How Do I Know If My Business Should Be Filing in Multiple States?With the speed at which technology is changing and the borderless environment in which we now live, businesses often find themselves unknowingly doing business in states other than the one they call home.
In fact, in today’s business environment, very few companies do business in only one state. Further, it is not unusual to find that small to medium-sized closely held companies are doing business in several states — or even all 50. And it’s no secret that states are struggling financially. As such, they are all competing for your tax dollars.
A review of your company’s interstate activities can help comply with the various tax laws and identify valuable tax-saving opportunities.
So, how do you know if your business should be filing in other states?
A state’s power to tax your business depends on its connection (or nexus, as it is referred to in the world of accountants and attorneys) with the state. The level of nexus required, however, may vary depending on the tax involved. The four most prevalent state taxes are:
• Sales and use taxes;
• Corporate income taxes;
• Franchise taxes; and
• Payroll taxes.
Many early nexus cases involved sales and use taxes. Technically, the consumer is responsible for those taxes, but because of the impracticality of collecting them from individuals, states have placed this burden on the seller.
Do you have an economic presence?
Going back to the founding fathers, the Commerce Clause prohibited states from imposing tax on out-of-state businesses unless that business had a ‘substantial nexus’ with the taxing state. Substantial nexus, as you can imagine, can be interpreted differently by each person. So how do we know what constitutes substantial nexus?
Well, as with all interpretations of the Constitution, the courts interpret the meaning. Here, U.S. Supreme Court decisions have determined that, for purposes of applying the commerce clause, ‘substantial nexus’ means physical presence. Thus, states cannot constitutionally tax an out-of-state business unless that business has some form of physical presence in that state.
In its landmark 1992 decision in Quill v. North Dakota, the U.S. Supreme Court ruled that a state cannot require an out-of-state seller to collect sales or use taxes unless it has a substantial physical presence in the state. Again, the meaning of ‘physical presence’ depends on the facts and circumstances. But, in general, you have a physical presence if you maintain offices, stores, manufacturing or distribution facilities, property, or employees in the state.
In the age of e-commerce, it’s extremely easy for companies to do business remotely with customers in states or countries where they have no physical presence. Many courts and state legislatures believe that economic presence is a more relevant indicator of a business’s connection with a state.
Over the last few years, there has been a trend in the courts toward eliminating the physical-presence requirement, at least for purposes of income and franchise taxes. But for now, physical presence is still required today to trigger sales and use tax-collection obligations, but many states require only a very minimal presence to establish nexus, and the courts are agreeing.
However, under Federal Public Law 86-272, states are prohibited from taxing a company’s income if its only activity in that state consists of the solicitation of orders or the sale of tangible personal property that is approved and shipped from outside of that state.
One caveat, though: this law does not apply to intangible property. Hence, several recent cases have allowed states to tax an out-of-state firm’s income on intangibles such as credit cards or trademark licenses, even though the firm had no physical presence in that state. A substantial ‘economic’ presence was sufficient.
For example, Connecticut has now instituted a ‘bright-line’ economic nexus test. A taxpayer is deemed to have substantial economic presence if it generates receipts of $500,000 or more attributable to the purposeful direction of business activities toward the state, examined in light of the frequency, quantity, and systematic nature of a company’s economic contacts with this state, without regard to physical presence, to the extent permitted by the U.S. Constitution.
However, Public Law 86-272 will continue to restrict Connecticut’s ability to impose a tax on income derived within its borders from interstate commerce if that activity was only the solicitation of orders of tangible personal property, and where those orders are sent from outside of Connecticut for acceptance and subsequently shipped from outside of Connecticut. And Connecticut is not alone. More states are pushing for economic presence in lieu of a required physical presence.
Am I doubling my tax obligations by crossing state lines?
You might think that establishing nexus with a state increases your tax exposure, but in some cases it does the opposite.
Consider corporate income taxes. Many states determine the portion of your income subject to their tax using a three-factor formula based on the percentage of your sales, property, and payroll attributable to the state. (In some states, the sales factor is double-weighted.) Others use a single-factor formula based on sales. If you’re able to apportion some of your income to a state with a lower tax rate, it can actually reduce your company’s tax bill.
Taking the ‘I’ll take my chances and let them find me’ approach can be a gamble.
Revenue-hungry states will continue to extend the geographical reach of their tax laws, and state agencies will continue to communicate with each other about state taxes. Along with companies, state revenue departments are also becoming more sophisticated.
For example, many states are starting to query vendor files of customers within the state. In-state auditors are looking at invoices to ensure that proper sales and use taxes are being paid for the out-of-state businesses with potential nexus in their state. From there, the states are generating nexus questionnaires to businesses that appear in their audits but are not showing as being registered in their state.
States are not only going after current taxes, but targeting businesses and individuals for back taxes from the date they first started doing business in that state. In addition to the tax, states are imposing penalties for not registering to do business in the state (which itself requires a fee and generally requires the company to file annual reports). The penalties for not registering, and penalties and interest for late filing and payment of taxes, can be substantial.
How can I be proactive to determine my company’s exposure to other states?
To ensure compliance with all applicable laws, be sure to periodically review your business’s interstate activities either internally with your accounting staff or with a qualified tax or legal advisor.
A nexus study may help you to understand your company’s obligations in the various states. It helps to identify your company’s normal business activities in relation to the various nexus standards, based on the type of tax (i.e. income, franchise, payroll, sales and use, or even a ‘privilege tax’ imposed by some states) and the states with which you may have connections.
Having the information up front before you begin a job or do business in another state can help you manage your company’s bottom line. Managing and planning for potential filing and tax obligations in advance can mean the difference between a profitable job and an unprofitable job.
This article is intended to provide a general overview of the multi-state tax environment. As always, you should consult your tax and/or legal advisor regarding the applicability of this general information to your business’s specific situations.
Jennifer Reynolds is a tax manager with the Holyoke-based certified public accounting firm Meyers Brothers Kalicka, P.C.; (413) 322-3542; [email protected]