Navigating the patchwork of laws and regulations that govern state and local taxes is never an easy task. Timothy J. Hilligoss, Shareholder – International Accounting, Practice Leader for Asia, and Bryan D. Powrozek, Senior Accountant – SME, both of Clayton & McKervey, P.C., analyzed and discussed important state and local tax (“SALT”) issues affecting all business at the last quarterly CFO/Controller Roundtable. The presentation and discussion touched on a variety of different SALT topics including:
- What is Nexus?
- Tracking Nexus
- PL 86-272
- Franchise Taxes
- Click Through Nexus
- Sales & Use
- Reverse Audits
- Other Issues
- Non-resident Withholding
What is Nexus?
For a state to levy a tax on a business, it must have nexus, or a connection. Nexus is generally created when a business has a physical presence in the state. This includes the following:
- Employing workers
- Owning or renting physical property
- Deriving income from within the state
Unfortunately, there is no one universal characteristic that creates nexus. Each state has its own laws and regulations governing when a business is subject to tax. In addition, each type of tax may have a different trigger for creating nexus. For additional information on nexus, please view “Top 5 Questions on State Income Tax Nexus.”
Businesses need to evaluate their nexus risk in each state they do business. It is critical to examine sales and wages by state and take the appropriate action in high-volume states. During our discussion, it became apparent this information was not always the easiest data to track and obtain. However, by working jointly with operations and other non-financial areas of the company, businesses often have the ability to gather and acquire the appropriate information to track nexus. States have begun sending nexus questionnaires to determine if a business should be paying taxes and filing tax returns within the state. Businesses that have ignored or do not closely track their multi-state activity could suddenly find a state tax authority claiming they have nexus and demand the business file all appropriate tax returns with penalties and interest. As mentioned during our discussion, states have many ways to track your business; Minnesota has tracked business sales through the 1099 issued from a customer. However, if a business is on top of its multi-state activity, many states have voluntary disclosure programs which allow businesses to get up to date with their tax filings without penalties. The following states were mentioned as “hot” states in regard to notifying tax payers of possible nexus:
- New York
PL 86-272 and its limits
Congress attempted to protect businesses from unfair and burdensome taxation from states by passing PL 86-272 in the late 1950s. PL 86-272 prevents a state from levying an income tax on a business simply because the business solicited sales in that state. PL 86-272 only applies to income taxes; it will not protect against sales and use, gross receipts, net worth or franchise taxes. If not careful, an unsuspecting business could wind up with a tax bill. The following states have substantial franchise taxes that would not be limited by the benefit of PL 86-272:
- Ohio (Commercial Activity Tax)
- Texas (Revised Franchise Tax)
- Washington (Business & Occupation Tax)
- Kentucky (Limited Liability Entity Tax)
Click Through Nexus
Click through nexus laws attempt to assign nexus to a business with no physical ties to a state. These laws look through the transaction to the unrelated website owner’s state of residence. New York’s highest court recently heard a case related to click through nexus laws. Amazon.com was receiving customers through an unrelated website and paying the owner of the website commissions. Neither Amazon nor the website owned physical property, employed New York residents, or shipped goods to New York under the transaction. However, the owner of the unrelated website was a New York resident. New York’s click through nexus law stated that since this was the case, Amazon.com was responsible for collecting and remitting sales tax to the State of New York. The high court agreed and Amazon.com was forced to pay sales tax. In addition to New York; Illinois, Kansas, Maine, Minnesota, and Missouri have passed similar laws. Illinois’ highest court recently struck down the state’s click through nexus law. The court ruled the law violated the Commerce Clause of the US Constitution and was preempted by the Federal Internet Freedom Act. The key takeaway, state tax laws change daily through legislation and litigation: knowing the impact could save or cost your business money.
Sales & Use
Unsuspecting companies are often hit with sales & use tax audits. It is vital that records are kept to ensure the audit process runs smoothly and efficiently. Some businesses are handling audits internally, while some are requesting the assistance of a CPA or other qualified individual. Businesses have reported auditors going back three to four years to examine electronic and paper records of the business. Two keys areas that auditors are examining are:
- Exemption Certificates – All businesses should keep their customer’s exemption certificates on hand. If your customer claims they are exempt from sales tax and you do not provide an exemption certificate, your business, not the customer may be responsible for the unpaid tax.
- Electronic files – Although it was discussed that auditors sample paper files, many have moved to requiring electronic data to audit. With sophisticated technology, auditors are able to extract key, often incriminating data, with ease.
To minimize the chances of an unfavorable audit result, businesses are encouraged to get into the habit of performing “self-audits.”
It is important to note that audits do not always have to be an expense to a business. They can also be a source of untapped funds. A reverse audit is designed to find instances where a company paid too much tax, as opposed to little as is the case of a traditional audit. Two forms of tax to perform reverse audits are sales & use and property tax. Industrial producers are exempt from sales tax & use tax for qualifying purchases. Many manufacturing businesses overlook the sales tax assessed on utilities. The portion of the utilities used in the industrial process should be exempt from sales tax. A reverse audit is designed to uncover these particular scenarios.
For businesses that elect to be treated as a pass-through entity, most states require that the business file a state income tax return along with their federal return. Pass-through entities pay no taxes and the underlying liability is passed through to the individual shareholders/members. Many states now require pass-through entities to withhold the non-resident shareholder/member tax liability on their behalf. The withholding is often at the highest marginal tax rate and without the benefit of exemption or deductions. This forces the shareholder/member to file a non-resident personal income tax return. The withholding may be avoided by having the non-resident shareholder/member sign a statement indicating they do not want the business to withhold taxes on their behalf and they personally take responsibility for the underlying taxes.
States use a variety of ways to apportion income. Some use sales as the single weighted factor, others use an evenly weighted three factor formula (sales, property, and payroll), while others use a blend of the two. It is very important to examine the sales definition for each state. In theory, no sale should be subject to double taxation, but the reality, sales are sometimes taxed by multiple states or not taxed at all. The following are examples of what may constitute a sale depending on the state’s respective definition:
- Where the Benefit is Received – The sale is sourced to the state where its benefit is most received by the customer
- Market Based – The sale is sourced to the state whose market it most relates
- Cost of performance – The sale is sourced where the work to complete the sale took place
- Throw Back Sales – If the sale can be sourced nowhere, the sale is “thrown back” to the state it originated from.
SALT is a dynamic and complex area of tax law. It will impact your business. Knowing your exposure can help avoid surprises, and may save you time and money.