For multi-state service based businesses, apportioning service revenue appropriately to each state is critical. Improperly apportioning service revenue to states can lead to over or under reporting of state tax liabilities. This can result in changes on examination with the attendant assessment of interest on any balance due. Correctly apportioning service revenue will not only assist a company with its compliance efforts with state tax authorities, but it will provide companies with planning opportunities to minimize overall state income tax exposure. All service-based businesses have state income tax exposure mainly because they are not protected under Public Law 86-272. The correct application of each state’s apportionment method impacts each company’s ultimate state tax expense.
State taxing authorities use different methodologies to determine how a company must apportion service revenues to their state. The most commonly used methodologies are:
- Cost of Performance Method
- Market Based Method
- Other reasonable methods, such as:
- Sourcing revenues where the services are performed or,
- Sourcing revenues based on a customer’s location
Cost of Performance Method
One of the most utilized methods of apportioning service revenues is the Cost of Performance Method. The Cost of Performance Method looks at the specific income producing activities to determine if a greater proportion of the income producing activity, based on cost of performance, is performed in a state. For example, if a greater proportion of the income producing activity is performed in State A, based on cost of performance, then all of the service revenue for that particular income producing activity is apportioned to State A. If a greater proportion of the activity is performed outside of State A, no service revenue would be apportioned to State A (this is the “all or nothing” approach).
If services are performed in more than two states, the greater than 50% test often gives way to the greatest cost of performance in relation to all the states test. For example, if an income producing activity involves three states (State A, State B, and State C) and State A has 40% of the costs and State B and State C have 30% of the costs each, State A will include 100% of the service revenue in its apportionment since that state has the greatest cost of performance compared to State B and State C.
Cost of performance is generally based on the direct costs associated with the income producing activity. Direct costs are not normally defined by state authorities and as such the Taxpayer and state authorities have flexibility in how they determine those costs. The term income producing activity applies to each separate item of income and means the transactions and activity engaged in by the taxpayer in the regular course of its trade or business.
Market Based Method
A method gaining more attention from state taxing authorities, the Market Based Method apportions service revenue based on where the service recipient benefits from the service. Some states have always imposed the Market Based Method but the larger taxing jurisdictions have realized this methodology will increase tax revenue. California has adopted this approach effective January 1, 2011.
Generally, this methodology more accurately apportions service revenues when a service based business performs services in one state, while the company’s customers are located in and derive the benefit, in another state. Under the cost of performance method, this service might be apportioned to the state where services are performed, quite a different result from where the benefit is derived reasonable apportionment amounts for state income tax purposes.
Where the Market Based Method applied, new companies can structure their activities to reduce state income tax exposure. For example, if a company is established in State P (which uses a cost of performance approach) and all services are performed in State Q (which uses a market based approach), while customers are located in State R (which uses a cost of performance approach), and a greater amount of the costs were incurred in State Q than any other state, no service revenue would be apportioned to any state. In this example, the company would benefit most when the states utilize a single sales factor formula. It should be noted there are other state variables that could affect the outcome of state tax liabilities; however, apportioning service revenue is one tax planning strategy companies should be aware of.
California, Georgia, Illinois, Iowa, Maine, Maryland, Michigan, Minnesota, Utah, and Wisconsin are a few of the states that have implemented the Market Based Method to apportion service revenues.
Other Reasonable Methods
The methods discussed above are the two most used methodologies states employ to apportion service revenues. However, some states allow Taxpayers to use other reasonable approaches such as apportioning service revenue where the services are performed or apportioning service revenue based on a customer’s location. In addition, some states use a combination of methods.
Understanding the different state laws regarding apportionment of service revenue is essential for multi-state service based businesses. This area in state income taxation is not uniformly consistent creating state tax savings opportunities including reduction of state tax liabilities and maximization of state tax incentives for businesses relocating to other states.
Please contact your dedicated Marcum tax professional to learn how this planning can create opportunities for your service based business.