Companies filing state income tax returns must determine how much income is reported to a state based on a combination of property residing in the state, payroll employed in the state and sales generated in the state (referred to as “apportionment factors”). In recent years, states have relied more heavily on the sales factor to generate more income for their jurisdiction. States generally require companies generating revenue from sources other than tangible property such as services, software or intangibles to apportion revenue either by the cost-of-performance method or a market-based sourcing method.
The cost-of-performance method sources all receipts to the one state with a preponderance of income-producing activity. This generally means the state where the work is performed to generate the revenue. The market-based sourcing method sources revenue to the state(s) where the customers receive the benefit of the service received or where use of the software/intangible is used.
The states are split on which methodology they use for sourcing income. The current trend is for states to use the market-based sourcing method. Use of that method allows states to tax out-of-state businesses even though they have no property or payroll in the state. The Multistate Tax Commission, whose function is to “promote uniformity or compatibility in significant components of state tax systems,” adopted model regulations in 2014 for states to use if switching to the market-based sourcing method. The regulations were finalized on February 24, 2017. Currently, there are 22 states that use market-based sourcing for apportioning revenue. Louisiana and Tennessee are the most recent, adopting for tax year 2016.
Multi-state filers with revenue from sources other than tangible property must determine which sourcing method the respective state is using. This creates an extra administrative burden on companies that may have to compile their revenue information under both the cost-of-performance and market-based sourcing methods. In addition, some companies could actually apportion more than 100% of their income to states where they file, depending on the specific facts and circumstances. Using the correct sourcing method is important to be compliant with state regulations and computing the company’s overall state tax liability.
To learn more about revenue sourcing and which method to use, contact us.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.