The way you can very simply think about the services that our firm performs is:
- We help people/businesses in varying degrees of tax crisis/controversy (our audit, collections, and criminal tax defense practices)
- We help people/businesses avoid these situations by bringing them into compliance.
- We help optimize our clients’ tax situations in order to save taxes, accumulate net wealth, and help their businesses grow.
However, within these service areas, perhaps our hottest practice area is in helping multi-state companies and/or those that have some international aspect comply with the laws and utilize their framework to succeed in their business. Increasingly, with the proliferation of technology and enhancement of logistics, more and more companies fall into this definition. A few years ago, you would not have thought of a smaller seller selling books on Amazon as a multi-state business, but the reality of the situation today is that these companies have operational impact well beyond their state’s borders. When they first come to us, our prospective clients do not really see themselves as multi-state businesses, but by the time we are finished with their matters, we have built them and effective and affordable framework for compliance.
The landscape has completely changed and will continue to change. The expansion of concepts such as economic nexus and the rapidly changing state laws and state enforcement priorities almost making writing about this subject a lost cause (the laws are changing that quickly). So, please take what you read here with a grain of salt, as time passes this page may quickly be not entirely accurate. That is not intentional, but you should understand that no legislative process, administrative law, or judicial interpretation is going to move as fast as technology does these days. As soon as the state issues a decision, it is almost obsolete because someone is doing things a different way. From our perspective, it is what makes this area of law so exciting, but in the same breath, it can be terrifying for our clients who are just trying to get compliant and stay out of trouble in an uncertain world. Businesses did not use to need to factor in this kind of fluidity.
Additionally, the states and in particular California, are becoming more and more aggressive in their definition of who has a filing requirement and who owes them tax. At times, it seems like more than half of our clients are out of state businesses who have somehow stepped into a California issue in some way shape or form. The majority of these businesses did so unintentionally, after all, who really thinks about the consequences of their business operations in a state that they are not in? Nevertheless, intent is not a factor in whether or not you are subject to multi-state taxation and because of a variety of factors, you may be operating and accruing liability in California and not even know it.
As mentioned, California is one of the more aggressive states in pursuing businesses that are located outside of its borders for tax revenue. California seemed to realize the fact sooner than other states that it could go after businesses and individuals that may have contact with the state of California, but who actually don't actually reside in California and who don't have voting power in California. Did you know that California has actually increased its base of operations and has offices now in New York, Texas and Illinois, which serve as regional jumping off points for out-of-state California tax compliance. That’s right, you can get audited in New York or Texas or any other state by a California auditor and be subject to California state tax.
Challenges for Multi-state Businesses:
- How do we manage and mitigate risk when the law is unclear or when we operate in different states with different or conflicting laws?
- How do we stay in compliance in light of a fast moving changes in certain sectors?
- How do we manage to avoid issues without dedicating substantial resources to our compliance? How can we make this cost effective and build an infrastructure that makes sense for the size of our company?
Multi-State Sales Tax Issue and the Amazon Example:
How complex do these issues get for small and mid-size businesses? Let’s talk about the recent problem of Amazon in the context of how complicated this area of law has become. Even if you are not an Amazon seller or even sell products, if you have customers in other states or employees/service providers, or hold inventory directly or through a 3rd party, you may want to take a minute to read the following.
Let’s paint a picture here. Amazon has been a wonderful thing in many people’s lives. You can get on Amazon, you can order a variety of products and have them shipped to you in about a day. Amazon is amazing in a sense that it has built a seemingly never ending pipeline of products that can be delivered to you with next day shipping, but on the other side of things it has opened the door for many companies to completely revolutionize their sales. Small companies have gone on Amazon and now see regular revenues of ten, twenty, fifty, or even a hundred million dollars. Amazon is big business for some companies, even the only channel for some businesses that sell exclusively on Amazon and utilize its logistical network.
