Recent Trends in State & Local Income Tax
Author: Mary Reiser
In the last five years, tax professionals around the country have observed important trends in state and local income tax. An increasing number of states are passing legislation targeting the tax dollars of out-of-state businesses taking advantage of their states’ marketplaces. Economic nexus standards are capturing taxpayers with an invisible but palpable presence in the states’ economies. Market-based sourcing methods are ensuring revenue derived from more and more remote transactions is being taxed at the source of the cash. As buyers and sellers evaluate their next transaction, both sides need to understand the implications of the tax environment on their potential deals.
Economic nexus typically takes the form of a sales-based standard. In some instances, such standards are as ambiguous as “substantial gross receipts” in a state. Businesses are left to grapple with the uncertainty of what “substantial” means to a state. In other instances, they take a more definitive approach, such as having more than $500,000 or 25 percent of sales to customers in the state. Then the question becomes whether an arbitrary dollar amount or percentage threshold is equitable for all businesses. For example, a small business with $26,000 of a total $100,000 in sales into a state has more than 25 percent of its sales into a state. On the other hand, a large multistate business may have $3 million of sales into the same state. Despite the disparities in size and ability to comply, the law says both of these businesses have nexus. As such, no business of any size can ignore the trend toward economic nexus.
Market-based sourcing requires service revenues be sourced to the state where the customer is located or receives the benefit of the service. Much like economic nexus, market-based sourcing presents its own challenges in clarity:
- If a customer has multiple locations, where does the customer receive the benefit of a service?
- If a service provider performs work at an off-site location, is the benefit received where the work was performed or where the customer is located?
To complicate matters, every state determines its own sourcing method, and often these methods are in conflict. What do businesses do when they sell services from a state that sources revenue where the work is performed to a state that sources revenue where the customer receives the benefit? Both states claim the same revenue as their own, and businesses are left either to pay tax twice on the same income or risk not paying one state.
Given this environment, even small-scale transactions can carry baggage for buyers and sellers. These legislative changes frequently lead to miscues in compliance for out-of-state businesses. Seemingly minor liabilities may balloon into larger issues when one factors in longevity and the aggressive penalties and interest imposed by state taxing authorities. Buyers must be able to identify these exposures at purchase and make strategic decisions about them moving forward. On the other hand, sellers need to be sure these types of issues do not become the Trojan horses of their prospective deals. Both sides of buy-sell transactions must be aware of state and local income tax trends toward economic nexus and market-based sourcing. These trends likely will have an important impact on their future deals.
For more information, contact your BKD advisor.