Is Your Business in Compliance with Market-Based Sourcing As States & Tax Enforcement Become More Aggressive?
Calculating how to source gross receipts (i.e. sales) is a key component in determining a company’s state income or franchise tax liability. Businesses that operate in multiple states should be aware of the growing trend in which states are migrating from a cost of performance-based sourcing method toward a market-based sourcing method when determining where to properly source gross receipts derived from sales other than tangible personal property.
This has become increasingly important amidst the pandemic as states are likely to be more aggressive with tax audits and compliance enforcement to search for revenue to overcome budget shortfalls. Noncompliance with state filing and tax obligations could have an unexpected significant detrimental effect on a company’s bottom line. Also, you will likely have to resolve any non-compliance issues with state sourcing methods in the due diligence process when you look to sell your business. As a result, it is paramount to understand the potential tax implications that this trend towards market-based sourcing may present to your business and how to remain compliant with state regulations to mitigate any potential exposure risk.
States have historically utilized the cost-of-performance method for purposes of apportioning service revenue to a particular state. The cost-of-performance method is defined in Section 17 under the Uniform Division of Income for Tax Purposes Act (UDITPA).
The rule states that sales other than tangible personal property are apportioned to the state where the income-producing activity is performed (i.e. Where the work is performed). If the income-producing activity is performed across multiple states, then generally the revenue is apportioned entirely to the state in which the greatest proportion of where the costs were incurred that generated the revenue. Therefore, this method is often looked at as an “all or nothing” sourcing approach since the majority state gets assigned all of the revenue, whereas the minority states receive no allocation. Where the income-producing activity occurred generally depends on where the direct costs (ex. labor, utilities, supplies) of performing the services were incurred. Typically, states that use the cost-of-performance method assign more income or loss to those taxpayers that run their business operations within the state since that is where a significant percentage of their direct costs are incurred. Furthermore, this method is thought to be rather simple to follow as it generally only focused on the efforts and locations of the taxpayer’s employees.
Alternatively, market-based sourcing brings about a complete shift in methodology as it is designed to source gross receipts generated from service revenue to the taxpayer’s “market” for those services, thereby more accurately reflecting the customer base for the taxpayer’s services.
Under this sourcing methodology, the destination of the service revenue is relevant rather than the location of where the revenue was earned. It moves away from an “all or nothing” approach and attempts to better match receipts to the source of the corresponding revenue stream. Additionally, it is generally intended to collect more tax from out-of-state businesses with significant economic activity, but little in the way of payroll and property.
The specific market-based sourcing rules employed by different tax jurisdictions vary widely from state to state. States typically define the market as either one of the following:
- Where the benefit is received
- Where the service is received
- Where the service is delivered
- Where the customer is located
For example, sales of services are sourced to California to the extent where the benefit is received. Per California statute, the benefit of a service is deemed to be received at the location where the taxpayer’s customer has either directly or indirectly received value from the delivery of that service. If the taxpayer’s customer is an individual, the benefit of a service is generally presumed to be received in California if the customer’s billing address is in California, as determined at the end of the tax year. If the taxpayer’s customer is a business entity, the benefit of service is generally presumed to be received in California to the extent the contract or the taxpayer’s books and records indicated that the benefit of the service was in California, notwithstanding the customer’s billing address.
Rules can also differ depending on a taxpayer’s industry.
Hierarchy and Sourcing Rules under Market-Based Sourcing
Some states determine ‘the market’ under market-based sourcing using a hierarchy approach. In this approach, if a taxpayer cannot comply with the general sourcing rule then the taxpayer must move to the next rule in sequential order.
It is important to note that the hierarchy approach may require documentation as to the reasons why a particular sourcing step was not attainable. For example, if the hierarchy is ordered as 1) State where the service is rendered; 2) Office from which the order was placed; 3) Billing address; then documentation may be required to state why service revenue was unable to be sourced to the state where the service was rendered.
Most states’ sourcing methods do not provide much information regarding how much documentation is needed in order to be considered sufficient. However, it is best practice to document this in order to strengthen your sourcing position in the event a state audit develops.
States typically have different hierarchy sourcing rules for individual customers than from business customers. Furthermore, some states may offer different sourcing rules for in-person services vs professional services and for services delivered to the customer by physical means vs services delivered electronically.
For reference, in-person services may be defined as where the service is received or delivered in physical presence of the customer, whereas professional services may be defined as services that require specialized knowledge, license or degree such as legal, accounting, financial, and consulting services. Generally, in-person sourcing rules control over professional service sourcing rules when overlapping occurs with respect to a service that meets the criteria for both definitions.
It is also noteworthy to point out that changing methods may prove to be problematic as some states require taxpayers to continue to use the method they chose and prohibit the taxpayer from changing the method from year to year without prior consent from the tax agency.
State Tax Nexus
Companies that operate in multiple states must apportion their income among the states in which they have nexus or a taxable presence. Nexus can be defined as developing a certain business connection with a state that allows a state taxing jurisdiction to impose its taxes on a company. In general, nexus is created for income tax purposes if a company derives income from sources within the state, owns or leases property in the state, or employs personnel in the state in activities that exceed “mere solicitation.” However, the requirements for determining nexus vary from state to state.
