Baker Tilly’s inaugural Tax Strategy Playbook discusses the outlook for the new year’s tax policy landscape, outlines how current tax policy impacts your business and discusses opportunities for tax planning and mitigating inherent risks. We delve into various areas within federal, global and state and local tax.
Navigate updates to state and local risk mitigation, remediation and planning, as well as state income tax updates with our playbook. We’ll also cover federal statutory limits on state taxation: Public Law 86-272, as well as optional entity-level state tax on pass-through entities. We also address state credits and incentives as a result of the Inflation Reduction Act, the importance of determining domicile and state tax considerations for remote employees.
The mechanics of how and where a business is subject to tax is a complex analysis comprised of many different considerations. For state tax purposes, depending on its individual circumstances, a business may be subject to tax in up to 50 states, Washington, D.C. and thousands of localities (collectively referred to as “states”).
Once a business establishes the requisite connection to a state that triggers tax compliance obligations, the jurisdiction may impose various types of taxes. Depending on both the business activities and state specific laws and regulations, a business may be subject to income, franchise, sales and use, payroll, excise, gross receipts and/or real and personal property taxes.
Each state has its own unique set of tax laws, regulations, guidance and compliance requirements, some of which change frequently. These state and local tax intricacies can result in unintended and unknown tax consequences for taxpayers.
The imposition of state and local tax is fraught with complexity and risks. Consequently, as a business grows into a multistate operation, it’s critical to evaluate the corresponding state and local tax implications. Any changes to revenue streams, employee locations, business property locations, customer base and sales into a state are all critical data points in evaluating the potential impact on a business’s state and local tax footprint.
Due to the intricate and ever-changing rules that govern the taxation of states, it is prudent for businesses to evaluate their activity on an annual basis to ensure all compliance obligations are met.
While state and local taxes are a significant source of revenue for governments, they can be a source of confusion and frustration for businesses. The complexity of state and local tax (SALT) laws varies across jurisdictions, and as a result, creates a formidable task for businesses attempting to navigate the tax landscape. In response, strategic approaches like SALT planning, risk mitigation and remediation play a pivotal role in a business being compliant for state tax purposes.
The planning process serves as a fundamental component of SALT-risk mitigation, enabling businesses to proactively identify tax-saving opportunities, formulate strategies to minimize SALT liabilities and establish robust policies and procedures for compliance. Central to this planning process are nexus studies, which form the bedrock of determining a business's tax obligations within a specific state or jurisdiction. These studies encompass an exhaustive analysis of various factors, including physical presence, economic activities and other variables that may potentially result in a tax obligation. Additionally, there are several SALT planning strategies that businesses can use to minimize their tax liability, such as structuring their business operations in a tax-efficient manner and taking advantage of state tax credits, incentives and deductions.
Remediation becomes essential when a business acknowledges potential tax liabilities due to past noncompliance. Businesses can likely rectify these issues through mechanisms like voluntary disclosure agreements (VDAs) with state tax authorities if specific conditions are met. VDAs provide a proactive avenue for businesses to report unpaid taxes, often resulting in limited lookback periods and reduced or abated penalties.
Engaging in SALT planning, risk mitigation and remediation is critical for businesses to ensure compliance with SALT laws. By identifying their tax obligations, businesses can take steps to mitigate their tax risks and minimize their tax liabilities going forward.
Nexus is the requisite contact between a taxpayer and state before the state has the authority to subject a taxpayer to tax. The determination of how and when a taxpayer creates nexus, and therefore a filing responsibility, for state and local income tax purposes continues to evolve. Most notable in this evolution has been the broadening application of “economic nexus,” a determination of nexus, based primarily on sales, that is made without regard to whether a taxpayer has any type of physical presence in a given jurisdiction.
Historically, the U.S. Supreme Court, via various decisions, had held that physical presence was required to create nexus. However, these cases were all specifically limited to sales/use taxes. This made their relevance to income tax questionable and left the door open for interpretation, on both sides.
A monumental shift took place in 2018 when the court decided South Dakota v. Wayfair. The Wayfair decision reversed the court’s earlier holdings that required physical presence to create nexus. The court listed various reasons for its reversal, most notably that the existing standard was overly formalistic and did not align with the realities of our modern e-commerce society. Although this was also a sales/use tax case, it had immense implications to taxpayers who’d long argued that the court’s overall intent had been to mandate physical presence to create nexus of any kind.
