State Income Taxes

You may owe state income taxes on your business profits in each state in which you do business. Your obligation does not depend on where the business is set up. For example, if you incorporate your business in Nevada but operate in California, you owe income taxes to California, the state in which you do business. (And you may owe a tax or fee to Nevada as well.)

Generally, state income taxes usually depend on having a nexus (connection) to the state. This is based on having a physical presence there, which may be evidenced by maintaining an office or sending a sales force into the state; merely shipping goods into the state without some additional connection is not enough to establish a business presence within the state. You may have a nexus to more than one state, no matter how small your business is.

If there is a business connection to more than one state, the business income is apportioned among those states. Apportionment is based on a sales factor, a payroll factor, and a property factor (each state has different apportionment formulas). For service revenue, two common apportionment methods are the costs of performance (COP) method, which is based on the actual work done within a state, or a market-based approach. The apportionment rules are highly complex, but there is some flexibility that permits you to shift income into the state with the lower taxes within certain limits.

Some states are moving toward commercial or financial nexus as a basis for imposing state income tax. Doing business with consumers and companies in other states may expose you to taxes that you never dreamed of. States are reaching out across their borders to grab revenue from out-of-state businesses in any way they can.

• Sourcing of services revenue. This is a tax on services performed out of state that benefit businesses within the state that imposes the tax (called “market-based sourcing”). For example, an advertising firm based in Connecticut provides services for a business in California. The State of California imposes a tax, to be paid by the Connecticut firm, on the services that benefit the California business. Believe it or not, a business can be subject to double taxation—income tax on revenue earned in its state plus the sourcing of services tax on the benefits received in another state. There is no credit that can be claimed for the out-of-state taxes; they are, however, deductible. So far, this type of income tax applies in Alabama, Arizona (phasing in through 2017), California, District of Columbia, Georgia, Illinois, Iowa, Maine, Maryland, Massachusetts, Michigan, Minnesota, Nebraska, New York, Ohio, Oklahoma, Pennsylvania, Rhode Island, Utah, Washington, and Wisconsin.

• Gross receipts tax. This is a tax on business revenue (“gross receipts”) within the state. Unlike an income tax, there are no deductions or other write-offs to reduce the tax exposure. Currently, the gross receipts tax (also known as the “turnover tax”) is imposed in Ohio, Texas, and Washington. Other states impose taxes that are a variation on the gross receipts tax theme: Arizona (called a transaction privilege tax), Delaware, Hawaii (general excise tax), New Mexico, Oregon (business and occupation tax), Pennsylvania, and West Virginia (to a very limited extent).

If you are a sole proprietor or an owner of a pass-through entity, you must file a state income tax return in every state in which your company does business (if such state has a personal income tax). For example, if an LLC does business in 12 states, all of which impose an income tax, each member of the LLC must file a personal income tax return in those 12 states.

Of course, even if you do business within a state, there may be no tax liability. For example, Wyoming does not have a personal or corporate income tax so there is no tax even if you do business in this state.

The filing deadlines for state business returns are not the same as the federal deadlines in all cases, so check with your state tax authority for the forms to file and when to file them. You may also need to obtain a state tax identification number for your business.

Corporations

Corporations may owe state corporate income tax. In some states this is called a franchise tax.

S corporations in most states are taxed in the same way as they are taxed for federal income tax purposes (i.e., income, losses, etc., pass through to shareholders to be reported on their personal income tax returns). In jurisdictions where the S election is not recognized (e.g., District of Columbia, New Hampshire, New York City, and Tennessee), an S corporation is taxed the same as a C corporation. However, if the S election is recognized and the corporation has shareholders who are not residents of the state, special rules may apply (for example, the corporation may be required to make tax payments on behalf of these shareholders).

In most states, the S election for state tax purposes is automatic if a federal election is filed. However, in about half a dozen states you must file a separate state tax election for S corporation status (merely filing the federal election is not sufficient for state tax purposes).

Some states, such as California, New York and Rhode Island, allow S status but also impose an annual corporate-level tax for the privilege of being an S corporation. The corporate-level tax applies even though the income and deductions of the corporation pass through to shareholders and are taxed on their personal returns.

