State Tax Planning for Corporations

CORPORATE TAX PLANNING TOPICS

Corporate Tax Planning

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Federal Tax Planning Strategies

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International Tax Planning for U.S. Corporations

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STATE TAX PLANNING RESOURCES

State Sales Tax Nexus Guide

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Navigating State Sales Tax Nexus Expansion to Ensure Compliance

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State Conformity to Federal Bonus Depreciation

The lack of conformity among state tax rules is a major challenge for corporate multistate taxpayers. The differences among state tax rules create difficulties and complexity even in dealing with what should be straightforward concepts – like a single transaction that may be treated differently in different jurisdictions. Researching relatively simple concepts, like what constitutes a tax year across states, can require extensive time and effort.

Attempts to comply with state tax rules and deal with their complexity may even drive business decisions. For multistate businesses, every single business activity must be carefully considered with respect to income tax withholding and sales and use tax consequences. This complexity doesn’t just make compliance difficult, but it can prevent multistate taxpayers from completing corporate tax planning.

To help alleviate this uncertainty, Bloomberg Tax offers insights into gray areas that can be daunting for multistate taxpayers as well as a comparison of state tax policies to help you understand when a corporation’s activities within a state might result in a tax liability.

Economic nexus for sales and use tax

A nexus is the requisite contact between a taxpayer and a state before the state has jurisdiction to impose tax on the taxpayer or require it to collect tax. The rules regarding where retailers must collect and remit sales and use tax have become increasingly complex in recent years. This is the result of sales transactions becoming more complicated, the increasing ease with which remote sellers can sell into a state without physical contact due to the internet, and the elimination of the physical presence requirement in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080, 2018 BL 219995 (2018).

In 2018, the U.S. Supreme Court issued a decision in South Dakota v. Wayfair, Inc., overturning the physical presence requirement for sales and use tax nexus. Today, sales tax nexus may be established when a business’s retail activity in a state meets a certain dollar amount and/or number of individual transactions.

Economic nexus vs. physical presence standard

Since the Wayfair decision allowed states to impose taxes on out-of-state taxpayers based on economic nexus, states and localities have become more emboldened about expanding their jurisdiction to tax multistate taxpayers in a variety of ways. States will look broadly at both physical and economic presence to determine nexus. Most states base their nexus standard on both physical presence and economic nexus.

Because nexus can be imposed on nonresident businesses that meet a specific economic threshold, businesses may have nexus in significantly more states than they had previously – especially businesses making online sales of taxable tangible personal property or services.

Currently, every state imposing a sales tax has an economic nexus provision. This does not mean, however, that the concept of physical presence is gone for good, as having a physical presence will generally still create nexus in states that have adopted economic nexus provisions.

As states continue to respond to Wayfair, taxpayers and practitioners must grapple with the effect these changes will have on the complexity of sales tax nexus and related compliance issues.

Destination-based vs. origin-based sourcing of sales tax

Every state that imposes sales and use taxes provides sourcing rules to identify the location of a sale and to determine which jurisdiction is entitled to the revenue generated from tax on the transaction. However, sourcing can be a complicated endeavor for taxpayers to determine. Sourcing rules vary from state to state and may depend upon the object of the transaction; the rules may be further complicated by the type of transaction and mode of delivery. As more and more taxpayers find themselves with nexus across the states, sourcing may become a more important issue as taxpayers have more states in which to source sales.

Sourcing rules generally attempt to incorporate the destination concept to impose the tax where the good or service is consumed or delivered. However, a state may choose to source sales on either a destination basis or on an origin basis, or even vary rules for interstate and intrastate transactions.

Destination-based sourcing is often used for sales of tangible personal property because the final destination of a transferred good can usually be determined. Because determining the destination of a sale of services can be difficult, some states use origin-based sourcing rules for those transactions. Origin-based sourcing rules, on the other hand, are easily enforced but can lead to economic distortion as they often result in a destination state receiving little or no tax. Most states use destination-based sourcing for interstate sales of tangible personal property.

