“Pitfalls of Expanding Business Across State Lines”

Mark Lubin and Jennifer Karpchuk’s article, “Pitfalls of Expanding Business Across State Lines” in CPA Now

Reprinted with permission from CPA Now, the blog of the Pennsylvania Institute of Certified Public Accountants.

Pitfalls of Expanding Business Across State Lines

By Mark L. Lubin, CPA, JD, LLM and Jennifer W. Karpchuk, JD

Practitioners who understand the business tax rules in their home jurisdictions sometimes face unanticipated exposures when a growing business client expands across state and local lines. This blog highlights some of the income tax and sales and use tax pitfalls that could arise for such businesses and their advisers.1 Through familiarity with potential exposures and the exercise of caution, unnecessary tax expense and exposure can be avoided.

Expansion-Related Nexus

Most U.S. states have income taxes and sales and use taxes. Income taxes are typically imposed directly on business entities (or owners in the case of pass-through structures). Sales taxes are typically imposed on purchasers of taxable goods and services, but a collection obligation is imposed upon the seller. Moreover, a reciprocal use tax is imposed upon a purchaser when sales tax is not collected by the seller or, in certain situations, when a seller is viewed as the ultimate customer.2 Failure to satisfy sales or use tax collection and reporting obligations can subject sellers to liability for the tax, plus interest and penalties.

Some level of connection, or “nexus,” must exist for a business entity to be subject to a state’s or locality’s taxing jurisdiction. Physical presence used to be required for a taxpayer to be subject to collection obligations for sales tax purposes, but those days are gone. Now, all states that impose a sales tax have adopted “economic nexus,” with varying monetary or number-of-sales thresholds for becoming subject to tax responsibilities. For income tax purposes, some jurisdictions use an economic nexus while others apply more traditional “factor presence” nexus principles, with varying thresholds as to when a taxpayer is deemed to have a sufficient connection to become subject to tax.3 Not understanding the thresholds and the company’s sales, property, and/or payroll within a state can lead to missteps.

Another trend that can increase tax exposure arose during the COVID-19 pandemic: the widespread practice of permitting workers to operate remotely. Many remote workers operate from residences in states or localities other than where their offices are located. Although taxable nexus typically results from the presence of employees in a jurisdiction,4 some jurisdictions provided temporary relief during the pandemic. Although the pandemic has dissipated, its impact on remote work has not.

These multiple factors present potential tax liability exposures. Practitioners who serve growing businesses can encounter these issues rather quickly, so it is a good idea to keep these considerations in mind:

• Different (lower) nexus thresholds, including not requiring any physical presence, can result in unanticipated income and sales tax exposure as businesses expand and make sales or provide services into new jurisdictions.
• Apportionment formulas may not operate consistently in new territories and the business’s home jurisdiction. Thus, businesses subject to income taxation despite a lack of physical presence may be particularly vulnerable to duplicative state taxation (without offsetting credits or similar allowances).
• Because statutes of limitation typically do not commence running until a tax return is filed, income taxation based on economic nexus may be asserted when it is no longer possible to obtain corresponding credits in other states.
• Remote workers can trigger nexus in states where a business doesn’t otherwise operate. The potential for worker recharacterization (i.e., independent contractors found to be employees on the basis of common law or other factors) can make businesses more vulnerable to this problem.
• Taxpayers claiming Public Law 86-272 protection from income tax should ensure they pay close attention to where their remote employees are located and what those employees are doing while working remotely to avoid an inadvertent loss of such protection.5

Income-Based Tax Measurement

Although state and local income taxes generally have a tax base similar to federal taxable income, multiple state and local taxation could result from tax base disconformity (federal-state differences, or differences among states) and differing rules regarding income allocation/apportionment.6 Moreover, business conducted through multiple legal entities are subject to varying rules regarding whether apportionment can or must be applied on a unitary (combined) or separate entity basis.7 Unitary apportionment may be more or less favorable than apportionment on a separate entity basis. These rules present planning opportunities and pitfalls that can easily be overlooked by businesses with a tax presence that is expanding (sometimes unknowingly) into new jurisdictions.

Practitioners serving expanding businesses should keep the following in mind regarding these issues:

• Rules regarding unitary vs. separate entity apportionment are typically fact-based, with the burden of proof usually being imposed on taxpayers. Thus, advance planning and good recordkeeping can significantly affect a business’s tax burden. Such planning should take into account differences in tax bases, allocation and apportionment rules, and unitary vs. separate entity principles.
• Potential planning considerations where separate reporting may be permitted or required include selection of legal entities to hold tangible or intangible assets, have employees, and make sales. Such planning is typically most effective when tax considerations align with business objectives, and where arrangements are in place before a taxpayer triggers tax nexus. Practitioners can often have a material impact by understanding their clients’ businesses, and preserving evidence that supports desired tax treatment.

As businesses increasingly expand and remote work continues to evolve, tax practitioners can provide substantial value by proactively anticipating potential exposures and identifying issues clients may face before expanding their businesses into new jurisdictions.

[1] Due to space limitations and differences in state and local tax laws and regulations, this article presents only a general discussion. For simplicity, the income tax discussion here is geared toward business conducted through C corporations, although similar considerations generally apply to business conducted through S corporations, partnerships, and limited liability companies taxed as partnerships.

2 Use tax is the counterpart of the state and local sales taxes. Generally speaking, when sales tax is not charged by the seller on a taxable item or service delivered into or used in a state, the purchaser is required to report and remit use tax. References to sales taxes in this article generally apply to both of these types of taxes.

3 The factors to which such treatment generally applies are property, sales, and/or payroll within the state.

4 Though beyond the scope of this article, employment tax obligations and exposure can also result due to such presence.

5 Public Law 86-272 is a longstanding federal law that limits a state’s ability to subject an out-of-state company to income tax where: the out-of-state company’s activities in the state are limited to the solicitation of sales of tangible personal property; orders are sent out-of-state for approval; and orders are shipped from out-of-state. For more information on this topic, see the CPA Now blog, Flexing State Tax Muscle: The Evisceration of Public Law 86-272

6 Multistate businesses are generally subject to apportionment on the basis of a formula that takes into account factors that include relative in-state amounts of some or all of overall sales, property, and payroll.

7 In general, where unitary apportionment applies, the apportionment formula is applied to the combined tax base for all legal entities participating in the business, rather than separately for each entity. The rules in this area vary by jurisdiction, but it is worth noting that taxpayers can sometimes invoke combined apportionment by establishing that multiple entities conduct one single (unitary) business. On the other hand, related taxpayers can sometimes be required to apportion on a unitary basis unless they can establish that they conduct separate businesses.

Mark L. Lubin, CPA, JD, LLM, is special counsel at the law firm Chamberlain Hrdlicka in Philadelphia, where his practice focuses on tax planning and complex business transactions. He can be reached at mlubin@chamberlainlaw.com.

Jennifer W. Karpchuk, JD, is co-chair of the state and local tax controversy and planning practice at Chamberlain Hrdlicka. She can be reached at jennifer.karpchuk@chamberlainlaw.com.