Affairs of state
Managing multistate taxation

In today’s business environment, few companies limit their activities to just one state. So it’s not unusual to find several states — or even all 50 — competing for your tax dollars. A review of your interstate activities can help your company comply with the various tax laws and identify valuable tax-saving opportunities.

What’s the connection?

A state’s power to tax your business depends on your connection, or nexus, with the state. The level of nexus required, however, may vary depending on the tax involved. The three most prevalent state taxes are: 1) sales and use taxes, 2) corporate income taxes, and 3) franchise taxes.

Many early nexus cases involved sales and use taxes. Technically, the consumer is responsible for those taxes, but because of the impracticality of collecting them from individuals, states have placed this burden on the seller.

Do you have an economic presence?

In its landmark 1992 decision for Quill v. North Dakota, the U.S. Supreme Court ruled that a state can’t require an out-of-state seller to collect sales or use taxes unless it has a substantial physical presence in the state. The meaning of “physical presence” depends on the facts and circumstances. In general, you have a physical presence if you maintain offices, stores, manufacturing or distribution facilities, property, or employees in the state.

In the age of e-commerce, it’s getting increasingly easy for companies to do business remotely with customers in states or countries where they have no physical presence. Many courts and state legislatures believe that economic presence is a more relevant indicator of a business’s connection with a state. Recently, there’s been a trend in the courts toward eliminating the physical presence requirement, at least for purposes of income and franchise taxes.

In Lanco, Inc. v. Director, Division of Taxation, for example, the New Jersey Supreme Court upheld the application of New Jersey’s corporate business tax on a Delaware company’s income from licensing trademarks to New Jersey stores. And in Tax Commissioner v. MBNA America Bank N.A, West Virginia’s highest court, the Supreme Court of Appeals, found that the state could impose its income and franchise taxes on an out-of-state bank with credit card customers in the state.

Both courts held that the physical presence requirement is limited to sales and use taxes and that a substantial economic presence is sufficient to trigger income and franchise tax liability. The taxpayers in both cases petitioned the U.S. Supreme Court for review, but the Court declined to hear either case. This may open the door for other states to expand their nexus requirements for income and franchise tax purposes.

How can you save?

You might think that establishing nexus with a state increases your tax exposure, but in some cases it does the opposite. Consider corporate income taxes. Many states determine the portion of your income subject to their tax using a three-factor formula based on the percentage of your sales, property and payroll attributable to the state. (In some states, the sales factor is double-weighted.) Others use a single-factor formula based on sales.

If you’re able to apportion some of your income to a state with a lower tax rate, it can reduce your tax bill. Here’s an example: A manufacturing company is based in State A but makes substantial Internet and mail order sales in State B, where it has no physical presence. State A’s business income tax rate is 10%, while State B’s is only 5%. Both states apportion income using a three-factor formula, with the sales factor double-weighted.

The company’s taxable income is $800,000. Its sales, payroll and property are distributed as follows:

If the company has no nexus with State B, all of its income will be taxed by State A, for a total tax liability of $80,000 ($800,000 x 10%). But if the company establishes nexus with State B — for instance, by having its sales reps travel into the state regularly — it can lower its tax bill. In this case, income and tax would be allocated to States A and B as follows (sales are counted twice because of double-weighting):

State A

[Sales (50%) + Sales (50%) + Payroll (100%) + Property (100%)]/4 = 75%

Tax = $800,000 x 75% x 10% = $60,000

State B

[Sales (50%) + Sales (50%) + Payroll (0%) + Property (0%)]/4 = 25%

Tax = $800,000 x 25% x 5% = $10,000

Establishing nexus with State B reduces the company’s total state tax liability from $80,000 to $70,000. The business could further reduce its tax bill by shifting some of its property and payroll into State B.

But before making the shift, the company also should evaluate whether this strategy would otherwise make good business sense. Keep in mind that this is a simple example. There are many other factors that could affect the outcome.

Are states pushing the limits?

Physical presence in a state is still required to trigger sales and use tax liability, but some state courts and legislatures have been pushing the limits of the Quill standard. Some states, for example, have passed legislation minimizing the level of activity required to establish a physical presence. Others have attempted to impose sales and use taxes on businesses that have no physical presence in the state but have an agency-like relationship with an in-state retailer.

The Streamlined Sales Tax Project, a joint effort of many organizations, including the National Governors Association and the National Conference of State Legislatures, may also affect nexus standards. As noted above, one of the reasons for the physical presence requirement is to avoid the administrative burden on companies if they were forced to comply with hundreds or even thousands of disparate state and local sales and use tax programs. The project’s goal is to remove this obstacle — and convince Congress to eliminate the physical presence requirement — by promoting a simplified national sales and use tax compliance system.

Paying more than you need to?

Revenue-hungry states will continue to extend the geographical reach of their tax laws, and state agencies communicate with each other about state taxes. To ensure compliance with all applicable laws, be sure to periodically review your business’s interstate activities with a qualified advisor. Failing to do so could result in paying duplicate taxes or just a higher tax bill. •