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 is based on the premise that it is possible and practical to isolate the taxable income of portions of a corporation’s business 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 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 is income arising from transactions and activity in the regular course of the taxpayer’s trade or business. It includes income from tangible and intangible property if the property’s acquisition, management, and disposition 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 taxpayer’s income 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’s 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.
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 sale’s origination point. There is something called the throwback rule, which says sales will be sourced to the origination point if either of the following is 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 origin. 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 income-producing activity location, which is determined based on where the greatest performance costs are incurred. What does the term income-producing activity mean? It applies to each separate income item and means the taxpayer’s transactions and activity are directly engaged. What do the 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.
So what are the alternate formulas for determining 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 reportingcan 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:
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. A 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 uses that address and location for the operating business, it may need to foreign register.
4. Some states like California would like every business with some 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.
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 Deloitte to determine best if your business violates 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 unsure if your business may need to foreign register, take the time and money to find out for sure before it is too late!
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.
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
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
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
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.
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