States are falling under hard times due to economic shortfalls and lowered subsidies from the federal government. This has led to state budget deficits and decreased funding for state-wide operations. Jurisdictions are looking for new ways to generate income by identifying commercial activity within their state that are operating tax-free. States are analyzing filings for payroll, sales and use, and income tax filings to determine if errors or loopholes are identified to provide additional tax revenue dollars as well as penalties and interest.
State tax departments are also looking at company websites and marketing media as a means to determine if companies are doing business but not filing in a particular state. The most significant, impactful way states are generating additional revenues are by amending the rules for allocating income.
The methods by which states allocate income are evolving as the U.S. economy has changed since the original release of the Multistate Tax Compact (“MTC”) in 1966. The MTC first introduced the three-factor formula (equally weighting a company’s sales, payroll, and property presence) which was adopted by many states while the country’s GDP was heavily reliant on manufacturing. Over the last few decades, the U.S. has shifted to a service-based economy and the taxation and allocation of income has re-aligned to reflect the economic change. Professional service providers (attorneys, architects, engineers, financial planners, etc.) are generally businesses which require less property and equipment to carry out their services. Further, the evolution of technology and the increase in outsourcing to foreign countries has also reduced the reliance on payroll costs of U.S. based service companies. These transformations have reduced the weighted importance of payroll and property factors and put more emphasis on sales, resulting in states shifting their formulae towards a single sales factor. Single sales factor apportionment is seen as a means to increase apportioned revenues from out-of-state companies, as well as a way to ease the administrative burden on taxpayers when filing.
Approaches to Sourcing Income
States utilize two different approaches when it comes to sourcing income from professional service providers. The methods are either:
- cost of performance sourcing
- market-based sourcing
Cost of performance sourcing is dependent on those states where the services are directly performed and market-based sourcing is based on those states where the benefits of the services are received.
Many states previously following the cost of performance method are shifting to market-based sourcing. Effective in 2014, Pennsylvania adopted the market-based approach for attributing sales. Pennsylvania is also one of several states to use the single-factor formula. For corporations, New York adopted a similar methodology one year later and published specific guidelines for certain service based industries however general guidelines for service providers should attribute income to New York “if the location of the customer is within the state”. For instance, a NY engineering firm performing its computer-aided designed and drafting (CADD) and blue-prints for a PA-based project would source the income for that project to Pennsylvania because both New York and Pennsylvania are market-based sourcing states. Proper allocation of revenues for market-based sourcing may cause difficulties if invoices are sent to a client’s office in one state, but the services are provided in a state which differs in their treatment of service receipts. Firms must be diligent in tracking the location of their services to accurately report sales.
When it comes to the cost of performance, the allocation of the sales are based on where the costs associated with the performance are born. Many service-based companies that utilize timesheets to track hours worked also have the option to identify the location of those hours worked. For instance, legal advice provided at a client’s office may be located in a different state than the attorney’s office where the research is performed therefore allocating service hours to two different states. Costs for a particular service may by derived from various sources which can have an impact of allocating the revenues. The MTC has included the activities and transactions performed on behalf of a taxpayer, such as those conducted by an independent contractor.
New Jersey is a cost of performance state, with a unique measure of “time spent” affecting this determination. For any services performed within and outside New Jersey for a specific income item, the receipts attributable to New Jersey’s allocation are based on the underlying costs or amount of time spent in the performance of the services within the state. New York followed this approach pre-2015.
The cost of performance method is particularly an area of concern for those companies that allow employees to work from home on a full-time or part-time basis. Service-based employers should consider the potential apportionment impact that home office/telecommuting could have on their revenues for state filing purposes. Allowing an out-of-state employee to work from home could generate nexus in that foreign state. In a New Jersey case in 2012, Telebright Corporation Inc. v. Director, New Jersey Division of Taxation, a company headquartered out-of-state was required to file corporate business income tax returns because income was being generated from an employee who was working remotely in the state. Telebright had remitted payroll taxes to New Jersey which triggered the Division’s investigation, but no other filings were being made. The state ruled that the services provided from the NJ home office were not de minimis. For tax years beginning in 2019, New Jersey will adopt the market-based method of sourcing service revenues.
This could also give rise to income that isn’t taxed by a particular state if, for instance, a Pennsylvania-based company is performing services in Pennsylvania to benefit a client in Connecticut, a state where the Company presently has no income tax nexus. Pennsylvania is a market-based state, while Connecticut is cost of performance state. This loophole spawned the concept of “throwback” and “throw out” rules when sales not treated anywhere revert back to the state of commercial domicile. Under “throwback” rules, such profits are taxed by the state where the sale originated. Under “throw out” rules, such profits are ignored in calculating the state’s share of total profits, by subtracting them from the apportionment denominator. For example, if Colorado has a single sales factor formula and a throwback rule, a firm with only 1 percent of its sales in Colorado and 75 percent of its sales in a state where it is not subject to an income tax would see those sales “thrown back” to Colorado. Colorado would thus be able to tax 76 percent of the firm’s profits.
States have implemented the sourcing methods discussed above but each jurisdiction has special rules and exemptions which can create complex scenarios. It is important to maintain accurate books and records to support uncertain tax positions. Withum recommends that multi-state service-based businesses continually review their state tax filings, revenue streams and website content. We can help by performing nexus studies and assist tracking revenue sourcing through the use of software. These practices can be a tax planning tool in instances where jurisdictions are examining tax returns and mitigate additional liabilities, interest and penalties.
Author:Dan Richardson, CPA, MBA | [email protected]
How Can We Help?
For questions or to speak with a member of Withum’s Professional Services Group, please contact us by filling out the form below.
