Kim Otto

As small businesses broaden their business activities, the scope of state taxation broadens as well. At Wright Griffin Davis, we find that many small businesses that sold goods to customers within a limited geographic area are now selling their goods online, shipping to out-of-state customers and making deliveries to customers in neighboring states.

Along with this shift come concerns about complying with state tax laws. Some business owners may not realize the simple act of driving across state lines to make a delivery is often enough to subject the business to taxes in the destination state.

State tax compliance can be cumbersome and costly but there are some factors that can be applied as a test to determine a business' potential risk of tax liability.

Constitutional statutes prohibit a state from imposing a tax on a business unless there is a connection between the taxpayer’s activities in the state and the taxing state. This connection is referred to as nexus. Each state has its own definition and list of activities that create nexus.

There are two broad types of nexus: physical presence and economic or market-based presence. Physical presence can include maintaining an office, having employees living or working in the state, repairing or installing equipment, owning property, soliciting sales or attending supplier meetings.

Small businesses that are taxable in more than one state will generally apportion their net income between the states. Apportionment factors are often based on three factors including sales, property and payroll. The presence of any of these three factors in a state increases the risk that a business will be taxable in that state. The recent decline in state revenues has led many states to shift away from a three-factor apportionment formula to a single factor formula based on sales. This shift can result in a larger amount of net income being apportioned to states where property or payroll is not present.

The ability to apportion net income to another state can be beneficial for some businesses. The shifting of income from a high tax state to a low tax state can result in substantial tax savings.

One example of a business that could take advantage of apportionment is a manufacturing company based in Michigan, with substantial sales outside of the state. Without apportionment, all of the company’s sales would be subject to the Michigan Business Tax (MBT). By establishing nexus in one other state, as defined by Michigan, the company could exclude all of its out-of-state sales from the MBT apportionment factor and substantially reduce the amount of MBT. Under the MBT, businesses qualify for apportionment if they are taxable in at least one other state regardless of whether the other state imposes a tax. The downside of creating out-of-state nexus can be the requirement to file income tax returns in the other state(s) and the extra work necessary to collect and report sales/use tax on sales (e.g. retail sales).

This strategy works particularly well for the MBT as the MBT does not have a throwback rule. The throwback rule generally requires businesses to include certain sales in the sales factor of the apportionment factor if the sales are not taxed in another state. Since the MBT does not have a throwback rule, sales that are not taxed in another state are considered to be “nowhere” sales and are not subjected to state taxation.

It is important to be proactive in protecting your exposure to state taxation. As states compete for revenues, many are aggressively pursuing out-of-state taxpayers with a presence in their state. If a business has never filed tax returns in a state, the statute of limitations does not apply so it’s possible to be liable for 10 years or more of income taxes and/or use taxes.

At Wright Griffin Davis we advise our clients to know their risk before receiving a letter or nexus questionnaire in the mail. Good strategic tax planning could even result in an overall reduction of tax liability.

Kim Otto, CPA, is tax manager at Wright Griffin Davis and Co., CPA’s.