How Can You Reduce Your State Tax Apportionment?
Owners of pass-through entities (S corporations, LLC/partnerships) that sell services or sell/license the right to use intangibles may benefit from analyzing how revenue is being sourced if the owners are residents of states with no income tax (e.g., Florida) or states with a low-income tax rate (e.g. North Dakota). C-corporations that sell services or sell/license the right to use intangibles may also benefit from looking at the state apportionment of their revenue—how revenue is being sourced to the states they file in.
The owners of pass-through entities (S corporations, LLC/partnerships) pay taxes on their share of total company income in their state of residence and may receive a credit for taxes paid to other states. For owners who are residents in Minnesota, the tax rate can be as high as 9.85%. However, owners that are residents of Florida pay no Florida income tax, and only pay taxes to the states they file in.
C-corporations and residents of states without an income tax only pay income taxes in the states they file in, based on the income apportioned to those states. Lowering the apportionment percentage to these states means paying less state income tax.
How are revenue sources determined?
The amount of income that is taxable in a state is generally determined based on an apportionment formula that may include property, payroll, and sales/revenue. The weighting of the property, payroll, and sales factors vary by state, with many states moving to a sales factor-only apportionment. Revenue sourcing focuses on the sales factor of the apportionment formula.
Sales of tangible personal property (goods) are generally included in the numerator of the apportionment formula based on the where the property is delivered or received. The sale of services or intangible assets are included in the numerator of the sale factor based on one of the following: 1) where the greatest cost of performance took place, 2) market-based sourcing, or 3) a variation of one of these. Market-based sourcing focuses on where your customers receive the benefits of your services or use of intangibles, and the shift toward using it is intended to reflect how the market itself contributes to taxpayer income.
The sales factor, or the sale of your products and/or services within a state, needs to be analyzed to ensure that the income apportioned to a state is correct.
Several key questions include:
What did your company sell (goods, services, intangibles, etc.)
- How was the product/service/intangible delivered?
- Where did the customer receive the benefit of the service?
- Where was the cost of performing services incurred?
- Where did the customer use the intangible?
Examples of potential tax savings
Example 1: A software company based in Minnesota operates as an S-corporation and licenses the right to use its software to a multinational fortune 500 company based in California for $5 million. The Fortune 500 company uses the software licenses all over the world at its various offices, so only 5% of the intangible property is used in California. The individual owners of the software company are Florida residents and the company has taxable income of $25 million and revenue/sales of $100 million.
Without doing a deeper dive, the sale to the Californian customer might get sourced to California because this is where the customer is located. Taking a deeper dive, we find that California sources the sales from intangible property to this state to the extent that the property is used in this state.
Without the deeper look, the software company and individuals would have been asked to pay $175,000 to California. Taking a deeper dive, $8,625 would be paid to California.
Example 2: A consulting company based in Minnesota operates as a C-corporation and provides services from its Minnesota offices to a company based in North Dakota for $5 million. The consulting company has taxable income of $25 million and revenue/sales of $100 million.
Without taking a deeper look, the sale to the North Dakotan customer might get sourced to North Dakota because this is where the customer is located. Taking a deeper dive, we find that North Dakota uses a cost of performance method for sourcing services, and no costs were incurred in North Dakota to create the sale.
Without the deeper dive, the software company would pay $53,000 to North Dakota—but taking a deeper dive, $0 would be paid to North Dakota.
As you can see, analyzing the state-specific laws can provide huge tax saving opportunities by decreasing the income apportioned to a state, and thus the taxes you or your company pays.