Professional Service Providers: Review Your State and Local Tax Obligations ASAP
By Steve Isakson, CPA, CGMA
If you’re a professional service provider with out-of-state clients, it’s important to know where you stand with state and local tax (SALT) obligations. That’s because the rules have changed, thanks in large part to the U.S. Supreme Court’s 2018 ruling in South Dakota v. Wayfair, Inc.
Here’s what you should know about the evolving SALT landscape, and how to make sure you’re in compliance.
It’s all about whether or not you’re creating nexus.
Nexus describes the degree of business activity that must be present before a taxing jurisdiction has the right to impose tax on a business. There are rules for how to define nexus for income tax purposes, and rules for how to define nexus for sales tax purposes. Many states refer to “economic nexus” rules for income tax purposes, meaning a business creates nexus if it exceeds certain economic thresholds related to sales, payroll, and/or property. But when it comes to defining nexus for sales tax purposes, the rules in many states have changed.
Historically, a business could only create sales tax nexus by having a physical presence in a state. But with the rise of e-commerce, states instead began using economic nexus rules for sales tax purposes, too. In many cases, these rules directly contradicted federal law, but what were businesses to do? Most businesses simply complied, but national retailer Wayfair challenged South Dakota.
How does South Dakota v. Wayfair, Inc. come into play?
To make a long story short: The Supreme Court ruled in South Dakota’s favor.
The ruling overturned the longstanding requirement under Quill vs. North Dakota that a business must have a physical presence in a state before the state can assert sales tax nexus. Specifically, it implied that South Dakota’s economic thresholds—sales of $100,000 or 200 transactions—were enough to create sales tax nexus.
Now, emboldened by the ruling, other states have adopted rules similar to South Dakota’s.
In which states are you creating nexus?
For sales tax purposes, most states don’t impose a sales tax collection and remittance obligation on professional services, but there are some that do. If you’re doing business in a state that imposes this obligation, make sure you’re in compliance with the new sales tax economic nexus rules.
For income tax purposes, once nexus is determined, a business must then determine how much of its income is taxed by the state. Traditionally, states have relied on one of two methods to source service revenue for apportionment purposes: cost-of-performance or market-based rules.
Cost-of-performance rules generally source service revenue to the state in which the service is performed.
Market-based sourcing rules generally source the sale of a service to the state in which the service or benefit of the service is received.
Over half of the states have adopted market-based sourcing rules due in large part to the development of the Internet and the ability of businesses to provide services remotely, which is a common practice for professional service providers.
Public Law 86-72, a federal safe harbor protection from state income tax assessment, does not provide protection to service businesses.
If your business is structured as a pass-through entity, such as an S corporation or a partnership, take special care to understand filing requirements for non-resident partners and shareholders. You will also need to take a close look at withholding requirements and/or composite return filing options.
The Takeaway: Know Your SALT Obligations
Rules regarding nexus and SALT have changed drastically over the last couple of years, and they continue to evolve. It’s important to know where you have nexus, so you can get a clear picture of your overall state tax compliance.
Your advisors at AEM are here to help. To assess your areas of risk, we can perform a SALT study, and can provide filing recommendations, too. Contact us today to learn more.