State and Local Taxes: Income Tax
Kim Tarnakow, CPA
The first state corporate income tax was enacted in 1901 by Hawaii, long before Hawaii was even a state. Since then, many states have adopted state income taxes. Currently, all but 5 states have true corporate income taxes, with the current marginal rates ranging from 1% to 12%. Like every other area of state and local taxes, income taxes are evolving. There is a trend of states opting for a gross receipts-based tax instead of or in addition to, an income tax. A gross receipts tax means a business may have a tax liability regardless of whether they have net income. In this overview of business income tax, several primary concepts of income tax will be addressed, including nexus, apportionment and the taxation of pass-through entities.
Nexus is the minimum contact with a taxing jurisdiction that gives that jurisdiction the authority to levy a tax for doing business. Traditionally, nexus was a physical presence standard, which means a business had to have a physical presence in a state to be subject to income tax. With the shift of business away from brick and mortar stores to being e-commerce based, the states had to do something to capture the tax dollars related to e-commerce, and to level the playing field for brick and mortar stores. States have shifted away from the physical presence nexus standard, with only a handful of states still requiring it.
Most states have adopted some form of an “economic nexus” standard. An economic nexus standard is one in which a business is deemed to have nexus in a state if the business is seeking to make a profit or develop a market in the state. This has been defined in different ways by each state and may include such activities as actively engaging in an activity for profit or pecuniary gain, trying to establish a market, carrying on any business activity, or deriving income from sources in the state. Some states have stipulated a sales dollar threshold for economic nexus, which once exceeded, creates a filing requirement.
Another nexus standard which some states have adopted is the “factor presence” nexus standard. A factor presence standard will typically set thresholds for sales, or, sales, payroll and property within the state. Once these thresholds have been exceeded, the taxpayer is deemed to have nexus, and therefore, an income tax filing requirement. It is important to understand the nexus requirements of each state in which you are conducting any form of business, as the requirements for each state are different.
Apportionment is the way total business income is assigned to each state in which there is nexus. Traditionally, apportionment for each state was based on the average of three equally weighted factors: sales, payroll and property. With the changes in the way business is conducted, many states have determined that the three equally weighted factors no longer accurately or fairly reflect the level of business a company has in a state. Currently, only 5 states are still utilizing the traditional equally weighted 3 factor apportionment formula. To better capture the true business being conducted in a state, almost one-third of the states, while still using three factors, have more heavily weighted the sales factor. Almost half of the states have gone to a single sales apportionment factor, which means that income from a business is assigned to a state solely based on the portion of total sales to that state.
Taxation of Pass-through Entities
Pass-through entities are subject to the same nexus standards as taxable entities. Many states have withholding requirements for non-resident owners. Withholding requirements may apply to specific owner entity types, be mandatory and may or may not relieve the owner from a separate state filing requirement. Many states also have the option of filing a composite return on behalf of non-resident owners, which relieve the owners of filing a separate return. The rules vary by state as to who is eligible to be included in the composite return, if an election is required to be included or excluded from the filing, the minimum number of owners required, etc. State composite payments made on behalf of an owner are treated as a distribution to the owner. The owner may get a federal tax deduction for the state taxes paid (subject to the SALT deduction limitation) and a credit for taxes paid to another state on their resident state return.
A hot topic in the pass-through area involves the federal SALT deduction at the individual level. Under the Tax Cuts and Jobs Act, the SALT itemized deduction on an individual return is limited to $10,000. To work around this limitation, several states are considering the taxation of the pass-through entity at the entity level. Under this scenario, the entity would be subject to the state tax similar to a corporate taxable entity. With the entity paying the tax, the state tax would be deductible for federal tax purposes at the entity level, thereby, avoiding the SALT limitation at the owner level.
Pass-through income being taxed at the owner level for federal purposes and at the entity level for state purposes is not a new concept. Several states have not recognized pass-through entity status for many years. Some of the states considering this change have indicated that the taxation of the pass-through entity will be mandatory, while in other states, it will be an election. Developments in this area should be watched.
Income taxes are typically one of the first taxes that come to mind when thinking of SALT. With all the nexus changes in recent years, a business should annually review where they are doing business, the location and amount of sales, and the applicable nexus standards in those states. Once a determination has been made as to where the company has nexus, care must be taken to ensure that the sales, property and payroll are being sitused properly between the states. Having any of the apportionment factors sitused incorrectly could potentially lead to more income being taxed in a higher tax state. Finally, if you are a pass-through entity, in addition to annually reviewing nexus and apportionment, the owner level filing requirements and options should be analyzed to see that the best alternatives for your company are being utilized.
If you have any questions about your SALT standings, please contact Kim Tarnakow at firstname.lastname@example.org or at (205)733-8265.