Multistate
Taxation
Does the Nevada Corporation or
LLC
have to Register as a Foreign Corporation
in Another State?
Now, that you know which entity is best
for your situation, the key question is, when you decide to be a Nevada
Corporation or LLC, do you have to register to do business in your
home state or other states for that matter?
This is one of the most misunderstood
concepts in the business of forming entities in Nevada. First,
we are going to explain the subject of multi-state taxation, then
give you some examples of when you do have to
register and do not have to register in another state. Then if you
do, what are the advantages of forming the entity in Nevada first,
then registering in your home state, as opposed to just forming a
corporation in your home state.
In order to answer the question do you
have to register your entity in another state as a foreign entity
doing business there; you must understand the multi-state taxation
rules.
To better understand the multi-state
taxation rules there are concepts to understand and, once you understand
them separately, piece them together like a chain, and then the concept
of multi-state taxation will make sense.
Now with our outline in place let’s
explain multi-state taxation on the factors that go into the decision, "Do you have to register as a foreign entity doing business
in another state?"
Jurisdiction to Tax
Jurisdiction to tax basically means where
is your business going to be taxed. In our context we will refer to
state taxation. It could be possible that if you are doing business
offshore, this is a different jurisdiction to that of the United States
and a whole different set of rules come into play as to where those
transactions are taxed. This section will be concerned about doing
business in the United States and, if your entity is based in Nevada,
is that entity subject to tax in other states or jurisdictions. In
other words, if you form a Nevada corporation and live in California,
are you going to have to register as a foreign corporation in California
and pay state corporate income taxes (and other taxes) on a portion
of money this Nevada corporation earned?
Nexus
Nexus in relation to state taxes means
the degree of presence or activity required by a business within
a state before the state in question has the legal authority to impose
a tax on the business. In others words, does California (in our example)
have any authority to tax the Nevada corporation?
What Activities Create Nexus?
What actives that your business enters
into create Nexus or, another term would be substance, for the entity
in question. If you have these in a state, then the entity in question
would be considered to have Nexus:
So, if your Nevada entity had the above
in Nevada, then the entity would have Nexus in Nevada. Is it quite
possible that the same entity may have the Nexus in another state
also? Absolutely! Therefore, why pay additionally for nexus in Nevada?
Let’s take a closer look at Nexus.
There is some requisite presence for
Nexus. That is determined by state statue and limited by both the
U.S. Constitution and Federal legislation. The constitutional limits
to Nexus are covered in the:
-
Due Process Clause
-
Commerce Clause
The Due Process Clause is concerned
with "fair warning". Also, it requires "some definite
link, some minimum connection, between a state and the person,
property or transaction it seeks to tax." (Miller Bros. V.
Maryland, 347 US 340, 1954)
The Commerce Clause is concerned
with burdens on interstate commerce. The commerce clause requires
substantial nexus, fair apportionment, non-discrimination towards
interstate commerce, fair relation to state services (Complete
Auto Transit, Inc. v. Brady, 430 US 274,1977)
There are also federal legislative limitations.
The main limitation is Public Law 86-272. Public Law 86-272 prohibits
a state from taxing the net income of a foreign corporations
whose only business activities within the state consist of the solicitation
of orders for the sale of tangible personal property.
In other words, if you are merely soliciting orders in another state
that is not considered doing business in that state. This is a critical
concept to understand in how your business functions.
Public Law 86-272
does apply to:
- Net income-based taxes
- Activities limited to solicitation of orders
- Taxpayers engaged in the sale of tangible personal
property.
Public Law 86-272
does not apply to:
- Sales/use taxes, net worth taxes or other taxes
not based on net income.
- Activities which exceed the solicitation of orders.
- Sales of services, real property and intangible
property.
Here is a list of certain activities
that are unprotected activities under Public Law 86-272. In
other words if you do these activities you are expected to register
as a foreign entity doing business in another state.
-
Providing technical assistance
-
Maintaining a company office
-
Repairing or servicing product
-
Approving sales
-
Account collections
-
Replacing spoiled product
-
Storing products not related to
solicitation.
Here is the list of activities that
are protected under Public Law 86-272. In other words if you
do these activities that is ok and you will not have to register in
another state to do business.
-
Stock of free samples for salesmen.
