Are you the owner of a company doing business in multiple states? Are you the person responsible for making sure that the state tax filing requirements for your company are met on a timely basis? If so, it is important for you to understand how you may be required to apportion your company’s income among the states. The first step in determining which state to source your sales revenue to for income tax purposes is to determine what is being sold: products or services. This step is critical because revenue from the sale of tangible personal property is sourced differently than revenue from the sale of services. Following is a discussion of how revenue from the various activities will be sourced.
Tangible Property Sales
Destination State Method
The majority of states adhere to the Uniform Division of Income for Tax Purposes Act (UDITPA), which has adopted the destination state method. Under this method, sales of tangible personal property are sourced to the destination state. Therefore, regardless of where the products are made, assembled or shipped from, the revenue for income tax purposes will be allocated to the state where the customer ultimately resides.
Some states provide for an origin-based method of sourcing sales in limited situations. This method sources the revenue from product sales to the state in which the seller is located. For example, Oklahoma requires origin-based sourcing when the taxpayer is not doing business in the purchaser’s state. Similarly, Utah requires origin-based sourcing when the taxpayer is not taxable in the purchaser’s state.
Sale of Services
For the sourcing of services there are two main methods currently being used:
Cost of Performance Method
The first method is cost of performance method was adopted by UDITPA and is required by a majority of states. The cost of performance method assigns all sales other than sales of tangible personal property to the taxing state where the income producing activity is performed. In cases where the service is performed in multiple states, sales are sourced to the state where the greater portion of revenue was earned. The amount of revenue earned is determined by the cost incurred to generate the revenue in each state. For example, if the service provider is located in Indiana and provide services to customers in multiple states, the State of Indiana will source all of the revenue to Indiana as that is where the cost of performance lies.
There has been a shift over the past few years toward the second method: market-based sourcing, which allocates service revenue to the state in which the benefit of the service is received and will subsequently be used. Therefore, if an engineering firm from Michigan assisted with the design of a new bridge in Florida, the revenue generated from the services on the project would be sourced to Florida under this method (i.e., where the benefit is received).
When a company is doing business in two states with different methodologies on sourcing of services, the revenue can create a doubling up of taxation. For example, a service-based company located in Indiana is providing services to a Michigan client. Indiana will claim the sales under the cost of performance methodology, while Michigan will claim the sales under the market based sourcing rules (i.e., where the benefit is received).
Currently, laws for sourcing service revenues vary on a state-by-state basis. A significant number of states have adopted legislation requiring market-based sourcing to create additional tax revenue in situations where out-of-state service providers are servicing their in-state customers. Approximately 20 states are requiring market-based sourcing, with the majority of the other states requiring the cost of performance method. A few states have chosen to adopt entirely different methods.
It is important to distinguish between sale of products and sale of services, and to review the specific tax laws in each state when determining where to source your revenues. Please contact us if you would like to learn more about how these rules impact your state tax filing requirements or would like assistance assessing your company’s exposure for state taxes.