States impose a number of taxes on businesses: individual and corporate income taxes, general sales taxes, excise taxes, property taxes, license taxes, and gratuitous transfer taxes.
State income tax liability varies but most charge a flat rate of 1 to 10%. Some use a progressive marginal tax and a few states also have a state alternative minimum tax. Because taxable income and deductions must be apportioned to the different states in which it does business, the total income taxable by states may differ from the total income taxed by the federal government. Additionally, corporations can deduct state taxes as a business expense.
Sales and Use Taxes
Most states and many municipalities impose a sales tax on purchases of tangible personal property that varies from 3 to 11%; a few also assess sales tax on services and intangible assets. The seller collects the tax and is responsible for remitting the tax to the state. Businesses that sell products or services in multiple tax jurisdictions must determine how much was sold in each jurisdiction and pay the appropriate tax. Businesses must also file quarterly tax reports and pay the appropriate tax for each quarter.
Generally, a business is only obligated to collect sales tax if it has a nexus in the state or municipality. Although the definition of nexus can vary from jurisdiction to jurisdiction, it generally means that the business has a physical presence in the state or municipality. However, sometimes businesses that have affiliates who work to promote the company in exchange for commissions on sales, such as those who work for Amazon, are considered a nexus according to recent legislation that has been passed in various states, such as Illinois. Some corporations engage in online sales by using a subsidiary, which is usually set up so that its only physical nexus is in a state with no sales tax.
Almost all states that have a sales tax also have a use tax, which is a tax paid by the buyer for a product or service from out-of-state vendors that would be taxable if sold by an in-state vendor. Although not many people volunteer to pay the use tax, the argument for imposing it is to level the playing field for in-state businesses in relation to out-of-state businesses, especially since the advent of the Internet has made shopping with out-of-state vendors much easier.
If a business resells products to the general public, then it can generally obtain a reseller exemption that allows the business to purchase those products and services that are resold without having to the pay sales tax to the supplier. Generally, the reseller exemption is evidenced by an exemption certificate or a reseller code number. Suppliers generally require proof of exemption, since without it, the suppliers could be liable for the sales tax.
Any starting business that sells something should:
- determine nexus requirements for the collection of sales tax in every jurisdiction in which the business sells taxable goods or services;
- establish procedures to ensure that the taxes are collected, reported, and remitted in each of those jurisdictions;
- have a procedure for verifying and recording the sales tax exemption for otherwise taxable goods or services bought by resellers.
State and Local Income Taxation
Each state has the right to tax a business that has a physical nexus in the state, which is generally defined as having property or even personnel within the state. Public Law 86-272 prohibits any state from taxing businesses simply because of a sale of tangible personal property to customers within the state. However, the law does not apply to sales of services or intangible property. Some states assess tax if a business receives income for intangible assets, such as trademarks or licenses, thereby establishing an economic nexus in the state.
Note that the definition of nexus may differ for income taxes and for sales taxes. A business may be required to collect sales tax in one jurisdiction but not be subject to the income taxation of that jurisdiction. The converse may also be true.
Taxable income, as defined by the state, usually begins with the federal taxable income before special deductions, such as net operating loss deductions and the dividends-received deduction. The resulting income is most commonly modified by:
- adding back the federal deduction for state income taxes, since they are obviously not deductible from state taxes;
- subtracting interest earned from federal bonds, since they are not subject to state taxation;
- accounting for differences in depreciation methods between what the state requires and what the federal government requires;
- adding back any interest earned on municipal bonds that are subject to state taxation but not to federal taxation.
Additional differences vary according to the state.
When a business operates in more than one state, then the business must apportion both its income and deductions according to the amount of business that it does in each state. If income or deductions, such as indirect and administrative costs, cannot be allocated to a particular state, then a formula is used to determine the allocation for each state.
The rules for allocating business income may differ from the rules for allocating nonbusiness income, which includes interest, dividends, rent, and royalties, and in some states, the rules also differ for reporting gains and losses from the sale of business or investment assets. Some states apply the apportionment formula only to business income while other states apply it to both business and nonbusiness income. Other states apportion only the business income and allocate nonbusiness income to the state in which income-earning assets are held.
The disadvantage of individual allocation is that detailed records must be kept of earnings and expenses earned in each tax jurisdiction. Apportionment is much simpler, since it requires only taking the total business income and expenses and apportioning the income according to a formula.
To standardize the state taxation of business income, most states have adopted the Uniform Division of Income for Tax Purposes Act (UDITPA). Apportionment is determined by the amount of business activity within each state by using 3 ratios involving sales, payroll, and property.