Economic nexus threshold calculations

The state economic nexus thresholds established in the wake of Wayfair describe the extent of sales made into a state, in terms of dollar amounts and/or number of transactions, sufficient to require a remote seller to collect and remit the state’s sales tax. Predictably, the advent of economic nexus hasn’t suddenly created uniformity among states; economic nexus threshold dollar amounts and transaction numbers vary from state to state.

Beyond the differences in the economic nexus thresholds themselves, the new rules have created new gray areas in calculating whether the thresholds have been met. States have different rules on which sales count toward the threshold (e.g., exempt or wholesale sales, or sales made through a marketplace) and have varying time frames within which the thresholds are calculated. Now that all states that impose sales tax have implemented economic nexus laws, an increasing number of taxpayers will require guidance on precisely how to calculate whether thresholds have been met.

Tax collection in the sharing economy

The sharing economy, also sometimes called the “on-demand economy,” has created an opportunity for individuals who aren’t ordinarily in the business of selling to offer their homes, cars, transportation services, and other items for sale, use, lease, or rent to a global customer base through online platforms.

These third-party platforms handle the details, usually for a fee, of arranging the transactions between the buyer and the owner-seller or the service provider. Many of these platforms have no ownership interest in the goods and do not directly provide the service offered for sale. Some third-party vendors, such as online travel companies, acquire hotel rooms or airline seats and then resell them to customers.

For goods and services flowing through the sharing economy that are subject to state sales and use tax, one of the major questions is: Who is responsible for collecting and remitting the tax due – the owner of the property, the provider of the services, or the third-party platform? Existing state tax laws and rules, drafted for a different era, often don’t provide a clear answer for sales made as part of the sharing economy. However, states are increasingly imposing collection obligations on third parties who facilitate the short-term rental of an owner’s vehicles.

Marketplace facilitator transactions

Another area that’s seen rapid policy changes is the tax collection obligations of online retail marketplaces. More sellers are using marketplace platforms to facilitate their sales of tangible personal property and services online. Due to their small size, many of these sellers are unlikely to create nexus with any state outside the place where they are headquartered.

However, the total sales by all sellers made through these marketplace platforms represent a large amount of uncollected sales tax revenue. Like the adoption of economic nexus laws to collect taxes from remote sellers, states have recently adopted requirements for marketplace facilitators to collect tax on sales made through their platforms. These laws still leave many unanswered questions, such as the proper way to calculate whether a facilitator has met a sales threshold, whether a facilitator must collect other taxes, and the administrative requirements for both facilitators and sellers.

Cryptocurrency as a taxable sale

A major consideration from a state tax perspective is whether the purchase of virtual currency or cryptocurrency is a taxable sale for sales and use tax purposes, or how to treat the purchase of tangible personal property or services with cryptocurrency. Therefore, tax preparers and taxpayers should seek guidance on how to calculate the sales tax due on purchases made with virtual currency or cryptocurrency, and how to report such sales to state taxing authorities.

Many states haven’t yet issued guidance on the tax treatment of virtual currency or cryptocurrency. In states that have not addressed the tax issues arising from the use of virtual currency or cryptocurrency, taxpayers may want to examine the state’s approach to taxing the sale and use of other types of currency or other intangible property, as well as research whether the state conforms to the federal tax treatment of convertible virtual currency.

Economic nexus for corporate income tax

Corporations and their tax advisors may need to determine income tax nexus in a variety of contexts: In some cases, a corporation that started off doing business in only one state grows quickly and fails to recognize it may have triggered nexus in several states. In other cases, a company may need to review the nexus positions it took in various states after it changes tax managers. A company might change an earlier position after deciding that the former tax manager either incorrectly concluded that the company wasn’t subject to tax or pursued an overly aggressive nexus policy. Alternatively, a company may have missed one of the many recent state tax nexus developments and need to reevaluate its nexus positions.

Income tax nexus determination standards

States typically follow one of three general approaches to make income tax nexus determinations:

1. States that adhere to a physical presence standard base nexus on the presence of employees or property within their borders.
2. States that adhere to an economic nexus standard consider nexus to be triggered merely by making sales into the state.
3. States that adhere to a factor presence nexus standard base nexus on taxpayers exceeding a specified threshold of physical or economic presence in the state.

