Join Ellen Minnig, Tax Director at PKF Mueller, for an in-depth interview on state income tax. In this episode, Ellen provides insight on reducing a business entity’s state tax burden and additional state planning considerations.
Ellen Minnig, J.D., LLM Taxation, MSA
+1 312 975 1646
[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 Ellen Minnig from our tax department for a discussion on state income tax. But before we begin, let’s find out more about our guest.
[00:00:17] Ashley: Ellen Minnig is a Tax Director here at PKF Mueller. Ellen has over 20 years of tax experience in public accounting and industry work. She is also a key member of the firm, state and local tax group.
[00:00:33] Ashley: Ellen, thank you so much for joining us today.
[00:00:36] Ellen: Thank you, Ashley. I’m happy to be here.
[00:00:38] Ashley: And with that, let’s jump right in. Can you describe what State Nexus footprint is?
[00:00:43] Ellen: Yes. A state nexus footprint is generally where a business is operating within the United States, there can be a worldwide footprint as well, but I’m focusing on just the US footprint and basically we look at what is going on in states that, a company that is involved in selling to multiple states, what is going on for their purposes in each state. In terms of do they have an office, do they have a warehouse? Do they have employees? Are they considered to be doing business in the state? Are they registered as either a corporation or an S corp or a partnership in the states? And are they foreign to the state or is that their state of incorporation or organization? So looking at all those factors creates a nexus footprint, and that is what we base the income tax filing on.
[00:01:52] Ashley: As a follow up to that what is PL 86-272?
[00:01:56] Ellen: PL 86-272 has been around for a long time, and it is a federal law, that basically states that in certain circumstances, state Nexus will not be established with minimal factors of basically presence in the state.
[00:02:16] Ellen: So PL 86-272 says that if you ship goods from outside the state, or from your state to another state, and all that’s going on in the state you’re shipping to and actually probably selling to residence in the state.
[00:02:33] Ellen: Basically when you ship in, if all you’re doing there is, you might have some independent contractors or employees, but they’re not management and they’re solely for marketing purposes. So, they’re soliciting sales, from residents in that state, but they’re not doing anything further. In other words, if they make cold calls, for instance, to sell products, when they do that, they don’t close the sale. They basically, see if the potential customers interested and then refer them to the headquarters so that they can deal with them and place an order and so on. So they’re very minimally involved in basically what the company’s doing in that state.
[00:03:19] Ashley: How does apportioning or allocating income help reduce a business entity’s state tax burden?
[00:03:24] Ellen: The reason that apportionment and allocation are important is you look at Nexus, you see where should I file, you look at that footprint and you also look at states that you could file in, but it’s not as clear.
[00:03:39] Ellen: And then there are states that perhaps say, due to PL 86-272, you’re doing so little in the state and you only have marketing employees soliciting sales, nothing else. You don’t have property or other hallmarks of Nexus in those states. So for those type of states, you may want to, consider not filing and, and that’s sometimes a judgment call.
[00:04:06] Ellen: Sometimes it’s very borderline whether you do have Nexus or not. Perhaps those employees occasionally do something else, so they may create Nexus. Perhaps they deliver goods to customers in the state, which would create Nexus. You kind of look at what is the total picture in that state and then in all states, and you look at where is it best for me to file?
[00:04:29] Ellen: Where do I have the most risk? And what are the advantages and disadvantages of filing in different states? And the apportionment is basically, the formula where PL 86-272 will exclude the sales for a state that you only have solicitation of employees. So in other words, in that state, you’ll have zero apportionment.
[00:04:53] Ellen: But in other states, you may have 10% of your sales in Tennessee or Kentucky and for that purpose, those sales are included in the apportionment formula and in calculating that generally it’s based on what are the sales in this state, divided by total sales in every state.
[00:05:14] Ellen: That’s a very basic look at apportionment factors. Some states use, say for instance, double sales over total sales. Some states still use three factor apportionment, which you’d look at property in that state divided, by total property in the us and same with employees and sales. So you look at three factors and then average those together.
[00:05:40] Ellen: But predominantly states are going to sales apportionment. They’re not looking at as much at Nexus creating factors like property in the state or employees in the state. So states are trying to focus on what are your sales in this state in relation to the entire country? And that’s an important consideration because the more you report sales in certain states, the more, you wanna look at their tax rate in that state and also at their exclusions, modifications, because you generally start with federal income and federal income after deductions, and then modify that and that’s used for state income.
[00:06:23] Ellen: You wanna look at the rates in those states, because once you get state income, then you create your apportionment factor, say 10% of total sales. And with that apportionment factor, you multiply your total adjusted federal income by that factor and then multiply by the state tax rate.
[00:06:45] Ellen: That’s the basic process and you can see that in the end it’s very important where you’re apportioning and what the state rates are for those states.
[00:06:56] Ashley: What is throwback or throwout of sales for state apportionment?
