Will state tax changes help or hurt engineering and architectural firms?
Massachusetts, market-based sourcing and more
INSIGHT ARTICLE |
This article first appeared in the Fall 2014 issue of ACEC Insights, a publication of the American Council of Engineering Companies of Massachusetts.
Have you heard about the big tax law changes occurring in Massachusetts? Have you thought about how these changes could impact your business? The changes will likely be challenging for engineering and architectural companies to manage but may provide exciting tax planning opportunities for companies with customers outside Massachusetts.
For some time, the U.S. economy has been increasingly driven by service businesses that cross state and international borders, while state tax laws have been slow to adapt. Engineering, architectural and other service businesses with customers in multiple states have for many years been navigating arcane state tax laws developed primarily for businesses that sell goods and products. Oftentimes, these old laws create a disproportionate amount of tax in the state where the architectural or engineering firm is located, effectively generating state tax on greater than 100 percent of income.
A recent trend amongst states to modernize their taxing regimes for these businesses is the adoption of the so-called “market-based sourcing” rules. Practically, these new rules are intended to better attribute tax dollars to the jurisdiction in which the customer benefits from the service, as opposed to where the service business is located. There are currently 15 states that have adopted market-based sourcing rules. Massachusetts is one of those many states that have recently changed their laws, effective for tax years beginning on or after Jan. 1, 2014. Thus, most businesses will need to address these rules during 2014 year-end planning discussions.
So how do these rules work for engineering and architectural firms based in Massachusetts? In general, if a business has customers in more than one state, its income will need to be divided amongst these states using a three-factor formula based on property, payroll and sales. While the property and payroll factors are generally more straightforward, there is considerable controversy over how sales should be sourced. Previously, sales were considered to be attributable to Massachusetts if the income-producing activity took place in Massachusetts or the costs of performing the service were incurred in Massachusetts. For example, if your customer was based in New Hampshire, but you did the majority of the work in Massachusetts, the income from that service would have been sourced to Massachusetts. However, under the new market-based sourcing rules adopted in Massachusetts, the sale is sourced to the location where the market is based. Because it is not necessarily clear where the market for a sale is based, the Department of Revenue has developed a set of proposed rules to guide taxpayers in making this determination.
While the proposed regulations with respect to other services are long and complex, the rule for engineers and architects is clear: the sale is sourced to Massachusetts if and to the extent the engineering and architectural services are provided with respect to real or tangible property located in Massachusetts.
The proposed regulations provide the following example to illustrate this specific rule for engineers and architects: Architecture Corp provides building design services to individuals and business that are resident in Massachusetts and other states. Architecture Corp’s sales are assigned to Massachusetts if the location of the building project to which the design services relate is in Massachusetts.
Similarly, an architectural or engineering firm may have customers who are headquartered in Massachusetts, but engage the firm to provide services outside of the state. For example, a financial services firm located in Boston wants to open a new office in another state and engages an architectural firm located in Massachusetts to do the work. If there are visits to the site, a filing obligation is created in that state, and under the new Massachusetts rules, all income from the project is sourced to the other state because this is where the project is located. The fact that the customer is headquartered in Massachusetts is irrelevant.
There may also be potential for this shift in the sourcing rules to be a tax planning opportunity in situations where states have different sourcing rules in place. For example, say Firm X is located in Massachusetts and has a project in New Hampshire. New Hampshire sources a sale to the state where the income-producing activity takes place, similar to Massachusetts’ old regime. If Firm X is taxable in New Hampshire and files a tax return in the state, the sale will be sourced to Massachusetts under New Hampshire rules, sourced to New Hampshire under the new Massachusetts rules and, thus, potentially reduce total state tax liability. It should be noted, as discussed above, that the business must be taxable in the other state; otherwise, the sale is disregarded and will have no impact on the tax liability in Massachusetts.
These sourcing rules are very complex and will impact not only businesses organized as C corporations, but also S corporations, partnerships and limited liability companies. While states are trending toward market-based sourcing, it is unlikely that there will be uniform rules that will make it easier for taxpayers to follow or state authorities to administer. At a minimum, engineering and architectural companies should have systems in place to appropriately track sales by job location, and not necessarily where the customer is located. Many businesses will rely on their tax advisors, but even tax professionals who are not regularly involved with these types of issues may struggle to understand these complex rules.