COVID Funding Tips for Small Businesses
Establishing a separate legal entity is step one in separating your and business assets.
The next step is to ensure you are in compliance, which can mean many things, including compliance from a Secretary of State level to compliance from a business credit level to compliance at a state taxation level (and federal).
All areas are critical.
Let’s discuss an area that is not often discussed until it is too late, and that considers the multistate taxation rules, which will help determine which states your entity will need to register to do business.
In our industry, where Nevada and Wyoming corporations are promoted, this is the reason why benefits such as saving state corporate income taxes or privacy rarely come into play because if you live and do business in another state, the Nevada entity will need to foreign register to do business in that state.
There may be state taxes at your state level, and your name and information are probably going to be more exposed.
Two important points, first, if you are operating as an LLC taxed as an S corporation, for example, it is a flow-through entity with no federal taxes paid and, in many states, no state taxes.
An informational return is required to be filed at the federal and state level (in most cases), and the tax is paid at the owner’s level. This comes into play when someone says, “I live in Arizona, and I want a Nevada LLC taxed as an S corporation to save state corporate taxes here in Arizona.”
There are not any state taxes on LLCs taxed as an S corporation in Arizona anyway.
This is typically promoted in relation to a C corporation, which has state corporate taxes in most states but usually is the wrong entity for the small business owner (because of double taxation and the goals of the small business owner, especially a home-based business owner is to have low overhead and high-profit margins).
The second point is that privacy is often overrated because I find there is a common pattern to strive for so much privacy and that basic asset protection is missing.
Most do not think it through with capitalization, issuing ownership interest…
Back to the subject at hand, when does your company have to foreign register or qualify to do business in another state? There are two ways to look at this, what does the state say about this at the Secretary of State level, and more specifically, what does the multi-state taxation rules say about it?
Each state has some basic rules that may help determine what is considered doing business in their state, and therefore state taxes may be due.
Let’s take a look at California and Texas. California is one of the highest taxed states in the country. They have an annual $800 minimal franchise tax fee that applies to all entities (except in year one for corporations). California has a state tax rate for all entities, and that is why they spend more time on the California Franchise Tax Board website to let you know what is considered doing business. On this site, https://www.ftb.ca.gov/businesses/faq/734.shtml, the California Franchise Tax Board defines doing business in California as ‘doing business’ means actively engaging in any transaction for financial gain. That is a very wide interpretation of what is considered doing business.
Texas does not have a state corporate income tax, but they have a franchise tax.
The franchise tax is a privilege tax imposed on corporations, including banking corporations and limited liability companies chartered in Texas. The tax is also imposed on non-Texas corporations that do business in Texas.
The Texas Franchise Tax fee is just a fancy name for state income taxes. But from a marketing point of view, if the state can promote, it has no personal income taxes and hit the businesses harder to help them from a political point of view.
If you are doing business in Texas, like owning real estate, it will trigger the Texas Franchise tax fee, which Corporations pay the greater of the tax on net taxable capital or net taxable earned surplus.
There are two approaches. One is the taxable capital of a corporation’s stated capital (capital stock) plus surplus. Taxable capital for an annual report is based on the end of the corporation’s last accounting period in the calendar year before the calendar year in which the report is due.
The tax rate on taxable capital is 0.25 percent per year of the privileged period. Earned surplus for an annual report should be reported beginning with the day after the ending date on the previous franchise tax report and ending with the end of the corporation’s last federal accounting period in the calendar year before the calendar year in which the report is due.
The tax rate on earned surplus is 4.5 percent.
There is an easy way that the California Franchise Tax Board will determine if you are doing business in California. They will subpoena your business credit card and look at where the transactions occur.
If they are all in California, for example, and you formed a Nevada LLC. You did NOT register to do business in California.
You will be subject to the California franchise tax fee plus penalties and interest. From California’s point of view, if you were doing business in Nevada and lived in California, most of your expenses should be where you are doing business. This is a good rule of thumb for any state.
Does this mean anytime you go into another state, your LLC or Corporation will have to foreign register? No.
More often than not, you may be doing business in another state and not be realizing it and be subject to state taxes. The best way to blow this is to hire employees in another state.
If you do that, the entity will need to foreign register and pay taxes in that state. You may be thinking, is having independent contractors an exception? Yes, that does not constitute doing business in another state.
Does that mean the solution is to have independent contractors only work for your company outside your state? No.
You must follow the IRS’s test for employees vs. independent contractors. Please don’t wait until it is too late to find out you really have employees working for you! Here are the tests: https://www.irs.gov/newsroom/understanding-employee-vs-contractor-designation
When I started NCP back in 1997, several times during the first two years, I spoke to Deloitte, the big global tax firm. They invested $400-$600 per hour to understand these basic concepts because no one in our industry addressed these issues or concerns.
To answer the question; do you have to register your entity in another state as a foreign entity doing business there; you must understand the multistate taxation rules.
To better understand the multistate taxation rules, there are concepts to understand and, once you understand them separately, you should piece them together like a chain.
Then the concept of multistate taxation will make sense. Let’s assume you have a Nevada LLC or Corporation, and the thought is, does that entity need to foreign register in another state? Here are the key terms to understand and points to consider.
