Since most companies have a calendar year-end, they are probably working to gather information to prepare their income tax returns. As this information is being gathered, it might be a good idea to analyze the data for its accuracy and whether other issues may be created by the information. Here are some best practices companies employ to reduce exposure and identify opportunities for state and local tax savings.
Many companies will look at their payroll/withholding liability accounts on the balance sheet to determine whether new employees who reside in states outside the company’s current footprint were added. That review will focus on whether a new state income tax filing is created by hiring a resident of that state or opening a location in that state. Reviewing the in-state activities of that employee (salesperson, service technician, or remote employee) helps them determine whether a new state income tax filing is necessary. The determination that the employee is a salesperson may cause some companies to limit their review because they assume the employee’s activity is protected by federal law (Public Law 86-272). However, the analysis should not end there. The in-state activity of a salesperson may create nexus for non-income-based taxes (e.g., Ohio’s CAT tax, New Mexico’s gross receipts tax, Texas’ margin tax, and Washington’s business and occupation tax) and may create sales tax nexus in that base state and any additional states in the salesperson’s territory.
Sales Tax Filings/Collections Review
Sometimes companies will compare the states where sales taxes are collected against those in which income tax returns are filed to determine whether any new income tax filings are required. While the company’s in-state activity may be protected for purposes of income tax filings, you may want to gather information to support that position because many states now send nexus questionnaires to taxpayers registered for one tax but not registered or filing for other tax types.
In addition, you may want to verify that sales tax returns are being filed in the states in which the computer software system has computed sales tax. A detailed reconciliation of your sales tax accrual accounts is highly recommended. Every once in a while, we find companies that are not registered and not filing sales tax returns in states in which tax has been collected from their customers. Even the inadvertent failure to remit tax collected from others is generally met with harsh penalties, no statute of limitation, and limitations on the ability to utilize voluntary disclosure programs.
Apportionment Factor Review
Generally, companies will run reports on sales by state to determine amounts to be used for apportionment purposes, but few companies invest much time to ensure that the reports conform to state apportionment rules. As more states adopt “bright line” tests based on sales volume to determine economic nexus, lack of review could become more expensive. We generally recommend doing some level of validation of the apportionment data to ensure it is accurate. We have seen various situations in which the data was not accurate or was misleading, including:
- Data extracted by billing address rather than delivery address. This may lead to invalid data if sales are sourced to the headquarters, but the tangible property is actually delivered to plants, distribution facilities, or customers in other locations.
- Sales may have various components like printing versus fulfillment. When the materials are printed, an invoice may be created for the product only, which has a “ship to” location of your production plant. When the product is later fulfilled to customer locations, only the invoice for fulfillment or delivery charges is sourced to the destination state. Most states source the product sale based on the ultimate destination.
- Invoices are issued for down payments before the actual product is shipped. However, these invoices may not be recognized as sales for tax purposes at the same time if the project straddles tax years.
- If you provide services, you may need to determine whether the states use market-based sourcing versus the cost-of-performance method. The sales-by-state report may be accurate for market-based states that source sales based on where the customer receives the benefit of your service; however, you may need to gather other information if you have filing requirements in states that still use cost of performance, which sources sales to particular states based on the costs necessary to perform a particular service.
Since many states are now using single-factor sales for apportionment, you may not review property by state as closely anymore. Many customers now require their suppliers to have a specific amount of inventory backlog in the direct vicinity of their plant, or customers are requiring inventory to be located on site that is treated as a sale only when used by the customer. It is a best practice to discuss with your sales or customer service departments whether there are any unique customer scenarios related to inventory requirements. Maybe the amounts are small so separate inventory balances are not regularly maintained, or the amount is determined to be de minimis for internal reporting purposes. However, there typically is no de minimis standard for inventory in a state, so this may create income tax nexus.
Property Tax Accrual Review
Many states issue their property tax bills in December, so companies are adjusting their accruals based on the current bills. If the amounts have changed significantly, it may be appropriate to review the facts to determine whether an error was made internally or by the assessing party. If the valuation of the property has dramatically increased, you may want to evaluate utilizing a third party to informally review the situation before the next year’s filing or the current year’s appeal window.
We recommend that companies have their operations people complete an internal nexus questionnaire to document new activities, new personnel, and new locations on an annual basis. This will allow the company to evaluate its current state filings and any new filings that may be needed. At the same time, the internal review might identify states in which the company no longer has a requirement to file state and local tax returns. It is also a good idea to identify those states in which the company is registered with the Secretary of State (or similar agency) to transact business as a foreign corporation and determine whether state sales, income/franchise, gross receipts, and withholding tax returns should also be filed. Simply because a company is registered to transact business in a state as foreign corporation does not automatically mean that other tax returns should be filed; however, business activities should be closely evaluated to determine whether state returns are required.
While time constraints and filing deadlines may limit the ability to perform detailed reviews at this time, we recommend setting aside some time during the year to perform these types of procedures. If issues are identified, we recommend reviewing the facts with a third party who has significant state and local tax experience. Wipfli has a team of individuals who perform these reviews for both our fullservice clients and other companies. A little effort to review these areas may save significant tax dollars, minimize potential penalties and interest, avoid tax exposures, and eliminate issues raised if the company is sold.