[00:07:00] Ellen: So throwback or throwout are concepts that basically allow the ideal for state governments is to tax a hundred percent of your revenue in the U.S. However, that doesn’t always happen due to lack of Nexus. So if you have sales in a state, but PL 86-272 protects you, in other words, you have zero apportionment you don’t have Nexus. Then those sales generally would not be taxed unless they’re thrown back to your home state.
[00:07:38] Ellen: You generally have a primary state, a headquarter state where you’re incorporated or where your headquarter offices are, and that state will seek to throw back sales from other states where you’re not being taxed.
[00:07:54] Ellen: One of the main reasons you might not be taxed in another state is PL 86-272. And if those particular sales are not thrown back, for instance, state of Illinois, if that’s where your headquarter base is, if they are not thrown back for apportionment purposes, then they’re lost.
[00:08:13] Ellen: So there’s a concept called throw out, where those sales are never taxed for state purposes because, and this is only for apportionment. In other words, throw back and throw out, only apply to sales for a apportionment of purposes. So you’re calculating a ratio of federal income that’s going to be reported in that state.
[00:08:37] Ellen: And that’s where the throwback of sales occurs. It becomes part of the apportionment formula. It’s an important concept because not every state has throwback. Illinois has a very strong throwback rule, and in fact, it’s very aggressive on throwback, whereas some other states have no throwback rule like New Jersey and so potentially the sales in other states that are not taxed for various reasons, including PL 86-272 in those states, potentially those sales are never taxed for state purposes in the U.S. So that’s a great result for taxpayers, but a bad result for state governments.
[00:09:22] Ellen: States tend to try to identify sales that have not been taxed and either throw them back or they try to establish Nexus and send notices and say, you know, you’re subject to Nexus in the state and you need to pay tax. And that way they keep an eye on all sales. But you can see if you have some states that do throw back and others that don’t, some states that allow throw out of sales completely from the apportionment formula, you can see that, in the end, the apportionment may not be a hundred percent of federal adjusted income.
[00:09:59] Ellen: So if it’s not a hundred percent, if you’re only say taxing state for state purposes only, if you’re only taxing 70% of your income nationwide, that’s a good result for taxpayers.
[00:10:12] Ellen: They’d rather not pay tax on a hundred percent of income. So it is worth looking at, does this state, for instance, Illinois require throwback? Is there any way I can avoid throwback? Would it be better to file in another state with a lower tax rate and that way minimize tax burden and that is a very important concept that I think goes unnoticed quite often for more mid-size companies, that it would impact their overall state tax burden if they would take time to decide where to file and where to apportion income. So it’s an important concept because Illinois has one of the top five rates in the country.
[00:10:55] Ellen: It has a 7.5 percent income tax rate and a 2% replacement tax. So 9.5% and basically only six, seven states have a, have a rate as high as 9% or above. So Illinois is a very high taxing state, so it’s important to remember that. And in certain states there is Nexus or there are Nexus factors, it might be better to file in that state file income tax.
[00:11:26] Ellen: And based on that income that you’re apportioning, it’s taxed at say a 4.5% rate. So that’s, depending on the volume of sales, it can be very helpful to look at each state you’re doing business in and determine whether certain rates are lower, and you should file in those states rather than throwback to Illinois.
[00:11:50] Ashley: How can throwback or throwout impact state tax burden?
[00:11:54] Ellen: So I guess we’ve been talking a little about that already, but it is important because I’m going to focus on Illinois because I think that’s an important state for a lot of our clients. So Illinois is a very aggressive throwback state.
[00:12:11] Ellen: So for instance, if you don’t pay income tax in Kentucky, even if you do pay, their franchise tax, or similar with Tennessee, Illinois will try to take those sales and throw them back for apportionment purposes and make the Illinois apportionment rate higher. So in other words, they might have a 50% rate, but if they throw back the sales from Kentucky and from Tennessee, they may have a 70% rate of apportionment for federal income.
[00:12:47] Ellen: So that kind of change with a 9.5% tax rate is significant. It’s very important for multi-state companies that are headquartered or primarily they’re high level operations are in Illinois, so they file in Illinois as a home state, those companies really need to look at do I need to file another states?
[00:13:11] Ellen: Would I be able to lower my tax burden significantly? Because many other states are at a 4.5 or 5% tax rate, so much lower than the 9.5% in Illinois. Basically we all can assume that Illinois is going to try to throw back revenue as much as possilbe. Because it increases, its tax collected. So it’s, it’s very important to look at could I actually file income tax in Kentucky and Tennessee?
[00:13:42] Ellen: And even though that’s a bit of a burden to have to file a return and have it prepared and pay for it in the end, perhaps that would save significant revenue because those states tax at lower rates in Illinois.
[00:13:58] Ashley: What state credits are available to the taxpayer?
[00:14:01] Ellen: So state tax credits are another good reason to possibly file in a state. And again, you know, filing in a state carry some risk. The state could audit at some point and the state will have you on their radar, but some states have break credits and like I said, some states have very low tax rates.
