Estimating state-level taxes is generally easier when you operate in only one state. But manufacturers and distributors that cross state lines may be subject to tax in more than one state. Although this may complicate matters during tax filing season, it also offers opportunities to lower your company’s state tax liability, if you know the relevant state tax laws and plan ahead.
The Concept of “Nexus”
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 in a given state that’s substantial enough to trigger that state’s tax rules and obligations.
Precisely what activates nexus in a given state depends on that state’s 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 a state, either with your own workforce or by hiring others to perform the work on your behalf.
A minimal amount of business activity in a given state might not create tax liability there. For example, an OEM that makes two tech calls a year across state lines might not 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.
If your company licenses intangibles or provides after-market services to customers, you may need to consider “market-based sourcing” to determine state tax liabilities. 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 occur and will be used in another state, that state will tax the revenue gained from said 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 (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 consider 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. 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 be valuable. 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.
Naturally, if your company licenses intangibles or performs after-market services for customers, you’ll also need to identify whether the state in question uses market-based sourcing. Your Elliott Davis tax advisor can help you understand state tax issues and provide a clearer picture of the potential tax impact of crossing state lines.