Beyond solidifying that physical presence was not a requirement, Wayfair further empowered states to create and/or broaden their statutes and regulations around economic nexus for income tax purposes. Today, the majority of states have some type of economic nexus provision for income tax purposes.
As a result of the evolving economic nexus standards, multistate taxpayers may need to analyze their operations and sales to determine whether they are subject to income tax in any state outside of where they have historically filed.
In 1959, Public Law 86-272 (P.L. 86-272) was enacted to limit the states’ power to impose a net income tax on an interstate business in specific situations. P.L. 86-272 generally provides that a state or local government cannot assess a net income tax if a foreign (out-of-state) corporation’s only business activity carried on within the state are solicitation of orders for sales of tangible personal property if specific requirements or exceptions are met. It is important to note that the protections afforded by P.L. 86-272 are limited to sales of tangible personal property and income tax.
Generally, P.L. 86-272 protection is applicable if an out-of-state corporation’s only business activities conducted within the state are:
Solicitation includes explicit or implicit speech or conduct that invites an order along with essential ancillary activities in the order-inviting process. For example, P.L. 86-272 does not offer protection when a salesperson provides post-sale support, even if it encourages future sales. This support is considered a separate function from order invitation. Whether the activities of a business are protected under P.L. 86-272 is a very fact-specific analysis.
Over the years, the Multistate Tax Commission (MTC) has adopted guidelines which define solicitation and specify “protected” and “unprotected” activities for purposes of P.L. 86-272. While many states have adopted the MTC’s guidelines, others have drafted their own. Most recently, the MTC issued guidance on how P.L. 86-272 applies to modern business activities with a focus on the activities conducted via the internet. As a result, specific states (e.g. California, New York and New Jersey) have issued guidance relating to internet-based activities as it relates to the protections afforded by P.L. 86-272.
Moreover, additional complexities arise in states that provide for combined reporting and/or consolidated returns. The application of P.L. 86-272 can vary depending on whether the state has adopted the “Joyce rule” or the “Finnigan Rule.”
Although P.L. 86-272 remains unchanged, the application of the law continues to evolve on a state-by-state basis as businesses continue to grow. Properly utilizing this protection can lead to significant tax savings; however, claiming this protection for unprotected activities can be costly. It is important to regularly revisit positions for operational changes and additional state guidance.
Most states conform to the federal pass-through tax treatment unless the pass-through entity voluntarily elects to be taxed at the entity level. Over the last few years, the majority of states have enacted optional pass-through entity taxes (PTETs). State PTET elections arose in response to the state and local tax (SALT) deduction limitation enacted by the Tax Cuts and Jobs Act (TCJA) of 2017. For tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, this provision limits individual taxpayers to a maximum itemized deduction of $10,000 for all state taxes paid.
The benefit of the PTET election is the ability to take a federal deduction at the entity level for state taxes paid as entity level deductions for taxes paid are not subject to the itemized deduction cap regardless of the amount claimed. The deduction reduces the taxpayer’s overall taxable income by reducing the amount of flow-through income reported to the owners.
While the availability of state PTET elections as a workaround to the SALT limitation is often beneficial to taxpayers, it does not come without its own set of challenges. Specifically, as PTET filing elections are enacted on a state-by-state basis, there is a wide array of rules and enforcement that vary by jurisdiction. As such, taxpayers should closely review the administrative details of how and when elections should be made. Unlike tax return filing deadlines, if an election due date has lapsed, the ability to make an election is lost.
Additionally, prior to making PTET elections, appropriate analysis to determine and evaluate the advantages and disadvantages of electing in should be completed. Examples of PTET election considerations, by state, include:
Due to the lack of uniformity among state PTET laws and regulations, we recommend consulting a SALT advisor prior to electing in to a PTET regime. Proper modeling and planning can help taxpayers fully utilize the benefits and prepare for any drawbacks of making a PTET election.
Recent legislation, including the Inflation Reduction Act (IRA), has incentivized the production and consumption of clean energy, carbon emissions reduction and among other items, promoting domestic energy security and manufacturing. One of the primary ways the IRA encourages this activity is through various tax credits and incentives.
