Businesses operating across state lines must determine the amount of their income that is subject to tax in each state. Generally, this is done using what is known as “formulary apportionment.” Given that states regulate the apportionment methods they allow and are not required to use a uniform approach, the varying methods — especially the different ways states source and weight a taxpayer’s sales activities — may result in excessive taxation overall. Multistate businesses should review the apportionment options and rules in the states and localities where they are taxable for potential opportunities to reduce their tax bill and to ensure they are reporting and paying the correct amount of tax.
Formulary Apportionment in General
In general, taxpayers with multi-state activities apportion their business income or loss among the states where their activities occur. Formulary apportionment is usually accomplished by means of a fraction, with the numerator accounting for the business’s in-state activities and the denominator accounting for the business’s activities everywhere. The fraction is then converted to an apportionment percentage, which is applied to the taxpayer’s apportionable income. The result is the amount of the taxpayer’s income that is subject to net income tax in that state. Accordingly, the computation of the apportionment percentage may have the largest impact on the taxpayer’s state income tax return.
Apportionment Rules Vary by State
Generally, state apportionment formulas account for the taxpayer’s property, payroll and sales (or receipts) activities. Historically, states used an equally weighted three-factor formula. Over time, many states have gradually given more weight to the taxpayer’s sales, for example, by double-weighting or even a triple-weighting the sales factor. The current trend is to apportion income based on sales alone using a single sales factor formula. States may also apply special apportionment formulas to certain industries, including financial services, transportation, broadcasting and publishing. Elective formulas, such as for manufacturers, may present planning opportunities.
The exact composition of each factor (property, payroll and sales) varies by state and industry. Some common areas of differences among the states include:
- Determining when property is used in the business and should be included in the property factor.
- Treatment of executive compensation in the payroll factor.
- Whether occasional or isolated sales are included in the sales factor.
Sales Sourcing Methods
The sales factor can present interesting and challenging issues. Sales of tangible personal property are generally sourced to the state where the property is delivered — but there are several notable exceptions that could result in sales being sourced to a different state. For example, sales to the federal government or sales that are shipped to a state in which the seller is not subject to income tax may be sourced (or “thrown back”) to the state from where the shipment originated.
With respect to sourcing receipts from sales of services and intangibles, there are two primary methods:
- Market-based sourcing, which requires the taxpayer to source sales based on where the customer receives the benefit of the service or where the service is delivered.
- Cost of performance sourcing, which generally requires the taxpayer to source sales to the state where the service was performed based on its costs of performance.
Businesses should note that some states apply different sourcing rules (and even different apportionment formulas) depending on whether the taxpayer is a C corporation, an S corporation or a partnership.
Because of the lack of uniformity among state apportionment rules, it is common for more or less than 100% of a business’s apportionable income to be apportioned among the states in which the business operates. Multistate businesses should be cognizant of how much of their total taxable income is subject to state tax while working within each state’s rules and regulations to ensure accurate reporting and the lowest possible tax liability. In some cases, a state may have more than one method businesses can use. In addition, where a state’s usual apportionment methodology does not fairly reflect the amount of business done in the state, the state may allow the taxpayer to apply to use an alternative method of apportionment. Accordingly, the application of state income apportionment formulas, including sourcing of receipts, requires a detailed understanding of a taxpayer’s business, transactions and states of operation, among other facts and circumstances.
Additional State Apportionment Considerations
There are many additional factors to consider when reviewing state apportionment methods and calculations. Some of these include:
- Does the state distinguish between apportionable “business” income and allocable “non-business” income? Depending on the state’s rules, non-business income may be excluded from apportionable income and allocated to a different state.
- Does P.L. 86-272 impact the sourcing of receipts? P.L. 86-272 is a federal law that prohibits a state from imposing a net income tax on an out-of-state person soliciting the sales of tangible personal property and whose contacts with the state are limited to certain “protected” activities.
- Don’t forget local jurisdictions. Localities that impose net income taxes may have apportionment formulas and sourcing provisions that differ from state rules.