Join Chris Benson, for an in-depth interview on apportionment and sourcing. In this episode, he provides insights on what apportionment is, methods used to source revenue, and red flags to look out for.
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[00:00:00] Ashley: Hi, I’m Ashley, and you’re listening to “The Business Owner’s Guide Podcast: Tips, Trends, and Talks From a CPA.” Today, we welcome Chris Benson from our Tax Department for discussion on apportionment. But before we begin, let’s find out more about our guest
[00:00:12] Ashley: Chris joined PKF Mueller in late 2021 as a State and Local Tax Manager with over six years of public accounting experience. Chris is an accomplished multifaceted state and local tax professionals, serving clients, including law firms, real estate and construction, healthcare, private equity, manufacturing, and distribution, eCommerce and storefront retail, transportation, and a variety of service providers.
[00:00:32] Ashley: Chris, thank you so much for joining us today. And with that, let’s jump right in. Chris, what is apportionment? And when is it used?
[00:00:38] Chris: Hi Ashley. Um, while the foundation of the concept of apportionment originates from the US Constitution, uh, much of the modern framework for assigning taxable income among the states was established by a 1959 Supreme Court decision. In a case between Northwestern states, Portland Cement Company, and the state of Minnesota.
[00:01:01] Chris: Um, in that case, the company was determined to be liable for Minnesota income tax, despite having activities in Minnesota, limited to the solicitation of orders that were fulfilled from a home office in Iowa. In response to that decision, one of, if not the most well known federal laws concerning state taxation was passed by Congress. Uh, Public Law, 86-272, otherwise referred to as the Interstate Income Act of 1959.
[00:01:29] Chris: That Act was enacted to limit the interstate taxation of companies whose activities in a state were limited to solicitation of sales or other diminimus specifically articulated activities. Notably the law applies only to sellers of tangible personal property. In other words, physical goods, uh, as well as numerous other restrictions and has been the most substantial limiting factor in the ability of states to impose an income tax on out-of-state businesses for the past six decades. While PL 86-272 limited activities, which give a, a state, the right to tax a business’s income, another model law, the Uniform Division of Income for Tax Purposes Act, or UDITPA uh, was issued in 1957 and adopted by the majority of states. Although the trend in recent years has really been to move away from historical UDITPA concepts.
[00:02:24] Chris: Under UDITPA an equally weighted apportionment formula based on level of in-state sales property, and payroll is used to provide a relatively fair and duplicative approach to determining the proportion of a multi-state operating businesses income that may be taxed by each state of operation.
[00:02:43] Chris: The alternative to income apportionment is direct allocation, which rejects the factor based assignment of income and provides for assignment of a source of income wholly to a single state. Direct allocation is generally reserved for items that are ancillary to a business’s operations, such as subleasing investment, income, or royalties.
[00:03:04] Chris: And it’s typically scrutinized by state taxing authorities to a higher degree than the statutory apportionment formulas. All businesses with multi-state operations must determine whether an item of income is apportioned or allocated and, uh, under either method to which state income will be assigned.
[00:03:23] Ashley: Is the apportionment formula the same in every state?
[00:03:25] Chris: Well, that would, uh, be convenient, but as with most matters of state taxation, there is a lack of uniformity among the states that should be considered in evaluating the tax impact of a businesses state footprint. Um, that said the trend of the past decade and a half has been away from the three factor formula standard and toward an apportionment formula based on solely the volume of sales activity in the state.
[00:03:53] Chris: Really a notable shift and not the property and payroll components of the historical formula were generally what gave states the right to impose tax on out of state companies, leading to potential incongruities between the activities that give rise to taxation and the activities that determine the extent of taxation.
[00:04:12] Chris: States have slowly adopted the simplified apportionment formula in the past decade on the theory that large corporations making extensive sales into their state will assume more of the tax burden than local businesses with higher concentrations of property and payroll in the state, possibly achieving the best of both worlds and generating more tax revenue and promoting popular public policy that purports to shift tax burden away from its own citizens.