Amazon has also created significant problems from a sales and use tax perspective (and from a state income tax perspective as well). Let’s say you purchase a TV at Best Buy. You go to Best Buy and you purchase a TV, and the TV costs you $1,000, and then you pay sales tax on that TV. It used to be that if you bought the same TV on Amazon and were shipping that product into the state of California, you would not be paying sales tax on that product because it was an interstate transaction. This put in-state businesses at a competitive disadvantage because customers could go online and skip out on the sales tax and purchase the same product for less. As online sales grew and grew, this started to cut into the revenue for a number of states. So, California and a number of states addressed this issue by expanding the concept of what it meant to do business in California (a concept called nexus). One of the ways that they increased nexus in California is by saying that if you held inventory in California, either directly or through a 3rd party, you had nexus with California and needed to collect sales tax from California customers.
So, if you are an Amazon retailer that is located in New York, you may never go to California. Your business is in New York, you ship products out of New York to Amazon warehouses, and you stay in New York. You do not even come to California on vacation. So, if you believe you are a New York company (which you are), why would you think twice about California and the laws that it has on its books?
This is what the law did. These laws opened up and evened the playing field so that California could tax businesses that were not located physically within its borders. For Amazon sellers, a lot of the Amazon sellers will ship their products to Amazon's warehouse and then they do not really keep track of what happens after they ship to the warehouse. What Amazon does is you can be a New York seller located and shipping goods into a warehouse in Pennsylvania, and that order should fulfill customer demand. Amazon may send those products from its Pennsylvania warehouse to a network of other warehouses that Amazon has. By doing that and as Amazon acting as an agent for you, Amazon essentially creates nexus in a variety of different states. This is exactly what happened in California. Amazon moving their sellers’ product here availed those sellers to California law.
The Fallout from Amazon:
Now here is the problem for the sellers. California put these laws in the books in 2013, so a long time has passed since they were in effect. And this creates a situation where all of these companies were making sales in California and not charging tax or, in other words, accumulating significant past sales tax liabilities. We have seen situations in the firm of multiple millions of dollars, even tens of millions of dollars where sales tax was not being collected. That's a lot of unpaid tax, not to mention interest and penalties that will continue to accumulate over a multi-year period. The situation can often be worse for smaller businesses. If you only do a couple million in sales per year, your margins probably are not that great, and there is not much left over, if anything, to pay four or five years of sales tax liability.
The Wayfair Case and its Impact on Business
However, at the same time this was going on, the Supreme Court changed the landscape of multi-state taxation forever with the Wayfair vs. South Dakota case.
Without going through the complete history, there was a case in the early 1990s called Quill vs. North Dakota, which ruled that in order to have economic nexus with a state you must have some sort of physical presence. Meaning a state could not tax you for business done with that state unless you had more contact like having a presence there. So the states were capped and a limit was set on where they could tax. However, the states hated the Quill decision because it limited their ability to tax businesses that were outside of their state borders, like Amazon. However, gradually and with the rise in technology impacting interstate commerce, the states tried to find new ways to tax businesses for things that did not involve physical presence.
For example, many states have passed laws that said you can be held liable for sales tax/state income tax if you're operating through an agent or if you're conducting significant marketing activities. So, the states turned the argument from physical presence inside a state and made it an argument about the level of contacts with a state. Which, absent a ruling from a federal court, the states are free to make their own laws for matters within their own state. So, the concept that you needed physical presence with a state to be subject to economic nexus there was already starting to disappear. However, finally the Supreme Court overturned the Quill decision and essentially gave their blessing for looser interpretations of economic nexus.
The problem is that, while the Court overturned Quill, it did not really provide any clear indication on what constitutes economic nexus. In the Wayfair case, South Dakota had set a limit that if you do over $100,000 in business in their state, that will constitute as significant activity. So, there is a threshold and a fairly high one to cross before economic nexus has been met. But what about in other situations where states do not have the same types of standards? There are only eight states that mirror South Dakota’s test.
Without judicial restraint here, the states can essentially do what they want. It is very possible, for example, that California's law could be unconstitutional from a federal perspective. However, without some intervention from the courts of from Congress, there is nothing that limits California’s ability to govern itself internally. Nor is there anything that would prevent the forty nine other states from doing the same thing without any uniform standard. Theoretically, we could have fifty states with fifty different definitions of economic nexus.
The other thing Wayfair did not address retroactivity with respect to this economic Nexus provision. It is fairly certain that going forward that economic Nexus laws will be continue to be upheld at least if they meet the general guideline that South Dakota put forward. What is really unclear is can states go back retroactively and enforce economic Nexus provisions. For example, before 2018, can the states really go back and enforce state sales tax and state income tax laws against out of state entities?
