Companies with operations in multiple states should seriously consider having a periodic state income and franchise tax “checkup”–a review of the taxpayer’s operations, organizational structure, intercompany transactions and state income tax returns to determine if the company is operating in the most tax efficient manner. This article outlines the major steps that should be undertaken in such a state tax checkup to determine if there are opportunities to operate more tax efficiently.

Nexus Study

The first step in a state tax checkup is a nexus (meaning a tie or link to a state) study to determine if the company is filing appropriately in each state in which it is doing business. As companies grow over time, there is a tendency to overlook filing requirements in states where no business was conducted in the past but where new business activities have commenced. This oversight can be costly since not filing the required state income tax returns on time will subject the company to late filing penalties and interest. Service providers and companies not protected by a specific statutory exception will likely have nexus in most states in which they have employees. The basic nexus study should identify each state in which the company currently has a state income tax filing obligation. It is very important to recognize that, subject to Constitutional limitations, nexus standards vary among industries and states. Therefore, the nexus statutes of every state where the company has operations should be reviewed to determine if nexus exists based on the company’s current activities. Whether or not a business has nexus with a particular state may vary from year to year if the company’s activities in the state are not continuous. In other words, just because the company was required to file a return in State X last year does not necessarily mean that the company has an obligation to file in State X again this year, and perhaps more importantly, just because no return was required in State X last year does not necessarily mean that no return is required in State X this year.

Apportionment Review

The next step in the checkup is a review of the methodology and factors used by the company to apportion its business income among the states in which it operates. In many cases companies will overstate their taxable income in a state by using an incorrect apportionment methodology or by including in the property factor of the relevant apportionment formula (discussed in more detail below) assets that are no longer in service in that state.

A look at the apportionment rules applicable to operations in the State of Georgia illustrates why taxpayers should review their apportionment methodology. Georgia has adopted a market-based approach by which income from services rendered is apportioned to the state where the customer is located. As a result, revenues received by a multi-state taxpayer for the performance of services would be subject to taxation in Georgia only if the customer is based in Georgia. Many companies, however, incorrectly apply a different apportionment rule (such as one based on the location where the services are performed) and, as a result, report revenues received from customers outside the state as Georgia sales because the services were performed in Georgia.

The formulas used to determine the required income apportionment vary greatly among the states. A three-factor formula that takes into account property, payroll and sales in the state is the most common, although the weight given to each factor frequently differs from state to state. Some states use four factors, while others take only one factor into account. Even if a state’s apportionment formula appears to be clear, there may be some latitude in determining what is properly includible in the numerators of the property, payroll and sales fractions used to calculate the overall apportionment factor.

Only income from multi-state business operations is subject to apportionment. Nonbusiness income, such as dividends and interest, is instead usually allocated entirely to the state of domicile of the company. However, there is no uniform definition of nonbusiness income, and the relevant state laws must be reviewed to determine what is considered income subject to allocation to a particular state.

Organizational Structure Analysis

Next in the checkup is a review of the taxpayer’s organizational structure to determine if it is tax efficient. The organizational structure is probably the single most important factor in determining the overall level of state taxation for most companies. If the existing structure has not been implemented with tax efficiency in mind, a change in the structure can often reduce overall state tax liabilities. Whether a business is subject to income taxes or franchise taxes, or both, in a particular jurisdiction will frequently be determined by the type of entity through which the business is conducted. For example, in some jurisdictions franchise taxes are applicable to “C” corporations but not to partnerships or limited liability companies. In addition, changing the form of a subsidiary from a “C” corporation to a limited liability company may result in a more favorable apportionment factor in a state or may permit the use of losses in subsidiaries. In other words, the overall state tax liability might be reduced by converting existing corporate subsidiaries to limited liability companies or partnerships. Companies may also be able to increase their tax efficiency by separating specific operations into different entities; for example, separating sales and distribution operations into different entities may allow some income to be shifted from a jurisdiction with a high tax rate to one with a lower rate. In some cases, filing a combined or consolidated return can reduce taxes in a particular state without changing the organizational structure of the company at all.

In determining what changes to the organizational structure should be implemented, it is important to run pro forma income and apportionment numbers to determine the effects of the changes being considered. It is also important to review the company’s business operations and goals to confirm that, in addition to increasing the tax efficiencies of the company, the new structure makes sense from a business perspective as well.

Documentation and Review of Intercompany Transactions

If the taxpayer has a complex structure that involves intercompany transactions (or if intercompany transactions would result from the structural changes being proposed–e.g., the separation of sales and distribution functions into separate entities), then the checkup should include an analysis of those transactions. Management fees, factoring fees, loans and other intercompany transactions can provide substantial state income tax savings if properly structured and supported by a transfer pricing expert. To avoid potential state audit challenges, it is important to have intercompany transactions well documented with written contracts between the parties and supported by a current transfer pricing study. Any existing intercompany pricing reports should be reviewed and updated as necessary.

Review of State Tax Returns

The final step in the checkup is a review of previously filed state income tax returns to determine if all available tax credits have been claimed. Most states offer income tax credits to companies that increase jobs or capital expenditures in their state, and those tax credits can substantially lower the company’s effective state tax rate. For example, the State of Georgia offers businesses many state income credits, such as the new jobs credit, the investment tax credit for manufacturers and telecommunication providers, the research and development tax credit and the childcare services credit. There are also many other income tax credits available in Georgia and in other states that may substantially reduce a company’s income tax liabilities. A state tax checkup can also include a review of the company’s sales tax returns and property tax returns that can lead to additional tax savings.

Annual State Tax Review Recommended

Most businesses operating in multiple jurisdictions should review their state tax activities annually to determine if there are opportunities to increase their tax efficiencies and improve their profitability by lowering their tax expenses. The annual review also helps to uncover potential tax exposure issues, especially if the company has complicated tax structures in place. Uncovering those tax exposure issues before a state audit provides an opportunity to fix many problems prospectively and helps to ensure that tax benefits are preserved.

Reviewing and adjusting your operations to increase state income and franchise tax efficiencies can mean lower taxes and a lower cost of doing business, making your company more competitive in the marketplace.