Physical presence nexus standard

For decades, a key constitutional question has been whether the states must use the physical presence test established in Quill Corp. v. North Dakota, 504 U.S. 298 (1992) when making corporate income tax nexus determinations. Although Quill’s physical presence requirement was overruled by the Wayfair decision in 2018, that decision leaves a trail of state-level court decisions and administrative guidance on whether physical presence should be the standard for corporate income tax nexus.

In Quill, the Court declared that the potential taxpayer must have a substantial connection with the taxing state. In the context of sales and use tax collection obligations, substantial nexus meant that the potential taxpayer had a physical presence in the state and that such physical presence was more than de minimis.

However, the Court left open the question of whether the sales and use tax requirements for nexus also apply to corporate income taxes. In the absence of clear guidance from the high court, many state appellate courts have found that an out-of-state corporation doesn’t need be physically present within their jurisdiction to establish nexus for income tax purposes.

Economic presence nexus standard

The first court decision on the issue of economic nexus for income tax purposes was the South Carolina Supreme Court in Geoffrey Inc. v. South Carolina Tax Dept., 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993). In Geoffrey, the state supreme court held that an out-of-state corporation, Geoffrey, was subject to the state’s income tax (and license fees) even though the company had no physical presence in the state. Several other state appellate courts have found that the physical presence standard established in Quill is limited to sales and use tax determinations.

As a result, unless the U.S. Supreme Court rules otherwise or federal legislation is enacted, there is no uniform bright-line standard for determining whether substantial nexus exists for corporate income taxes. Without clear guidance in this area, states and corporations often disagree on the level of economic activity within a given jurisdiction that creates substantial nexus.

Factor presence nexus standard

Most states have adopted factor presence nexus standards to create clearer, more consistent nexus standards across states to help multistate taxpayers comply. Although this practice is not directly related to the Wayfair decision, many states now impose factor presence nexus standards, where payroll, property, or sales thresholds are used to determine corporate income tax nexus.

The Multistate Tax Compact (MTC)’s model statute on factor presence, Factor Presence Nexus Standard for Business Activity Taxes, uses both economic and physical presence to determine nexus. Specifically, the model statute uses several factors to quantify the level of activity that constitutes economic nexus. Nexus is triggered under this standard only if one the following thresholds is exceeded during the tax period:

• $50,000 of property.
• $50,000 of payroll.
• $500,000 of sales.
• 25% of total property, total payroll, or total sales.

Many states have factor presence standards based on the MTC model but may have modified factors and thresholds.

Telecommuting as a nexus-creating activity

The continued prevalence of remote work has the potential to create nexus for taxpayers across states, making tax compliance even more difficult. While many states waived nexus for telework during the height of the pandemic, these administrative waivers have almost all expired. As a result, taxpayers need to be aware that their new work arrangements could likely create nexus for corporate income, franchise, sales, or gross receipt taxes. Thirty-six states have indicated that as few as one to six telecommuting employees would create nexus for corporate income and sales tax purposes, even if those employees aren’t involved in sales solicitation activities.

Taxation of pass-through entities

Pass-through entities are the hybrids of business taxation: business entities for which tax liability is generally attributable to the amount of individual income tax imposed on partners, members, owners, or shareholders. However, states are increasingly applying corporate income tax concepts, such as business or nonbusiness income and apportionment, to pass-through entities operating in more than one state, and it’s often unclear how these concepts are applied in each jurisdiction.

States also take different approaches to how they impose income tax on the gain recognized by the disposition of an out-of-state corporation’s or nonresident individual’s ownership interest in a pass-through entity that does business within their jurisdiction.

Another area of uncertainty arises from the varying mechanisms states use to collect tax from nonresident owners, members, partners, or shareholders of pass-through entities. There’s little uniformity among jurisdictions with how these collection procedures are applied. Therefore, complying with each state’s unique rules requires a careful analysis of each jurisdiction’s laws.

