Multistate Taxation Issues - Module 5 of 5

Multistate Taxation Issues - Module 5 of 5


Module 5: Multistate Taxation Issues

Whether it’s an annual payment to the local property assessor’s office or federal income taxes remitted to the IRS, most American taxpayers must pay tax bills to more than one jurisdiction. This is a natural consequence of the fact that federal, state, and local governments are all empowered to levy taxes. However, some taxpayers face unique tax challenges by virtue of the fact that they live and work in different jurisdictions, or because they employ people who live in different states.

Those with financial interests that cross state lines are responsible for fulfilling the respective tax obligations of each jurisdiction in which they do business. As a result, multistate tax issues often arise when people work in one state and live in another or when they complete business transactions in multiple states. This module provides an overview of the unique issues raised by multistate taxation as well as the policy responses lawmakers have developed to address them.

Incomes in Multiple States

Income derived from activities in one state may trigger tax liability regardless of the taxpayer’s residence. However, thanks to the constitutional prohibition on double taxation by multiple states on the same income, taxpayers earning income in multiple states must carefully account for what they owe to each jurisdiction in which they worked. In fact, depending on the circumstances, employees who travel outside of their states of residence for business purposes may be required to file an income tax return in every state in which they traveled – sometimes even if they were in the jurisdiction for just one day. Individual income tax liability for nonresidents may depend on any of several factors, including in which state the taxpayer earned money, how long he or she was in that state and whether the visiting jurisdiction has a relevant compact or agreement in place with the taxpayer’s home jurisdiction.[1]

States have divergent standards regarding what triggers personal income tax liability for non-residents, but common standards have developed across several jurisdictions. The “first day” rule, for example, is one common standard state revenue agencies impose on employees that temporarily work in a state. Under the rule, a taxpayer who works even for one day in a state in which he does not live owes income tax to that state. Most states follow the first day rule, which means that most nonresident employees are subject to income tax liability if they earn any amount of taxable compensation in the state.

Among states that do not follow the first day rule, income tax liability for nonresidents is still usually based on how long the person worked in the state. However, these jurisdictions begin to impose non-resident income tax liability at time periods ranging from ten days to two months of work in a state. For example, nonresidents do not incur income tax liability in Arizona until they have been in the state for more than sixty days in a given calendar year. Likewise, Maine begins to tax nonresident income earned within state lines after the taxpayer has been in the state for at least twelve days in a calendar year. New Mexico, New York, North Dakota and Connecticut follow similar policies.

Some states assess income tax liability on an income-earned basis, meaning that taxes are collected once a nonresident earns a threshold amount. The base income ranges from just $800 per calendar year in South Carolina to $10,650 per year in Minnesota. Georgia follows a hybrid approach that integrates a threshold requirement for both income and time spent in the state, and other states have executed compacts and agreements that affect individual tax liability.[2]

Federal Restrictions on Multistate Taxation

Each state may be empowered to levy and collect taxes within its jurisdiction, but Congress has attempted to pass a set of federal laws designed to regulate the complicated processes for determining tax obligations in the context of multistate taxation issues.[3] The recently reintroduced Mobile Workforce State Income Tax Simplification Act, as a prime example, would create a set of uniform, flexible tax liability laws for employees working across state lines. [4]

The Act exempts compensation earned in more than one state from being taxed in any state other than the state in which the worker resides or the state where an employee performs employment duties for more than 30 days in a calendar year. Once a nonresident worker meets the 30-day-per-calendar-year threshold working requirement, the nonresidential state’s income tax laws and withholding requirements would kick in. The taxes collected by the nonresidential jurisdiction could then be credited against the worker's income tax liability in her state of residence to avoid the possibility of double taxation.[5]

In 2015, the Supreme Court heard the case Comptroller of Maryland v. Wynne, which involved a challenge to a Maryland tax law that provided only a partial tax credit for residents who earned income out of state. Some Maryland taxpayers ended up paying taxes twice on income earned outside of the state. The Supreme Court held that this double taxation was unconstitutional, and Maryland’s law was invalidated. Now, in order to avoid unconstitutional double taxation, state income taxes must be apportioned so that taxpayers are only assessed for taxes due on income earned within the state.[6]