From a federal tax perspective, the credits enacted by the IRA will likely have a significant impact for affected taxpayers. However, the state impact can be significantly more complex, as each state can choose whether to conform to federal treatment. States who do choose to conform may do so automatically (a system called “rolling conformity”) or selectively (a system called “static conformity” or “fixed-date conformity”). Additionally, even if a state automatically conforms to the federal legislation due to rolling conformity, it has the ability to decouple from specific sections of the legislation. Generally, many states will enact a credit similar to the federal credit or may create its own based off the federal credit.
The IRA has spurred an increase in companies agreeing to projects that are eligible for specific energy facility investment credits, including but not limited to: Solar power, renewable gas or anaerobic digesters using animal or food waste for electric generation. However, energy facilities can be expensive to build.
While the federal energy credits may not always be available in a particular state, they generally have various corresponding credits and/or exemptions to incentivize taxpayers to build applicable facilities in the state. The exemptions and credits typically apply to sales and use and/or property taxes imposed by the state.
If a taxpayer’s project location has flexibility, it is important to research the various state and local credits and incentives available to determine which location allows the maximum benefit to the taxpayer. If location is driven by the purchaser of the energy produced, it is still advisable to research the availability of credits and incentives by state to ensure the taxpayer is taking advantage of all benefits available.
Proper planning is essential when a taxpayer is considering changing domiciles. While we often use the term “residency” in everyday conversation to describe the state of a taxpayer’s home, the proper term is “domicile.” A taxpayer may have many residencies, or dwelling spaces, but can only have one domicile or home to which they return. For a taxpayer to establish a domicile in a new state, they must abandon their current domicile.
Changing domiciles, which a taxpayer may do for numerous reasons including tax planning, is fraught with uncertainty from a tax perspective. States are often hesitant to relinquish tax revenue, leaving taxpayers who change domiciles at high risk of audit. State domicile audits are extremely subjective in nature; investigations are often fact-intensive, requiring taxpayers to provide a great deal of personal information. Audits often don’t begin until a year or two after the taxpayer has relocated and the appeal of an unfavorable result can take several years. It's important to note that expats (taxpayers who relocate abroad) can unintentionally remain domiciled in a U.S. state if they don’t properly abandon it.
Intention on making a permanent home is the critical factor in determining a taxpayer’s domicile and there are a myriad of factors that show intent. Obtaining and following expert advice and maintaining appropriate documentation are crucial to ensuring a taxpayer’s domicile change is respected.
While certain employers have always had teleworking or remote workers, the COVID-19 pandemic dramatically increased the availability of remote work arrangements, many of which remain in place today. Remote work in a specific state may trigger a number of state tax issues including payroll withholding, unemployment insurance and state tax nexus issues.
Generally, states require employers to withhold certain state employment taxes (e.g. payroll tax) based on where the employee performs services, which may not be the employee’s state of residency. State employment taxes become due once an employee has worked the requisite amount of time in a state. However, many businesses inadvertently misunderstand the potential implications of remote employees.
Despite the rise in remote employment arrangements, many employees have not changed their employee residency location. As such, these employees may be working outside their state of residence for long durations of time, whether due to continuous travel or as the result of a permanent move. Meanwhile, affected employers are likely only withholding payroll taxes in the employee’s home state of residence when they may meet the criteria to be required to withhold in multiple states.
Employers should make every effort to understand where their employees are working, as failure to properly withhold and/or remit payroll taxes to a state can come at a high price, as states will often assess penalties in addition to attempt to collect the tax liability. If a state considers the employer’s failure to file and remit taxes intentional, it may have the power to impose additional substantial penalties, potentially as high as 100% of the tax liability.
In addition to employment tax implications, a remote employee may create additional state filing requirements in states where the employer has not historically engaged in business activities. This may include income tax, sales and use tax, gross receipts, local occupational taxes, various excise taxes and/or local license filing requirements.
Therefore, it is critical that an employer understands where its employees are working, living and/or traveling to for long durations to confirm its current state tax filing profile is appropriate.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments. Baker Tilly US, LLP does not practice law, nor does it give legal advice, and makes no representations regarding questions of legal interpretation.