The Ever-Changing State of State and Local Taxes
Missing Pieces of the Nexus Pie
While the federal courts have established a set of standards for determining nexus for sales and use taxes, there is no clear-cut rule that service providers can use for determining nexus for income based tax purposes. As a result, states have started applying several new standards, such as economic nexus and factor presence (also known as bright-line nexus). Out-of-state service providers can establish economic nexus by directing consistent and substantial economic activity to the state or deriving income from a state’s local market. This requirement can be met by making sales to customers in the state or receiving income from intangible property in the state — even if the business has no physical presence in the state. Massachusetts and New York have established thresholds to define substantial economic activity.[1] California and Connecticut have adopted bright-line nexus rules, which set forth thresholds for property, payroll and sales within a state. [2]
Alternatively, the factor-presence standard was established by the Multistate Tax Commission. It uses certain threshold levels for property, payroll and sales factors that, when exceeded, establish nexus. [3] One of the ways states have avoided the income base tax issue is by adopting commercial gross receipts and activity taxes. Ohio was one of the first states to use factor-presence nexus to determine commercial activity tax. California, Colorado, Michigan, New York and Oklahoma have also used factor-presence nexus with their own threshold levels to determine nexus in each state. To take it a step further, New York uses both economic and factor-based nexus rules.
Apportionment Challenges
Once service providers establish nexus with more than one state, the next daunting challenge that they face is how to fairly apportion taxable income to each state. The two most widely used methods are Market Based Sourcing and Cost of Performance. An increasing number of states have abandoned the Costs of Performance rules in favor of Market Based sourcing, which tries to identify the market for service and intangible income. In general, this method assigns receipts from sales of services to the location of a service provider’s customers or the destination where its customers receive the benefits of the service. This sourcing approach differs significantly from the historically used Cost of Performance method.
States that continue to use the Cost of Performance method generally require that a service provider source revenue to each state based on where the services were performed. The Cost of Performance approach typically assigns more weight to the state in which the service provider conducts their business operations, because that is the state where the company maintains a greater portion of the direct cost.
Because of the lack of uniformity among the rules in various states, many nuances create practical uncertainty in their application. It is critical that service providers look to their accounting system and job costing system to ascertain the correct client “market” location that is benefiting from the service, and as equally important, the location of the direct income-producing costs when performing the services.
If your firm has any questions regarding the latest trends in state and local taxation or would like to discuss a strategy for ensuring accurate state and local returns, a WithumSmith+Brown, SALT specialist can help.
Ask the Experts
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Barry H. Horowitz, CPA, MST, Partner State and Local Tax Group Leader T (609) 520 1188 [email protected] View Experience
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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
[1] See Mass. Gen. L. Chapter 63 § 39; N.Y. Tax Law § 209(2).
[2] See Cal. Rev. & Tax. Cd. § 23101(b); Conn. Gen. Stat. § 12-216a.
[3] See Factor Presence Nexus Standard for Business Activity Taxes, available at www.mtc.gov
