State Taxes

State Taxes

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State Taxation

KatieJ said:
“Here’s the general principle: States may tax residents on All income, regardless of source; and most do so, including Pennsylvania and Arizona. States may also tax nonresidents on income from sources within the state; all states that impose comprehensive individual income taxes do so, including Pennsylvania and Arizona. Income from personal services has its source where the services are performed. Therefore, if you are a resident of State A and you work in State B, both states generally will tax your earnings.

There are several ways in which the double taxation inherent in this system is mitigated. The most common is that the state of residence allows a credit for the tax paid to the source state, limited to the proportion of the resident state tax that relates to that “double taxed” income. In that case, the residence state in effect cedes the tax to the source state. There are a few pairs of states that stand in reverse credit relationships to one another; California and Arizona are an example of such a pair. A resident of one of those states working in the other looks, not to the state of residence, but to the source state for a credit for the tax paid to the residence state. Thus the source state cedes the tax to the state of residence.

Also, there are some pairs of states, mainly contiguous, that have reciprocal agreements whereby a resident of State A working in State B pays tax on his earnings only to State A. PA has reciprocal agreements with several other states, but not with AZ.”

Multistate Activities on Flow-through Entities

KatieJ also said:

For individuals… States can, and most do, tax residents on all of their income, from all sources. (There are a few states that allow residents to apportion out some business income from out of state sources.) In addition, states can, and most do, tax nonresidents on all income arising from sources within the state. Thus an individual who is a resident of State A and has income from a source in State B (such as wages for services performed there, property, or business carried on in that state) must report and pay tax to both states on that income.

The resulting double taxation is generally mitigated by one of several mechanisms. The most common is a credit granted by the residence state for the tax paid to the source state, limited to the proportion of the resident state tax that relates to the “double taxed” income. A few pairs of states stand in a reverse credit relationship, whereby the source state grants the credit. CA and AZ are an example of such a reverse credit relationship. Another mechanism is a reciprocal agreement, such as those between VA and MD, PA and MD, NJ and PA, etc. Under those agreements, an individual residing in one state and working in the other pays tax only to the state of residence. These agreements generally apply ONLY to wages for services performed in the nonresident state; they usually do not apply to income from business activities, rental property, etc. located in the nonresident state. Usually the source state will tax that income regardless of the reciprocal agreement, and the residence state will allow credit for the tax paid to the source state.

The state corporation commission or department of corporations generally has nothing to do with the filing of income tax returns. Generally annual reports, often accompanied by a nominal fee, are required of business entities that are organized or qualified to do business in the state, and such reports are usually filed with the corporations commission. Business tax returns are filed with the state tax authority. Requirements for registration of a foreign entity (one organized outside the state) with the corporations commission may be different from the requirements for filing an income tax return or an information return for a flowthrough entity.

For a Subchapter C corporation, or an LLC electing to be taxed as a C corporation, which is a taxpayer in its own right, a return is generally required if the entity has due process/commerce clause nexus in the state and is not protected from income taxation by federal law (Public Law 86-272). A return may be required in the state of incorporation, but if there is no business carried on there, no tax measured by income will be imposed (there may, however, be a fixed-dollar minimum tax in the state of incorporation). A state cannot tax income arising from out-of-state activities. Usually income is apportioned among the states where the business is carried on by a mathematical formula. The historic formula, still in use in 13 or 14 states, is the equally-weighted average of three factors: in-state property to property everywhere, in-state payroll to payroll everywhere, and in-state sales to sales everywhere. The modern trend is to place more weight on sales than on the other factors; many states “double weight” the sales factor, and a number of states have adopted or are moving to a single factor of sales. Theoretically there should be no overlap, but due to the differences among state formulas it is likely that less or more than 100% of a multistate business’s income will be subject to state taxation.