Some states that recognize S status still tax some of the S corporation's income (e.g., S corporations in Indiana and Kentucky pay tax on their capital gains and excess passive income, while Massachusetts taxes the corporation on net profits over a certain amount but shareholders are not taxed on these profits).

For more information about the state income taxes, contact the tax or revenue departments of each state in which you do business. You can find contact information in Table 29.1 or through www.statelocalgov.net.

Other Income-Based State Taxes

States seem to be able to dream up new taxes when there is a need for revenue. For example, in New York, there is a Metropolitan Commuter Transportation Mobility tax imposed on self-employed individuals and business owners in New York City and the 7 counties that surround it. For self-employed individuals, the tax is 0.0034 of net earnings from self-employment, even if they do not venture into New York City. The tax is paid by self-employed individuals along with their state income tax returns. Find information about this tax at www.tax.ny.gov/bus/mctmt/.

Employment Tax Obligations

The Federal Insurance Contribution Act (FICA) set up a (Social Security and Medicare) system to provide for old age, survivors, disability, and hospital insurance of workers. Both you, the employer, and your employees contribute to this system. The Federal Unemployment Tax Act (FUTA), together with state unemployment systems, provides payment to workers in the event of unemployment. Only employers pay this tax.

You must withhold from your employees’ wages income tax and the employee portion of Social Security and Medicare tax. These taxes are referred to as trust fund amounts because you, as employer, are holding the funds in trust for your employees. You must pay over these amounts to the IRS. You must also pay the IRS the employer portion of Social Security and Medicare tax, which is the same amount that the employee paid, plus FUTA.

Are severance payments paid to terminated workers treated as wages for purposes of employment taxes? It depends on which court you ask. In a Quality Stores case in 2010, a U.S. district court ruled that severance payments are not wages for purposes of FICA; the Sixth Circuit agreed with the lower court. However, in an earlier case called CSX Corporation Inc., a federal appeals court said just the opposite. Now the U.S. Supreme Court has settled the matter in favor of the government, ruling that severance payments to terminated workers are wages for employment tax purposes.

Employment taxes must be figured to the penny. You cannot round off employment taxes to the nearest dollar (as you can with income taxes).

Special Rules for Tips

Tips that employees receive are taxable wages for purposes of employment taxes. Employees are supposed to report their tips to employers so that employment taxes can be applied. However, as a practical matter, this is not always the case.

The U.S. Supreme Court has said that the IRS can use an estimated aggregation of unreported tips to assess FICA tax on employers; the IRS does not have to audit each employee to determine actual unreported tips for purposes of determining the employer share of FICA.

To avoid this forced rate upon employers, the IRS has developed voluntary compliance agreements for industries, such as the restaurant industry, where tipping is customary. These agreements are designed to enhance tax compliance among tipped employees through education and avoid employer examination during the period that the agreements are in place. They include:

• Tip reporting alternative commitment (TRAC)—avoids the establishment of a tip rate, requires all employers to educate employees on tip reporting requirements, requires employees to report monthly to employers, and provides for audits of those employees who underreport.

• Tip rate determination agreement (TRDA)—sets a tip rate through employers cooperating with the IRS; requires employees to sign a Tipped Employee Participation Agreement with the employer (75% of whom must sign).

• Employer-designed tip reporting alternative commitment (EmTRAC)— solely for those in the food and beverage industry whose employees receive both cash and charged tips, this program generally follows the TRAC program.

• Gaming Industry Tip Compliance Agreement (GITCA)—solely for the gaming (casino) industry.

Service Charges

Restaurants that have an 18% service charge for large groups (e.g., 8 or more people) or other similar charge cannot treat the charge as a tip. Instead, service charges are considered wages subject to the usual income tax and FICA withholding. This means that the service charges are not taken into account by employers when figuring the credit for FICA on tips (see Chapter 23).

