The federal income tax system is often discussed and, with the exception of its many intricacies, the general concept is largely grasped by taxpayers. There is less discussion, publicity and awareness by taxpayers of how state tax compliance systems are run and the many differences that exist among them.
How do individual states decide who is entitled to tax a business with activity in multiple states? What factors do they use to determine how much income is taxed? Do all states assess the same types of taxes? Are there changes happening currently in the state tax arena that business owners should be aware of? Let’s compile the answers to these questions, compare tax policies between various states and review the changes the current economic and political climate is ushering in.
State tax is predicated on the idea that each state has the right to tax entities domiciled within its borders. Many states also exercise the right to tax income earned within the state by non-resident businesses. With state boundaries less significant as businesses expand nationally and globally, a state’s right to tax is less clear.
A state’s ability to tax income relates to a concept called “nexus.” Nexus for tax purposes can be defined as the extent to which a state has connection to a business’s income and consequently, the right to levy taxes.
Business Income Tax
State income tax rules for businesses work much differently than the rules for individuals when multiple states are involved. Through a concept aptly known as “apportionment,” a business allocates its net income for the year across the various states in which it operates. The apportionment factors can vary but are usually some combination of revenue, payroll expense, equipment, property, inventory and rent expense.
Each state typically requires a few adjustments to the amount of income calculated for federal tax purposes. Once adjusted, this income is then subjected to the state’s respective apportionment percentage to determine how much income will be subject to tax in that state.
The range of the states’ corporate income tax rates is from 0 to 9.9 percent (Pennsylvania).
North Carolina assesses a 6.9 percent tax rate and South Carolina a 5 percent rate, ranking each 27th and 42nd highest, respectively.
Due in part to a down economy, increase in Internet sales bypassing the purchasers’ state sales tax, and some income tax ideological shifts, states are in need of revenue and are becoming more aggressive and creative in efforts to generate it. The revenue streams being tapped are typically from businesses, specifically those engaged in e-commerce.
Historically, for sales tax purposes, nexus was not considered established for products delivered by U.S. mail. Without nexus, vendors had no ability to collect sales tax on out-of-state purchases. The recent trend has been for states to expand the definition of nexus and require businesses to withhold sales tax through a movement called “agency nexus” (aka “click-through” or “Amazon” nexus).
In 2011, 15 states enacted, or began legislative action to establish agency nexus, not only because of the need for additional tax revenue, but also the recent challenges to a Supreme Court case inferring that a business does not establish nexus unless it has a physical presence in a state.
Some states are also supplementing income tax or doing away with it altogether by creating alternative taxes. Ohio, for example, taxes gross receipts instead of net income. Many states (including North Carolina) have a franchise tax, which can be based on a company’s equity, net book value of their fixed assets or other non-profit indicators. These sorts of business privilege taxes provide states with tax revenue even when companies are not profitable, thus ensuring the states’ receipt of tax dollars.
Whether it is rooted in fiscal ideology, changing economic conditions or other factors, state tax policies vary from state to state and from the federal tax code. Businesses should keep state tax compliance in their thoughts, especially as states continue to look for additional sources of revenue. Policies across states can be as varied as the weather. Tomorrow’s forecast: probable continued change with a 100 percent chance of increased state efforts to collect on what each deems to be its proper share.