An important question to ask when it comes to facing taxation in another state is: “Do we have ‘nexus’?” Essentially, this term indicates a business presence that’s substantial enough to trigger that state’s tax rules and obligations. Nexus has been and remains the focus of companies considering whether and how they’d be taxed across state lines.
Precisely what activates nexus in that state depends on its chosen criteria. Common triggers include employing workers, using a local telephone number, owning property, and marketing products or services in the state. Depending on state tax laws, nexus could also result from installing equipment, performing services, and providing training or warranty work in the state. This applies either with your own workforce or by hiring others to perform the work on your behalf.
A minimal amount of business activity in a state probably won’t create tax liability there. For example, a furnace repairman who makes two calls a year across state lines probably wouldn’t be taxed in that state. As with many tax issues, the totality of facts and circumstances will determine whether you have nexus in a state.
Opting for market-based sourcing
If your company licenses intangibles or provides after-market services to customers, you may need to consider “market-based sourcing,” instead of nexus, to determine state tax liabilities. However, not all states have adopted market-based sourcing. And states that have adopted this model may have subtly different rules.
Here’s how it generally works: If the benefits of a service take place and will be used in another state, that state will tax the revenue gained from that service. “Service revenue” generally is defined as revenue from intangible assets — not the sales of tangible personal property. Thus, in market-based sourcing states, the destination of a service is the relevant taxation factor rather than the state in which the income-producing activity is performed. (This is also known as the “cost of performance” method.)
Essentially, these states are looking to claim a percentage of any service revenue arising from residents (customers) within their borders. But there’s a trade-off: Market-based sourcing states sacrifice some in-state tax revenue because of lower apportionment figures. (Apportionment is a formula-based approach to allocating companies’ taxable revenue.) But these states feel that, even with the loss of some in-state tax revenue, they’ll see a net gain as their pool of taxable sales increases.
If your company is considering operating in another state, you’ll need to look at more than logistics and market viability. A nexus study can provide insight into potential out-of-state taxes to which your business activities may expose you. There’s a possibility that, because of differing state rules, you may find yourself subject to tax in more than one state.
If that happens, you’ll need to navigate the rules with caution to determine how best to reconcile the inconsistencies. Once all applicable income, sales and use, franchise and property taxes are factored into your analysis, the effect on profits could be significant.
Bear in mind that the results of a nexus study may not be negative. If you operate primarily in a state with higher taxes, you may find that your company’s overall tax liability is lower in a neighboring state. In such cases, it may be advantageous to create nexus in that state by, say, setting up a small office there. If all goes well, you may be able to allocate some income to that state and lower your tax bill.
Not a simple decision
Issues surrounding nexus and market-based sourcing are somewhat complicated. Knowing the rules is critical. Contact your CPA to discuss the options.