Sometimes it's not easy to distinguish between a tip and a service charge. A customer's payment can be treated as a tip only if all of the following conditions are met:

1. The payment is made free from compulsion

2. The customer has the unrestricted right to determine the amount

3. The payment is not the subject of negotiation or dictated by the employer's policy

4. The customer has the right to determine who receives the payment

If you show computations of various percentages as tips possibilities, this does not create a service charge

Paying Employment Taxes

When employment taxes must be paid to the IRS is determined in part by the size of the tax liability. The largest employers (more than $50,000 in employment taxes in the previous calendar quarter) pay (“deposit”) their employment taxes semiweekly (every 2 weeks); those that are not quite as large ($50,000 or less in employment taxes) do so every month. Employers of very small businesses (less than $2,500 in employment taxes in the calendar quarter or previous calendar quarter) can submit their employment taxes along with their quarterly employer tax returns. The smallest employers ($1,000 or less for income tax withholding and FICA or a FUTA payment under $500) can pay annually. For FUTA, this means employers with 8 or fewer employees qualify for making one annual payment.

In the past, most employers deposited their taxes with a bank using a paper deposit coupon issued by the IRS. Now all employers, other than those that pay their taxes with returns, must deposit taxes electronically using the Electronic Federal Tax Payment System (EFTPS) (www.eftps.gov). With EFTPS, funds are transferred from your bank directly to the U.S. Treasury.

Very small employers that are not required to use EFTPS can voluntarily do so. One benefit of doing so is the ability to schedule payments in advance. Note that using EFTPS does not give the IRS access to your bank account. If you wish to voluntarily enroll, you can do so online at www.eftps.gov or call 1-800-945-8400 or 1-800-555-4477.

Penalty for Failure to Pay Employment Taxes

As an employer, you are required to deduct and withhold income taxes and FICA from your employee's compensation. If you fail to do so, or if you withhold an insufficient amount, you are still liable for the correct amount.

There is a 100% penalty imposed on persons who are responsible for paying employment taxes but willfully fail to do so. This penalty, called the trust fund recovery penalty (because an employer pays income tax withholding and the employee's share of Social Security and Medicare taxes into a trust fund maintained by the government for the employee's benefit), is a personal one against an owner, officer, or other responsible person. Thus, for example, a shareholder in a corporation who serves as company president may be personally liable for this penalty even though a shareholder generally is not liable for corporate debts.

Even if there is more than one responsible person, the IRS can collect the entire tax and penalty from one person. It is up to that one person to try to recover a portion of the payment from other responsible persons. If you make a written request, the IRS must notify you of the name of the person that it has determined to be responsible and whether it has attempted to collect the penalty from other responsible persons. There is federal right of contribution (to collect a share of the penalty by someone who has paid it from someone else who is also responsible) where there are multiple responsible persons.

Penalty for Delinquent Deposits

Unless you can show reasonable cause for failing to deposit required amounts or paying deposits directly to the IRS instead of depositing the employment taxes, you will be subject to a penalty. The penalty schedule is designed to encourage employers to comply with deposit requirements as quickly as possible. The penalty for delinquent deposits and penalty relief are explained in Appendix B.

In view of this substantial penalty, it is essential that employment taxes be paid. If you are experiencing a cash crunch, see that these taxes are paid before satisfying other creditors.

State Employment Tax Obligations

As mentioned earlier in this chapter, as an employer, you should check out your obligation, if any, for state employment taxes.

State Income Tax Withholding

If your business is located in a state that imposes a personal income tax, you are required to withhold state income tax from your employees’ compensation. You can obtain information about state withholding rates by contacting your state tax authority (see Table 29.1).

If you have employees who live in another state, you are only required to withhold tax for the state in which your business is located. (The employees may be entitled to a credit for taxes paid to another state.) However, you may withhold state income tax for the state in which the employees reside so that they do not have to grapple with state estimated taxes. If you make such an accommodation, you must still withhold state taxes for the state in which your business is located. If you do business in more than one state and have employees who work in more than one location, you must withhold state income tax in each state in which they work. In one case, for example, withholding was required for a professional baseball player for each state in which he played ball, not just in the home state. Withholding in this case was based on the number of days he played in each of these other states.

Employment Tax Filing for All Businesses

If you have employees (even if you are your corporation's only employee) and your annual taxes exceed $1,000, you must report quarterly to the IRS. Use Form 941, Employer's Quarterly Federal Tax Return, to report any income tax withholding and FICA withholding and payments made during the quarter.

