each state’s specific regulations.
Review State Tax Filings
Conducting a comprehensive review of past state tax filings is crucial for identifying discrepancies and securing accuracy. Try focusing on high-risk states known for aggressive tax enforcement, such as California and New York, and consider filing amended returns if differences are found. Regular reviews and internal audits help maintain compliance and preempt state audits.
Assess State Tax Credits & Incentives
Most states offer various tax credits and incentives to attract businesses (e.g., credit for job creation, research and development, etc.). Evaluate your business's eligibility for these programs and see if your company complies with the requirements. Proper documentation that supports claims for these incentives is key.
As with any tax credit, we highly suggest monitoring any and all changes in state policies to leverage potential benefits.
Evaluate Intercompany Transactions
Always scrutinize intercompany transactions to make sure your business complies with state transfer pricing rules, which prevents income shifting to lower-tax jurisdictions. Maintaining detailed documentation to support pricing can help ensure transactions are at arm's length. As with anything tax-related, be aware of state-specific transfer pricing regulations.
Determine State Apportionment Specifications
State apportionment determines how much of a business’s income is subject to tax in each state it operates within. So, a key piece of the multi-state tax puzzle is identifying the apportionment in the states you conduct business.
State Apportionment Formulas
States will use various formulas to determine a business's apportion income. Many leverage the traditional three-factor formula, which takes into account sales, property and payroll. However, some use a single sales factor where a business' sales drive the amount they're taxed.
For instance, the state of Virginia uses a double-weighted sales factor formula. This means factors impacting sales have more weight than factors related to property and payroll.
In contrast, Maryland uses a single sales factor formula for corporations, but for pass-through entities like S corporations and partnerships, income apportionment still involves property, payroll and sales factors to determine the portion of income attributable to the state.
Sales Factor Sourcing
Rather than using an apportionment formula, states may use one of the following sales factor sourcing approaches:
- Market-based sourcing: This method allocates sales to the state where a customer received the service/benefit. The focus of market-based sourcing is a customer’s location, not where the seller performs the service or incurs costs. For example, if a software company based in State A sells software to a customer in State B, the sales revenue is sourced to State B since that's where the customer lives and uses the software. California, Massachusetts and New York are examples of states that use market-based sourcing for services.
- Cost-of-performance sourcing: Sales are based on where the seller incurs costs to perform a service. The emphasis is on the location of the business activities rather than the customer's location. Georgia and Virginia are two states that use cost-of-performance sourcing for services.
Some states use a combination of these methods depending on the type of transaction or service provided.
State Specific Considerations
Be aware of state-specific rules like throwback and throwout rules, which impact how sales are attributed to states. Special apportionment rules may also apply to specific industries, such as manufacturing, transportation and broadcasting.
- Throwback rule: Some examples of states with a throwback rule include Alabama, California and Illinois. This means that if a business sells products to a customer in another state where the business is not subject to tax (i.e., no nexus), the sales are “thrown back” to the state of origin. For instance, let's say a manufacturer in State A sells goods to a customer in State B. If the manufacturer does not have nexus in State B, the sales may be included in the sales factor numerator of State A, increasing the income apportioned to State A.
- Throwout rule: A throwout rule excludes certain sales from the sales factor denominator if they are not subject to tax in the destination state. New Jersey and West Virginia are states that have throwout rules.
- Industry-specific apportionment rules: As mentioned, the transportation industry usually has unique apportionment rules. For instance, an airline might apportion income based on the ratio of revenue passenger miles within the state to total revenue passenger miles. This method accounts for the nature of the industry where services (i.e., flights) span multiple states, and apportionment based on traditional sales, property and payroll may not be suitable.
Maintain Documentation
Maintaining detailed records to support apportionment calculations, including sales invoices, property records and payroll reports, should not be overlooked. This paper trail will ensure consistent reporting across states to avoid discrepancies and challenges from state tax authorities.
Also, be mindful of regularly updating your business's documentation to prepare for state audits.
Leverage Technology Solutions
To effectively manage multi-state tax obligations, businesses should adopt proactive strategies and leverage accounting systems to streamline processes.
Tax software and automation tools can drastically help your company efficiently manage compliance requirements. These tools can assist with tasks like tracking nexus, calculating apportionment and generating accurate filings.
If you want to take it a step further, integrating tax compliance solutions with ERP systems that monitor tax data, identify trends and detect anomalies will simplify the data collection process and assist your team with reporting tasks.
Stay Informed & Consult With Experts
As highlighted above, there are various measures your business can take to stay on the right track when managing multi-state tax regulations and compliance.
Internally, regularly monitoring legislative changes and updates in state tax laws, subscribing to tax news services and participating in industry forums can help provide your business with valuable insights. Providing your team with ongoing training on the latest developments and best practices will also reap positive benefits.
If you’re ever unsure of how to handle a specific situation, it never hurts to engage tax professionals who specialize in multi-state issues for insights and optimized strategies for your business. It may also be worth collaborating with legal counsel to address potential disputes and ensure compliance.
Overall, the key to handling multi-state taxes is being informed, quickly adapting to new regulations, updating internal processes accordingly and engaging in advocacy efforts to represent business interests in state tax policy discussions.
Need Help?
Navigating the complexities of multi-state tax due diligence and state apportionment requires careful planning and ongoing vigilance. If your business is interested in receiving personalized advice tailored to your organization’s needs, contact us here or call 800.899.4623.
