🧾Taxes and Business Strategy Unit 8 – State and Local Taxation

Key Concepts in State and Local Taxation

• State and local taxes (SALT) refer to taxes imposed by state and local governments in addition to federal taxes
• SALT includes income taxes, sales taxes, property taxes, and excise taxes levied by states, counties, and municipalities
• States have the authority to impose taxes based on their constitutions and laws, leading to variations in tax systems across states
• Local governments derive their taxing authority from the state, often through specific grants of power
• Businesses operating in multiple states must navigate complex tax rules and comply with each state's unique requirements
• Double taxation can occur when businesses are subject to taxes in multiple states on the same income or transactions
• Nexus, the connection between a business and a state that triggers tax liability, is a critical concept in SALT
• Apportionment and allocation methods are used to divide a business's income among the states where it operates for tax purposes

Types of State and Local Taxes

• Income taxes are levied on individuals and businesses based on their income earned within the state
  • States may have graduated or flat income tax rates, while some states do not impose an income tax at all
• Sales taxes are imposed on the sale of goods and services, collected by the seller, and remitted to the state
  • States vary in their sales tax rates and the types of goods and services subject to tax (e.g., clothing, food)
• Property taxes are levied on real estate and personal property, typically based on the assessed value of the property
  • Local governments heavily rely on property taxes to fund schools, infrastructure, and public services
• Excise taxes are imposed on specific goods or activities, such as gasoline, alcohol, or hotel stays
• Franchise taxes are levied on businesses for the privilege of doing business in the state, often based on the business's net worth or capital
• Gross receipts taxes are imposed on a business's total gross revenues, regardless of profitability
• Payroll taxes are withheld from employees' wages and remitted to the state for unemployment insurance and other programs

Tax Base and Jurisdiction

• The tax base is the total amount of income, assets, or transactions subject to a particular tax
  • States define their tax bases through legislation, which can vary significantly between states
• Jurisdiction refers to a state's authority to impose taxes on individuals, businesses, and transactions within its borders
• States have jurisdiction to tax residents on their worldwide income, while nonresidents are taxed only on income sourced within the state
• Businesses are subject to a state's tax jurisdiction if they have sufficient nexus with the state
• Nexus can be established through physical presence, economic activity, or other factors set by state law
• States often use bright-line tests or thresholds to determine when a business has nexus for income tax or sales tax purposes
• Businesses must carefully evaluate their activities in each state to determine where they have tax obligations
• Jurisdiction issues can lead to complex tax situations, such as when a business has employees working remotely in multiple states

Nexus and Its Implications

• Nexus is the minimum connection required between a state and a business for the state to impose taxes on the business
• Physical nexus is traditionally established through a business's physical presence in a state, such as having property, employees, or inventory
• Economic nexus is based on a business's economic activity in a state, such as generating revenue above a certain threshold
• States have increasingly adopted economic nexus standards following the Supreme Court's decision in South Dakota v. Wayfair (2018)
  • This case allowed states to require remote sellers to collect sales tax if they meet certain economic thresholds
• Nexus thresholds vary by state and can be based on sales revenue, transaction volume, or a combination of factors
• Once a business establishes nexus in a state, it must register with the state's tax authorities and comply with tax filing and payment requirements
• Nexus can trigger income tax, sales tax, and other tax obligations, depending on the nature of the business's activities
• Businesses must continually monitor their activities in each state to ensure they are meeting nexus thresholds and complying with tax laws

Apportionment and Allocation Methods

• Apportionment is the process of dividing a business's income among the states where it has nexus for income tax purposes
  • This ensures that each state taxes only its fair share of the business's income
• Allocation refers to assigning certain types of income, such as interest or dividends, to a specific state rather than apportioning it
• The Uniform Division of Income for Tax Purposes Act (UDITPA) provides a model formula for apportioning business income based on three factors:
  • Property factor: The average value of the business's real and tangible personal property in the state
  • Payroll factor: The total amount of compensation paid to employees in the state
  • Sales factor: The total sales revenue generated in the state
• States may give different weights to each factor or use a single sales factor formula that only considers sales revenue
• Alternative apportionment methods may be used for certain industries, such as transportation or telecommunications
• Businesses must carefully track their apportionment factors and allocate income to ensure accurate tax reporting in each state
• Inconsistencies in state apportionment methods can lead to over- or under-taxation of business income

Tax Planning Strategies for Businesses

• Businesses can engage in tax planning to minimize their state and local tax liabilities while complying with the law
• Nexus management involves structuring business activities to avoid creating nexus in high-tax states where possible
  • This may include using third-party distributors, limiting employee travel, or restructuring sales operations
• Apportionment planning focuses on optimizing the factors used in apportionment formulas to allocate more income to lower-tax states
  • For example, a business may locate property or payroll in states with favorable tax rates
• Tax credits and incentives offered by states can significantly reduce a business's tax liability
  • Businesses should research and apply for relevant credits, such as those for job creation, research and development, or renewable energy
• Structuring business entities and transactions can help minimize taxes and streamline compliance
  • For example, using a holding company structure or establishing separate entities for different business lines
• Transfer pricing strategies ensure that intercompany transactions are priced at arm's length to avoid scrutiny from state tax authorities
• Businesses should regularly review their state and local tax positions and adapt their planning strategies as laws and circumstances change

Compliance and Reporting Requirements

• Businesses must register with the appropriate state and local tax authorities in each jurisdiction where they have nexus
• Income tax returns must be filed in each state where the business has income tax nexus, reporting apportioned income and calculating tax liability
• Sales tax returns are typically filed monthly, quarterly, or annually, depending on the business's sales volume and state requirements
  • These returns report taxable sales and remit the collected sales tax to the state
• Property tax returns may be required annually, reporting the value of real and personal property owned by the business
• Payroll tax returns and unemployment insurance reports must be filed regularly to report wages paid and taxes withheld
• Businesses may need to obtain specific licenses or permits in each state or locality where they operate
• Failure to comply with state and local tax laws can result in penalties, interest, and legal action by tax authorities
• Businesses should maintain accurate records and documentation to support their tax filings and respond to potential audits
• Engaging with tax professionals, such as CPAs or tax attorneys, can help businesses navigate complex compliance requirements and minimize risk

Recent Developments and Future Trends

• The Wayfair decision has led to rapid changes in state sales tax laws, with many states enacting economic nexus thresholds for remote sellers
  • Businesses must stay informed about evolving sales tax requirements in each state where they sell goods or services
• States are increasingly adopting market-based sourcing rules for apportioning service income, which assign sales to the state where the customer receives the benefit of the service
• The growth of the digital economy has led to new challenges in taxing online transactions and services, such as streaming or cloud computing
  • States are exploring ways to tax these activities, such as digital advertising taxes or data usage taxes
• The COVID-19 pandemic has accelerated the trend of remote work, raising questions about the tax implications of employees working from different states
  • Businesses must navigate the complexities of withholding taxes and establishing nexus based on employee location
• States are facing budget pressures due to the economic impact of the pandemic, which may lead to increased tax enforcement and efforts to expand tax bases
• Proposals for federal legislation, such as the Remote Transactions Parity Act, could standardize some aspects of state and local taxation for remote sellers
• Businesses must stay proactive in monitoring legislative developments, court decisions, and administrative guidance that could impact their state and local tax obligations
• Investing in technology solutions, such as tax compliance software and data analytics tools, can help businesses efficiently manage their SALT responsibilities in a rapidly evolving landscape