Pass-through entity-level nexus

States are uncharacteristically uniform in their treatment of pass-through entity ownership for purposes of creating nexus. In most states, owning an interest in a pass-through entity doing business in the state, no matter what type of ownership interest is held, creates nexus.

In 80% of jurisdictions, nexus is created when an out-of-state corporation owns any of the following in-state pass-through entity interests:

• Investment LLC or partnership interest.
• General partnership interest.
• Limited partnership interest.
• Management LLC interest.
• Nonmanagement LLC interest.
• Disregarded entity interest.

In most states, an ownership interest in an entity that only manages real property located in state would create nexus.

States are also overwhelmingly likely to impose nexus on an S Corporation parent if a qualified subchapter S subsidiary (QSub) is doing business in the state.

Apportionment and sourcing rules

As more taxpayers are filing and paying taxes in more states, sourcing becomes a bigger issue. When preparing corporate income tax returns, a multistate corporation must analyze each state’s sourcing rules to determine how it must apportion income among the states in which it does business. Traditionally, states used an equally weighted three-factor apportionment formula based on property, payroll, and sales.

As the nation’s economy evolved from one heavily focused on manufacturing to a more service-based economy, the states’ apportionment formulas evolved as well. The states now generally employ one of three main apportionment formulas:

1. The traditional three-factor formula.
2. A weighted three-factor formula placing extra emphasis on the sales factor.
3.  A single-factor formula focusing solely on the sales factor.

When calculating the sales factor, receipts from sales of tangible personal property are commonly sourced to states using a different methodology than receipts from other sales, including receipts from leases, licenses, or rentals of tangible personal property, real property, services, intangibles, and cloud computing or software-as-a-service (SaaS) transactions.

For receipts other than those from sales of tangible personal property, states generally follow the cost-of-performance method, the market-based sourcing method, or a hybrid of the two.

Cost-of-performance sourcing method

For years, nearly all states used the cost-of-performance rule when sourcing receipts from sales other than sales of tangible personal property. Under the cost-of-performance rule, these receipts are sourced to a state if the greatest proportion of the income-producing activity is performed in the state.

While only a few states still follow this approach, jurisdictions differ in the way this sourcing method is applied when the income-producing activity is performed in more than one state. Most states use an “all-or-nothing” approach, where all the receipts are sourced to a single jurisdiction based on where the greatest proportion of the costs of performance occur. Other states use a proportionate method, or pro rata approach, in which receipts from the income-producing activity are sourced proportionately to each state where the cost of activity occurs.

Market-based sourcing method

Most states have moved away from the cost-of-performance method and now source receipts from sales other than sales of tangible personal property using a market-based approach based on the state where the taxpayer’s market for the sale is located.

Although market-based sourcing continues to gain widespread acceptance, the implementation of this sourcing method varies greatly among market-based sourcing states and takes into consideration several factors when determining the location of the market. Implementation of this approach may also vary among categories of receipts within a single state. This variation adds additional complexities to any already difficult area of state taxation.

To further complicate sourcing issues, some states apply different sourcing methods to different categories of receipts (e.g., receipts from services, intangibles, or cloud computing transactions) even when the different receipts are all considered receipts from sales other than sales of tangible personal property.

Yet other states use the same sourcing method for receipts from all types of sales other than sales of tangible personal property but will apply the method differently depending on the type of transaction from which the receipts arose. In many cases, states define the market and cost-of-performance differently, and taxpayers are left to interpret complex sourcing statutes. This diversity in approaches requires practitioners and taxpayers to examine every single revenue stream to determine how it should be reflected in the sales factor and the jurisdiction to which the amount should be sourced. This lack of uniformity across the states in defining the market makes it difficult to adopt a multistate approach.

No matter the method, compliance burdens abound. The differences in sourcing methods and how they’re applied can create challenges for multistate taxpayers. For example, if you’re a service provider headquartered in a cost-of-performance state, you’re likely going to have 100% of your income sourced to that state and you’re likely to have sales sourced to market states.

