New Market-Based Income Tax Poses Challenges

States are changing the way they calculate business income taxes, with some adopting a market-based approach.
Joseph F. BurnettJanuary 22, 2014

Analysis_Bug3Some say it’s because of the increase in virtual Internet-based companies. Others say it’s due to the growth of the service-based economy. And certainly the states’ need for revenue is playing a role, as is the states’ desire to appear more tax friendly to companies located or thinking of relocating in a state.

Whatever the cause, a growing number of states are changing the way they calculate business income taxes. As of Jan. 1, Massachusetts became the latest to adopt a market-based approach to income tax for service companies ranging from consultants to payroll providers to software design firms. It joins more than a dozen states, including California, that have rethought their approach to calculating income tax.

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Traditionally, states have embraced cost-of-performance rules, which allocate taxable income based on where the work is actually performed. But in today’s online and service-based economy, it’s possible for a New York company to perform work for a Massachusetts-based business without ever stepping foot in the Bay State. By changing to market-based sourcing, Massachusetts can now tax a portion of the income derived as soon as a company delivers a service to a customer within its borders. As such, it can tax any revenue generated from a sale to that customer, and the resulting tax revenue can be added to the state’s coffers.

Joseph F. Burnett

Joseph F. Burnett

The trend toward a market-based approach is accelerating. The shift means that companies must now pay close attention to not only the location of their customers but also to the state rules in effect in those locations.

Who benefits? The states, for one, since they will be able to capture additional tax revenues and shift some of the tax burden to out-of-state businesses. In some cases, companies as wel may find these new tax methodologies offer a financial benefit. Service companies in high tax states such as California, for example, may pay less tax because they have clients in states with lower income tax rates.

Those whose clients are located in higher-tax states that have adopted market-based sourcing, however, may see their tax bills rise. And those who have clients located in states such as South Dakota, Nevada and Wyoming that don’t currently levy any business income tax will likely find that their sales are now taxed by their home state — even if they travel to that no-tax state to do the work.

Accountants are already benefiting from the trend, since most service businesses now need to file tax returns in multiple states. Companies will need to overhaul their bookkeeping to make sure that they’re tracking not only where the services are performed but also where their customers are located. In addition, they need to stay up to date on state tax law changes around the country.

Each state that has adopted market-based principles seems to have its own approach, making every state law slightly different. In addition, many states are sticking to the old formula and only levying tax on work physically done within their state. In some states, guidance over how these new laws should be applied is still evolving. Indeed, there is a real possibility that companies may face double taxation as multiple states try to lay claim to the same sale.

So how will the states track down violators to make sure they pay up? In recent years, the states have developed lots of innovative ways of identifying potential tax evaders. At one point, New Jersey pulled over trucks on the N.J. Turnpike to see if the company was paying taxes in the state. And while service companies may be delivering their products electronically, the states will clearly be looking for new and creative ways to document the relationship.

Joseph F. Burnett, CPA, is a manager at Wolf & Company in Boston. He has more than 13 years of experience providing personalized tax planning and compliance services to family-owned and venture-backed businesses, their owners and their executives.