State Apportionment Background
The goal of income apportionment is to allocate an amount of income or loss to each jurisdiction that is proportional to a taxpayer’s taxable activities in the jurisdiction. The state apportionment rules vary from state to state. Generally, in the past, states required apportionment of a company’s income based on three evenly-weighted factors:
However, due to today’s economic landscape, more and more states are requiring additional weight towards the sales factor such as double weighing the sales factor. Furthermore, more and more states have adopted a single sales factor apportionment method.
One of the reasons in this shift in more heavily weighing the sales factor is because the traditional three factor apportionment method could be seen as a disincentive in increasing property and payroll investments, thereby discouraging investment and job creation in the state. Alternatively, a single sales factor apportionment method deemphasizes the property and payroll factors and therefore can be seen as an aid when states compete with each other for jobs.
The importance of the sales factor continues to increase due to the shift in states either weighing more heavily on the sales factor or adopting a single sales factor method altogether for state apportionment purposes. Section 15 under the UDITPA defines the sales factor as a fraction, the numerator of which is the total sales of the taxpayer in this state during the tax period, and the denominator of which is the total sales of the taxpayer everywhere during the tax period.
Generally, states require sales of tangible personal property to be sourced to the destination state. However, for sales from rendering services and selling or licensing intangible property such as software, states are moving away from a cost-of-performance to a market-based sourcing methodology.
Additional Rules To Consider
Other additional rules that some states may have in regards to their market-based sourcing regulations are the look-thru and throw out rules. Services that are delivered electronically through or on behalf of a customer are sourced to the end users under a state’s look-thru rule.
In other words, a taxpayer’s market for service revenue may be the customers of the customer. Some states have implemented a throw out rule where if a taxpayer is not taxable in the state (does not establish nexus) in which the revenue is to be assigned under market-based sourcing rules then the sale is excluded from the numerator and denominator of the sales factor.
Lack of Uniformity Among States
The lack of uniformity among states regarding sourcing of receipts from sales other than tangible personal property may result in either over-apportionment or under-apportionment. In other words, depending on the combination of states in which a taxpayer conducts business in, gross receipts may potentially be sourced in multiple states resulting in double taxation or no state at all. Therefore, a taxpayer’s total state tax liability will greatly depend on whether the states in which it has nexus in use either the cost-of-performance method or market-based sourcing method.
Consider these examples:
Company X is located in State A. State A follows the cost-of-performance method and sources gross receipts to the state in which the greatest portion of the costs to generate the income were incurred. Company X renders consulting services to a client located in State B, market based sourcing state that assigns service revenue to the location of the customer.
Based on the sourcing methods of State A and State B, the revenue may be sourced as follows:
- 100% to State A, where the greatest portion of costs to generate the income were incurred; and
- 100% to State B, where the customer received the benefit
Company X is located in State A. State A is a market-based sourcing state that assigns revenue to the location of the customer. Company X renders consulting services to a client located in State B, a cost-of-performance sourcing state that sources gross receipts to the state in which the greatest portion of the costs to generate the income were incurred. The majority of the costs that generated the income were incurred in State A.
Based on the sourcing methods of State A and State B, the revenue may be sourced as follows:
- 0% to State A because the location of the customer is in State B
- 0% to State B because the greater portion of the costs to generate the income were incurred in State A
Compliance Recommendations for Taxpayers
Taxpayers that operate in multiple states should consider the following recommendations to remain in compliance with state tax laws.
- Determine which states your business has developed nexus in for income tax or franchise tax purposes
- Identify the types of income that are being generated by a business that potentially may be impacted by the Cost-of-Performance Method and Market-Based Sourcing Method
- Determine what sourcing methodology the states employ in which your business has developed nexus in
- Quantify the tax liabilities resulting from applying the sourcing methods in the states that you have nexus in
- Analyze the type of data your accounting and billing systems can generate relative to each method and consider investing in updates and enhancements to your systems
- Consider tax planning opportunities such as investing in property and/or payroll in states that you have nexus in that are market-based sourced states
Please bear in mind that the intent of this article is to outline the requirements of state tax law for you in broad terms. You should consult with your tax advisor as there may be many technical requirements and details involved.
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Manager & CPA
With the firm since 2014, Eric has become an integral part of the firm’s tax team. Eric focuses on providing various tax advisory services for high net worth individuals, corporations and partnerships as well as providing state and local tax (SALT) advisory services to businesses of all sizes in order to mitigate risk, identify tax savings opportunities and remain in compliance with various state and local laws.
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About Traci Getz
Partner & CPA
Traci is a partner with Ryan & Wetmore, PC and is based in our Frederick, MD office. The Frederick office is home to the firm’s small business services department. Traci currently works with clients on individual, corporate, and tax compliance issues along with a variety of accounting and consulting services for small and medium-sized business owners.
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