How Things Stand Today:
The real landscape after Wayfair is this: as long as you have some level of minimum contacts with a state like California, you are going to be subject to their jurisdiction. It also means that given the revenue that is being generated from all of the out of state entities, you can expect businesses to be liable for sales tax collection and filing and potentially state income tax payment and filing in a variety of different states. If you are considered to have nexus within a state, even if you are located outside of that state, having nexus is equivalent to essentially having a branch office within that state. They look at it for state income tax purposes and they look at it for a state sales tax purposes.
With respect to compliance, the most important thing going forward is understanding that this issue is not going to just go away. It is something that is going to continue to increase and continue to provide problems for businesses and the people that work for them. The states are going to get more and more sophisticated in enforcing these types of laws.
The important thing is you really need to understand what the problem is. You need to understand what the state knows about you. You need to understand how big your liability is, and you need to make a responsible decision on how to deal with those issues, and that is really, really important. You do not want to rush to judgment or rush to compliance because that's a really big mistake to make because a lot of times, you are just opening up a problem without really dealing with the problem or by creating a problem that's much bigger.
Eventually, someone will catch up to you based on your activities. Depending on your level of contacts, depending on your presence outside the state, either online or otherwise, there may be different ways to manage your mitigated risk but the important thing to realize is, eventually, they will try and find you and they probably will find you, because of the emphasis that state revenue departments are placing on this issue. If you have not be caught or contacted yet, now is the perfect opportunity before the states get too sophisticated and before the states increase their enforcement efforts. We recommend getting a compliance or at least manage or mitigate the issue as soon as possible.
In conclusion, multi-state sales/use tax issues can be particularly complicated and difficult for a business to deal with. Many CPAs do not fully understand the issues because many CPAs do not focus on sales tax issues and the same can be said about internal CFOs as well. Because the issue is complicated and so few firms practice this area of law because of the complexity, you really need a specialist to help you deal with these issues. At Brotman Law, we take a novel approach, because our focus is about the health and well-being of our clients’ businesses. We put a cost-effective compliance plan that is easy to manage and gather resources around our clients in order to help them manage their situations effectively.
Multi-State Payroll Tax Issues:
There is a lot of misunderstanding and a lot of confusion with respect to the ways that companies are reporting their payroll tax obligations when they have employees/independent contractors in multiple states. Without oversimplifying the issues, companies should really be looking at where services are being provided. To the extent that services are being provided in a state, then that particular state where the services are being provided is going to want to collect payroll taxes associated with those services. There are some exceptions to this, but generally speaking where services are being performed, is where tax is going to be permitted and paid.
If you have a situation where you have somebody in California and they are flying to the state of Florida, and they are performing services exclusively within Florida, you are not going to file California payroll tax returns. You are going to file Florida payroll tax returns. Even if somebody is physically living in another jurisdiction, payroll tax liability will extend to the state that services are being performed and where the work is done. You will fall under those states laws, with respect to labor. So it is very important that you understand that and are reporting payroll taxes correctly because most payroll companies do not catch this.
Payroll taxes can also be a problem when you have agents, affiliates or independent contractors located in another state. To the extent that you have independent contractors in multiple states, you may be subjecting yourself potentially to the state payroll taxes and state income tax liability. A quick word about the independent contractors is that the relationship between independent contractor as an individual and a business is being put under scrutiny by a variety of states.
In California for example, there's a case called Dynamex. And Dynamex essentially boils down independent contractors to a three part test which mirrors the three part test that is in a variety of other states. Many states including California are making a proactive attempt to really narrow the scope of independent contractors. Why are they narrowing the scope of who gets classified as an independent contractor? This is because the states collect payroll tax revenue on people who are considered employees of a business where as they do not collect tax on independent contractors. Traditionally, the way that most employers think about independent contractors is that those people only are working a limited number of hours or they are working from their home location, or they're providing services to a number of different people. Depending on the state, you may have a different definition of what is considered an independent contractor. So, for example, in California traditionally there was a seven factor test for determining whether somebody was or was not an independent contractor. However, recent court decisions and legislation have made this a little bit simpler.
- How much control does the employing unit have over the independent contractor?
