State tax laws encompass many aspects of business including sales and use tax, payroll tax, income and franchise tax and others.
If your business has a customer, contractor, property, payroll, or performs services across state lines, you have exposure for compliance with the myriad state tax laws. The rules are complex, continually evolving and have a tremendous degree of inconsistency among the states.
States are becoming more aggressive at looking for tax dollars, so it is important to understand and manage your state tax exposure. Penalties and interest may be assigned if a state determines that a return was required but not filed.
The power of states to impose taxes is limited by the federal Due Process Clause and the Commerce Clause in the U.S. Constitution. The Due Process Clause requires “nexus,” or a minimal connection, and a rational relationship between the income attributed by the entity and the state. In addition, the Commerce Clause requires the tax to be fairly apportioned and fairly related to the service provided by the State.
These constitutional factors regarding nexus may be satisfied where the taxpayer has purposefully directed its activities at the state’s economic forum. The taxpayer need not be physically present in the state for there to be some form of taxes required. States such as California are creating a “bright line” test which more clearly indicates when “economic nexus” has been established.
As it relates to establishing nexus, there generally are three factors that are considered: sales, property and payroll. Each state defines the unique parameters for all of these factors. For sales of services, one state may consider the sales to be in the state if the services are performed in the state. Another state may claim the sales if the benefit of the service is enjoyed in the state. Still other states may claim the sales if the greater cost of performance is within the state relative to the cost of services performed in other states. When looking at the sales factor, some states include contractors and some consider just employees. Often an office or employee in a state will indicate that business is being directed to the state, and thus nexus is established.
The factors used to consider nexus for services are similar in nature to those used for apportioning service income to the states. Some states, such as Illinois, use a single factor apportionment based on where the benefit of the service is enjoyed.
Others states give double weight to the sales factor and equal weight to property and payroll. Still other states use all three factors equally weighted. Each state has a unique way of defining each of these factors. Sales of tangible goods have different rules depending on the circumstances.
For flow-through entities such as S-corporations and limited liability companies, there will also likely be individual taxes due by the owner based on the entity’s flow-through income being apportioned to that state.
Some states, such as Illinois, require the entity to file and pay the individual tax for nonresidents. Other states allow a composite filing which permits non-resident individuals to file one return instead of requiring each owner to submit separate individual nonresident returns.
• Michelle DellaMaria is a CPA and certified valuation analyst with Caufield & Flood Certified Public Accountants in Crystal Lake. Caufield & Flood can be reached at 815-455-9538.