Business and professional services providers: State tax insights
INSIGHT ARTICLE |
Business and professional services providers may already understand the myriad potential compliance headaches and administrative burdens of state and local taxes. Without a disciplined, integrated approach to planning for the full range of state and local taxes, many firms face bottom-line draining and resource-straining audits, assessments, nexus inquiries and other costs. It is imperative to develop a complete understanding of your tax position across all jurisdictions and to develop an integrated approach that helps to minimize your effective state rate, uncover planning opportunities, and streamline demands on your people and processes. Business and professional services providers should keep the following state and local tax considerations in mind:
Where does my business need to file? Nexus describes the degree of business activity that must be present before a taxing jurisdiction has the right to impose tax on a business. Multistate businesses may be subject to a number of state and local taxes once a sufficient nexus is established. Additionally, the states have collectively been pushing the boundaries of state and local tax nexus for years, most recently through the adoption of economic sales tax nexus standards and the elimination of the physical presence requirement by the South Dakota v. Wayfair decision. Economic nexus standards for income tax purposes have existed for a number of years. These standards presume nexus exists with the state if certain thresholds in sales, payroll and/or property are exceeded. Business and professional services providers need to review these economic nexus standards, especially considering that Public Law 86-272, a federal safe harbor from state income tax nexus, does not generally apply to service businesses.
Once nexus is determined, a business must then determine how much of its income is taxed by the applicable states. There are two primary methods to sourcing service revenue: cost of performance and market based. Cost of performance generally sources service revenue to the state in which the service is performed. Market-based sourcing rules generally source the sale of a service to the state in which the service or benefit of the service is received. More states are adopting market-based sourcing rules due in large part to the development of the internet and the ability to work remotely as opposed to working on-site. This is especially common with business and professional services providers. As of Jan. 1, 2018, over half of the states have adopted market-based sourcing rules with at least four additional states planning on implementing market-based sourcing by 2020. Additionally, there are various complexities within the market-based sourcing approach that should be considered, such as identifying where the customer is located or where the customer will receive the benefit, as well as the benefit of the service received at the taxpayer’s commercial domicile, billing address or office. Tax planning around these various rules is essential to minimize total taxes and to avoid being taxed on the same income twice.
Partner reporting requirements
As if nexus and apportionment complexities were not enough, business and professional services providers structured as a flow-through entity have to also deal with complex partner and shareholder state requirements. Nonresident partners or shareholders are generally required to file tax returns and pay taxes in all states in which the flow-through entity conducts business. Many states also have withholding requirements with respect to nonresident partners and shareholders. These rules can be very complex and cause many reporting issues for flow-through entities, which may result in penalties for failure to comply. To reduce the burden of having to withhold and file individual tax returns, states allow flow-through entities to file composite returns on behalf of their nonresident partners or shareholders. Composite returns come with their own set of complexities for flow-through entities. While this reduces the cost of individuals having to file on their own, a composite tax return is generally taxed at the highest individual rate and does not permit personal exemptions and itemized deductions. It is recommended that individuals consult with their tax advisor to determine if participating in a composite return is preferred over nonresident withholding.
Sales and use tax
Lastly, don’t forget about sales and use tax. On June 21, 2018, the U.S. Supreme Court issued its decision in South Dakota v. Wayfair, overturning the long-standing "physical presence” nexus standard established under Quill v. North Dakota in 1992. With this decision, the U.S. Supreme Court has opened up the possibility for states to impose sales and use tax collection and remittance responsibilities for remote sellers based solely upon their economic presence in the state. While this case has a direct impact on sellers of tangible personal property, it also has implications for business and professional services providers. While most states impose a sales tax on the sale of tangible personal property, at least seven generally impose a sales tax on broad categories of services, including business and professional services.
Business and professional services providers have many complex state and local tax items to consider, some of which were discussed above. Many of these items vary greatly among the states and are constantly evolving. Providers need to understand where they have nexus and what the nexus determination ultimately means to their overall state tax compliance processes. Multistate business and professional services providers with questions should speak to their tax advisors on how to develop an integrated approach to these implications.
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