State Apportionment of Taxable Income

As the business grows and expands, it may create a nexus in other states, requiring the company to file tax returns in multiple states. Here, we will discuss how taxable income is allocated or apportioned in several states.

In the previous newsletter, we had seen that a corporation that was initially formed, for example, we used illustration of “CA Corp” where the company was incorporated in California (CA), leased office space and hired employees to conduct the business of selling tangible personal properties in CA. At this point, we can say that the company has a definite connection or nexus in CA. Therefore, CA Corp will need to file CA state tax return. Then as business gradually grew and expanded, where CA Corp started to sell in other states and leased business space as well as hired employees in the other states, the company created nexus in those states. Now the company has nexus in multiple states and must file
multiple state tax return. We will discuss how taxable income is apportioned or allocated to multiple states to which we calculate the respective state tax liabilities.

First of all, before we can consider state taxable income, we must first calculate federal taxable income, as name suggest all companies must file a federal corporation tax return (report) to the IRS on an annual basis. Federal taxable income is calculated based on Internal Revenue codes and regulation. The states will take this Federal taxable income as their starting point. As each state is independent and governed by their own laws and regulation, each state must make adjustment to the federal taxable income to arrive at state taxable income. Some examples of adjustment include state corporation tax deducted on the federal taxable income or depreciation deductions because state regulation may not conform with the federal regulations.

Apportionment and allocation methods

Business vs non-business Income

Apportionment applies to business income. Business income is referred to the income generated from the company’s normal and ordinary course of business. For example, if the company’s business is selling tangible personal property like CA Corp’s wireless charging device, all income related to the sale of such products are considered as business income and is subject to apportionment. On the other hand, if CA Corp becomes profitable and accumulate cash and decided to invest in stocks. Income such as dividend received from the stocks or capital gains when the stock is sold will be considered non-business Income. Non-business income will be subject to allocation.

Apportionment assigns taxable income to the nexus states based on some formulary approach. On the other hand, allocation usually assigns non-business income to the state where company’s headquarter is located. So, in our example, if CA Corp has 1M capital gain from the sale of investment stocks, such gain will be allocated and taxed only in CA. This approach makes sense when you consider that capital gain has nothing to do with other states.

Types of business Income
  1. Sale of tangible personal property
  2. Providing services

In this discussion, we will focus on apportionment of income related to sale of tangible property. Apportionment of income related to services has their own methodology that differ from tangible personal property and will be pick up next discussion.

Currently there are two main methods of apportionment of business income for companies dealing in personal tangible property. They are as follows:

  1. Three factor Formula: Considers the ratio of Property, Payroll and Sales factor in each individual state to the totals of respective factor to come up to apportionment percentage of nexus sate. Currently there are 14 states that employ this method. Examples include Alaska, Florida, Hawaii, and Massachusetts among others.

  2. Single sales factor: Considers only the ratio of sales factor of each state to the total sales amount of the company to determine the apportionment factor of the company. There are thirty states that employ this method. Examples include California, Illinois, Michigan, New Jersey, New York, Pennsylvania among others.

Illustration of the Methods:

Let’s continue with CA Corp, that had business office, warehouse and employees in CA and later as business grew, decided to open new business locations in Hawaii and New York. As of December 31, 2022 the following were their apportionment factors: (note: CA Corp had sales to Illinois where they do not have nexus, all tangible goods were shipped from CA’s warehouse)

CA (headquarter)500,000200,000800,000

Calculation of Apportionment factor

CA: (single sales factor)= (800 + 200)/1500
NY (single sales factor)=400/1500=26.66%
HI (3 factor)=100/750
= (13.33% +16.66%+6.6%)/3
Sales throw back

To prevent “no sale “situation like when CA Corp sold to customers located in a non-nexus state like Illinois, CA requires that sales sold to IL, throw the sales back to CA. As a result, 200K of sales to IL will be redirected back to CA and increase the nominator by 200K to increase the apportionment factor. Other situations where sales throwback come to play is when goods are shipped directly from overseas manufacturer to the US company’s US customer. So, in this case, sales will be redirected back to the headquarter state or in our case, CA. Please be aware that not all states apply the throwback rule, such as TX where one need not throw back to TX. So, if company that stores inventory in TX, sells goods to a non-nexus state there is no need to throw back to TX, resulting in lowering the apportionment factor and ultimately lowering the taxes.

State taxable Income

Finally, we will apply the respective apportionment percentages to each state’s pre taxable Income to calculate the post taxable income. For illustration’s sake, let’s assume the state taxable income is 800K for each respective state. Then the product of apportioned taxable income by state’s tax rate would give us the state tax liabilities as follows:

Statetaxable income x apportionmentpayrollsales
CA(800K x 66.66%) = 533.33K8.84%47.16K
HI(800K x 12.22%) = 97.77K6.40%6.25K
NY(800K x 26.6%) = 213.33K7.25%15.46K

Benefits of multi-state taxation: We can see that CA has the highest tax rate amongst the other state, therefore the sifting of taxable income to other lower tax rate state would produce a lower aggregate tax liability. For example, if the company’s only nexus was CA or in other words 100% apportionment, then the total tax liability would have been 70.7k as opposed to 68.87k when they filed CA, HI & NY as shown in the above example. In our next newsletter, we will continue our discussion of apportionment related to services.