Corporations with a taxable presence in multiple states must assign, or apportion, their total taxable income to each state. Apportionment is designed to prevent over-taxation of company profits by spreading business income among states. First things first, a company must determine in what states to file. For government contractors especially, this is of the utmost importance because improper filing could potentially lead to bid protests. How a company ensures compliance is through the determination of nexus, which in the most simplest of terms is the connection between a company and a state. This connection is derived from the business conducted within the state and from there, whether or not state rules deem this activity subject to income taxation. Only when nexus has been established does the state have the ability to levy tax on the income of a business.
As mentioned before, apportionment is meant to divide corporate income among nexus states. That being said, states are not uniform in the calculation of taxable income; each state has the right to choose an apportionment formula based on the three factors of sales, payroll and property. Note: due to the differences from state to state, apportionment percentages do not always sum to a perfect 100%. States can employ all three factors, or a variation. Some of the more common formulas are as follows:
• Equally weighted three-factor apportionment where all factors are considered:
Sales within the state + Payroll within the state + Property within the state
Total sales Total payroll Total property / 3
• A three-factor apportionment formula where the sales factor is weighted more (double in most cases):
Same as above except the sales factor is multiplied by 2
• Single-sales factor
Sales within the state = Apportionment percentage
Formulas for tax year 2014 are listed here on the Federation of Tax Administrators website. Most states, as is apparent in the chart, have adopted the single-sales factor. This recent trend from the three-factor weighted-average method, which was first introduced with the Uniform Division of Income for Tax Purposes Act in the 1960s, to the single-sales factor (SSF) is due to state political interests. With the emphasis being placed on sales over payroll and property, there is said to be an associated economic incentive for companies to bring in more employees, thus creating more jobs, and to shift current fixed assets or build new property in a SSF state. On the other side of the spectrum, out-of-state companies that have more sales in a SSF state as opposed to payroll or property will end up paying more taxes. While this is perceived to be a beneficial policy for states, most taxpayers will be facing the disadvantages of the single-sales factor.
What constitutes sales within a state, or property and payroll for that matter, also depends on the state and could be discussed at great length. State taxation is anything but simple! With year-end tax planning quickly approaching, it is a good idea to evaluate your multistate situation with your tax advisor. Reviewing this information could lead to potential tax benefits. Are you filing where you should be? Or shouldn’t be?