-
Renting space for temporary display
-
Assisting with product display
in retail shops
-
Maintaining informal home offices.
-
Recruiting / training/evaluating
of sales employees by regional managers.
-
Certain mediations of credit disputes
So let’s give you some examples
of one area that demonstrates the limits of the solicitation on orders.
Example #1:
You have a business based out of Nevada. All the nexus for this company
is in Nevada along with the employees. The business sells ski lifts.
You send employees to Colorado to only solicit the order of
a ski lift. In other words, your employee makes the presentation,
and the acceptance of the presentation as to credit, terms and financing
all have to go through the home office in Nevada for acceptance. That
is not considered doing business in Colorado. But, two weeks later
the same employee goes back to Colorado to inspect the ski lifts after
they were shipped and installed. The art of inspecting the
ski lift crossed over the definition of solely solicitation of an
order and therefore was considered doing business in Colorado and
the entity had to register to do business in Colorado! What the Nevada
company could have done would have been to hire an independent contractor
in Colorado to do that part of the job. Then the Nevada company would
not be doing business in Colorado!
Example #2:
Budweiser sends beer salespeople around the country to solicit the
sale of beer. If the sales fall under the true definition of soliciting
sales then Budweiser does not have to register to do business in these
various states. What happened was Budweiser started sending the Clydesdale
horses to the same cities as the salespeople and the horses were considered
business promotion, which is different from solicitation of sales?
The horses were promoting the sales of beer!
These two examples presuppose a couple
of things:
-
That the companies had nexus
in their main state of operations.
-
They had employees who lived
and did the work in other states for these companies.
Now, what about a business that can
be based from anywhere? Let’s say you have a home based business
based elsewhere and you set up all the nexus in Nevada. Let’s
say it is a one-person corporation. Do you have to register to do
business in your home state where you are doing the work out of your
home? Absolutely! Why? Because you are physically doing the work out
of your home. You are not soliciting orders for the Nevada based office;
you are actually getting the order, closing the deal and collecting
the check all at once! This is the category most entrepreneurs’ fall into!
Division of Tax Base
Now, that you understand nexus and the
difference between soliciting business and promoting it, it is critical
to understand the background of how the states divide up the tax base.
The Commerce Clause requires that a state
may tax only that part of a corporation’s income that is fairly
attributable to its income-producing activities in the state. There
are three general approaches in handling this division of tax base.
There are:
-
Separate accounting
-
Specific allocation
-
Formulary apportionment
Separate accounting
is based on the premise that it is both possible and practical to
isolate the taxable income of portions of a business that a corporation
carries on within a state. Based on practical and theoretical flaws,
separate accounting is rarely used.
Specific allocation
assigns certain types of income to particular states using nonformulary
rules. Generally applied to income not related to the operational
or unitary business of the taxpayer.
Formulary apportionment divides a taxpayer’s business income among the states
in which it does business. A formula is used to generate an apportionment
percentage that is based on the relative amount of a taxpayer’s
in-state activities.
So Which Approach do the States
Use?
There is an act called the Uniform Division
of Income for Tax Purposes Act (UDITPA). UDITPA is a state tax
model for allocating and apportioning income among states.
Nearly half of the states with a corporate income tax have adopted
UDITPA.
UDITPA has created three tests for determining
the allocation and apportionment of income among states. They are:
- Business income
- Three-factor formula
- Alternative formulas
Business income is income arising from transactions and activity in the regular course
of the taxpayer’s trade or business and includes income from
tangible and intangible property if the acquisition, management and
disposition of the property constitute integral parts of the taxpayer’s
regular trade or business. Business income is always apportioned.
Non-Business income
is all income other than business income. Principal types may include
dividends, interest, rents/royalties and capital gains. Nonbusiness
income is always allocated.
The Multi-State Tax Commission (MTC) regulations state that "the income of the taxpayer is business
income unless clearly classifiable as nonbusiness income. Therefore, taxpayers should be prepared to defend nonbusiness income!
Three-Factor Formula
UDITPA apportions business income
using an evenly weighted three-factor formula of property,
payroll and sales.
The property factor purpose is
to measure the corporate presence in a state. Property is included
in the numerator if it is "owned or rented and used in this state." There are three property factor issues of concern.