Sales Factor = Sales within the State / Total Sales
Payroll Factor = Payroll within the State / Total Payroll
Property Factor = Property within the State / Total Property
These factors are then weighted according to state rules, then combined to determine the percentage of taxable income that is reportable to each state:
Percentage of Taxable Income Reported in State = Sales Factor × Sales Weight + Payroll Factor × Payroll Weight + Property Factor × Property Weight
The weighting of the factors is determined by state law. Many states apportion equal weighting to each of the factors. However, many states double the weighting factor on sales, and some states consider only the sales factor. Greater weighting is given to sales, because sales are more likely to be more prevalent in more states, especially since the primary goal of most businesses is to expand sales, thus allowing each state to collect more tax from more businesses that do not have a significant payroll or property base within a state. Nonetheless, a few states do allow the business to choose the weighting of the factors from a prescribed set.
Because states have differing definitions of the 3 factors or have different weightings of the factors, total apportionment percentages will probably not equal 100%.
Net operating losses are also apportioned across different states in the same manner as net income. However, the forward or backward deductibility of the NOL is determined by state tax law.
Each state has its own definition of the sales factor, but there are commonalities. The sales factor is the gross sales revenue minus returns, allowances, and discounts. Interest, service, and carrying charges that are incidental to the sale are also usually included. The sales factor includes sales of inventory or services but not sales of intangible business property.
For allocation and apportionment purposes, the source of the sales is determined by what is referred to as the ultimate destination concept, which equates the source of each sale to the point of delivery. However, about half of the states have a throwback rule that redefines the sales source to be the state in which the sale originated if the destination state does not assess an income tax. So if a business operates in a state without a throwback rule and has 50% of its sales in a no-income tax state and 50% of sales in a state with a corporate income tax, then if the sales, payroll, and property factors are weighted equally, the amount of income subject to taxation would = (50% +100% +100%) ÷ 3. However, if the business is located in a state with a throwback rule, then 100% of its sales are factored into determining the taxable income.
The payroll factor includes wages, salary, commissions, and any other compensation paid to employees, although some states exclude compensation paid to corporate officers. The payroll factor for a given state is calculated by dividing the total payroll for that state by the total payroll for the business.
Payroll is considered applicable to a given state if the employee primarily works there. In some cases, however, it may be the employee's state residence. If the employee spends varying amounts of time in different states, then the location of the employee's base of operations is determinative.
For many businesses, the property factor is the largest determinant of the apportionment of state income taxes. The property factor equals the average value of real and tangible property, whether it be owned or leased, that is used within the state divided by all such property that the business uses. Generally, the property is valued by its historical cost plus any improvements, but no depreciation is considered, although some states use the adjusted tax basis or the book value of the property. If the value of the property varies over the course of the year, then the average of the beginning and end value is used.
State Income Tax Reporting by Affiliated Corporations
If a corporation is part of an affiliate group that files a consolidated federal tax return, then the treatment of the group will differ according to state laws. Most states allow consolidated returns of at least those businesses that have a nexus in the state, and some states even mandate a consolidated return.
Several states have adopted what is called a unitary approach to taxing a business, if it is a unitary business, meaning that the affiliated groups are integrated and interdependent in conducting their business. In such a case, the consolidated state tax return is required. In the case of a unitary business, the apportionment rules still apply, but they are applied to the total income of the unitary business even if some of the affiliates do not have a physical nexus in the state. (It could be said that any out-of-state affiliates have an economic nexus because they are part of the group.)
Unlike the federal system, some states may even require that foreign subsidiaries be included as part of the unitary business. However, some states allow what is called the waters-edge election by which multinational corporations can limit their unitary state reporting only to those businesses and activities within the United States.
State Taxation of Partnerships, LLCs, and S Corporations
Most companies that have a significant presence in multiple states are C corporations, because a C corporation only has to file 1 tax return for each state. On the other hand, flow-through entities, such as partnerships, limited liability companies, and S corporations do not file a tax return, though they may file an information return, so each of the individual owners will have to file a tax return in each of the states that the entity conducts its business, which is a major drawback of using flow-through business entities to operate a multistate business.
Generally, partnerships are treated the same as individuals, since the partners pay the tax rather than the partnership. However, each partner must file a state tax return in every state in which the partnership has a nexus. Partnership income is generally apportioned according to the same rules that corporate income is apportioned. Because of the compliance burden, some states allow large partnerships to file state tax returns on behalf of the partners.
Because a limited liability company, under federal tax law, can choose to be taxed as a partnership or a corporation, most states tax the LLC the same as the federal government, either as a partnership or as a corporation. However, some states tax LLCs as a partnership without regard to the partnership's federal election.
S corporation shareholders must also file a separate tax return in each state where the corporation has a nexus. Some states may also assess the state corporate income tax on S corporations. Moreover, franchise taxes are also usually assessed on partnerships, LLCs, and S corporations.
Since some states require an election to be an S corporation that is separate from the federal election, an S corporation under federal law may also have to elect S corporation status in some states; otherwise they will be treated as C corporations. Some states do not even recognize an S corporation, so treatment as a C corporation cannot be avoided in those states. Thus, an S corporation should determine its status in each state in which it has a nexus.