How To Advise Clients on Multi-state Income Tax Compliance
Discussing multi-state income tax compliance with our clients is no picnic. It might rank pretty high on your list of “difficult conversations”.
Let me give you some ammunition and encouragement.
Be Specific About What Causes Nexus for Their Business
Ask enough questions to obtain a rigorous understanding of what your client is going to be doing in which states. Then apply your knowledge to provide the client with specifics about what is causing a filing requirement.
For example, are they sending executives to client sites to negotiate contracts for services? That is not a protected activity under Public Law 86-272, so they will have to file in those states. They will need to apportion the executive’s salary to the states that he or she is traveling to.
Are they training customers on how to use their products or services? In most cases, those training activities are going to lead to a filing requirement in the states where they are conducting the training.
Those are just a couple of examples of what causes nexus beyond the obvious activities like opening an office in another state or hire an engineer who works from his/her home. You need to understand your client’s sales process and activities and what are and are not protected activities so you can advise them on when they have nexus.
Don’t Sugar Coat the Risk
First you give the client the news that changes in his or her business mean the business will need to file income tax returns in more than one state. Let’s say it’s not a grey area – they’ve opened an office, or they have employees in another state engaging in unprotected activities.
In many cases, the client will then ask “how will they catch me”? My advice: don’t get sucked into those conversations. Our job as tax advisers is to discuss the requirements with our clients. You can provide an estimate of what the tax liability will be in XYZ state. But engaging in speculation about “how they will get caught” is a slippery slope, and unproductive.
No you can’t force your client to file a tax return in another state. Some clients might decide for business reasons to risk the penalties and interest that might result from not filing. That’s their decision.
One compromise might be to “file in the big states”. An easy starting point to evaluate which states might be “big” is to have your client prepare a simple schedule of sales by state.
Your job is to quantify the risk so they have the information they need to make the decision.
Explain that State Income Taxes are not a Zero Sum Gain
Regardless of the form of their business entity: partnership, S corporation, C corporation, or sole proprietorship – filing in more than one state does not mean their overall state tax burden stays the same.
This will not be intuitive to the client so you’ll have to explain why and provide an example or two.
The easiest to understand is that state tax rates are different. If your client’s business is headquartered in a low tax or no tax state and then expands into California, for example, chances are very high that the business will pay more state taxes simply because California’s tax rates are higher than most states.
There are also differences in apportionment methodology to consider. In the old days, apportionment meant single factor payroll, property, and sales. Few states are that straightforward now. Some double weight sales, some just use sales alone. Some states have throwback, some use market based sourcing for sales of everything except tangible personal property, some use the traditional cost of performance model.
Don’t overwhelm your client with every possible permutation, but give them enough examples to demonstrate that venturing into other states does not mean their current state income tax burden is merely spread around among more states.
Certain States are Worse Than Others
Your client may be appalled to learn that some states will tax there business activities regardless of whether the business earns a profit. Yes it seems un American, but you need to inform them.
For example, Texas is generally considered a business friendly state. True it has no personal income tax. But even S corporations and LLCs are required to file and pay the Texas Franchise Tax. It’s not based on taxable income, so the company can have a loss and still owe.
Ohio, Hawaii, and Washington have taxes based on gross receipts. No these are not income taxes and this blog post is supposed to be about multi-state income taxes, but they are particularly onerous so be aware of them.
My own lovely state of California is far from tax friendly. LLCs are subject to a gross receipts tax. S corporations must pay an income tax of 1.5%. The individual income tax rate for business income flowing through on K-1s is taxed as high as 13.3%. The income tax rate for C corporations is 8.84%.
Be Up Front About Your Fees
Preparing state income tax returns is not a trivial exercise. Every state has its own rules about what is included in the apportionment factors. There are waters edge elections to consider. Joyce vs. Finnigan. Unitary states. Market sourcing vs. cost of performance. You get the idea.
And of course, the rules change from year to year. And your client’s business will change, too.
Provide your clients a realistic estimate to prepare their additional state income tax returns. Educate them about the additional information you will need so they (and you) are not scrambling before the deadline. Pay attention to estimated tax payment requirements, too.
What I Hope You Got Out of This
Multi-state income tax compliance is challenging. Be proactive. Discuss what causes nexus, estimate the additional state tax liabilities, and be up front about your fees.
Do you have advice for your fellow tax practitioners on how to talk to clients about multi-state income tax compliance? Best practices? War stories? Please share in the comments below.