- How integral is the job function of the independent contractor to the production of revenue for the business?
- How well can the employer/taxpayer establish that the independent contractor is truly and independent business?
If you have a business and the production of revenue is dictated by the services being performed by independent contractors, typically those independent contractors are not independent contractors they are employees of that business to the extent that independent contractor services are integral to the core function of the business. There are very broad reaching issues with independent contractors particularly in multiple states.
First, there is obviously a significant payroll tax liability depending on how many independent contractors that you're using and depending state by state if you're using a large pool of independent contractors in a particular state you can be cruising for a payroll tax audit. For example, we have a company located in the State of Georgia that was relying on a pool of independent contractors for ancillary services to that business. Those independent contractors were found to be employees within California and created a liability for that client.
Second, depending on the state, if an independent contractor is operating on your behalf in a state that you do not have a physical presence in, then you may be considered doing business in that state and then you are going to have to deal with state income tax filing and compliance issues as well (along with probably owing that state some money).
So, there are a lot of variables to consider for businesses with multi-state work forces. You will need to examine where the labor force is for your business and what services are being performed (i.e. are services being performed in multiple states). However, there are other issues to consider as well. Although the gains are traditionally smaller, there can be optimization benefits (i.e. saving money) along with the importance of making sure you are in compliance to avoid any issues.
The good news is that you have come to the right place for help with this. Our knowledge of these issues and the interaction with other tax and business issues make our firm a great choice to put your company in the best position possible. We understand not only the tax implications, but the practical business implications of having a multi-state workforce and can help you navigate a variety of challenges when dealing with these issues.
Multi-State Income Tax Issues for Businesses:
Traditionally, states have been looking at state income tax from an apportionment standpoint. They have been looking at where the percentage of your revenue is, where your employees are and where your inventory is being held. That is still true for a variety of product related businesses. They are going to look at your level of contacts with a particular state. Then to the extent you have nexus within that state, it will seek to tax all the income associated with their state.
For example, if you are in California and you have employees in California and Illinois. Illinois is going to want the proportionate share of its revenue that is being earned in the State of Illinois or that is being generated by those employees. So, your organization needs to find balance between its activities in different states. If you are principally headquartered in California, for example, you should not be treating all of your income as subject to California state income tax. Rather, you should be allocating it among the different states that you are touching.
This can create a big problem for organizations, but can also create a huge opportunity for significant tax planning. First, the problem. If your California business is reporting all of its income in California and not allocating some toward the state of Illinois, it will face a big challenge when it gets audited by Illinois, especially for years that are past the statute of limitations on getting a refund in California for the tax that you overpaid. Essentially, you are going to pay state income tax twice on the income that you earned, not to mention interest and penalties in Illinois for the underpayments of tax.
With respect to service businesses, mostly States are going to tax you from a state income tax perspective on the location of services that are being performed. This gets a little bit complicated because you could have a situation where services are being performed for particular items generating revenue in a variety of different States. For example, you could have a client in Arizona and you're in California and you're doing a certain amount of services in California and a certain amount of services in Arizona.
Really what this comes down to for most states is a balancing task. You're not going to be able to take a fee for a service project and microscopically split between California and Arizona, but you can just do a general balancing test. The nice thing with respect of State income tax reporting particularly through proactive is you get a chance to take the first position and will probably face little chance of challenge as long as that position is fair.
Now for the good news. Shifting income away from high tax jurisdictions can offer incredible savings for an organization if multi-state income tax planning is being done properly. If you are located in multiple states, does it make sense to base your operations in a high tax jurisdiction like California? Do you have options based on the logistics of your operation to switch your headquarters to a different State? When you are a multi-state company, even for businesses that have not really traditionally thought of themselves as multi-state companies, you have an option where your home base is, and there are certain tax advantages obviously between different States, some tax businesses very high some tax businesses very low on where you want your home base of operations to be. You can have a certain amount of choice of entity and it's really important multistate tax planning, to figure out how to best navigate your state income tax liabilities.
