Sourcing Sales across States to Reduce State Income Tax

Companies engaged in selling services might miss an opportunity to minimize their statewide income tax liabilities. By sourcing sales to states where they incur costs, companies may realize significant tax savings.

Under many state laws, companies may allocate income derived from sales of services to states based on where the seller incurs costs, rather than on the customer's location. By analyzing where the greatest cost of services is incurred, where services are solicited and where customers are located, taxpayers can determine where they can source the sale of services. To the extent taxpayers source gross receipts from services to states with lower income tax rates, they may realize significant tax savings. Sourcing is not always obvious, and the correct application of the rules often depends on business operating practices.

In general, a multistate business determines its state income tax liability by distributing its total business income across the states in which it does business. Typically, a state uses a formula apportionment to accomplish this distribution. Under this method, a business distributes its total income among the states based on the percentage of sales, property and payroll in each.

The sourcing of sales to a state, represented in the apportionment formula as the sales factor, is a relatively simple process when a business sells tangible personal property. It merely assigns sales to the customer's location. However, when a business provides services, it does not necessarily source the income it receives in the same manner. According to most state laws, a company must source its sales of services and intangibles to a state in which its income-producing activities are located, based on costs of performance. Other states employ alternative methods, such as sourcing sales based on solicitation or using the "market approach."

Sourcing Sales on Costs of Performance

The Uniform Division of Income for Tax Purposes Act (UDITPA) is a model act governing the allocation of income among states. Most states follow UDITPA's sales-factor rules, which provide that sales of other than tangible personal property are attributed to a state if the income-producing activity is performed in that state, based on costs of performance. Generally, any activity whose performance creates an obligation of a particular customer to pay a specific price is an income-producing activity. Therefore, to determine the states to which it should apportion its sales, a company should determine where it performs services that give rise to its income. For example, a company may agree to perform certain services with a customer located in state X, but it may actually perform most of the activities in state Y. After identifying the location of its income-producing activity, the next step is to measure the proportionate level of activity, determined by the costs of performance. Put simply, a company uses the direct costs associated with performing the income producing-activities to measure that level of activity. Depending on the states' rules, the company could source its revenue in whole or in part to Y, even though its customer is located in X.

While most states use the UDITPA method, many vary their application of the rule. Some states employ an "all or nothing approach," by which they attribute all of the sales to a state where the business performs its income-producing activity totally. Other states have a pro-rata allocation, in which they divide a company's sales among states, depending on the performance level in a particular state, as measured by costs of performance.

Other Sourcing Rules

At least one state, Ohio, adopts a solicitation approach to sourcing service receipts. As its name suggests, the solicitation approach requires a taxpayer to source sales to the state in which the sale was principally solicited. Alternatively, several states source the sales of services similar to the sale of tangible goods by using a market approach, which sources sales to the state in which customers receive the services.

Compliance and Planning

Given the complexities of complying with tax laws across the country, many companies simply settle on the simplest (but not necessarily the most correct or beneficial) method when calculating their multistate income tax. However, following careful analysis and planning, a business may enjoy tax savings to the extent it is able to source sales to states with lower effective tax rates.

From Monica Tillett, J.D., Los Angeles, CA, and Michael Santoro, J.D., Chicago, IL