In the today’s global economy, remote work is no longer the future – it is now. Thanks to technology, employees in the professional services field now have greater flexibility to do business whenever and wherever they need to. Telework also benefits professional services firms by retaining employees who would otherwise have to resign because of a move, or life-changing event. But the new footprint outside a business’s home state may create a substantial connection, or nexus, which allows a state to assert jurisdiction to impose income tax on the business.
Generally, if a company is doing business outside of its home state, there will be an income tax filing obligation for each state where the company is doing business. The determination of reportable state income is based on complex and state-specific rules known as income apportionment. Factors to be considered include where the business’ property, employees and sales are located.
Historically, the location of property and employees have carried the most weight. For example, the cost of performance method looks to where the costs associated with the performance of services occurred. However, because of changes in technology and the business environment that allow business to be performed electronically, an increasing number of states are considering the location of customer sales as the primary factor in determining taxable income – also known as the market-based sourcing method. This method assigns the sales receipts to the location of the firm’s customers or the destination where its customers receive the service benefits.
Income tax nexus triggered by employee activity in a state where the business does not have a market may not always result in an unfavorable tax situation, although there may be an annual tax return requirement or minimum tax. As an example, consider a human resource manager who works from his Connecticut home two weeks every month, and travels to work in California for the rest of the month. The business is now required to file a Connecticut income tax return and a California income tax return, and the assignment of business Connecticut income is based on the revenue sourced to the state. Since the business does not have any customers in Connecticut, there will only be a minimum tax liability.
If income tax nexus is triggered because of business expansion into a state’s market, the state tax exposure will likely be more than a minimum tax. As an example, a service company signs a two-year contract with a new customer in Pennsylvania and expects total revenue of $1 million from the engagement. The Pennsylvania tax liability is determined based on revenue sourced to the state over the company’s total revenue. The company can expect an increase in Pennsylvania tax liability, if the revenue from this contract accounts for a significant portion of the company’s business for the year.
For many professional service firms, their client base changes often – depending on the market and economy. They may find it difficult to keep up with state tax compliance requirements. After the South Dakota v. Wayfair decision, a few states adopted an economic nexus threshold for income taxes where no physical presence is required. Massachusetts, Pennsylvania, and Texas adopted a gross receipts threshold of $500,000 beginning in 2019 and 2020. Hawaii adopted an income tax filing threshold based on the number of business transactions and gross receipts, and this year the Oregon Corporate Activity Tax added a factor-based threshold for registration and filing returns. Firms will need to track customer activity to identify when a specific revenue stream has exceeded the economic nexus threshold required by states.
If a professional service company is a flow-through entity, such as an S-corporation, partnership or a limited liability company, there is generally no state income tax (other than a minimum tax) at the entity level. Owners, partners and shareholders are required to pay income tax on their share of business income. The state income tax nexus of the business will have a direct impact on the owner’s personal state tax compliance. If there is an owner who is a nonresident of the firm’s home state, the owner’s and the firm’s state tax exposure will become more complicated.
There are certainly ways for a professional service firm to be proactive in managing state income tax compliance. Here are a few practical steps to consider:
- Manage the firm’s “footprint” to identify what may trigger income tax nexus: Review employee activities, such as traveling to different states for various durations, to determine if state income tax nexus exists. If a firm’s profession requires registration for a state business license, any activity performed in a state will likely have income tax nexus implications.
- Make sure recordkeeping supports income tax reporting: Review time and billing systems to determine if locations where services were performed, and customer received benefits, can be tracked. Otherwise, have a separate record keeping system in place for tracking multi-state activity.
- Maintain contemporaneous documentation: For a project that requires physical presence in a different state, such as client meetings, the physical presence should be documented in writing as services are performed to support revenue sourcing for state income tax reporting. Document where services performed are used by the customer.
- Manage online business platforms: Online platforms, like Zoom, allow a business to service customers without in-person meetings and provides an ability to reach a broad customer base. This business model will likely expose a company to multi-state income tax filing where the volume of business in other states exceeds the economic threshold adopted by those states. Review customer records during the year to identify state tax exposure early on.
- Tax planning: Identify all states where there is some connection (through payroll, property or sales). Gain an understanding of each state’s apportionment rules, so the firm can control whether it has nexus with those states. Identify the states that use the cost of performance method vs. the market-based sourcing method. Determine what documentation will be needed at year-end to comply with state filing requirements.
Managing multi-state tax exposure requires professional service firms to understand where their services are performed, how their services are delivered to their clients, where their clients are located and where their services will be used. Once those locations have been identified by state, a determination of which states use the cost-of performance method vs. market-based sourcing method will enable firms to determine how their state tax obligations will be calculated. Best practices are to track this information throughout the year and identify each new state where business is conducted to understand the multi-state exposure in advance of filing tax returns.
For additional information, reach out to BPM’s Professional Services Industry Group.