Authored by Miroslav Georgiev on January 12, 2021
In a world that is becoming more global, many companies have focused their resources on dealing with new international markets. While important, it is also imperative businesses do not take their eyes off the ball at home.
Every year state and local taxes play a larger role in the corporate tax season. Combined with the fact that companies are doing business in more places than ever before, the result is that no tax consideration can be missed when preparing taxes. Evolving tax codes, recent court cases, and the impacts of COVID-19 are only a small portion of the full picture.
To help make that picture a little fuller, we have put together eight state and local tax planning considerations that companies should be sure they cover before tax season.
State and Local Tax Planning Considerations
Every sale, every employee, every asset. Understanding nexus is an important first step when assessing state and local tax considerations. It includes a comprehensive list of every connection that a business has with a state or municipality, including sales, payroll, inventory, rent, and fixed assets. Nexus considerations will help ensure awareness if the business trips any thresholds for various types of taxes at the state and city levels such as sales and use taxes, income taxes, and taxes not based on income.
It’s on every company’s mind this year: will my filing be different because of COVID-19? When it applies to state and local taxes, the answer is: maybe. If a company is working remotely and its people decide to move out-of-state, it probably creates nexus for the company and potentially adds an additional tax obligation. But because many of the workers are only temporarily remote, many states have waived taxable presence for them, many others have simply not addressed the matter at all, and a small group of states have prescribed details on how remote workers affect apportionment. The clearest way to understand whether COVID-19 will affect tax liabilities is to check the impact on a state-by-state basis.
3. Sales Tax
$100,000 or 200 separate transactions. After the Supreme Court’s decision in South Dakota v. Wayfair, that is the threshold that a business’ sales need to meet in a given state in order for their online sales to be taxable. While not every state has adopted the ruling’s implications, most have adopted similar thresholds.
4. Income Tax
More and more states and cities are taxing out-of-state businesses on income earned in the state based on the economic nexus standard introduced by Wayfair. While the proportion is relatively low right now, it is a trend that Clayton & McKervey is watching. Hawaii, Massachusetts, Pennsylvania, Texas, and Washington have all adopted economic nexus thresholds for income tax purposes, as have the cities of Philadelphia and San Francisco.
After a business reaches the threshold to establish nexus with more than one state, they must apply the tax codes in each to apportion their tax burden. Depending on the state and the industry, every apportionment will be different, but generally applies some matrix of property, sales tax, and payroll. Cost of performance and market-based sourcing are two common methods states apply when sourcing service revenue. Knowing which applies to a given state is critical. Cost of performance has service revenue sourced to the state where the income was performed. On the other hand, market-based sourcing—quickly becoming the standard-bearer—has service revenue sourced to the state where the service was received. While more states are moving towards the latter, ensuring that a nexus report includes the proper sourcing revenue principles is crucial to correctly calculating tax liabilities.
6. Pass-Through Considerations
As pass-through entities, partnerships, LLCs, and S-corporations each have separate tax rules than a C-corporation. When applying state and local code, the two relevant returns are composite and withholding. Composite returns generally fulfill the filing requirement of out-of-state partners and shareholders, and include the apportioned income as a single entity. It is a restrictive method because not all states allow for composite returns and not all taxpayers are eligible to use the format, but in the cases where those restrictions do not apply, composite returns are preferred. On the other hand, generally state withholding tax returns do not satisfy the filing requirements for partners and shareholders, who each must file their own returns with the state taxing authority.
Whichever method is applied, both are considered distributions to partners or shareholders, and journal entries may be necessary to remove from state tax expense accounts. When these taxes are treated as distributions to individual owners, the federal deductibility is limited by the SALT Cap. This is the $10,000 limitation on the amount that can be claimed for state and local taxes on Schedule A of Form 1040. Several states are considering legislation that would levy the tax at the pass-through entity level instead of the individual level upon an entity’s election. If the tax is levied on the entity instead of the individual, the entity would be able to deduct the tax for federal purposes and it would no longer be treated as a distribution. Business owners will need to keep an eye out to take advantage of these opportunities when a state adopts the appropriate legislation.
7. Voluntary Disclosure Agreements (VDAs)
When companies establish nexus with a state, oftentimes they unintentionally omit registering or filing appropriate tax returns for the period starting when taxable presence began. As such, they are liable for fees and even legal liabilities from state taxing authorities and the IRS. Understanding the often-innocent mistake, many states have set up voluntary disclosure programs that allow companies to retroactively acknowledge and pay outstanding taxes owed when the company was operating in the state. Most states and cities offer them, and they are designed to encourage compliance by eliminating large portions of penalties, limiting the look back period for past due returns, and providing audit protections.
8. Amnesty Programs
Similar to VDAs, amnesty programs allow penalty-free payment of outstanding taxes. Time windows and eligibility vary by state, but companies should always take advantage of the program if need be.
State and local tax planning obligations are a complex aspect of tax season that companies are increasingly having to deal with and spend resources on. Understanding the subtleties of each state and municipality can be challenging, but the tax team at Clayton & McKervey can help businesses of any size make sense of tax season. For additional information, call us at 248.208.8860 or click here to contact us. We look forward to speaking with you soon.