[00:04:40] Chris: In practice, perfect tax policy doesn’t exist in a formula that benefits a company with one set of facts may disproportionately harm another similarly sized company with a different set of facts. Besides the most common sales factor or equally weighted three factor formulas, other apportionment formulas are used such as the three factor with varying weights placed on the sales.
[00:05:02] Chris: Two factors using the sales and property or sales and payroll or property and payroll, or a variety of industries, specific formulas. Careful review of the applicable apportionment formulas and income sourcing methods is a valuable tool in the business planning stage. Fundamental decisions, such as where to establish an operational facility, a warehousing facility, etc. can be make-it-or-break-it decisions depending on the interplay of state law, relative to the business’s operations. In the extreme case, a single item of income could be taxed in full by two different states. Conversely, a single item of income may not be taxable in any state with effective transactional planning and operational flexibility.
[00:05:49] Ashley: What methods are used to source revenue?
[00:05:51] Chris: How revenue is sourced is really dependent on the nature of the revenue stream. For sellers, the tangible personal property, including manufacturers, wholesalers, retailers, the assignment of revenue is relatively straightforward. Sales are sourced to the state in which the product is delivered or at the point of sale, in the case of in-store retailers. If a business is not taxable in the state sales are shipped to due to federal or state protections um, such as the aforementioned PL 86-272, many states require the sale to be assigned to the state it was shipped from.
[00:06:29] Chris: For service providers, the sourcing of revenue is considerably more complicated and increasingly comprised of state legislation that calls into question the limits of state taxation, and is largely untested by the US Supreme Court. In general, while the protections of PL 86-272, do not extend to service providers. It remains generally accepted that some degree of property or payroll otherwise stated as physical presence, is required for your state to impose income tax.
[00:07:00] Chris: Nonetheless, many states have enacted laws that would appear to provide for taxation of out of state service providers without physical presence in the state with some states defending such laws more aggressively than others. Most recently, the states of California and New York have begun asserting that physical presence may be approximated or established through activities conducted via the internet. In response to a proposed modernization of PL 86-272, which was recommended by the Multistate Tax Commission, uh, a trend, which businesses should anticipate other states to follow in the coming years. Ultimately the tension of ever expanding state law and the framework of federal law may force the conflict to be resolved by the US Supreme Court. Similar to the sweeping decision made in 2018 for sales tax collection requirements.
[00:07:53] Chris: For the time being however service providers generally source revenue on one of two ways with numerous exceptions and distinctions. Primarily service revenue is sourced upon either a market basis or performance cost basis. In states following a market approach, the revenue is sourced to the state in which the is customer is located, where the customer ordered the service from, or where the service was beneficially received. In states following a performance cost approach, the revenue is sourced to states in which it was principally performed from. Industry specific standards may require other sourcing methods, such as revenue miles and the transportation industry or Nielsen ratings in the broadcast industry.
[00:08:38] Ashley: Won’t the conflicting state laws impact the tax paid by apportioning businesses?
[00:08:42] Chris: Oh, absolutely, and that’s really why effective planning at the beginning of the business life cycle, as well as ongoing maintenance of the state footprint health check is essential to the success of a multi-state business operation. Affective leveraging of state apportionment laws can be the difference between an industry leader and a straggler that never quite manages to turn a profit. Particularly in the case of service providers, where sourcing laws can be more fundamentally opposed than in the relatively standardized, tangible, personal property sourc Consider for example, an internet consulting business located in the state of Illinois that provides consulting services for a concentrated group of customers in Texas, because Illinois is a market-based state in Texas sources services to the location from which they were performed a company with this fact pattern, would achieve 0% effective apportionment among the two states it does business in. None of the customers are in Illinois and none of the work is done in Texas. This company pays no state income taxes and can price it services aggressively, not withstanding the impacts of other economic factors.
[00:09:56] Chris: Conversely the same company based in Texas with an Illinois customer market would pay state taxes on effectively 200% of its income with Texas taxing every dollar of work performed in Texas and Illinois taxing every dollar of work performed for an Illinois customer. A company with this setup would have to do considerably more business to achieve the same profit margins as the company with the preferable state apportionment.