If your annual employment taxes are anticipated to be no more than $1,000 (total compensation is about $4,000), you may qualify to file annually, rather than quarterly. The IRS notifies eligible employers that they do not have to file quarterly on Form 941 but instead can file Form 944, Employer's Annual Federal Tax Return. Once you have been notified by the IRS to file Form 944, you continue to do so until you are notified that you are no longer eligible for this form. If you think you qualify for annual filing but have not received notification from the IRS, you should contact the IRS and say you want to file annually. Even if you qualify to file annually, you can opt out of using Form 944 and instead file quarterly if you follow simple IRS guidelines. If you are a farmer required to file Form 943, you cannot use Form 944 in any event, even if you meet the definition of a small employer.

You must also file an annual return to report the payment of federal unemployment insurance. Use Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return.

Employment tax forms can be signed by facsimile, including alternative signature methods such as computer software programs or mechanical devices.

Note: Reporting for employment tax obligations is separate from income tax reporting.

If you discover an error in a previously filed Form 941 or 944, correct the error using Form 941-X, Adjusted Employer's QUARTERLY Federal Tax Return or Claim for Refund, or Form 944-X, Adjusted Employer's ANNUAL Federal Tax Return or Claim for Refund. There is no “X” form for amending Form 940; simply use Form 940 and check the “amended return” box at the top of the return.

Sales Taxes

If you sell goods or provide certain services within a state that has a sales tax, as the vendor you are required to collect the tax from the purchaser and remit the tax to the state agency. Generally, the same test used for state income tax purposes to determine whether you do business within a state applies for sales tax purposes as well. If you do not do business within a state, you are not required to collect sales tax on goods shipped within that state. If you sell online, you may or may not have a presence in another state (for example, maintaining a server in another state may establish a nexus there).

As part of the Trade Facilitation and Trade Enforcement Act that became law in February 2016, states are permanently barred from imposing sales tax on Internet access. The handful of states that had imposed such tax at the time this law was enacted must eliminate the tax by June 30, 2020.

The Streamlined Sales and Use Tax Agreement, which took effect in some states on October 1, 2005, attempts to simplify and standardize some sales tax rules to make it easier for businesses to collect this important revenue. For information about states participating in the agreement, go to www.streamlinedsalestax.org. Various bills, including the Marketplace Fairness Act and the Online Sales Simplification Act, would require most online sellers to collect sales tax on sales to out-of-state customers. Check the Supplement for any update on these measures.

Familiarize yourself with how the sales tax works. For example, some states impose an origin-based sales tax while others have a destination-based tax. If goods are returned and you refund the purchaser's money, you may be entitled to a deduction or credit for the sales tax you originally collected.

When you must remit sales tax to the state depends on how much you collect. You must also file certain returns reporting your collection activities.

Contact your state tax authority (see Table 29.1) to request a sales tax package. This will explain whether you must collect tax (and how much) and when to pay it to the state and file sales tax returns. You can simplify your sales tax obligations by using a Certified Service Provider (CSP), a company approved by the Streamlined Sales Tax governing board:

• Avalara (www.avalara.com)

• Accurate Tax (www.accuratetax.com)

• Exactor (www.exactor.com)

• Sovos (http://sovos.com)

• TaxCloud (https://taxcloud.net)

• Taxify (www.taxify.com)

• Taxmetry (www.taxometry.com)

The CSP will provide technology assistance to ensure proper collection and remittance of the tax to the CSP for payment to the appropriate state or states. There is no cost to you for using a CSP (it is paid by the states), and you are insulated from a state audit on sales tax (the state can only audit the CSP with respect to your collections).

Use Taxes

If you buy goods out-of-state, you may be liable for a use tax on the purchase. (In effect, your state is collecting the sales tax you would have paid had you made the purchase in-state.) Generally, the tax is imposed on the purchaser (though some states may collect the tax from the seller).

Before you pay any use tax, check to see if the sale is exempt from the tax. Exemptions often exist for items that will be resold (including components of products for resale), used for capital improvements, or used in research and development.

Even if the vendor does not charge a use tax because it has no responsibility to pay the tax to your state, you may still be liable for it. In effect, you may be required to “self-assess” the tax.