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Firm Growing? So Are Your State Tax Filing Requirements
Your firm is expanding its reach. Opportunities have arisen in California, Illinois and Texas. You are sending some of your partners out to each potential worksite to meet with clients and scope out local service providers. You are ecstatic when you land the jobs. In developing the project work plan, you figure that you’ll have partners and staff for a total of 30 days at the various locations.
With expansions such as these, additional state tax filings are typically required. Furthermore, there may be a requirement to register for the authority to do business with the Secretary of State and/or the state professional licensing board (both of which should be vetted with your legal counsel). In this article, we’ll focus on “nexus,” which is the connection to a taxing jurisdiction that creates a tax filing responsibility.
Traditionally, an income tax filing requirement was triggered for a business when that company opened an office in a state and loaded that office with employees and assets. That’s the easy nexus determination – your business should file in that new state. But what happens when you send a single employee into a state for a short period of time? How about having an employee telecommute from another state while attending only quarterly meetings at the office? Or suppose you hired a contractor to do on-site work in another state instead of sending one of your staff? These are all activities that may create a significant enough connection to a state to cause a tax filing obligation.
Let’s get a little technical. A state is not permitted to subject a business to a tax if the four prongs of Complete Auto Transit v. Brady (430 U.S. 274, 279 (1977)) are not met. Those four prongs are as follows:
- There must be a substantial connection or “nexus” between the taxpayer’s activities and the state;
- The tax must not discriminate against interstate commerce;
- The tax must be fairly apportioned; and
- There must be a fair relationship between the tax paid by the business and the services provided by the taxing jurisdiction.
Of these tests, most arguments with taxing authorities likely come about because of the substantial nexus requirement. This is because just how much “substantial” is can be open to interpretation, with Departments of Revenue across the land seeking to make the definition of the term as close to nothing as possible.
The state of Michigan provides a fairly extreme example of how low the line can be drawn. Michigan Compiled Laws Section 206.621(1), which addresses what businesses are subject to the State’s corporate income tax, provides that a taxpayer has substantial nexus if the taxpayer has a physical presence in the State for a period of more than one day during the tax year.
In light of the fact that many conclusions related to the existence of nexus can be gray, it is important to think through what the potential exposure might be related to having a substantial connection with a state. If the filing responsibility is questionable and the revenue sourced to the state is small, one may be willing to take on a risk related to non-filing. However, if the revenue sourced to the state is large and there is the potential for a considerable tax liability, a business should closely examine its activities in the state and seriously deliberate whether to file a tax return.
It should also be noted that more and more states are applying what is known as an “economic nexus” standard. With economic nexus, the historical physical presence standard is removed and replaced by the notion that deriving income from a state is enough to create a tax filing responsibility. Certain states, such as California, have established a bright-line revenue test for making this determination. California’s threshold is $536,446 for tax years beginning on or after January 1, 2015, while other states have thresholds as low as $267,000 (Washington State’s current threshold for the business and occupation tax). Thus, if your firm derives income greater than this amount from customers that receive the benefit of your services within California, the company should have a California income tax filing responsibility. And that is regardless of whether the firm ever set foot in the state.
On occasion, a business will recognize that it should have been filing tax returns in a state for a number of years going into the past. In such cases, the tax exposures can increase exponentially because of the age of the liabilities, with penalties and interest often doubling the actual tax exposure. Fortunately, many states provide a voluntary disclosure program, which is a taxpayer-friendly avenue to resolve these matters. If a taxpayer qualifies for such a program, most states provide remarkable benefits such as a limited look-back period and the assurance of penalty waiver.
It is great that your firm is growing and seizing opportunities to expand its reach. With this can come an increased state tax filing burden, as discussed above. Be certain to understand the tax costs that come along with being a flourishing firm. Contemplate your actions. Communicate with your tax advisor. And then get back to growing.
Feel free to reach out to us if you have any questions regarding the above or other tax issues.