December 15, 2022

State Tax Issues Related to Contract Brewing

By Joseph Feehan, Partner, Tax & Business Services

State Tax Issues Related to Contract Brewing Food & Beverage

Contract brewing is often an important part of expanding and growing a brewery. It allows a business owner to meet increased demand without immediate capital expenditures. For the contract brewer, it allows their brewery to operate closer to full capacity and creates additional streams of income while evening out production schedules. Properly structured, such arrangements can be a win for both parties.

When entering a contract brewing agreement, there are many things to consider. One item that might not immediately jump to mind is state income taxes. It’s not the most obvious issue when exploring hiring a contract brewer, but it is very important.

In this article, we will identify a few high-level state tax issues brewers might consider before outsourcing production. We’ll do so through the lens of a small brewery located in Massachusetts that has attracted a devoted following and continues to grow and find new customers. Our brewer is struggling to meet increased demand for their beer but is not quite ready to make the investments — in both property and personnel — that it would take to meet this demand. They decide to explore hiring a contract brewer.

Activity That Might Create State Tax Issues

If the contract brewer is in the same state, there might not be any immediate changes. However, if the contract brewer is in a different state, new state income, franchise, and payroll tax obligations may arise.

Let’s consider our Massachusetts-based brewer who decides to engage a contract brewer. Our brewer currently only has property and employees in Massachusetts. While they sell beer in multiple states, they have not yet had enough sales or activity to have to file income tax returns outside of Massachusetts.

Our brewer also prioritizes quality control and may want to oversee certain parts of the process. Of course, they also want to sample batches of the final product. If our brewer shipped their raw ingredients to New York and held title to those while they were kept at the contract brewer, it would create a state tax issue. Owning property within a state is generally enough to create a state income tax filing obligation or “nexus.” Similarly, traveling to a state to oversee the brewing process, inspect inventory, sample beer, or perform other quality control tasks is generally sufficient to create nexus. Our brewer would also need to consider withholding payroll taxes for work performed in New York by its employees.

This might come as a surprise to our brewer, who might have previously sent sales representatives to other states to drum up business and relied on federal law protections to avoid filing state income tax returns. However, sending employees out of state to solicit sales and sending employees to manage production create different state tax outcomes. Sending employees to manage contract brewing, supervise production, or perform quality control would not be a protected activity under federal law.

Steps to Manage State Tax Nexus

When entering a contract brewing arrangement, our brewer should understand the above issues and proactively work with legal counsel. For example, a contract might be structured to transfer title to any raw ingredients to the contract brewer so that our brewer does not hold title to property outside of Massachusetts. Any unused inventory could be shipped back to Massachusetts as a sale of inventory. The contract could also be worded to allow samples to be shipped to Massachusetts, and to provide for virtual oversight.

Managing the process without sending employees to a new state is worth considering if you want to avoid creating nexus. The contract should also be structured so that our brewer does not take title to the final product in New York or hold any inventory at the contract brewer. Our brewer might consider having the contract brewer ship the finished product back to Massachusetts or directly to its customers. In such cases, states should generally look to the shipping destination when determining where to source the sale.

In addition to the nexus in New York, our brewer should keep an eye on where they and the contract brewer ship the beer. Many states require a taxpayer to file a return once they exceed a certain level of sales. For example, if a state has a rule that nexus is created once a taxpayer makes $500,000 in sales, our brewer would exceed that amount once they shipped $400,000 of beer to the state and the contract brewer shipped $200,000 of contracted brewed beer to the same state.

Hopefully this article helped you understand some issues that might pop up when using an out-of-state contract brewer. Addressing such issues proactively is always a great idea. The professionals at Marcum are available to discuss your specific facts and circumstances.