Is your business providing services to customers in multiple states or is it planning on expanding into a new state? That’s great! Being able to offer your services to customers in multiple states can be a fulfilling and exciting outcome from running a successful business but it also creates several challenges. There are numerous physical, logistical and legal problems created by having customers located in multiple states, so last thing you are probably thinking about is income taxes. However, being aware of a few key rules and some careful planning can potentially help you save on your tax bill at the end of the year.
When a company has taxable business activities in multiple states, it entitled to have its income fairly apportioned, or allocated, amongst the taxing states. In order to comply with this requirement, states have traditionally adopted one of two methods of apportioning income:
- Three-Factor Apportionment Formula – Income tax is based on a weighted average of a company’s sales, payroll and property in that state.
- Single-Factor Apportionment Formula – Income tax is based solely on a company’s sales.do
With each passing year, more and more states have been adopting a single-factor sales apportionment formula with well over twenty states currently using the formula in 2019. Additionally, many states that still use a three-factor formula, place more weight on the sales factor.
What does this all mean to your business? In general, your company’s sales will be the determining factor of how much income is taxable to each state it is doing business in.
Sourcing of Sales of Services
After understanding how your company’s income will be apportioned, it is important to understand how a state determines whether or not your company’s sales of services will be included in that particular state’s apportionment formula. As noted above, sales are typically the most significant factor in determining taxable income, which means sourcing can play a more significant role in determining income taxes than apportionment.
In general, a state sources sales of services using one of two methods:
- Cost-of-performance method – Sales of services are assigned to the state in which the income-producing activity is performed. If a company performs the income-producing activity in two or more states, the sale is assigned to the state in which a company performs a greater proportion of the income-producing activity than in any other state, based on the costs of performance.
- Market-based method – Sales of services are assigned to the state in which the customer receives the service.
Recently, the market-based method for sourcing sales of services has been the trend in state taxation with over half of the states adopting some form of a market-based rule as of January 1, 2019. With the knowledge of the sourcing methods states use, it is possible for you to do some strategic planning to help minimize taxes.
Take Advantage of Sourcing Rules to Minimize Taxes
Since the majority of states are either using a single-factor apportionment formula or heavily weighting the sales factor, a good first planning step is to focus on each state’s sourcing rules that your company is doing business in. If your company has flexibility of where its services are provided from, it may have the ability to take advantage of sourcing rules.
For example, imagine your service business is located in State A, which applies the most prevalent sourcing method – the market-based approach, while your customer is located is State B, which applies the cost-of-performance method (See Example 1 below).
As you can see, the sourcing rules mean your company’s income won’t be taxed in either state.
Now, envision the business and customer locations are flipped (See Example 2 below).
As a result of the change, the revenue is sourced to both states, resulting in double taxation.
The examples above show paying attention to sourcing rules can provide tax savings, while ignoring them can create tax headaches. It is also important to know that many states have special rules for specific industries, and the laws of each state your company is operating in need to be examined before implementing a strategy.
Determining the taxability of your service company’s income can be a daunting task. Proper planning is the key to taking advantage of or avoiding the pitfalls of state laws related to the apportionment and sourcing of your company’s sales of services. Need help navigating state tax laws as they relate to your company? Start here.