In conclusion, as you can likely tell from our discussion, the income tax issues that face multi-state businesses can seem overwhelming at first because there are a lot of moving parts. However, the benefits of compliance and more so from the potential tax savings associated with multi-state tax planning are worth the effort. In our experience, we have found that a lot of businesses are not reporting properly with respect to states that they are doing business in. You want to have a very good understanding of where you are reporting to, why you are reporting there, and to make sure that you are taking a position that is most favorable to you. There are going to be situations where there are going to be conflicts among the states in how they believe that you should report. There are also situations where there is a great deal of opportunity as well. Our team can help you navigate these issues for maximum benefit as well as for maximum gain.
Multi-State Residency Issues for Individuals:
Multi-state tax issues do not just impact businesses and, in reality, they impact people much more frequently. People move around a lot, so there are situations where you get residency issues for people who are in different states than their companies, or who tend to travel a lot. Residency laws vary from state to state. It is impossible to cover every single state law, but suffice it to say that, in most states, if you lived in a there for more than six months out of the year, you are going to be deemed a resident of that state. In California, The underlying theory of the regulations is that the state with which a person has the closest connection to during the taxable year is the state of his residence. [CC&R § 17014(b)].
If you are a resident of a particular state like California, then you're going to be taxed on your ‘worldwide’ income. The state is going to seek to tax you, based on the fact that you were a resident in that state. If you live in California six months a year, and if you lived in Arizona for five months of the year, say for five months and twenty-eight days, then you would be considered a California resident, you pay California tax on all of that income. Actually the way it would work, is that you would pay income tax in Arizona for the income earned there and would receive a credit for that on your California taxes (California has a higher state income tax rate than Arizona). In the inverse of that situation (six months in Arizona), you would pay Arizona income tax as an Arizona resident and only be tax in California for California source income.
From residency perspective you’re going to want to pay attention to where you are, where you are performing services and where you are subject to tax. There obviously are conflicts with a lot of states with respect to taxation schemes just as there is on the corporate side. If you are an officer for example of a company and you do a lot of travelling, you may find it wise to move your home base to a different state other than the one you actually live in. There are obviously practical considerations for people with families and/or children.
This gets challenging for a variety of reasons. First, for states that are very close together, particularly north-eastern states where there's a lot of movement back and forth where you can cross two or three state lines in a given day. Second, there is a lot that goes into changing ones residency and states can be aggressive when it comes to interpretations of what it means to be a resident of their state. Most states operate on the principle of a domicile.
The term “domicile” has been defined as the one location with which for legal purposes a person is considered to have the most settled and permanent connection. A person may only have one domicile at a time and they retain that domicile until acquiring another one elsewhere. In order to change one’s domicile, a person must actually move to a new residence and intend to remain there permanently or indefinitely. When taxpayers begin making connections with a new location, but do not actually abandon their old location, they will continue to be domiciled in and residents of the first location until they actually move into the new location.
Here are the variety of factors that California looks at when it performs a residency analysis:
- Location, size, and value of residential real property
- Location of spouse and children
- Where do your children attend school (minor children only)
- Where does the taxpayer claim the homeowner’s property tax exemption
- Taxpayer’s telephone records
- The number of days that the taxpayer spends in California vs. other states and the general purpose of those days.
- The location where the taxpayer files his returns, both federal and state returns, and the state of residence claimed on those returns.
- The location of the taxpayer’s bank and savings accounts.
- Origin point of taxpayer’s checking account transactions and credit card transactions
- State where taxpayer maintains membership in social, religious, and professional organizations
- State where taxpayer registers his automobiles
- State where taxpayer maintains drivers licenses
- State where taxpayer maintains his voter registration and taxpayer’s voting participation history
- State where taxpayer obtains professional services
- State where taxpayer is employed
- State where taxpayer maintains their business and business license
- State where taxpayer maintains there professional licensure
- State where taxpayer holds investment property or assets
- Third party testimony about taxpayer’s residency
In conclusion, you want to make sure from a residency perspective, you are doing things from a tax-efficiency standpoint. There can be major consequences in personal residency situations, such as with sales of a company, capital gains income, and with retirement distributions. The best thing that you can do is plan these income distributions in advance and give yourself enough transition time in between leaving one jurisdiction and establishing domicile in another state to avoid scrutiny. Alternatively, you want to make sure you adequately protect yourself by documenting your change in domicile, and/or fight adverse residency determinations. This is an area where the state tends to place a lot of focus, so having an experienced tax team by your side to navigate these challenges can really make the difference.