Among the COVID-19 challenges facing businesses today, state and local income taxation has gained further attention with remote workers. As states continue to release guidance on how they will approach telecommuting, we will continue to keep you informed. This is also a time to revisit sales apportionment to ensure you are both compliant with ever-changing rules, and taking advantage of differing sales factoring methods.
One consequence of the long-term shift toward service-based economy is how states determine the corporate income tax, sales tax, and employee payroll withholding requirements for companies that are active in multiple states. The lack of a consistent nationwide approach can create complexities for companies that have facilities, sales, or personnel in multiple jurisdictions.
Further, the rise in telecommuting during COVID-19 has focused additional attention on the issue. So far, only a handful of states have issued specific guidance regarding the tax questions that arise when a company’s employees work remotely from other states. Telecommuting employees can create income tax, sales tax, and payroll withholding issues for their employers.
Nexus—The Basic Question
The term “nexus” is used to describe a situation in which a business’s presence or activities in a state make it subject to that state’s tax laws. In the past, the most common factor for determining nexus was a company’s physical presence in a state. States were generally prohibited from imposing tax requirements on a company that was based out of state, even if the company sold its products within the state.
As online sales grew, many states began asserting that physical presence is not the only way to establish nexus. In several court cases they argued successfully that nexus could also be established if a company has a significant economic presence in a state, regardless of whether it has physical facilities there.
Moreover, the shift to a service-based economy has generated even more fundamental changes. In many instances, the nexus standard is that states apply to the sale of tangible, physical products are different from those they use to determine nexus for service-oriented businesses.
As a result, determining nexus has become more complicated. Not only do today’s rules vary from one state to another, they also may vary within a state, depending on the type of tax being collected. For instance, the nexus rules for requiring a company to collect sales taxes may differ from those used in determining if a state has income tax liability.
Apportionment—Who Gets What
In addition to how they determine nexus, states are also changing how they determine what portion of a service-based business’s taxable income should be subject to corporate income tax. Historically, states used what was known as the cost-of-performance method, in which taxable income was apportioned to the state where the company performed the majority of its income-producing activity.
As the basis of the economy shifted toward the sale of services, many states began developing new apportionment formulas that would enable them to tax out-of-state service providers for sales within their borders. These new approaches, known as market-based sourcing, allocate taxable income—and the company’s relevant tax obligations—to the state in which the benefit is received, or the service is used; rather than the state in which the value was created.
Further complicating things, states use different methods to evaluate how taxable income is apportioned. Some states use a three-factor method, which considers a company’s sales, payroll, and physical assets – but most are now moving toward a single-sales-factor approach, which apportions taxable income based solely on sales.
The Search for Consistency
The intergovernmental Multi-state Tax Commission has been working to promote uniformity across the various states, and has gained widespread acceptance on general concepts of market-based sourcing and single-sales-factor apportionment. Nevertheless, many variations continue, and full consistency—if it ever occurs—is likely to be years away.
This means that, for the foreseeable future, properly sourcing taxable income from the sale of services will continue to be a challenge for taxpayers. Any service business with sales, facilities, or personnel in multiple states must be prepared to analyze its sales using several approaches, and then determine which approach is appropriate for each jurisdiction in which it has nexus.
Please reach out to your Mueller Prost specialist for support in determining your company’s state and local tax obligations.