Estimating state taxes is generally easier when you operate in only one state. However, manufacturers and distributors that cross state lines may be subject to taxes in more than one state. Although this may complicate matters during tax filing season, it could also offer opportunities to lower your company’s state tax liability.
The Concept of Nexus
When it comes to facing taxation in another state, it is important to know if you have nexus. Essentially, this term indicates a business presence in a given state that is substantial enough to trigger that state’s tax rules and obligations.
Precisely what activates nexus in a given state depends on that state’s chosen criteria. Common triggers include employing workers, using a local telephone number, owning property and marketing services in the state. Depending on state tax laws, nexus could also result from installing equipment, performing services and providing training in a state, either with your own workforce or by hiring others to perform the work on your behalf.
A minimal amount of business activity in a given state probably will not create tax liability there. For example, a CFO that makes two tech calls a year across state lines will most likely not be taxed in that state. As with many tax issues, the totality of facts and circumstances will determine whether you have nexus in a state.
If your company licenses intangibles or provides after-market services to customers, you may need to consider market-based sourcing in order to determine state tax liabilities. Not all states have adopted market-based sourcing and states that have adopted this model may have subtly different rules.
Generally, if the benefits of a service occur and will be used in another state, that state will tax the revenue gained from said service. Service revenue is defined as revenue from intangible assets. In market-based sourcing states, the destination of a service is the relevant taxation factor, rather than the state in which the income-producing activity is performed.
Essentially, these states are looking to claim a percentage of any service revenue arising from residents (customers) within their borders. However, market-based sourcing states sacrifice some in-state tax revenue because of lower apportionment figure (apportionment is a formula-based approach to allocating companies’ taxable revenue). These states feel that they will see a net gain as their pool of taxable sales increases.
If your company is considering operating in another state, you will need to consider more than logistics and market viability. A nexus study can provide insight into potential out-of-state taxes to which your business activities may expose you. Once all applicable income, sales and use, franchise and property taxes are factored into your analysis, the effect on profits could be significant.
Keep in mind that the results of a nexus study may not be negative. If you operate primarily in a state with higher taxes, you may find that your company’s overall tax liability is lower in a neighboring state. In such cases, it may be advantageous to create nexus in that state by potentially setting up a small office there. If all goes well, you may be able to allocate some income to that state and lower your tax bill.
Naturally, if your company licenses intangibles or performs after-market services for customers, you will also need to identify whether the state in question uses market-based sourcing. Your tax advisor can help you understand state tax issues and provide a clearer picture of the potential tax impact of crossing state lines.