Alternative apportionment

It’s common for either a taxpayer or a state to feel that the state’s normal apportionment formula unfairly apportions the taxpayer’s business income. In these instances, either party may seek to apply an alternative apportionment formula.

The party seeking an alternative method generally bears the burden of showing why the standard apportionment formula creates distortions and how the proposed alternative method leads to a more equitable outcome.

State tax addbacks

For many states, the computation of taxable corporate income starts with either federal taxable income before net operating losses and special deductions (i.e., federal Form 1120, line 28), or federal taxable income after net operating losses and special deductions (i.e., federal Form 1120, line 30). By contrast, several states don’t use federal taxable income as a starting point. Instead, these states require taxpayers to separately compute state taxable income using principles like those used in computing their federal taxable income.
States utilizing federal taxable income as a starting point often require taxpayers to make several modifications to determine their state taxable income. These modifications may include the:

• Addition of federally tax-exempt state and local interest income.
• Income-based taxes deducted in computing federal taxable income.
• Federal net operating loss deduction.
• Federal dividends received deduction.

However, not only do these modifications vary by state, but they are also often subject to the policy interpretations of their state tax departments.

States require addback for taxes paid

Many states disallow deductions for income-based taxes imposed by states or localities, even though such taxes are generally deductible for federal purposes. In other words, these states require that nondeductible state and local taxes be added back to federal taxable income to calculate state taxable income. Some states don’t allow a deduction for any income-based state or local tax, whereas other states only disallow income-based taxes paid to their own state.

State tax practitioners must understand the differences among state laws in determining the deductibility of state and local taxes. Furthermore, practitioners must know when a state determines another state’s corporate tax to be income-based. Because some state corporate taxes (e.g., the Texas Franchise Tax) have an income component, but are not entirely based on income, the determination of whether the tax is based on income varies by state.

Combined reporting

With the continued enactment of mandatory combined reporting regimes, many states that impose a corporate income tax now require corporate parents to file a single return that includes the tax attributes of their subsidiaries. However, even among the states that require combined returns, there is a lack of uniformity.

Combined reporting requirements

The methods used to determine the composition of a combined group varies among states. In all states that require combined reporting, the entities that must be included in a combined group are determined according to the jurisdiction’s definition of a “unitary business.” Most of those states also look to an ownership threshold of more than 50% to determine which entities must be included; however, a few states use an 80% threshold.

The method a combined group must use to compute tax also varies. Some jurisdictions compute a group’s income tax liability on an aggregate basis and allow members to share tax credits and losses among one another. Other states require each member to compute income on a separate basis and don’t allow members to share credits or losses with the group.

Additionally, important differences exist in the way in which the numerator of a combined group’s sales factor is calculated. Some states include the in-state sales of a combined group member that lacks nexus with the jurisdiction in the numerator of the combined group’s sales factor, but other states exclude such sales.

Voluntary disclosure agreements (VDAs)

Voluntary disclosure agreement (VDA) programs allow taxpayers to voluntarily report and pay previously unpaid or underpaid taxes to a state tax revenue department in exchange for relief from penalties and/or interest. While almost every state offers a VDA, eligibility varies.

Given the complexity of current state tax rules and the continuing need for states to keep their coffers full, VDA programs are likely to continue as a useful tax administration tool.

One important thing that taxpayers should know about these programs is that taxpayers generally need to enter negotiations anonymously.

Bonus depreciation

Bonus depreciation allows taxpayers to deduct a specified percentage (30%, 50%, or 100%) of depreciation in the year a qualifying property is placed in service.
Qualified property is defined as property that meets the following three requirements:

1. It is MACRS property with a recovery period of 20 years or less.
2. Either its original use begins with the taxpayer, or it was not used by the taxpayer or a predecessor in the five years before the taxpayer’s current placed-in-service year. And it meets certain other used property acquisition requirements.
3. It is placed in service before 2027 (or before 2028 for certain longer production period property that is acquired before 2027 or acquired pursuant to a written binding contract that became binding before 2027).