What is state tax apportionment and how do you calculate it?

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State income tax is a direct tax on business income you’ve earned in a state. It sounds straightforward, but this is a complex topic: States have various ways of calculating how much of your corporation’s business income is attributable to its presence and activity there. Each state gets to decide what matters most — your payroll, property, or sales — and in what ratio to account for them. This can make calculating state income tax complex, particularly if you do business in multiple states.

Tax teams that are equipped with a knowledge of state requirements, and that have the technology to help track their many facets and frequent changes, are best positioned to stay in compliance.

What is apportionment in taxes?

Apportionment is the assignment of a portion of a corporation’s income to a particular state for the purposes of determining the corporation’s income tax in that state. The state determines how much of your earnings are a result of business done in that state so it can charge you the right amount of income tax. Allocation and apportionment in U.S. tax differ in that allocation covers non-business income, while apportionment covers business income.

Which types of businesses are subject to apportionment?

The only type of business that must pay state income tax the way an individual does is a traditional corporation, otherwise known as a C corporation or C corp. This is because C corps are considered taxable entities; they are required to file state tax returns separate from the personal returns filed by their owners and employees.

Other types of companies, such as S (Subchapter) corporations, limited liability companies (LLCs), and partnerships usually do not need to pay corporate income tax. Instead, they are subject to “pass-through taxation”; the individuals involved in the business pay state tax on their income from the business, while the business doesn’t pay separately.

What are the types of state apportionment formula?

There is no single rule defining the process of state apportionment. The formula differs from state to state. Most states use one of three apportionment formulas:

An equally weighted three-factor formula that takes payroll, property, and sales into account in equal measure, also known as the
A single sales factor formula, which bases taxes solely on a company’s sales within the state
A three-factor formula in which the sales factor is given different weight from the other elements, such as a double-weighted sales factor

States have differed on how to incorporate the sales factor in apportionment. In the early days of state tax apportionment laws, states did not include sales in the calculations, relying only on payroll and property. Over time, sales has become a more important factor in states’ apportionment calculations.

For instance, California recently implemented a revised apportionment formula that places a greater emphasis on sales, shifting away from the traditional three-factor formula. This move has resulted in businesses recalibrating their tax strategies to align with the new requirements. Similarly, Texas has introduced a blended formula that considers both sales and payroll as significant factors in determining state tax apportionment, thereby influencing tax planning for companies operating within the state.

This shift has presented some difficulties: For example, one element of that decision is figuring out whether sales should be counted based on the customer’s location, the seller’s location, the location to which goods are delivered, or some other metric.

If a state can’t accurately capture a business’s activity by using any of the standard formulas, it can opt to use alternative methods of calculation for apportionment. A business may petition for the use of such an alternative, which might include separate accounting or customization of factors.

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How do you calculate state tax apportionment?

States calculate apportionment in various ways depending on the formula being used.

Using the Uniform Division of Income for Tax Purposes (UDITPA), or three-factor formula, a state accounts for the percentage of a company’s payroll, property, and sales that were based in the state and then divides that number by 3 to come up with the percentage of income the state can tax. For example, if 50% of a company’s payroll, 50% of its property, and 20% of its sales are in New Mexico, the state would be able to tax 40% of the firm’s net earnings.

A single sales factor method makes for an easy calculation: The state can take the percentage of the company’s sales that took place in the state based on whatever standards the state maintains. If a company is in New York or Connecticut, for example, the state can tax 20% of the company’s profits if 20% of its sales are made in the state.

To calculate the apportionment for a three-factor formula with a variable sales factor, the formula still considers payroll, property, and sales, but it gives extra weight to sales. A common way of doing this is to give sales double the weight. In Massachusetts, for example, a company that has 20% of its profits in the state would add 40% into the formula for sales. After adding up the amounts — say 50% of property and 50% of payroll, plus the 40% of sales — you divide this number by 4. In this case, Massachusetts could tax 35% of the firm’s net earnings.

What challenges might tax teams face when calculating apportionment?

Multi-state apportionment can be a concern. Companies that do business in multiple states face the challenge of tracking corporate income tax laws in multiple — perhaps many — places. On top of that, sales tax laws are complex and frequently change. Staying in compliance across the board is extremely difficult, if not impossible, especially for small teams without a lot of bandwidth to track every detail of state tax law.

With the surge in e-commerce activities, states have been actively reevaluating their approach to sales apportionment, particularly concerning digital transactions. States like New York and Illinois have implemented guidelines to include digital sales in their apportionment calculations, recognizing the growing significance of online commerce. This shift has compelled businesses to adapt their accounting practices to accurately capture and report digital sales for tax purposes, further emphasizing the need for advanced technological solutions to manage these complexities.

These teams need compliance solutions to stay on top of their company’s state income tax obligations. To help in navigating the complexity of tax rules and changes for each state, consider an industry-trusted tax and accounting research tool. It uses artificial intelligence and machine learning to deliver fast, accurate answers, updated forms, and state-specific IRS insights to your thorniest tax questions.

To streamline your entire state tax apportionment process, consider a comprehensive tool such as the Thomson Reuters ONESOURCE State Apportionment module. This web-based software solution can help you manage your data, consistently apply the right calculation methods, and provide a trackable solution for audits. With tools such as these, even the smallest tax team can stay on top of everything it needs to know to manage state income tax.

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