State Tax Considerations for Service Businesses

It’s becoming very challenging to stay abreast of the rules surrounding state tax compliance, not to mention developing processes to track how various states source revenue and determine when taxpayers have triggered nexus requiring registration and tax return reporting. Here’s an overview of the subject, plus a couple factors to consider when deciding to conduct business in a state.

States source revenue in one of three methods. The first, and increasingly the most common, is market-based sourcing, which means the revenue is sourced to the state where the client is located. The second method is cost of performance, which involves sourcing the revenue based on the state where the majority of the services are performed. The third method, a bit of a hybrid of the other two, sources revenue based on services performed within the state versus those performed outside the state where clients are located.

As mentioned, most states are increasingly changing their apportionment and state sourcing rules to source revenue based on where the client is located rather than where the services are performed, otherwise known as market-based sourcing. In some instances under this arrangement, companies could actually apportion more than 100 percent of revenue, based on a combination of applicable state sourcing methods in those locations where the taxpayer conducts business. There could also be situations when there is less than 100 percent of revenue apportioned, depending on the respective states involved and related sourcing rules. In some states, there exists a “Throwback Rule” that requires revenue that’s not allocated to any state be allocated to states with this rule.

A growing trend among states is to enact gross receipts-based taxes, which are based on revenue and not on the net profits of the organization. Six states have currently enacted such a tax. In some cases, the tax has replaced corporate income taxes, but pass-through entities that are traditionally taxed under the personal income tax rules will still be subject to both income and gross receipts tax.

A relatively recent change in Pennsylvania law involves mandatory nonresident income tax withholding on payments to vendors that are not state residents but perform services onsite within the commonwealth. Unless a company receives a valid exemption certificate, they’re required to withhold nonresident personal income tax on payments that exceed $5,000 per year.  This requirement also depends on the vendor legal structure.

States are also taking advantage of the decision in Wayfair v. South Dakota (a sales tax case) to impose economic nexus for taxes beyond sales/use, including income tax. Pennsylvania was one of the first to adopt economic nexus post-Wayfair. While the protections afforded under P.L. 86-272 are still relevant and need to be considered, taxpayers – especially those in the service industry – will likely have additional state income tax filings.

As you can see, the number of regulations to comply with tax compliance requirements at the state level is continually increasing. This article has only addressed income and gross receipts tax; there are many sales and use, personal property and miscellaneous taxes that companies should consider before onboarding clients in a new state.

If you would like additional information or just want to have a discussion regarding the potential tax impact of your company’s state activity, contact your Schneider Downs tax advisor.