In practice, the apportionment process can be onerous. The concept of a reciprocal agreement was developed as a response to the 2015 ruling.[7] To avoid the challenges associated with calculating individual income tax liability across jurisdictions, some states have agreed to reciprocity agreements.[8]

These agreements vary in form and function. For example, some reciprocal agreements allow employers of one state to withhold taxes based on the state of the employee’s residency instead of the employer’s state or the state where the employee performed the work. Other agreements allow residents of one state to work in another without having to file nonresident state tax returns there. Some reciprocal agreements even exempt nonresident workers from having to file taxes in the state if they hail from specific other states.[9]

To make sure taxpayers qualify for rights and exemptions under many reciprocal agreements, they must begin by filing the proper paperwork with their employers. Employers and businesses must comply with the payroll and withholding requirements of each jurisdiction to which they have a sufficient connection.

Multistate Corporate Income Tax

Businesses that operate in multiple states can incur corporate income tax liability in several jurisdictions.[10] Because most large corporations conduct business in more than one state, many businesses face tax obligations in multiple jurisdictions. This has raised issues in administering state corporate income taxes that policymakers are still working to address.[11]

Tax policies regarding how to distribute profits from multi-state corporations among the states in which they operate are still developing. Some jurisdictions require corporations to divide taxable profits into in-state and out-of-state portions through an apportionment process. However, not all states use the same apportionment schemes, and whether a business is subject to the tax laws of a particular jurisdiction depends upon whether the company has a “nexus” to the state. [12]

The Constitution requires that a business have a “minimum connection” with a state for the state to be allowed to levy taxes against it.[13] If a business has property in a state, regularly sends its employees or independent contractors to the state for work, conducts the sale of goods or services within the state, avails itself of the state’s marketplace or has employees located in a state, it most likely has a nexus to the state. Even with a nexus, though, states only have the authority to tax the in-state portion of a corporation’s business – that is, the income earned as a result of the business’ activities within the state. If the corporation does not conduct at least a minimal amount of business in the state, it may not levy any taxes against the corporation.

When businesses derive income from states with which they have no nexus, the income is known as “nowhere income,” and it is not taxed by any state. To address issues created by “nowhere” income, several states have created “throwback” rules, which allow the state where the sale originated to tax the profits and to exclude that tax from its state’s share of total profits.[14] These rules are designed to identify and tax profits earned in other states but not taxed by those states.[15]

Uniform Rules on Income Tax Division

The Uniform Division of Income for Tax Purposes Act is a uniform law that helps regulators determine business tax liability based on the amount of business activity that a multistate business incurs in each jurisdiction with which it has a nexus. The law also lays out the guidelines by which states can establish their tax rights on profits and determines in-state tax liability using the ratio of sales the company made within the state to the company’s total sales. This is meant to prevent businesses from being subject to multiple taxation.[16]

The Multistate Tax Compact, a model law drafted in 1966 that incorporates the Uniform Division of Income for Tax Purposes Act, addresses some of the special tax issues that affect corporations that trigger tax liabilities in more than one state. The Compact created the Multistate Tax Commission consisting of tax administrators from all member states. States that incorporate the Compact into their legislation can become member states, which makes that state’s top tax administrator a member of the Commission. The Commissioners work together to promote fairness and uniformity in rules and regulations of state taxation of interstate commerce.

Specifically, commissioners are responsible for “drafting and updating of corporate income tax and sales and use tax audit manuals under the provisions of which it performs joint tax audits on behalf of the states (a joint audit is one performed on a taxpayer on behalf of several states at the same time); the operations of its audit, litigation, nexus, and uniformity committees; and the increasing willingness of its member states to resolve over taxation and under taxation problems on an equitable basis through the mechanism of the Commission.”[17] Additionally, the Commission is responsible for conducting legal research, participating in litigation on behalf of the member states, presenting legal programs and audit seminars, publishing tax publications and discouraging the increasing tendency of the federal government to intrude into the field of state taxation of interstate businesses. Because it is a model law, however, actions taken under the authority of the Multistate Tax Compact have only advisory effects on member states. [18]

The Uniform Division of Income for Tax Purposes Act also creates a policy commonly known as the “three-factor formula.”[19] The law recommends an apportionment that relies on three factors to determine the share of a corporation’s profits to be taxed between the states.[20] The formula balances the three factors of a corporation's overall property, payroll and sales, each of which are averaged equally.[21] First, it takes the percentage of the corporation’s nationwide property located in the state. Second, the percentage of a corporation’s nationwide sales made to residents of the state is taken into consideration.[22] Third, the percentage of corporation’s nationwide payroll paid to residents of the state is determined. Together, these figures determine the proportion of the company’s nationwide income that is due to a particular jurisdiction.