Jurisdiction to Tax
Jurisdiction to tax basically means where your business is going to be taxed.
In our context, we will refer to state taxation. It could be possible that if you are doing business offshore, that is a different jurisdiction from the United States and a whole different set of rules come into play as to where those transactions are taxed. This section will be concerned about doing business in the United States.
If your entity is based in Nevada, is that entity subject to tax in other states or jurisdictions? In other words, if you form a Nevada corporation and live in California, are you going to have to register as a foreign corporation in California and pay state corporate income taxes (and other taxes) on a portion of money this Nevada corporation earned?
In relation to state taxes, Nexus means the degree of presence or activity required by a business within a state before the state in question has the legal authority to impose a tax on the business. In other words, does California (in our example) have any authority to tax the Nevada corporation?
What Activities Create Nexus?
What activities that your business enters into create Nexus or, another term would be substance, for the entity in question? If you have these in a state, then the entity in question would be
considered to have Nexus:
- Presence of an office
- Phone line for the office
- Fixed property
- Business license
- Acts of Employees
- Acts of independent contractors
- Presence of intangible property
If your Nevada entity had the above in Nevada, then the entity would have Nexus in Nevada.
Is it quite possible that the same entity may have the Nexus in another state also? Absolutely! Even if you have Nexus in Nevada, you may still have to register in your home state and pay state taxes there. Let’s take a
a closer look at Nexus.
There are some requisite presences for Nexus. That is determined by state statute and limited by both the U.S.
Constitution and federal legislation. The constitutional limits to Nexus are covered in the:
- Due Process Clause
- Commerce Clause
The Due Process Clause is concerned with “fair warning.” Also, it requires “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” (Miller Bros. V. Maryland, 347 US 340, 1954).
The Commerce Clause is concerned with burdens on interstate commerce. The commerce clause requires substantial nexus, fair apportionment, non-discrimination towards interstate commerce, fair relation to state services (Complete Auto Transit, Inc. v. Brady, 430 US 274,1977).
There are also federal legislative limitations. The main limitation is Public Law 86-272. Public Law 86-272 prohibits a state from taxing foreign corporations’ net income whose only business activities within the state consist of the solicitation of orders for the sale of tangible personal property.
In other words, if you are merely soliciting orders in another state, that is not considered doing business in that state. This is a critical concept to understand how your business functions.
Public Law 86-272 does apply to:
- Net income-based taxes
- Activities limited to solicitation of orders.
- Taxpayers engaged in the sale of tangible personal property. Public Law 86-272 does not apply to:
- Sales/use taxes, net worth taxes, or other taxes not based on net income.
- Activities which exceed the solicitation of orders.
- Sales of services, real property, and intangible property.
Here is a list of certain activities that are unprotected activities under Public Law 86-272. In other words, if you do these activities, you are expected to register as a foreign entity doing business in another state.
- Providing technical assistance
- Maintaining a company office
- Repairing or servicing a product
- Approving sales
- Account collections
- Replacing spoiled product
- Storing products are not related to solicitation.
Here is the list of activities that are protected under Public Law 86- 272. In other words, if you do these activities, it is ok, and you will not have to register in another state to do business.
- Stock of free samples for salespeople.
- Renting space for temporary display
- Assisting with product display in retail shops
- Maintaining informal home offices.
- Recruiting / training/evaluating of sales employees by regional managers.
- Certain mediations of credit disputes
Let’s give you some examples of one area that demonstrates the limits of the solicitation on orders.?
Example #1: You have a business based out of Nevada. All the nexus for this company is in Nevada, along with the employees. The business sells ski lifts.
You send employees to Colorado to only solicit the order of a ski lift. In other words, your employee makes the presentation, and the acceptance of the presentation as to credit, terms, and financing all have to go to the home office in Nevada for acceptance. That is not considered doing business in Colorado.
Two weeks later, the same employee goes back to Colorado to inspect the ski lifts after being shipped and installed. The art of inspecting the ski lift crossed over the definition of sole solicitation of orders.
Therefore, it was considered doing business in Colorado, and the entity had to register to do business in Colorado! What the Nevada company could have done would have been to have hired an independent contractor in Colorado to do that part of the job.
Then the Nevada company would not be doing business in Colorado.
Example #2: Budweiser sends beer salespeople around the country to solicit the sale of beer.
If the sales fall under the true definition of soliciting sales, Budweiser does not register to do business in these various states. What happened was Budweiser started sending the Clydesdale horses to the same cities as the salespeople, and the horses were considered a business promotion, which is different from solicitation of sales? The horses were promoting the sales of beer!
These two examples presuppose a couple of things:
1. That the companies had nexus in their main state of operations.
2. They had employees who lived and did the work in other states for these companies.
Now, what about a business that can be based from anywhere?
Let’s say you have an e-commerce based business established in Nevada, and you set up all the nexus in Nevada. Let’s say it is a one-person corporation.
Do you have to register to do business in your home state where you are doing the work out of your home? Absolutely! Why?
Because you are physically doing the work out of your home. You are not soliciting orders for the Nevada based office; you are actually getting the order, closing the deal, and collecting the check from your home state.
This is the category most entrepreneurs fall into.
Our company, NCP, incorporates in all 50 states and can support you with a complete formation and foreign qualification into other states as required.