If your business operates in more than one state, you probably already know that each state wants to lay claim to the right to tax your income. It’s like kids fighting over the last slice of pizza, except the slice in this case is your tax dollars.

To keep things somewhat fair, states use apportionment formulas to decide what share of your income they can tax. Let’s walk through the most common methods you’ll run into, so you’re not caught off guard at tax time.

Market-Based vs. Performance-Based Sourcing

First, each state has rules for how it sources service revenue. This is all about figuring out which state gets to claim your service income.

• In performance-based sourcing states, the state taxes income where you actually perform the work. For example, if you have remote employees in Texas providing consulting services to a client in New York, Texas may want to tax that income, as your employees performed the work there. Most states have moved away from performance-based sourcing in recent years. However, Texas, Mississippi, and Arkansas remain performance-based states, and a handful of other states are predominantly cost-of-performance (COP) states, although they may have special rules for certain types of transactions or industries.
• In market-based sourcing states, a state taxes income where the customer receives the benefit. In that same consulting example, New York may argue the income should be taxed there because that’s where the client uses the service.

Think of it as “where the work happens” versus “where the benefit lands.” Different states have different rules, which can make things a little messy if you serve clients nationwide.

Plus, states can look at the location of your customer in a number of ways. Returning to our example above, say your Texas-based employees provide remote tech support services to a client with offices in ten states. Where is the customer receiving the benefit of the service? Is it where your employees are located? Is it the corporate headquarters where you send the bill for your services? Or is it the ten individual offices? 

The Three-Factor Approach

Once you figure out which states want a slice of your income, the next step is to figure out how big a slice they want. Traditionally, states used a three-factor formula to apportion income. It includes:

1. Property. The proportion of your real estate and equipment in the state.
2. Payroll. The proportion of your employee wages in the state.
3. Sales. The proportion of your sales to customers in the state.

The idea here is balance. States figured that if you have property, payroll, and sales within their borders, they should each count toward how much income they can tax.

Weighted Three-Factor Approach

Over time, states decided sales deserved more attention, probably because sales are easier to measure and harder for businesses to shift around. So they adjusted the formula by giving sales a heavier weight compared to property and payroll.

For example, instead of a straight 33%/33%/33% split, you might see something like 50% sales, 25% property, and 25% payroll. This shift means if most of your customers are in a particular state, even if you don’t have much property or payroll there, that state may still get a bigger slice of your income pie.

Single Sales Factor

Finally, some states went all in on sales-only apportionment. Under this approach, your tax liability in a state is based solely on your percentage of sales in that state. Property and payroll don’t matter.

This method tends to benefit businesses with large operations, like factories or offices in a state, but most of their customers elsewhere. It also encourages companies to set up shop in a state without worrying that hiring more workers or buying more equipment will increase their tax liability.

Why Apportionment Matters

The whole point of apportionment is to prevent double taxation, where two states tax the same income. By creating formulas to divide up your tax base, states aim to ensure each gets only its fair share. 

But in practice, things don’t always line up neatly. If one state uses performance-based sourcing and another uses market-based sourcing, the same service revenue might get taxed in both places. If you’re running a multistate business with complex operations, these mismatches can leave you caught in the middle. Tax credits and treaties sometimes soften the blow, but the risk of overlap is real and worth planning for.

Knowing whether a state uses market-based sourcing or performance-based sourcing, or whether it follows a three-factor, weighted, or single sales factor formula, can help you plan ahead and avoid unpleasant surprises at tax time.

If all of this makes your head spin, you’re not alone. State tax rules can get complicated fast. Contact Countless for guidance on business income apportionment and keeping your multistate tax strategy on track.