DP/CC nexus exists if there is a physical presence (e.g., employees, representatives, property) in the state. In addition, DP/CC nexus may exist without a physical presence if the entity is engaging in activities that create and maintain a market for its products or services in the state. This is known as economic nexus. The U.S. Supreme Court has so far declined to rule on the constitutionality of economic nexus. Some states will assert it, some will not.

Public Law 86-272 (the Interstate Income Act of 1959, 15 U.S.C.A. ยงยง381-384) protects certain businesses that have DP/CC nexus from state taxes on or measured by income. A state cannot impose such a tax on a business whose activities in the state are limited to the solicitation of sales of tangible personal property, where the orders are sent out of the state for approval and the property is shipped to the purchaser from outside the state.
For flowthrough entities (FTEs) such as S corporations, partnerships, and LLCs taxed as partnerships, the rules are a little different. Most states follow the federal flowthrough treatment of these entities, but some states tax them at the entity level just like a C corporation, while others do both — impose an entity-level tax and also tax the owners on the flowthrough income. Generally an information return must be filed by an FTE in a state if the FTE is organized or qualified to do business there, if it has DP/CC nexus and is not protected by P.L. 86-272, and sometimes if it has one or more resident owners there.

If the flowthrough character of the entity is followed by the state, all of the owners, resident and nonresident, are also taxpayers in the state. For purposes of determining a nonresident owner’s source income from an FTE doing business in the state, generally the apportionment rules described above are applied. Again, if the nonresident owner is an individual, the individual must file a return and pay tax on his or her distributive share of the FTE’s income apportioned to that state. Usually the individual’s residence state will allow credit for the tax paid to the source state.

A large multistate partnership may give each partner a schedule showing how much income is taxable in each state where the partnership does business, in lieu of a stack of state K-1s. The partner reports 100% of his distributive share as taxable income in his state of residence (assuming it imposes a comprehensive individual income tax), and files a nonresident return in each of the other states. Many states require the partnership to withhold state income tax on the distributive shares of the nonresident partners; in that case, the K-1 or schedule will tell the partner how much was withheld for each state, and the partner can claim that as a credit against the tax due to that state. Generally the residence state will allow credit for the taxes paid to the other states, except for reverse credit relationships and other differences.

Most states will allow (and some require) the partnership to file a composite nonresident individual income tax return on behalf of the nonresident partners, particularly those who have no other income from sources within that state. In that case the partnership is responsible to pay the tax on behalf of the nonresident partners. Each will receive a schedule from the partnership showing the amount of tax that was paid on his behalf, and can claim credit on his resident state return for that amount.

For a personal service partnership, such as an accounting, law, or consulting firm, the partners may receive guaranteed payments in addition to their distributive shares of the partnership’s income net of the GPs. In most states the GP is treated exactly like the distributive share for sourcing purposes; i.e., instead of allocating the GP to the location of the particular partner’s office, the GP is apportioned among the states in the same way as the distributive share. California has a special rule for such partnerships whereby 60% of an active partner’s income from such a partnership (including both GP, if any, and distributive share) is treated as if it were payroll for apportionment formula purposes, and assigned to the numerator of the factor at the partner’s principal office location. California for many years also allocated 60% of the partner’s income to the office location, so a nonresident partner would pay California tax on only an apportioned share of 40% of his partnership income; however, the other states never went along with that, and that provision was repealed a number of years ago.

Income Taxation

KatieJ also said
:
“States have the power to tax all of the income of residents, regardless of source. With a few exceptions, states that impose comprehensive individual income taxes (more or less parallel to the federal individual income tax system) exercise that power. With very few exceptions, the state where you live will tax all of your income. It does not matter where you earned it — Texas, Florida, a foreign country… it’s all taxable in your home state.

States also have the power to tax income of nonresidents arising from sources within the state. If Texas or Florida had an individual income tax, they would have taxed the income you earned by performing services there. In that case, North Carolina would have given you credit for the tax you paid to the source state, limited to the proportion of your North Carolina tax liability that related to the “double taxed” income. Since neither of those states has an individual income tax, there is no liability to those states, and no credit.”

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