State Tax Planning for Corporations

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.

Conformity to federal tax reform

After almost 30 years without major tax reform, the Tax Cuts and Jobs Act (TCJA) was passed in 2017 followed by the CARES Act in 2020. Accordingly, states have had to determine the impact of federal changes on their tax base. To complicate matters, while the TCJA reduced the benefits of several tax provisions, such as the treatment of net operating losses (NOLs), the CARES Act retroactively reversed some of these taxpayer-unfriendly changes, leading to questions of whether states would follow suit.

While many states follow federal tax rules, some states decouple from certain federal tax provisions. Nearly every state that imposes a corporate income tax conforms to the Internal Revenue Code (I.R.C.). in some manner; however, that conformity can be rolling, static, or a hybrid of the two. Rolling conformity states automatically conform to the current version of the I.R.C., including all changes, and require legislation to decouple from specific I.R.C. provisions. By contrast, static conformity states conform to the I.R.C. in effect on a particular date and require legislation to incorporate changes since the static conformity date into the state tax code. This inconsistency adds to the already difficult task of identifying how each state is responding to the changes made by the two federal tax acts: the first, which repealed, and the second, which retroactively reinstated, many of the same provisions.

Increased TCJA conformity

The enactment of the TCJA brought sweeping changes to the federal tax code. Primary corporate income tax changes included lowering the corporate tax rate and creating a territorial tax system for multinational businesses. The TCJA made significant changes to the cost recovery mechanisms and deductions available for businesses.

States have largely settled on TCJA conformity, but each year a number of states change or adapt specific provisions.

States continue to adopt CARES Act changes

States have generally conformed to most of the CARES Act provisions, and more states have conformed with certain sections modified by the CARES Act. States continue to conform to CARES Act provisions at their own pace, but there’s a clear trend toward conformity.

States continue to adopt the change made by the CARES Act to I.R.C. § 1106(i), which provides that any forgiveness or cancellation of the Paycheck Protection Program loans won’t be taxable.

Other popular revisions were those made to I.R.C. § 168, which retroactively classifies qualified improvement property as 15-year property, and I.R.C. § 170, which increases the contribution limit of taxable income that may be deducted under the charitable deduction.