A Case Study in Apportionment
For companies with operations in different states, tax time can be confusing. Common questions include those regarding which states to file in and how much income to apportion to each. The following hypothetical case is designed to highlight the key steps in the process of determining state tax filing requirements and related tax liability.
Multistate, Inc.
It’s just after the end of the 1994 fiscal year for Multistate, Inc., a company that has seen significant growth during that year. The company expanded operations into jurisdictions beyond its home state of Maryland, including work at a newly established branch office in Virginia and on-site at a Federal government location in the District of Columbia. Multistate had expected to have no tax liability for the current year but, through a combination of unforeseen circumstances and several missed tax planning opportunities, now finds itself with $100,000 of taxable income. Sam, the company’s new controller, is trying to sort through Multistate’s state tax situation. Sam needs to determine the states in which Multistate is required to file, how much income should be allocated to each, and the amount of tax due, if any.
Establishing Nexus
The first thing Sam must do is identify those states for which Multistate may have a filing requirement. Such a requirement usually results from establishing “nexus”. Nexus, which can be loosely defined as having a taxable business presence, can result from one or more of the following activities within a state:
- Maintaining a legal domicile or principal place of business
- Maintaining an office or use of a facility
- Rendering services
- Soliciting or taking orders
- Use of capital or equipment
In reviewing these criteria, Sam notes that Multistate maintains its headquarters facility in Bethesda, Maryland and leases a two-person office in Arlington, Virginia that is used to service a Navy contract. Since Multistate maintains an office in each state, Sam concludes that Multistate will be required to file in both Maryland and Virginia. Multistate also employs five technicians under a fixed-price maintenance contract at the Navy Yard in the District of Columbia. Since Multistate renders services and pays employees in D.C., Sam decides a tax return must be filed there, even though the company has no office of its own in D.C. and is conducting its business on Federal government property.
Multistate also applied for and received a business license in 1994 in Arizona in anticipation of winning a contract at a Phoenix air force base, but the contract award has been delayed until at least 1995. Based on his research, Sam concludes that even though Multistate is licensed to conduct business in Arizona, the company is not required to file an Arizona tax return since it does not have an office or employees in the state, nor has it met any of the other aforementioned criteria for creating nexus.
After some additional checking, Sam discovers that Multistate also had an office in California that closed in 1992 upon termination of the related contract. He further learns that even though there has been no further activity in the state, the company remains licensed to do business there. Moreover, Sam recently received a notice from California asking why Multistate didn’t file a state tax return for 1993 and pay at least the required minimum franchise tax of $800. Worse, the notice indicates that California has gone on to estimate Multistate’s taxable income for 1993 as being equal to 100% of the reported Federal taxable amount, and has calculated the tax due and assessed penalties and interest for failure to file and late payment. After doing some research, Sam decides that since Multistate did not file its 1992 California return as a “final” return, it should have filed for 1993 and will now have to do so and may even need to file for 1994.
Apportionment
In order for Sam to determine how much taxable income should be reported to each state, he needs to look at their various rules for apportioning, or allocating, income among one another. He finds that most use a three-factor formula based on gross receipts, payroll, and property. He learns that the definitions of gross receipts and payroll generally are pretty much self-explanatory, but notes that the definition of property has a twist: it includes leased property, i.e., office and equipment rent, with total rent multiplied by a factor of eight in most cases to yield an equivalent property cost.
Armed with this knowledge Sam begins to assemble the necessary financial information to do an apportionment worksheet. The general ledger reflects total 1994 revenue of $2,000,000. In order to determine how much to apportion to each jurisdiction, Sam turns to the detailed contract revenue analysis and supporting documents. The on-site work in D.C. represents a separate contract with revenue of $25,000 per month and has been in existence since October 1993. Sam calculates 1994 revenue for D.C. as $25,000 X 12, or $300,000. Identifying the amount attributable to Virginia is not as clear-cut, since the work performed there constituted only a small part of the relevant contract. From the labor distribution report, Sam determines the direct labor cost associated with the Virginia portion of the contract to be $100,000. Given that Multistate’s direct labor “multiplier” (i.e., the markup on direct labor representing indirect costs and fee) is in the range of 2.00, Sam estimates that $200,000 of revenue is allocable to Virginia. Sam concludes that all remaining revenue should be apportioned to Maryland, since the company had no activity in either of the other two states with nexus potential, California and Arizona.
Payroll
To calculate payroll applicable to each state, Sam compares the amounts in his general ledger to unemployment tax reports. He knows that many states have begun to cross-check and compare information included in these and other filings to the apportionment calculation. He assumes (correctly!) that discrepancies can trigger an audit. Sam finds that the payroll amounts he used in his state apportionment schedule, which came from the general ledger and contract cost summary, do not agree to the various state unemployment returns. Although alarmed at first, he ultimately pinpoints the discrepancies as being due to the fact that the unemployment returns reflect cash basis payroll amounts, while the general ledger shows accrual-basis salaries and wages. He prepares a reconciliation to document these differences.
Property
To compute the property factors for each state, Sam examines his fixed asset listings and personal property tax returns. Multistate owns property with an original cost of $150,000 and an undepreciated value of $100,000. Computer equipment purchased in 1994 with a value of $20,000 after depreciation is located in the Virginia office; all remaining property resides at headquarters. Multistate’s 1994 rent expense includes $10,000 for the Virginia office space, $25,000 for the headquarters’ office space, and $2,500 for two photocopiers used in Maryland. No rent was paid in D.C. since all space and equipment used in that locale were furnished by the Federal government.
Based on this information, Sam calculates the separate revenue, payroll, and property factors and then averages them to compute an overall factor for each jurisdiction as demonstrated in Table 2 on page 2.
After identifying the respective apportionment factors, Sam prepares a final table showing the amount of taxable income to be allocated to each state. From this he will be able to compute the appropriate amount of state tax expense for financial reporting purposes and will be able to evaluate whether sufficient estimated tax payments have been made in the appropriate states. He also reminds himself of the need to file a 1993 return for California marked “final”.
Now that Sam has the apportionment information set up in a series of linked spreadsheets, he realizes that he can easily begin to perform “what-if” analysis to consider the relative tax cost of doing business in different states, and to begin to develop strategies for minimizing Multistate’s overall state tax liability.
Copyright © 1995 Friedman & Fuller, P.C.
