As noted, apportionment refers to the manner in which income is divided between various taxing jurisdictions. Several factors combine to create complexity and confusion. Over time, a number of states have moved from an evenly weighted formula to one in which receipts receive more emphasis. Our video overview sets the stage for our pitfalls, risks and opportunities discussions.
What is apportionment?
Apportionment is just the way states divide up your income among themselves, and there's really two ways of doing it: one is allocation, one is apportionment. They are related however different concepts. So allocation is specifically assigning a particular item of income to a particular state, items such as interest, dividends, non-business income are typically allocated or specifically assigned to a specific state.
Apportionment on the other hand is how states divide up your overall regular recurring business income among themselves. Obviously if every state in which you did business tried to tax you at a hundred percent there'd be nothing left over for you which states are generally okay with but taxpayers are not. Apportionment is usually done through some formula or method, so usually historically it's been a three factor formula evenly weighted of property, payroll and receipts.
Over the last several years, maybe decade even, more and more states have gone away from that evenly weighted three factor formula to a single factor formula consisting of just receipts, and even states and aren't there yet or more heavily weighting the receipts factors that you may see a four factor formula where the receipts are double weighted and the property and payroll make up the remainder of it. Historically when most of these apportionment formulas were written and when they came into being we were a very goods based economy so selling widgets was selling tangible personal property. These formulas and most of the methods worked very well when that's where we're selling, you knew where you were delivering the property, delivering what you were selling, whether it was someone walking into a store or you actually shipping it by common carrier. As we've moved away from a goods and tangible property sort of economy to more of a knowledge-based economy and intangible sort of economy more and more companies are more and more finding that they are making their income through those intangibles, so instead of shipping widgets they're now shipping intellectual property or shipping software or performing services. We’re a very service based economy now so more and more states have moved from the traditional what I'll say point of delivery which worked well for tangible goods, they’ve gone to more of a market-based sourcing for services as well. Historically states used a cost performance method for sourcing receipts from services so they would look at where the service was actually performed or where other costs were located such as third party costs, your buildings, machinery, etc. more and more states have gone away from that now because they thought it was too complicated, many of them didn't do cost performance studies, didn't understand them and as a practical matter many auditors just looked to where the service was performed anyway. So over the past decade again more and more states have started to move towards market-based sourcing for services as well as intangible property.
The next thing I would do once I have that high level of quantification is go through and challenge all my assumptions. Things like sourcing - am I sourcing the revenue properly? What about the apportionment? A lot of those underlying assumptions very often can help you negate some of the exposure and some of the liability. Maybe the states you have nexus in that you need to file for the last several years have a lower tax rate than the states you are currently filing in and you may be able to go back and amend current year returns. So you need to figure out the impact it will have on your current filings as well as challenge all those assumptions and see if those liabilities really hold true and see what the true level of exposure is.
The next thing you can do once you've quantified the amount is actually go and enter into some sort of agreement with the state. Virtually every state has some sort of voluntary disclosure program and very often states come up from time to time with amnesty programs which both let you come forward on a voluntary basis and clear up past liabilities that you have with the state.
What are my agreement options?
A VDA is a voluntary disclosure program where you get to come forward to the state and generally they limit the look-back period anywhere from three to five years so let's say you find out you had Nexus going back ten years well you could limit that look-back period for three to five years and they will generally waive all penalties and you're just subject to the interest and the tax due for that time period. Now for sales tax if you've collected tax and failed to remit it you still need to pay all of the back taxes, they don't let you keep anything that you collected wrongfully and what they do is you can come forward to the state, some states let you begin the process under an anonymous basis others you have to disclose up front, and you limit the look back period to get the penalties waived and then you can enter into the agreement the state gets you on their tax rolls so that you're filing going forward. An amnesty agreement on the other hand has gotten a lot more publicity I'll say in the last several years with more and more states coming out with limited terms they're usually only run for three months and states will often waive interest and penalties but it may have an unlimited look-back period. Also some states have come out and said well we're only waiving half the penalties or maybe half the interests so you really need to look at each state's program and figure out what makes the most sense. Usually when an amnesty program has been enacted the voluntary disclosure program is suspended during that same time period so you really need to figure out which one fits the best for you.
If I have nexus exposure, what are my next steps?
Well the first thing we'll do is determine whether they do have nexus because very often some of them come forward and think they have nexus in various states and they don't, or they may have it in totally different states. We’ll also make sure they're looking at the right taxes: often we've seen people come and they may be looking only at one tax, let's say sales tax, and they don't realize well you need to do all your taxes, you need to do income tax as well or franchise tax, and so we make sure all the taxes are included and take a more holistic approach. We’ll also help them consult on things like are you sourcing your revenue correctly or is what you're selling if the sales tax issue is what you're selling actually subject to tax there because very often a lot of these issues get very complicated and sometimes clients get confused on the issues and what they thought was a huge issue may be less of an issue and maybe what they thought was a minor issue ends up being a big issue.
In this Apportionment overview, Gary Bingel discusses challenges and opportunities and how planning can help manage overall tax liabilities, and knowledge can help mitigate potential exposures and combat aggressive taxing authorities on audit.
Defensively, your tax team wants to avoid pitfalls associated with nexus. On the other hand, understanding nexus can open the door for opportunities such as Voluntary Disclosure Agreements or amnesty.
A major nexus pitfall includes unpaid taxes, uncollected sales tax and flow-through entity issues are sometimes missed. Avoiding sticky situations requires an understanding of what creates nexus for different taxes, and in different jurisdictions.
In this Nexus overview, Gary Bingel discusses how Nexus varies state by state, the contacts required to generate taxes, "physical presence" and other key focus areas including remote employees, and new sourcing rules among others.