State Income Tax for Businesses – A General Understanding

When I write these blogs, topics are often derived from stories I have seen online or have eavesdropped. They are usually told by misinformed (through no fault of their own) individuals who think that if they make one simple decision, they can avoid income taxes, especially when it comes to state income taxes. However, state income taxes are much more complicated, both for business and individuals than one might think. In this blog, I will focus on businesses…specifically service-based businesses. I will also do my best to distill the topic down to three major areas, nexus, revenue/payroll/property sourcing, and apportionment.

NEXUS

Nexus is fancy way of saying “connection.” If your business has nexus to a state, it means that you are likely required to file a tax return and that you may need to pay income tax. Nexus can be triggered by performing services or selling goods to end-users in a state. Employees in a state may also cause nexus even if that state is not the state in which your business operates. Physical property in a state, particularly real estate, could cause your business to have nexus as well. Every business has nexus to at least one state, even if it is a state that does not impose an income tax. However, be careful here! States that do not impose an income tax likely have other forms of tax to pay such as a gross receipts tax or a form of franchise tax.

APPORTIONMENT

After you have figured out nexus for your business, you will then need to figure out how to calculate the percentage of your business’ total net income that will be taxed to a given state. Apportionment factors are formulas used to do just this. Each state uses either a single-sales factor formula, a three-factor formula including revenue, payroll, and property, or some derivation of the three-factor formula (e.g., sales may be doubled to give greater weight). So, what would this look like? For revenue, the numerator would be the amount of revenue sourced to a given state and the dominator would be the total amount of revenue generated by the business. So, for example, if your business generated $1,000,000 of total revenue and you have sourced $250,000 of this revenue to Maryland, then your revenue factor for Maryland would be 25%. Interestingly enough, Maryland is now a single-sales factor state. If your business’ net income is $400,000, the amount of net income apportioned to Maryland would be 25% of $400,000 or $100,000. Question is: how do we source revenue, payroll, or property?

REVENUE/PAYROLL/PROPERTY SOURCING

Sourcing is the way we develop the numerator in apportionment factors. Each state has its own sourcing rules. For purposes of keeping this blog from getting too long, we will focus on revenue sourcing for service-based companies since most of my clients operate service-based businesses and revenue is the most important of the three factors. However, payroll and property sourcing will not be too dissimilar. There are different revenue sourcing rules for the sale of tangible goods which I may touch on for a different blog post. For revenue sourcing for service-based companies, there are three main rules:

- Market-based – where the end-users of your services receive benefits. For example, if your company is in Virginia but you provide services to a client in Maryland. The revenue will be placed in Maryland’s revenue numerator.

- Greater of Cost of Performance – This is an all or nothing rule. If the state where you perform greatest cost of your services uses a greater of cost of performance rule, then all revenue is put in the numerator for that state. Using the example above, the revenue would be placed in Virginia’s numerator because Virginia is a greater of cost of performance-based state. It would also be placed in Maryland’s numerator because the benefit of the services are received in Maryland. If the cost of performance was lower in Virginia than another state, then none of the revenue wold be sourced to Virginia even if a portion of the cost to perform services happened in Virginia.

- Proportional Cost of Performance – This rule is similar same as the greater of cost of performance rule except that the amount of revenue goes into a state’s numerator at the proportion of in-state cost over total cost. So, to see that graphically it would be: (in-state cost / total cost) x revenue = state revenue numerator

CONCLUSION

To properly calculate state taxes for a service-based business, you need to first understand which states your business has nexus. You then then need to source your revenue, property, and payroll to each applicable state to identify the numerators for the apportionment factors. Lastly, you will calculate the apportionment factors for each state so you can multiply these factors to total net income to get an appropriate state taxable income figure. If you have further questions regarding state income tax or would like to have a state nexus study completed, please contact me, abs@westhighlandtax.com or call us at 571-445-0201