Doing Business in Multiple States -When Does Your Company have to Register? Part II

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Division of Tax Base
Now, that you understand nexus and the difference between soliciting business and promoting it, it is critical to understand the background of how the states divide up the tax base. The Commerce Clause requires that a state may tax only that part of a corporation’s income that is fairly attributable to its income-producing activities in the state. There are three general approaches in handling this division of tax base. There are:

  • Separate accounting
  • Specific allocation
  • Formulary apportionment

Separate accounting is based on the premise that it is both possible and practical to isolate the taxable income of portions of a business that a corporation carries on within a state. Based on practical and theoretical flaws, separate accounting is rarely used.

Specific allocation assigns certain types of income to particular states using nonformulary rules. It is generally applied to income not related to the operational or unitary business of the taxpayer.

Formulary apportionment divides a taxpayer’s business income among the states in which it does business. A formula is used to generate an apportionment percentage that is based on the relative amount of a taxpayer’s in-state activities.

So Which Approach do the States Use?
There is an act called the Uniform Division of Income for Tax Purposes Act (UDITPA). UDITPA is a state tax model for allocating and apportioning income among states. Nearly half of the states with a corporate income tax have adopted UDITPA.

UDITPA has created three tests for determining the allocation and apportionment of income among states. They are:

  • Business income
  • Three-factor formula
  • Alternative formulas

Business income is income arising from transactions and activity in the regular course of the taxpayer’s trade or business and includes income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayer’s regular trade or business. Business income is always apportioned.

Nonbusiness income is all income other than business income. Principal types may include dividends, interest, rents/royalties and capital gains. Nonbusiness income is always allocated.

The Multistate Tax Commission (MTC) regulations state that “the income of the taxpayer is business income unless clearly classifiable as nonbusiness income. Therefore, taxpayers should be prepared to defend nonbusiness income!

Three-Factor Formula
UDITPA apportions business income using an evenly weighted three-factor formula of property, payroll and sales.

The property factor purpose is to measure the corporate presence in a state. Property is included in the numerator if it is “owned or rented and used in this state.” There are three property factor issues of concern.

  • Location
  • Valuation
  • Intangibles

The payroll factor like the property factor purpose is to measure corporate presence in a state. Payroll is allocated to the state where unemployment insurance contributions are paid; a theory based on the Model Unemployment Compensation Act.

The sales factor recognizes the contribution of market states in the production of income. Sales of tangible personal property are sourced differently from “sales” of services or intangibles.

The sales of tangible personal property are generally sourced to states based on the destination point of sale.
Under certain conditions, sales of tangible personal property will be sourced to the origination point of the sale. There is something called the throwback rule which says sales will be sourced to the origination point if either of the following are true. :

  • The purchaser is the U.S. Government
  • The taxpayer is not taxable in the state of destination.

There are two reasons sales to the U.S. Government are sourced to the state of origination:

  • The destination of a government sale may not represent the market state’s contribution.
  • The destination of a government sale is not always documented, for security reasons. Here is an example of where sales would not be taxable in the state of destination. Sales to states where the taxpayer is not taxable are sourced to the state of origination. This rule attempts to prevent certain sales from escaping inclusion in any state’s numerator (“nowhere sales”).

How are sales that are other than tangible personal property handled? Sales of intangible property or services are sourced 100% to the location of the income-producing activity, which is determined, based on where the greatest costs of performance are incurred. What does the term income producing activity mean? It applies to each separate item of income and means the transactions and activity directly engaged in by the taxpayer. What does costs of  performance mean? It means the direct costs determined in a manner consistent with generally accepted
accounting principles and in accordance with practices in the trade or business of the taxpayer.

Alternate Formulas

So what are the alternate formulas for determined income sourced to
different states? Here is what it says in UDITPA, “If the allocation and
apportionment provisions of UDITPA do not fairly represent the extent of
the taxpayer’s business activity in the state, the taxpayer may petition for a
departure from the standard apportionment formula.

California and Combined Reporting
Now, let’s look at a specific state like California and see how they handle
the multistate taxation issue. California has two main concepts to
understand, they are:

  • The Unitary business concept
  • The Combined reporting concept

The Unitary Business Concept
California uses the unitary business concept to determine business income subject to apportionment. Their unitary business approach extends to multicorporate enterprises through a requirement of combined reporting for unitary groups of corporations. The next question is what constitutes a unitary business? There are two things:

  • A contribution and dependency test; and
  • Three unities test

The contribution and dependency test refers to where the operation of the portion of the business done within that state is dependent upon or contributes to the operation of the business without the state, then the operations are unitary. There are three unities tests (Butler Brothers v. McColgan, 315 US 501, 1942):

  • Unity of ownership-more than 50%
  • Unity of operation-evidenced by central purchasing, advertising, accounting and other “staff” functions.
  • Unity of use-evidenced by a strong centralized executive force.

Nexus & Combined Reporting
The Courts have ruled that combined reporting can include corporations without nexus since combined reporting is merely an extension of formulary apportionment (Edison Cal. Stores v. McColgan, 176 P2d 697, 1947). Combined reporting even extends to multinational companies. The U.S. Supreme Court has ruled that combined reporting can be extended to include non-U.S. parents and subsidiaries (Container Corp. of America v. FTB, 463 U.S. 159, 1983 and Barclays Bank, PLC v. FTB, 512 U.S. 298, 1994).

Current Developments in Multistate Income Tax:
Electronic Commerce on the Internet

Electronic commerce refers to the ability to perform transactions involving the exchange of goods or services between two or more parties using electronic tools and techniques.

There are three issues involved with electronic commerce and state income tax issues. There are:

  • Nexus
  • Public Law 86-272
  • Apportionment of income

Nexus again refers to the domicile of the company. If the company has an office, employees, phone lines… what state are those located in.

Public Law 86-272 again deals with the solicitation of business. Actually maintaining a Web site with an in-state server may exceed the solicitation of orders. Digitized product such as software, movies, or music albums may not be considered intangible property.

Here are a few other basics reminders to consider:

1. If you own real estate in another state that collects rents your LLC is doing business in that state and needs to foreign register.
2. If your business hiring employees in another state it will need to foreign register.
3. If you have a partner in another state and the business is using that address and location for operating business it may need to foreign register.
4. Some states like California would like every business that has some type of connection to California earning money there to foreign register (the other issue that California will charge out of state residents the highest state personal California tax rate before their profits leave the state. This becomes an issue when the partner lives in a low personal tax rate like Nevada, Florida, or Texas as an example.
5. Your accountant may not know anything about this subject? Why not? This is a very specific tax niche to understand and you may want to invest $600 for an hour to speak to a big tax firm like a Deloitte to best determine if your business is in violation of any state laws.

How does this come back to haunt you? Ever hear the saying, “climbs up the ladder as an independent contractor and falls and hits the ground and ‘poof’ they are an employee.” Now all the liability and taxes change instantly. Imagine having one of your “independent contractors” filing for unemployment benefits in another state after you let them go…that will create many red flags and issues in other states. Even if you have things in writing, your basic premise may be wrong and your business may be subject to state taxes and fees in another state. If your business falls into these possible categories and you are not sure if your business may need to foreign register, take the time and money to find out for sure before it is too late!