It’s a big country, and growing businesses may want to expand into new markets — in new states. Some companies do this by selling on-line or sending out mail-order catalogs. This usually doesn’t change their tax picture, other than the need to comply with sales and use tax laws (use tax is tax paid to your home state when you escape sales tax in another state).

However, when a business’s expansion includes physically moving into a new state — such as by taking office space, sending in a sales force, or warehousing inventory — state tax rules in that new jurisdiction begin to apply. This can complicate the tax picture of the business and its owners. Some key points to note…

OPENING DOORS

To start operating in a new state, a business must register with that state. This includes…

  • Registering to do business in the new state. Example: A business incorporated in Delaware that wants to expand into Maryland doesn’t have to incorporate in Maryland, too, but it does have to register with the department of state in Maryland to do business there. Check the registration rules and with what department you need to register for the state in which you want to register.
  • Registering for payroll tax purposes. When a business starts to have people working for it within a new state, the payroll tax rules of that state apply to those workers. This includes withholding tax rules (explained later) and unemployment insurance obligations.
  • Registering for sales tax collections. In most cases, the obligation to collect sales tax is based on the seller’s physical presence in a state (see below). For example, a Pennsylvania retailer selling to someone within that state is required to collect Pennsylvania sales tax on that sale and remit it to Pennsylvania.
  • TAXATION OF THE BUSINESS

    The ability of a state to impose its tax rules on a company depends on the company having a substantial “nexus” (connection) with that state. This usually means having a physical presence in the state.

    Income tax for a company with a physical presence in more than one state is based on an allocation of total income for the year. Each state has its own formula for making this allocation. Typically, the formula is based on three factors — payroll, assets, and sales.

    Whether a company has a nexus with a state isn’t always clear. Obviously, maintaining an office, store, or factory, or stocking inventory in a state creates a physical nexus.

    Economic nexus: New Jersey recently taxed a Delaware corporation whose only contact with the state was the licensing of its trademarks to its affiliate. And West Virginia imposed its state tax on a company whose only nexus with the state was the issuance of credit cards to state residents. Both these states based their taxation on economic nexus. The US Supreme Court has declined to decide whether a state can base taxes on an economic nexus, leaving this a viable basis for taxation — for now.

    Note: Any business with a nexus in a state must comply with that state’s income tax rules.

    INCOME TAX WITHHOLDING

    A company is required to follow the tax withholding rules of the state in which it is physically operating. This is true regardless of where it is headquartered or where the employees who work in that state live. For example, a Connecticut office of a New York–based company must withhold Connecticut state income tax from the wages of its workers in that office — even if all of the workers commute from New York.

    Caution: Failure of a company to comply with withholding rules can expose it to substantial penalties.

    Note: Workers can claim a tax credit on the income tax returns they file in their home states for the withholdings in their work state.

    Relief for business: The Mobile Workforce State Income Tax Fairness and Simplification Act of 2007 (H.R. 3359) currently before Congress would create a national withholding structure in the 41 states that impose a personal tax on wages and partnership income. This measure has the endorsement of the American Institute of Certified Public Accountants. Tax Hotline will keep you updated on this legislation.

    SALES TAXES

    Companies must collect sales tax on transactions they make under the laws of the states in which they operate. If they operate from more than one state, things can get complicated — the sale may come from one state while the goods are warehoused and shipped from another.

    The Streamlined Sales and Use Tax Agreement, initially finalized in 2002, with final amendments made in September 2007, attempts to simplify the problems faced by companies operating across state borders. With more than 7,000 sales tax jurisdictions (factoring in local sales taxes), it is extremely difficult for far-flung companies to comply with sales tax obligations. To check whether the state where you want to do business has adopted this agreement, and at what level, go to the Web site of the National Conference of State Legislatures at http://www.ncsl.org/.

    Solution: Work with a knowledgeable accountant to set up sales tax collection procedures. Also, consider working with a certified service provider (CSP) to automate this process. Examples: Avalara (www.avalara.com) and Exactor (www.exactor.com).

    Note: A bill pending in Congress, called the Sales Tax Fairness and Simplification Act of 2007 (H.R. 3396), would give states that have complied with the Streamlined Sales and Use Tax Agreement the authority to require out-of-state sellers to collect sales tax on remote sales — for instance, collecting sales tax on on-line sales from buyers in states besides the one where your business is located. There is a small-business exception — a seller that has gross remote taxable sales of less than $5 million would not be required to collect sales tax under the act.

    TAX TREATMENT OF THE OWNER

    Usually, owners of pass-through entities, such as partners, S corporation shareholders, and limited liability company (LLC) members, must file income tax returns in each state in which the company has a physical connection.

    Exception: A number of states, including California, New Jersey, and New York, allow composite filing — the entity files on behalf of all of its owners and pays income tax on their behalf. Composite filing saves administrative costs (fewer returns need to be prepared), but there’s a downside — the payment may be based on the highest tax rate in the state, costing taxes that could otherwise be saved if each owner filed separately. But if the owners’ resident state allows a full tax credit for the taxes paid to the nonresident state, even this won’t cost owners any extra taxes.

    The tax treatment for owners depends on the type of company…

  • C corporations. Owners who work for their corporation pay income tax only on compensation allocated to each state in which they perform services. For example, if a Texas C corporation opens an office in New York, a shareholder who works solely in the Texas office pays no personal income tax to New York — all of his wages are allocated to Texas.
  • Partnerships and LLCs. Owners must report their shares of the entity’s income allocated to each state. This is the case regardless of where they personally are based or whether they work a certain number of days within a state. Modifying the example above to be a Texas LLC that gets three-quarters of its revenue from Texas, LLC members would report one-quarter of their share of LLC income on a New York income tax return — whether or not they set foot in New York.
  • S corporations. Similar to C corporations, an owner-employee of an S corporation pays income tax on compensation based on where his/her services are performed. As discussed earlier, he can claim a tax credit on the income tax return he files in his home state for the withholdings in his work state(s). However, the owner’s share of theS corporation’s net income (earnings minus expenses, which include the compensation paid to the owner-employee) is taxed in the same manner as income from partnerships and LLCs.