Historically, any business with corporate income tax liability may opt to adopt the apportionment principles of the Uniform Division of Income for Tax Purposes Act. However, each company is subject to the laws of the jurisdictions with which they have established nexuses. Two-thirds of corporate income tax states follow the three-factor formula; the remaining one-third of states follow other methods. For example, some states use a single sales factor method, in which the only factor considered when determining the tax base is the company’s in-state sales.[23]

Multistate Sales and Payroll Taxes

For many businesses, whether a nexus exists proves difficult to determine. While the Supreme Court has delineated the baseline requirements for a nexus, each state has its own rules regarding what constitutes a business presence sufficient enough to trigger tax liability. This lack of consistency raises particular challenges for businesses that serve customers across many jurisdictions, such as internet wholesalers and retailers.

In the landmark case of South Dakota v. Wayfair, the Supreme Court affirmed that state and local sales taxes may be assessed against out-of-state business that ship to in-state customers so long as these laws are written in a manner that prevents an unnecessary burden on interstate commerce. Wayfair allows state and local governments to tax sales from companies located out of state only when compliance with the applicable tax rules are simple enough to not place an improper burden on interstate commerce.[24]

While double taxation is prohibited as a matter of constitutional due process, a federal law known as the Internet Tax Freedom Act prohibits multiple jurisdictions from levying taxes on the same online transaction. Thus, local sales or use taxes can be levied against companies only by the state, county, or district in which the transaction takes place.[25]

A corporation is responsible for withholding payroll taxes in the state where work is performed by the employee.[26] This is a state-specific responsibility; employees who work in a state trigger payroll and withholding regulations in that state, regardless of where the employer is located. Thus, much like corporate income tax, businesses that employ workers in more than one state must apportion their tax liability. The Uniform Division of Income for Tax Purposes Act determines this apportionment based on a payroll factor ratio that balances payroll within the state against the company’s total payroll.[27] The payroll factor includes wages, salary, commissions and other compensation. Other factors pertaining to the employee’s residence, the amount of time an employee spends working in another state and the company’s location are also considered. However, if an employee spends time in multiple states, then the computations get more complicated.

Conclusion

            Thank you for participating in LawShelf’s video-course in state and local taxation. We hope that you now have a better understanding of this area of tax law and we encourage you to take advantage of our other courses in taxation and in other areas. Best of luck and please let us know if you have any questions or feedback.



[1] Elaine S. Povich, “Road Warrior” State Income Tax Laws vary Widely, The Pew Charitable Trusts (Dec. 12, 2013), https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2013/12/12/road-warrior-state-income-tax-laws-vary-widely

[2] Problem: A patchwork of complicated nonresident income tax laws, Mobile Workforce Coalition, https://www.mobileworkforcecoalition.org/problem

[3] Elaine S. Povich, “Road Warrior” State Income Tax Laws vary Widely, The Pew Charitable Trusts (Dec. 12, 2013), https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2013/12/12/road-warrior-state-income-tax-laws-vary-widely

[4] Mobile Workforce State Income Tax Simplification Act of 2019, S.604, 116th Congress (2019-2020), https://www.congress.gov/116/bills/s604/BILLS-116s604is.pdf 

[5] Elaine S. Povich, “Road Warrior” State Income Tax Laws vary Widely, The Pew Charitable Trusts, (Dec. 12, 2013), https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2013/12/12/road-warrior-state-income-tax-laws-vary-widely

[6] Comptroller of the Treasury of Maryland v. Brian Wynne, 135 S. Ct. 1787 (2015).

