Multi-state income taxation is an issue that affects many companies, some of whom probably don’t even realize it. Unlike small- and medium-size companies doing business in the private sector, it is not at all unusual for a company to perform contracts in more than one state. Let’s consider the case of Joe Contractor, Inc., whom we’ll call “Joe” for the sake of simplicity. Joe, a Virginia corporation, has been performing on a company for the past five years using employees located at his Virginia headquarters as well as at a Federal installation in Arizona. Historically, Joe has filed income tax returns only in his home state of Virginia. Recently, Joe received a questionnaire from the Arizona taxing authorities inquiring about his operations in that state. After returning the questionnaire, Joe got word from Arizona that the state has determined him to be subject to Arizona taxes on a portion of the Company’s earnings (as an aside, Arizona first caught on to Joe when it noticed that he filed payroll tax returns for taxes withheld from his employees working in the state).
Since Joe has failed to file the required tax returns with the state of Arizona, the unfortunate result is that Joe is now liable for interest and penalties for both failure to file and failure to pay as well as the unpaid income taxes. Moreover, neither the penalties nor the interest are allowable costs in the performance of government contracts. In addition, Joe is in a Catch-22 situation as a result of the provisions governing the statute of limitations. Ideally, Joe would act to amend his Virginia income tax returns for the past five years to reflect the reduced income apportionable to Virginia as a result of Arizona’s claim. However, since Joe filed timely returns in Virginia, the statute of limitations has expired on the earlier returns and thus only the last three years’ returns may be amended. In Arizona, where Joe has never filed, the statute of limitations has not begun to run. Therefore, Joe will have to pay double state taxes on the income earned during the first two years of the contract with respect to the amount apportioned to Arizona.
As an industry, Government contracting has high exposure to multi-state taxation. A single contract with multiple performance sites is sufficient to expose a contractor to a myriad of state tax filing requirements. The situation can become even more complicated if the company happens to be an S Corporation. Common questions which surface concern matters such as what circumstances govern whether a contractor must file in a particular state, and if so, how to allocate income to that state.
Do You Have Multi-State Tax Exposure?
To determine if a corporation is subject to a state’s income tax, the state will determine if a company has “nexus” within that state. Nexus can be defined as sufficient contact within a state to require the filing of an income tax return.
Although nexus is defined on a state by state basis, certain activities or circumstances usually guarantee that nexus exists. Generally, nexus is present in the following situations:
- Domestication within a state
- Having legal domicile or a principal place of business within a state
- Employment of capital or property within a state
- Maintaining an office or other facility within a state
- Rendering services within a state
- Solicitation of orders within a state
Federal Law PL 86-272 bars states from claiming nexus if the only contact within the state is limited to the employment of salespersons or independent contractors whose only function is to solicit sales for out of state approval and fulfillment. This very limited exception dramatically restricts the activities of the salesperson or agent. In fact, in order to comply, all decisions and customer support must be handled outside the state in which the salesperson operates.
When confronted with a determination of nexus, contractors will often attempt to argue that taxes are not due in a given state because the contractor’s employees work on Federal property. However, since nexus is established by factors other than the mere existence of employees, such as the rendering of services or the employment of capital or property, the fact that the site of performance is on Federal property usually is irrelevant.
Given the current budget crisis, states are aggressively searching for new sources of revenue, and in many cases companies stand out as easy targets. Finding delinquent tax filers is often as simple as matching payroll, sales or property tax forms against required income tax filings. Most contractors who deny or ignore the existence of nexus within a state nonetheless file payroll, sales or property tax returns, as applicable. If the state fails to find a match it will usually begin an investigation of the entity in order to discover whether a reason exists for the failure to file.
Excluding the very narrow exception for in-state solicitation, even minimal activity in a given state will usually trigger a filing requirement, and possibly a tax liability along with it. If the liability is ignored it will continue to grow and compound as a result of penalties and interest. Contractors who have found it convenient to pretend that a filing obligation doesn’t exist are at high risk. The statute of limitations is of little help in such instances since it does not begin to run until a required return is filed; in fact, as demonstrated above, the existence of the statute may actually work against the taxpayer. Simply stated, now is the time to be in compliance.
Multi-State Tax Apportionment
States must fairly allocate or apportion the income between themselves. Apportionment is defined as the process by which entities divide their income between two or more states. Although each state has its own method of apportioning income, most states use a variation of the three-factor formula. The three factors normally used to apportion income are gross receipts, property, and payroll.
To illustrate the three-factor formula, consider the following illustration for Joe Contractor, Inc. , based on federal taxable income of $50,000 for the current year:
| Total | Virginia | Arizona | |
|---|---|---|---|
| Gross receipts | $500,000 | $400,000 | $100,000 |
| Payroll | $200,000 | $100,000 | $100,000 |
| Property | $300,000 | $200,000 | $100,000 |
The apportionment factor for Arizona would be calculated by dividing Arizona gross receipts, payroll, and property each by total gross receipts, payroll, and property, respectively. The three factors would then be summed and divided by three to calculate the Arizona apportionment factor as follows:
100,000/500,000 + 100,000/200,000 + 100,000/300,000 --------------------------------------------------- = .34 or 34% 3
Arizona’s apportioned taxable income is $17,000 ($50,000 * 34%). Conversely, Virginia’s apportioned taxable income is $33,000 ($50,000 * 66%).
The foregoing example is a simplified one and will not be typical of every situation. States not only use many variations of the three-factor formula, they also vary greatly in their definitions of gross receipts, payroll, and property. For example, some states include rent in the property factor (many states value rented property at eight times the annual rental). Gross receipts differ substantially between the states especially regarding the types of income which should be included in the factor and which gross receipts should be allocated directly. For example, some states allocate dividends directly to the state of domicile while others require allocation via the gross receipts formula.
Tax Planning Opportunities
States have different tax rates and apportionment methods which gives rise to significant tax planning opportunities. For instance, some states do not impose state income taxes at all, while certain others have relatively low rates. If a company can allocate income to such states, significant tax savings can be obtained.
Let’s return to Joe Contractor, Inc., who is contemplating moving corporate headquarters and starting a sales force. To evaluate the potential state tax consequences, Joe would first look at the taxes (payroll, income, sales, franchise, etc.) imposed by the various states under consideration and the associated tax rates. In addition, Joe would evaluate the income tax apportionment factors for each state and consider the likely tax impact. By calculating the taxes for each possible situation, Joe could minimize his state tax costs. Although state tax planning isn’t the only factor in considering how and where a company conducts business, it can be an significant one.
It is important to realize that most multi-state tax filers ultimately do not allocate exactly 100% of Federal taxable income to the states. The state factors tend to add up to less than or greater than 100%. This range is due to the differing apportionment methodologies and the fact that some states do not tax corporate income. Companies can apply for relief from unfair apportionment; however, the burden of proof rests with the taxpayer.
Contractors should carefully consider whether they are in compliance with state income tax filing requirements in all states for which nexus potentially exists. Given the increased enforcement effort being mounted by the states, more contractors are likely to find themselves in Joe’s situation; the resulting liability will not go away and penalties and interest can double the obligation in a strikingly short period of time.
Copyright © 1993 Friedman & Fuller, P.C.
