Fortunately, only rarely does anyone wind up paying tax on the same income twice. "Rarely" is the operational word because the way states handle the problem is not uniform.
In other words, if you do 45 percent of your business in state A and 55 percent in your home state of B, doesn't mean that 45 percent of your snow removal or ice management operation's income will be taxed in A and 55 percent in B. Depending on the rules in each state, the contractor may wind up paying slightly more or less. In fact, depending on the rules in each state the snow removal operation could wind up paying state tax on less than 100 percent of its income.
Paying state taxes on less than 100 percent of your income obviously depends on the states where you do business. It also takes a sharp snow removal professional with a clear understanding of state tax laws. Unfortunately, not only are state laws every bit as confusing as our federal tax laws, there are 50 of them to try and understand.
VIVA LA DIFFERENCE
When is a snow removal contractor required to file a tax return in another state? Even that becomes a complicated question, one that depends on the rules in the states where the business operates. If your snow removal business simply sends supplies into a state and no employees actually work in that state, the operation probably won't have to file income or sales tax returns in that state. Even if the operation sends independent sales reps into that state, it should still be able to avoid filing income tax returns.
If, however, the snow removal business has a sales office and takes orders some states exempt the operation from filing income taxes. Of course, once a contractor has property in a state, has employees or performs services in a state (or some other similar connection) they are usually required to file tax returns and pay taxes in that state. Not filing could result in penalties, interest and a host of other tax problems.
Many state taxing authorities have developed a more formal approach to dealing with corporations, partnerships, etc. It is often referred to as the "Massachusetts formula" (where it was first introduced) although it more commonly bears the descriptive title "three-factor formula" because it uses a business operation's sales, property and payroll to apportion its income between states. Although the general theory is almost universal, some states have modified the formula.
The concept is simple. The snow removal and ice management contractor computes a percentage for sales based on the sales in a state to the operation's total sales. The same is done with property and payroll. Add the percentages and divide by three. The result is the operation's apportionment factor. Apply that factor to the operation's pretax income for the year (after making any required adjustments to the income for the rules in that state) and the result is the income reportable to the state.
Although, at least in theory, the formula appears simple, not every state uses the same approach and, in practice, the rules are more complicated. Some states, for example, weigh one factor heavier than others. Some may double-weight the sales factor. That is, the sales factor is included twice and the total percentage is divided by four.
THE SALES FORMULA FACTOR
Generally, where a sale is allocated depends on where delivery takes place or the services are performed. If, for instance, the operation's only connection with New York is that it has an equipment servicing facility there, the income received for services performed for customers in the state count as sales.
If the operation is not subject to income tax in that state, most states consider that the sale belongs to the state where the operation is headquartered or goods are shipped. The same rule also applies to sales to the federal government.
Obviously, if a contractor does business in more than one state, it must keep careful records of where goods are shipped or where services are performed. In the case of services, sales are allocated to the state where the services are performed.
PROPERTY AS A FORMULA FACTOR
Property such as furniture and fixtures, machinery and equipment, computers, etc. as well as real estate including land and buildings as well as intangible property (bank accounts, stocks, etc.) is generally excluded from many formulas. And no, you can't escape by renting property. Every state has a method for including rented personal property and real estate in the factor, usually by taking the annual rent and multiplying it by eight.
Most states use an average of the beginning and ending values for property. Thus, even if you don't have any property in the state on January 1, but do have some at the end of the year, you'll have to include 1/2 of the year-end amount in your property factor. Inventory is included as part of your total property and property in a state but the rules vary on how inventory in transit must be counted.
Property is generally valued at net book value. That is, cost less depreciation. New York allows taxpayers to make an election to value the property at fair market value. Massachusetts requires taxpayers to use original cost with no reduction for depreciation and can require monthly averaging (rather than annual) if necessary in order to properly reflect the average value of the property.
FACTORING IN PAYROLL
Payroll usually includes not only salaries and wages but also bonuses, commissions, etc. Some states include amounts paid to independent agents, room and meals (e.g. provided by employer), etc. As a starting point, consider anything that you've got to include on an employee's W-2 as wages or amounts reportable on payroll returns as compensation.
SEPARATELY ACCOUNTING FOR STATE TAXES
While most contractors will apportion income using the general approach outlined above, many states allow businesses to use "separate accounting." Separate accounting is pretty much what it sounds like. The snow removal operation computes its net income based on the income and expenses in the state. Unless the operation in the state is almost a separate entity, this generally isn't easy. It can also be expensive.
Overhead, salaries of employees who work both in and out of the state, etc. must be allocated. However, despite the problems, it can result in significant tax savings if the operations in the state produce little or no income and the state has a high tax rate.
THOSE OTHER STATE TAXES
Many states impose a franchise tax as well as an income tax. The franchise tax is based on the property used in the business. Most states that have such a tax usually use the same factor for apportioning income to apportion the franchise tax.
It should go without saying that not all income is subject to apportionment. Certain items of income such as capital gains on the sale of property should be allocated to the state in which the property is located.
Of course, just because a snow removal operation has sales in another state doesn't guarantee that it can apportion some of its income to that state. Many states subscribe to a so-called "throwback rule." The theory is, even if an operation has sales in another state, if that state doesn't tax the income, the income belongs to the contractor's home state. If for example, a supplier has catalog sales in 10 states but only has employees and property in state A. State A will not allow the business to apportion its income.
A snow removal contractor should be aware that in some cases it may make sense to establish a presence in another state just so income can be allocated outside the home state. The higher the tax rates in the home state and the lower the tax rate in the other state, the more advantageous this becomes.
Doing business as an S corporation or partnership (or LLC), means state rules very similar to those for regular corporations. However, since the income of a partnership or S corporation is passed through to the owners, in most states there is no tax at the entity level (i.e., S corporation or partnership). At higher gross or net income levels, some states do impose a tax on the entity.
While personal income taxes may have been reduced in many states, the same is not true for corporations. State income taxes can cost a snow removal or ice management business 5 percent to 8 percent or more of its pretax income. That's not insignificant. Some planning can save substantial tax dollars. But beware, multi-state taxation can be tricky.
Mark Battersby is a Ardmore, Pa.-based financial writer and frequent Snow Magazine contributor.