[7] Tonya Moreno, Reciprocity: States That Do Not Tax Nonresident Workers,” The Balance (Apr. 16, 2019), https://www.thebalance.com/state-with-reciprocal-agreements-3193329

[8] Elaine S. Povich, “Road Warrior” State Income Tax Laws vary Widely, The Pew Charitable Trusts (Dec. 12, 2013), https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2013/12/12/road-warrior-state-income-tax-laws-vary-widely

[9] Tonya Moreno, Reciprocity: States That Do Not Tax Nonresident Workers, The Balance (Apr. 16, 2019), https://www.thebalance.com/state-with-reciprocal-agreements-3193329

[10] Top 10 Multistate Tax Issues Facing Companies, Thomson Reuters (Apr. 3, 2013), https://www.thomsonreuters.com/en/press-releases/2013/top-10-multistate-tax-issues-facing-companies.html

[11]  Corporate Income Tax Apportionment and the “Single Sales Factor,” Institute of Taxation and Economic Policy (August 2012), https://itep.org/wp-content/uploads/pb11ssf.pdf

[12] Michael S. Schadewald, Apportioning Income from Sales of Service, The CPA Journal (Oct. 2016), https://www.cpajournal.com/2016/10/01/apportioning-income-from-sales-of-services/

[13] Due Process Clause, U.S. Const. Amend XIV; What is Nexus? Sales Tax Institute, https://www.salestaxinstitute.com/sales_tax_faqs/what_is_nexus

[14] “Nowhere Income” and the Throwback Rule, Institute on Taxation and Economic Policy (Aug. 2011), https://itep.org/wp-content/uploads/pb39throw.pdf

[15] Scott Drenkard, A Very Short Primer on Tax Nexus, Apportionment, and Throwback rule,” Tax Foundation, (Mar. 28, 2016), https://taxfoundation.org/very-short-primer-tax-nexus-apportionment-and-throwback-rule/

[16] Corporate Income Tax Apportionment and the ‘Single Sales Factor,’ Institute of Taxation and Economic Policy (August 2012), https://itep.org/wp-content/uploads/pb11ssf.pdf  

[17] About the Multistate Tax Compact, With Suggested Enabling Act, Multistate Tax Commission,http://www.mtc.gov/getattachment/The-Commission/Multistate-Tax-Compact/About-the-Compact-and-Suggested-Enabling-Act.pdf.aspx,

[18] Id.

[19] Model Compact Article IV Division of Income, Uniform Division of Income for Tax Purposes Act, (Multistate Tax Comm’n, 2015), http://www.mtc.gov/getattachment/Uniformity/Article-IV/Model-Compact-Article-IV-UDITPA-2015.pdf.aspx

[20], Corporate Income Tax Apportionment and the “Single Sales Factor” Institute of Taxation and Economic Policy (August 2012), https://itep.org/wp-content/uploads/pb11ssf.pdf  

[21]  Scott Drenkard, A Very Short Primer on Tax Nexus, Apportionment, and Throwback Rule, Tax Foundation, (Mar. 28, 2016), https://taxfoundation.org/very-short-primer-tax-nexus-apportionment-and-throwback-rule/

[22] Corporate Income Tax Apportionment and the ’Single Sales Factor,’ Institute of Taxation and Economic Policy (August 2012), https://itep.org/wp-content/uploads/pb11ssf.pdf  .

[23] Cara Griffith, “Single Sales Factor Apportionment May Be Inevitable, But Is It Fair? Forbes (Sept. 18, 2014), https://www.forbes.com/sites/taxanalysts/2014/09/18/single-sales-factor-apportionment-may-be-inevitable-but-is-it-fair/#49480a94131c

[25] Internet Tax Freedom Act, Pub. L. No. 105-277, (1998); Jeffrey Stupak, The Internet Tax Freedom Act: In Brief, Congressional Research Service (Apr. 13, 2016), https://fas.org/sgp/crs/misc/R43772.pdf.

[26] Barbara Weltman, Payroll Concerns for Remote Employees, U.S. Small Business Administration (June 11, 2015), https://www.sba.gov/blogs/payroll-concerns-remote-employees

[27]  See, e.g. Ill. Admin. Code tit. 86 § 100.3360 (2000) (stating the payroll factor of the apportionment formula as contemplated in the Uniform Division of Income for Tax Purposes Act).

 

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