For years, Texas politicians have tried to lure business owners away from states such as New York and California, touting the Lone Star State’s lack of corporate or individual income tax. The idea of adding 9 to 13 percent to your personal income is hard to resist. But you may not want to pack up your office quite yet. Multistate business taxation rules have changed in recent years, and if you operate a service business across state lines — if you’re a consultancy or marketing agency, for example — your presumed tax savings might be smaller than you think.
Historically, states primarily taxed you based on the location of employees, offices and the business’ sales force. It was a question of where the work that created the income was performed, according to Shannon Ward, CPA and senior manager of Los Angeles-based Gursey Schneider, LLP. But now many states are enacting what are called “market-based sourcing tax laws.” For example: If you live in Texas and perform a service for an individual or company in California, then California requires your company to pay income taxes on the value of work received there. See how this can get tricky? And it gets worse: If you’re conducting businesses in any of the 19 states currently using market-based sourcing, you’re required to file and pay taxes in each of them. I spoke to one business owner who paid taxes in 17 states this year.
It wouldn’t be so complicated if every state adopted these laws; coordinating payments would be easier that way. But since 31 states haven’t yet, you’re at a high likelihood of double taxation, Ward says. For example, let’s say your business is based in New Jersey, which taxes your total income no matter where it comes from. But your clients are based in New York, a market-based state that wants to tax you for the work received in New York. Both can now collect tax on your revenue. Yet if the conditions were reversed — you live in New York but all your revenue comes from New Jersey — it’s conceivable that you would owe no tax at all.
For entrepreneurs operating a pass-through entity, such as an LLC or S corporation, the situation can be even more challenging. If you do business in the 19 market-based states, it’s possible that you (and each of your partners) will need to file a personal tax return for each state — and that’s on top of your corporate tax returns. It’s an accounting and logistical nightmare that will likely require you to pay income tax, and often a franchise tax, to do business outside your home state.
Details around this new taxation method vary from state to state — and even by industry — so before you make a move, do your homework and consult your tax expert. And keep in mind that promises made by politicians, especially regarding taxes, are never as simple as they sound.