[00:14:22] Ellen: So if you can move revenue into that state that you’re already earning there, basically, but you can report it in that state, you can use their credits to help you reduce the tax burden even more. And basically credits are a very annual specific kind of thing, they change every year.
[00:14:44] Ellen: Some states are more credit friendly certain years than others, but generally there are some credits that are around most of the time, for any state and those, the focus there would be if you have a new, say, a new office, a new location and you have employees potentially at that location and property.
[00:15:05] Ellen: That would be a situation where you probably need to file income tax in that state then. If you have sales related to the state residence, and if so, that new location is eligible for jobs credits based on new employees. Also based on investment in the state, in the locality, and also based on just actual property purchased in the state and offices in the state.
[00:15:36] Ellen: So based on those factors, generally every employee carries a dollar value for credits. Every new employee at a new location. And states love this because, you know, it’s, puts the state more on the map and it gives it more revenue for communities. And so they like to give out credits for new locations and new employees in the state.
[00:16:02] Ellen: So that’s, one area that most states do have, credits that are fairly similar, for that kind of situation. And if you are opening new locations or establishing new employees, it’s really important to think about those credits. They’re generally called jobs credits, but they also, have what is similar, which is investment tax credits, which means you’re investing in the community.
[00:16:28] Ellen: And those include enterprise own credits, which if you invest say a certain amount in property purchased to use in that enterprise zone, you’re given a tax credit every year for that property you purchased. That’s one example of an enterprise zone that’s how most enterprise zones in Illinois were.
[00:16:48] Ellen: And those investment tax credits can be offset against Illinois replacement tax. It is a really great deal and I think so many businesses just think, you know, the, the credits are a little too much to try to deal with, or maybe it’ll be too costly to set up the credits. And that’s really not the case.
[00:17:10] Ellen: They’re, they’re fairly easy to set up. The client can do a lot of the legwork and they’re very beneficial. So, it’s important to look for those investment and jobs credits. There are some other very lucrative credits, but not every business can read the benefits such as fuel tax credits but those are worth looking at too.
[00:17:31] Ellen: If the company uses a lot of fuel on site and not on the road, they’re eligible for fuel tax credits and that is both federal and state. Federal will compensate for those at about a 25% of every gallon rate. In most states, it’s about 17 to 19 cents per gallon used in operations off-road. So that’s a very significant credit if you use a lot of fuel, including a diesel gasoline and propane and some biofuels are also recognized for fuel tax credits. So that can be a wonderful area for great refundable credits. And that’s a nice thing about those credits as they are refunded. They aren’t carried forward to use in another year. If they offset tax and you’ve paid all your tax, then you get a refund. So a wonderful tool for making you know, your state, footprint valuable.
[00:18:36] Ashley: What state business deductions are available to the entity?
[00:18:39] Ellen: As far as business deductions, this tends to focus on community investment quite often. And then some states, just as a general rule, will allow some additional, deductions that aren’t allowed for federal purposes, such as an additional charitable deduction.
[00:18:59] Ellen: And sometimes they’ll allow additional deductions for investments or investment related property. So those are some of the things to think about with states. They may have a particular policy and laws where they do allow additional deductions depending on, you know, what kind of business you’re operating.
[00:19:22] Ellen: What are you doing in that business? Do you make significant charitable contributions and it’s really worth reaping the benefit of those additional deductions?
[00:19:33] Ashley: And finally, what are some additional state planning considerations?
[00:19:37] Ellen: Just to summarize, what’s important is to look at the Nexus footprint in every state. Look at apportionment and how it will be applied in each state and look at tax rates. And I think what I haven’t been able to do on a short podcast is highlight, which states are, are absolutely great for instance, New Jersey does not have throwbacks, so if you’re operating out of New Jersey, that tends to be very beneficial. But other states know that New Jersey doesn’t have it. So they look to see if you have Nexus and try to tax you, because those sales will be taxed nowhere. If they’re not taxed in the state, they’re earned in because New Jersey will not throw them back.
[00:20:20] Ellen: So that’s an example of a good situation. But not every client operates out of other states it’s often Illinois. It’s important to look at what states they do operate in, and then the SALT department could give them a more accurate picture of what states they could benefit from filing in, what states they might want to avoid.
[00:20:40] Ellen: But generally, for Illinois based businesses, it’s really important to look at throwback because if those sales do not have to be thrown back to Illinois, they’re usually taxed at about half what Illinois will tax at. So it’s a significant savings and it’s definitely worth looking at each year to minimize tax burden.
[00:21:02] Ashley: Well, I think this was a really great overview and thank you for your time today to explain state income tax. 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?
[00:21:13] Ellen: Sure they can reach me via email at email@example.com. They can also reach me at (312) 975-1646.
[00:21:26] Ashley: And thank you to our listeners. Don’t forget to visit us at www.pkfmueller.com to learn more about our firm’s services. You can also follow us on social media for more updates, insights, and upcoming.