-
Location
-
Valuation
-
Intangibles
The payroll factor, like the property
factor purpose is to measure corporate presence in a state. Payroll
is allocated to the state where unemployment insurance contributions
are paid; a theory based on the Model Unemployment Compensation
Act.
The sales factor recognizes the
contribution of market states in the production of income. Sales of
tangible personal property are sourced differently from "sales" of services or intangibles.
The sales of tangible personal
property are generally sourced to states based on the destination
point of sale. Under certain conditions, sales of tangible personal
property will be sourced to the origination point of the sale. There
is something called the throwback rule which says sales will be sourced
to the origination point if either of the following are true:
There are two reasons sales to the U.S.
Government are sourced to the state of origination:
-
The destination of a government
sale may not represent the market state’s contribution.
-
The destination of a government
sale is not always documented, for security reasons.
Here is an example of where sales would
not be taxable in the state of destination. Sales to states where
the taxpayer is not taxable are sourced to the state of origination.
This rule attempts to prevent certain sales from escaping inclusion
in any state’s numerator ("nowhere sales").
How are sales that are other than tangible
personal property handled? Sales of intangible property or services
are sourced 100% to the location of the income-producing activity,
which is determined, based on where the greatest costs of performance
are incurred. What does the term income producing activity mean? It
applies to each separate item of income and means the transactions
and activity directly engaged in by the taxpayer. What does costs
of performance mean? It means the direct costs determined in a manner
consistent with generally accepted accounting principles and in accordance
with practices in the trade or business of the taxpayer.
Alternate Formulas
So what are the alternate formulas
for determining income sourced to different states? Here is what
it says in UDITPA, "If the allocation and apportionment provisions
of UDITPA do not fairly represent the extent of the taxpayer’s
business activity in the state, the taxpayer may petition for a departure
from the standard apportionment formula.
California and Combined Reporting
Now, let’s look at a specific state
like California and see how they handle the multi-state taxation issue.
California has two main concepts to understand, they are:
The Unitary Business Concept
California uses the unitary business
concept to determine business income subject to apportionment. Their
unitary business approach extends to multi-corporate enterprises through
a requirement of combined reporting for unitary groups of corporations.
The next question is what constitutes
a unitary business? There are two things:
The contribution and dependency test
refers to where the operation of the portion of the business done
within that state is dependent upon or contributes to
the operation of the business without the state, then the operations
are unitary. There are three unity tests (Butler Brothers v. McColgan,
315 US 501, 1942):
- Unity of ownership-more
than 50%
- Unity of operation-evidenced
by central purchasing, advertising, accounting and other "staff" functions.
- Unity of use-evidenced
by a strong centralized executive force.
Nexus and Combined Reporting
The Courts have ruled that combined
reporting can include corporations without nexus since
combined reporting is merely an extension of formulary apportionment
(Edison Cal. Stores v. McColgan, 176 P2d 697, 1947). Combined
reporting even extends to multinational companies. The U.S.
Supreme Court has ruled that combined reporting can be extended to
include non-U.S. parents and subsidiaries (Container Corp. of America
v. FTB, 463 U.S. 159, 1983 and Barclays Bank, PLC v. FTB, 512 U.S.
298, 1994).
Current Developments in
Multi-State Income Tax:
Electronic Commerce on the Internet
Electronic commerce refers to the ability to perform transactions
involving the exchange of goods or services between two or more parties
using electronic tools and techniques.
There are three issues involved with
electronic commerce and state income tax issues. There are:
- Nexus
- Public Law 86-272
- Apportionment of income
Nexus again refers to the domicile of
the company. If the company has an office, employees, phone lines… what state are those located in.
Public Law 86-272 again deals with the
solicitation of business. Actually maintaining a Web site with an
in-state server may exceed the solicitation of orders. Digitized product
such as software, movies, or music albums may not be considered
intangible property.
Here are the latest current developments
in the area of apportionment of income. Tangible and intangible properties
are sourced differently for purposes of the sales factor. Sales factor
destination may not be identifiable if credit card is used for purchase.
Overall, you can be assured that more developments will be coming
soon in the area of Internet sales.
Now, let's find out why so many people
flock to Nevada each year!
How to Keep Your Business in the Top 5%!