Both taxpayers and state governments have been hit hard by the economy over the last few years. States have found themselves in budget shortfalls, and are under pressure to enhance existing funding, or create new sources of funding. Companies have seen decreased sales, and have been forced to reduce expenses in order to survive. While this obviously creates concerns for taxpayers, it also presents opportunities. One way is through the right to apportion income for income tax purposes.
What is the Right to Apportion?
A taxpayer generally pays tax in each jurisdiction based on their activity within that jurisdiction. When business is conducted solely within a taxpayer’s home state, and there is otherwise no connection with any other jurisdiction, the home state usually has the right to tax 100-percent of the taxpayer’s income. However, a taxpayer whose activities span several states must divide up its income among the states so that its income is taxed in an equitable manner from both the taxpayer’s and state tax authorities’ point of view.
Historically income was divided among states based upon the percentage of property owned, the compensation paid, and the revenue earned in each jurisdiction. Many states are moving toward a sales-factor only approach in order to increase the taxes paid by companies based outside the state. Nonetheless, the basic concept of apportionment remains, regardless of which factors are used. Apportioning income often presents taxpayers with the ability to lower their state income tax burden.
How is the Right to Apportion Established?
A company must meet certain requirements in order to apportion. The rule is that a company must have some kind of connection with more than one state, typically a physical connection. While this principle may seem straightforward, there is much more to it, as states differ on how this concept is applied. In some states, such as Florida, a taxpayer with enough connection outside of the state may apportion its income, even if the taxpayer is not actually subject to tax outside of Florida. Under this standard, a taxpayer may simply register to do business in a state that does not administer an income tax, (e.g., Nevada or Wyoming). Physical business activities outside the state are not necessary.
Some states are in the middle, like California. Under its laws, a taxpayer must actually conduct business outside of the state in order to apportion. Being incorporated or registering to do business outside of California is not enough. However, the taxpayer does not necessarily have to be subject to a tax in another state, nor does it necessarily have to have an office or other permanent place outside of California. The taxpayer may simply have employees entering the state for business reasons, for example. Other states are more draconian: New Jersey requires taxpayers to have a regular place of business outside New Jersey, plus the taxpayer must actually pay income tax to the state in which it has a regular place of business. This is perhaps the harshest standard, as a company may be subject to tax outside of New Jersey, but it still may not apportion its income on its New Jersey return. The taxpayer pays income tax to another state, but does not have an office or other place from which business is conducted it may result in double taxation. In this example, a portion of the income would be taxable outside of New Jersey, and 100-percent of the income would be subject to New Jersey income tax.
A growing number of states are adopting new standards in order to subject more out-of-state entities to their taxes. To increase revenue, many states are adopting what is called Economic Nexus. Under the economic nexus standard, a company may be subject to income tax as a result of having a customer or client in the state. In-state physical activities are not required. While this may pose a problem for out-of-state companies, it also presents an opportunity for taxpayers seeking to reduce their tax burden in their home states. Here, the right to apportion may be established by having out-of-state customers. No office or other business activity should be required outside the taxpayer’s home state if that home state adopts the Economic Nexus standard.
There are times when the cost of establishing the right to apportion may make it impractical. Establishing a place of business outside of a state often requires an investment in capital. Cost-effective ways of establishing the right may include sending personnel into a state, or having an employee work from home in a state where the taxpayer does not otherwise have business operations. In states that utilize the Economic Nexus, the cost of establishing the right may be minimal. For example, companies that sell via the internet may already meet the right to apportionment requirement in Economic Nexus states.
Finally, it is important to note that a company may already have the right to apportion. It is not uncommon for opportunities to be missed during the tax preparation process.
What is the Benefit to Establishing the Right to Apportion?
By establishing the right to apportion, companies may reduce their overall state tax burden. One way to do this is to establish the right to apportion to a jurisdiction that does not administer an income tax. For example, say that a company is based in Georgia, but 25-percent of its customers are located in Nevada (a state without an income tax). By establishing the right to apportion under Georgia law and by apportioning income to Nevada, about a quarter of its income may escape state taxation.
Another way to reduce tax is to apportion to a jurisdiction with a lower tax rate. Continuing with our example above, if a more than insubstantial number of this company’s customers are in Florida, a portion of its income should be taxed at a lower 5.5-percent rate, a savings of 1.6-percent on that income (disregarding the effect on a corporation’s state income tax deduction on its federal return).
One issue with establishing the right to apportion is the effect of states’ different requirements. A taxpayer may establish the right to apportion in one state, but still may not meet the standard in another state. For example, a company based in New Jersey with clients in Connecticut, but no place of business there, may be permitted to use apportionment on its Connecticut return, but not its New Jersey return. As stated above, a taxpayer must have a place of business outside of New Jersey in order to apportion income on its New Jersey tax return. However, Connecticut has roughly the same standard as Florida – that is, if another state has the right to impose a tax upon the taxpayer, regardless of whether it actually does impose a tax, the taxpayer should have the right to apportion. In this case, the taxpayer should be permitted to apportion its income on its Connecticut income tax return, but not its New Jersey return.
Your company has undoubtedly looked everywhere possible to reduce expenses and increase revenue. If you’re already operating on tight budget, seek additional opportunities to save money via your taxes. Consult your accountant to see if you’re eligible to apportion your income, potentially an area of significant savings.
About the Author:
Carl Richie, CPA is a Tax Manager at Kaufman, Rossin & Co., one of the top CPA firms in Florida. He can be reached at firstname.lastname@example.org.