Are you doing business in multiple states? Do you have remote employees in multiple states? Or a business partner that is headquartered in a different state? Perhaps your inventory is stored in a warehouse separate from the state your business is based out of? If any of this rings true, then brace yourself for the exciting journey of filing taxes in multiple states. Trust us, it’s more thrilling than you might think!
Many small business owners aren’t aware they need to file income tax returns in other states. That is, until they receive a “nexus questionnaire” from that state.
Filing income taxes in multiple states adds another layer of complexity to your tax filings. So let’s cover what it means to have “nexus” in another state and what to do if you have it.
What is nexus?
Nexus is a connection between a business and a tax jurisdiction (a state, in most cases) that establishes the business’s obligation to pay taxes in that jurisdiction.
There are two types of nexus:
- Physical nexus arises from having a tangible presence in a state. This presence can be anything from an office, warehouse, or store to having employees in the state. If your business has a physical footprint in a state, congratulations, you’ve established physical nexus!
- Economic nexus is based on economic activity within a state rather than physical presence. For example, if your business has a certain level of sales or transactions in a state, you’ve created economic nexus, even if you’ve never set foot there.
If a business owner is aware of nexus at all, they typically think of it in terms of sales tax obligations, but nexus can also apply to state income taxes. If your business has nexus in a state, you may be required to file and pay state income taxes there, depending on the state’s tax laws.
Understanding state-specific tax filing requirements
First things first: each state in the U.S. has its own set of rules that determine what activities (or level of activities) create nexus for a business. These rules can base nexus on earning revenue from the state or having payroll, property, or inventory in the state.
Since they want to make things as easy as possible for everyone, each state comes up with their own rules (that change constantly).
It’s important to make sure that you’re aware of each state’s filing requirements and any thresholds. These rules should be checked annually for any potential changes.
Income allocation and apportionment
The good news is that even if you’re required to pay tax in multiple states, you generally don’t have to pay tax on the same income in multiple states. That’s where income allocation and apportionment come in.
Apportionment means assigning a portion of your business income to a particular state to determine your tax liability in that state. And no surprise here, state tax laws for calculating apportionment differ from state to state.
Most states use one of three apportionment formulas:
- An equally weighted three-factor formula takes payroll, property, and sales into account equally
- The single sales factor formula bases taxes solely on a company’s sales within the state
- A three-factor formula gives sales a different weight than payroll or property
Calculating your state income taxes across multiple states is complicated, so it’s best to leave those calculations to a tax professional.
You can help them out by tracking your income by state. You don’t have to track income by state in your accounting software—you can use your CRM or even a spreadsheet. But you need to be able to generate a list of who you worked with, how much income they generated and where they are located. This isn’t just for your peace of mind but also to ensure compliance with each state’s tax laws. Inaccurate income tracking can lead to underpaying or overpaying taxes; neither is a fun scenario.
How to file tax returns when doing business in multiple states
Now that you know you have an income tax filing obligation, how do you file multiple state tax returns?
The answer, like most tax questions, is “it depends.”
If your business is a C corporation, the company will simply file taxes in multiple states and pay income tax in each one.
Some states assess tax on the business itself. The business is treated like a C corporation and pays tax directly. However, most states require the business to pass income through to the owners. Then, each business owner must file a nonresident state tax return and pay income taxes in each state where the business operates. These states typically require the business to withhold income taxes and submit that withholding to the state. When business owners file their state income tax return, they claim the withholding as a payment on their state return.
Some states provide an easy button for the owners and allow the business to file one “composite” or group return on behalf of all non-resident business owners. With a composite return, the owners aren’t required to file individual tax returns in that state. This option can simplify tax filing for you and your partners or shareholders, especially if they’re spread out across various states.
The PTET option: Potential tax savings
If the state offers a Pass-Through Entity Tax (PTET), you might want to consider this option.
The PTET applies to owners of pass-through businesses who would normally pay state income taxes at the individual level. Certain states allow individual owners to elect to pay the tax at the entity level. This provides a workaround for the $10,000 cap on state and local taxes on their individual returns.
Choosing the PTET could be more beneficial than filing a composite return.
Get trustworthy advice from an experienced tax advisor
Unless you’re a tax wizard, working with a tax professional who understands the intricacies of multi-state income tax issues is crucial. They can help you navigate the complex tax landscape, ensure compliance, and identify tax-saving opportunities. Believe it or not, needing to file returns in multiple states can present powerful tax-saving opportunities if done correctly.
Doing business across multiple states is a great opportunity to grow your customer base and revenues, but it comes with the complex responsibility of multi-state tax filing. If you need help understanding each state’s tax filing requirements, please reach out. We’re happy to help you manage your tax obligations across state lines. It’s truly one of our favorite things to do.