State of Flux
02.05.2016 | Long Island Business News
Many states are changing the way they calculate corporate income tax for service providers, such as accountants and financial advisors, basing it on where the service is provided rather than where the work is done.
While this may sound like a technicality, it’s a huge change, often resulting in lower state income taxes for companies based in New York or no taxation at all related to much of their revenue.
And it’s leading to higher state income taxes for companies based in other states that do a lot of business with customers in New York.
Under the new system, known as the market method, adopted in New York last year along with 18 other states, a corporation’s state income tax doesn’t result from where it does the work, has payroll and owns property.
It’s the opposite of the real estate aphorism of location, location, location: A corporation’s state income tax is based on the customer’s location.
New York as of 2016 reduced its corporate income tax rate from 7.1 percent to 6.5 percent in another move designed to be friendly to corporations based in the state.
“It encourages businesses to locate in the state,” said Wayne Berkowitz, partner in charge of the state and local tax group at Berdon, which has offices in Jericho. “If a business locates in New York, if sales are sourced where the customer is located [out of state], there will be no penalty for locating here, no tax here. They’ll pay less tax.”
This rewards firms for locating jobs in a state, such as New York, by not subjecting them to state income taxes for work done on behalf of out-of-state clients.
“It encourages business to locate in their state,” Berkowitz continued. “You can have your employees and facilities in a state. They won’t be a factor in your state income tax there.”
Seth Rabe, in charge of state and local tax services at Manhattan-based WeiserMazars with offices in Woodbury, said this frequently has led to lower taxes for New York corporations. But it can be a tax hike for firms based out of state.
“Now if you’re based in another state, but you have all your customers in New York, you potentially have to file a return and your revenue will be sourced to New York,” Rabe said. “You go from zero tax liability to something.”
California was first to introduce market based sourcing, which is simpler and more forgiving to local companies.
“They’re typically the first to adopt any new tax law,” Daniel Effron, a partner at Grassi & Co. in Jericho, said. “New York generally comes in after that. Each state has its own little tweaks.”
Nebraska and Arizona shifted in 2014 followed by Washington, D.C., Rhode Island and New York last year. Tennessee, as of July 1, 2016, will join the club but each is slightly different.
California applies the method to a wide range of entities such as partnerships, C corporations and S corporations, while New York’s new rule applies only to corporations.
“New York implemented this as part of corporate tax reform,” Effron said, noting that partnerships (including many law and accounting firms) don’t use the new method. “It’s only applicable to corporate tax payers.”
This could mean that New York will collect less corporate income tax overall, further reducing the corporate contribution to the state’s coffers, but potentially leading to more jobs.
Personal income taxes account for roughly $42.9 billion in annual revenue in New York, while sales tax accounts for $23.5 billion and corporate income tax accounts for $4.9 billion, Effron added.
“More states are coming on board with this concept of market-based sourcing,” Effron said. “It’s interesting how little is being discussed with clients on this issue. I think it’s one of the biggest, most sweeping changes in state taxes.”
The change also means firms are taxed solely on where revenue is provided rather than based on payroll and property, as in the traditional method.
“More and more states and cities like New York City are migrating toward a single factor, just the sales,” Effron continued. “It’s a 180-degree turn from the old rules.”
Even then, companies are only taxed based on customer location, if they have a “nexus” or connection to that state. If there is no nexus, that typically means no income tax related to that transaction.
Nexus traditionally has been defined as a site in a state, but that’s changing as well. Michigan defines nexus based on time a company’s workers spend in the state, while New York defines economic nexus as of 2015 as $1 million in sales.
“A lot of states are going to economic nexus, which hasn’t been challenged yet on a constitutional basis,” Berkowitz said. “Economic nexus says, ‘We’ll impute a nexus to you, because you do business with our citizens.’ Some states have a numeric threshold.”
Ed McWilliams, a manager at Cerini & Associates in Bohemia, said companies often can provide services via telecommuting without creating a physical nexus to states.
“If you don’t have nexus in those states, you don’t have to pay taxes on that work in those states,” he added. “Some states have a broad way of connecting. Other states have a narrow way.”
Due to the changes in the system, some companies end up paying more taxes than they owe. Cerini & Associates, for instance, helped a company obtain a $200,000 refund.
“They paid more New York State tax than they should,” McWilliams said. “A lot of people have a misunderstanding of how this works.”
Taxing companies based out of state in theory encourages them to expand in your state. But that could change.
“Everyone’s starting to do that. New York’s playing catch-up,” Berkowitz said. “Are new companies locating in New York? Yes. New York’s a desirable place to be. There’s no disincentive.”
Berkowitz believes eventually all companies, not just corporations, in New York will be taxed based on customer location and not a formula involving payroll, property and revenue.
“It’s not the norm yet, but there’s been a very large increase. I think shortly it’s going to be the norm,” Rabe continued. “It’s easier for the state to figure out where income should be sourced.”
Rabe also believes New York is likely to shift to the new method for all companies, including partnerships, which would affect many accountants and attorneys.
“A lot of people believe eventually they’ll source it the same way for partnerships too,” Rabe said. “The end result seems like a carve-out for lawyers and accountants. But I don’t know if it’ necessarily like that. I think it happened to pan out that way.”