More and more entrepreneurs need to understand small business multistate taxation because more and more small businesses are expanding the geographical boundaries within which they operate.
For example, if you have expanded your small business’s geographic boundaries and operate across three states, you are subject to multistate taxation.
For this reason, I want to give you a brief overview of how this small business tax accounting works.
Note: In my post next week, I’ll identify a handful of common ways to dial down your out-of-state tax burdens.
The first thing to understand is that only states in which your business has nexus can tax you.
Essentially, nexus means enough of a connection or a tight enough link that the state can tax you. But this all gets a little fuzzy—or at least seems that way the first time you look at this topic.
For example, my CPA firm operates in Washington state. Not surprisingly, Washington state can tax me. But other states where I have no presence and no connection can’t. Makes sense, right?
Where nexus gets tricky is anytime things aren’t clear-cut. But the general rules are if you don’t own property in a state, if don’t employ people in a state, and if don’t generate revenue inside a state, you don’t have nexus.
Even a little bit of property or payroll or revenue generation creates nexus, however.
For example, if you store inventory in some other state. Or if you hire some telecommuting employee. Or if for a few hours you roll into a state and, say, give a speech or teach a class or do some consulting, you have nexus.
And two other details to keep in mind. First, if you have customers or clients in some other state, that doesn’t mean you generate revenue in that other state. For example, when our CPA prepares a tax return for some client in California, we do the work in Washington State. So Washington State gets to tax that money. California—even though the tax return goes there—doesn’t get to tax the money.
A second thing to know: Rented property counts as property. For example, if you buy a warehouses in Arizona for your business, that creates nexus. But if you rent a warehouse in Arizona for your business, that also creates nexus.
A Few Words About Public Law 86-272
Here’s the next thing you need to know: For income tax accounting purposes, mere solicitation of orders for the sale of tangible personal property doesn’t create nexus in a state.
This protection is afforded by a federal law known as Public Law 86-272 (often abbreviated P.L. 86-272.) The relevant chunk of the law appears below:
No State, or political subdivision thereof, shall have power to impose, for any taxable year ending after September 14, 1959, a net income tax on the income derived within such State by any person from interstate commerce if the only business activities within such State by or on behalf of such person during such taxable year are either, or both, of the following:(1) the solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the State; and(2) the solicitation of orders by such person, or his representative, in such State in the name of or for the benefit of a prospective customer of such person, if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are orders described in paragraph (1).
For example, if you sell furniture and you travel to a bunch of different states trying to get retailers to carry your product, that activity—even though you’re running around those states—doesn’t create nexus.
By the way, if you employ someone to do this in some other state—merely solicit orders for sales of tangible property property—that employment and payroll also doesn’t create nexus.
And just to be thorough, if that sales person drives a company car and uses a company laptop for his job, that property also doesn’t create nexus.
Most states will say, however, that if you or any employee do anything other than “merely solicit” you do have nexus.
For example, If the sales person signs the purchase order? Nexus. if you or a sales person does training? Nexus. If the sales person also provides a bit of customer service? Nexus.
Understanding Apportionment Arithmetic
A third and final thing you want to understand if you’re beginning to go multi-state is the arithmetic of apportionment.
As a general rule, when you have nexus in a state, the state makes you pay income taxes on a chunk of your profit as determined by a three-factor apportionment formula.
A three factor apportionment formula divides your income into thirds and then allocates each third based on how that third is spread across the states where you operate.
If your business earns $300,000, the $300,000 is split into three $100,000 chunks of income.
One of the $100,000 chunks is allocated based on where the revenue is generated. If the revenue is split evenly between State A and State B, for example, $50,000 of that income “goes” to State A and $50,000 “goes” to State B.
Another of the $100,000 chunks is allocated based on where the firm owns property. So if the firm’s property all sits in State C, State C gets that entire $100,000 chunk.
The third final $100,000 chunk gets allocated based on where the firm’s payroll occurs. To make this easy, say that the firm employs three identically paid employees in three different states: State A, State B and State C. In this case, that last $100,000 gets split like this: $33,333 “goes” to State A, $33,333 “goes” to State B and $33,333 goes to State C.
To pull all this together, based on the three preceding paragraphs, State A and B both get to tax $83,333 (they are each getting $33,333 of taxable income from the payroll apportionment and $50,000 of taxable income from the sales revenue generation apportionment). State C gets to tax $133,333 (because it gets $100,000 in taxable income from the property apportionment and $33,000 from the payroll apportionment.)
Some Exceptions to Expect
Let me make a final comment about the apportionment arithmetic. While the general rule is states use the three-factor appointment, exceptions abound.
In the earlier paragraphs, for example, I pretended each of the states uses the three-factor appointment formula. But more and more states, it seems, now use a single factor appointment (that single factor being revenue generated).
Further, some states tweak the appointment formula to double-weight sales. In effect, these states quarter a firm’s profits, then allocate one quarter using sales, one quarter using payroll, one quarter using property, and then allocate another, fourth quarter using sales again.
And then things can get even more complicated. California, it turns out, uses a double-weighted sales apportionment formula—but also allows taxpayers to make an irrevocable election to use a single “sales factor” apportionment.
Three Final Comments
I want to make three other comments about small businesses multistate taxation before I close.
First, note that public law 86-272 provides protection to out-of-state businesses from state income taxes. However, that federal law doesn’t protect a business from excise taxes like state sales taxes and franchise taxes (like those levied with great relish by California.) So you need to be careful if you’re selling stuff that’s subject to sales taxes or you’re doing things that trigger franchise taxes and you’re relying on P.L. 86-272.
Second, you should know that if you are facing multistate taxation in your small business, you can rather effectively grind down both the tax costs and the risks if you plan ahead. (I’m going to talk about that in my next post.)
Third, a growing handful of states ( California may be the worst) are attempting to expand the range of activities that trigger nexus at least for excise tax purposes and say, essentially, that if you have customers in the state you may have tax to pay. (For more information on this bit of extortion in the case of California, you can refer here.) I think this is ridiculous and surely a violation of federal laws. (A small business doing $3,000 of annual revenue from three equally-sized customers, per California’s rules, may owe California $800 of franchise tax, income taxes, and possibly sales taxes if one of those customers is in California.) But you need to be alert to this sort of bullying–especially if you’re visible in your multistate activities.
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