[00:10:22] Chris: But realistically it is not always possible to prioritize state tax considerations and shaping fundamental business decisions, nor should it be the only factor considered. However, when starting a business, new or planning growth opportunities, the effective leveraging of conflicting state income tax laws should always be one of the many points considered before making potentially irreversible decisions.
[00:10:47] Ashley: What are the primary red flags to look out for with apportionment computations?
[00:10:51] Chris: That’s a great question. Um, the, the red flags are really always going to change or be tailored to client by client, industry by industry, business by business. Um, but that said a few of the common elements that I personally look out for when I am reviewing an apportionment or sourcing analysis. The first and foremost would probably be the use or the citation of the Public Law 86-272. Um, if I, if I see Public Law 86-272 reliance, um, we, we need to be aware that this is a law that was drafted in the 1950s and does not, uh, explicitly or even implicitly address all of the ways that businesses do business in the modern environment. So we need to be careful with reliance on that law and ensure that it is proper to a claim, the protections of, of the federal law, and if so that the implications are being properly applied, meaning, um, throwback laws are being applied correctly in, in the appropriate states where a destination state is not taxable. And the ship from states needs to report those sales instead. Um, that I look for state non-income taxes that are not protected by the federal law, for example, California’s LLC fee.
[00:12:29] Chris: Um, whether the activities have been fully evaluated and truly deemed diminimous in nature and not simply looking at where employees are located on a permanent basis. Um, it, I ask about trade shows back hauling warranty and repair services, installations, and technical support. And now with more ambiguity than ever the extent of customer interactions through internet mediums um, very much just a, uh, a stop and ask questions, sort of tax position to take. Um, doesn’t mean that it is incorrect, but it, it, it means questions should be asked.
[00:13:12] Chris: The second item I look out for is whether total company apportionment is stated at a hundred percent. If there’s one rule to live by and the world of multi-state apportionment it’s that a hundred percent is almost never a correct answer.
[00:13:30] Chris: Um, due to the. Conflation of, of state apportionment laws and sourcing laws because states don’t follow the exact same laws it generally is going to mean two different states treat a single item of income two different ways and therefore, a hundred percent overall apportionment would more generally indicates a preparation mistake than a, uh, correct apportionment picture.
[00:14:01] Chris: Um, thirdly, I would look at whether revenue sourcing has been applied to the revenue streams correctly. It’s capturing the correct information. For example, tangible personal property sales should have a ship-to and ship-from location for every sale. Meaning there should be two data sets for services. Uh, there should be a performance location and a customer location for every sale.
[00:14:29] Chris: So again, two data sets. And, uh, really a takeaway there being, if you’re working with one data set of sales revenue, you really only have half of the picture. And for the states that don’t follow the rule used to produce that data set, the information would not be correct.
[00:14:48] Chris: Um, finally I look at, for corporations, whether unitary analysis has been applied correctly uh, within the combined group, um, Joyce and Finnegan rules, which are cases originating from the state of California are applied correctly. Um, those cases deal with whether every member of a combined group or only the members of the combined group with Nexus include their apportionment factors for the total company apportionment computation, and then within partnerships, that same analysis would look at whether flow through apportionment of unitary partnerships or direct allocation is required under the applicable state law. And those are really just a couple of a handful of tools and in the bucket when it comes to reviewing or preparing apportionment and sourcing, um, but probably the most common areas of scrutiny.
[00:15:50] Ashley: Well, I think this was a really great overview and thank you for your time today to explain apportionment, what it is, methods used to source revenue, and red flags to look out for. If any of our listeners have any questions or would like to learn more, would you please share how they might be able to reach you?
[00:16:04] Chris: Absolutely you can reach me directly at C Benson, firstname.lastname@example.org or give me a call at (630) 524-5267. The PKF Mueller SALT Team can be contacted for consultations at SALT@pkfmueller.com.
[00:16:25] Ashley: And thank you to our listeners. Don’t forget to visit us at pkfmueller.com to learn more about our firm services. You can also follow us on social media for more updates, insights, and upcoming events.