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Posted: January 05, 2010

Finding your way through the state-tax maze

Expansion's fun, but the taxes next door can bite

William Mueldener

So you've decided to launch your business in a neighboring state. Terrific. Conquer that state and then the rest of the U.S. There's something to consider first, however, before you get in too much trouble: State tax laws.

I know it's not exactly what you wanted to be bothered with amid the excitement of your expansion, but businesses operating in other states possibly owe taxes there. It's easier to avoid problems than get hauled before a state tax judge, who can impose audits, back taxes and fines.

People tend to put state tax considerations aside because federal taxes represent, on average, 30 to 35 percent of income. State taxes can bite as well. Sales taxes, state income taxes and property tax on all business-owned assets are standard and could add up to a cost of 15 percent or more on a cumulative basis. Here are some important factors to consider as you make your move into other states:

What's the 5-year plan look like?

Try to project where you are and where you plan to be in five years. If you open a distribution center in one state, it might be simple, but if the plan is to expand into a third state in two years and a fourth two years after that, it's going to become more complicated.

Taxes apply to a multiple of business activities

Most states have an income tax on revenues earned in that state. But there also might be a sales tax on all of the assets your business buys at 7- or 8 percent. Additionally, there may be a personal and real property tax on top of that.

The total of all the taxes imposed on you is not represented by one tax but by the cumulative total of all the taxes that come into play. Ask yourself, "What kind of business am I doing? Services? Retail of tangible goods?" Overlay that knowledge with the specific state taxes that are imposed and you'll get a clearer picture on how that state tax will impact your business. Avoid the mistake of assuming all states will tax your business in the same manner.

Multiple state operations complicate taxes

The issue is further complicated if a business is looking at operating in multiple states. A business owner needs to determine what dictates whether he has a taxable presence in those states and what dictates the taxes that relate to his business. Then consider that analysis in light of the multiple states in which the business will operate.

Let's take state income taxes for an example. Each state determines the portion of taxable income that may be taxed by various factors. One method used by an increasing number of states is to look at the ratio of sales made in their specific state versus sales everywhere and then apply that ratio to the business' adjusted federal taxable income. While multiple states may use the same "sales" factor method to allocate income, each state may define sales and how they are sourced differently which can have a dramatic impact on the end result.

As previously mentioned, states have different qualifications on whether you have a taxable presence. For example, a business can sell computers into Nebraska without paying state income tax so long as the company only has a sales force that travels into the state. However, if that sales force also trains its customers, then the business may be deemed to be selling a service and the business will be subject to state income tax. It varies by state and by activity.

Don't pay more than your competitors

The last thing you want to do is create a competitive disadvantage to yourself by paying more than your share of taxes. Differences in state tax laws can create that. We have clients in the energy business who have paid effectively 10 percent more on pipe than their peers due to sales tax and property tax (pipe was the business' single largest expense). Simple planning and understanding of state tax laws regarding purchasing and warehousing could have eliminated the taxes and increased the company's profits by 10 percent. So if you are in a capital-intensive business or any other business line, it behooves you to understand the tax laws in the state you're operating.

On top of that, states routinely push tax incentives to locate in certain depressed areas. If your competitor has a distribution center in one of those areas, they are going to beat you on the total profit of their goods or services. States offer a wide variety of incentives; some examples include interest-free loans or rebates of sales tax incurred on business purchases. It's worth it to do your research and get some advice before you expand.

Nuances in state laws can create opportunity as well as excess tax

Business owners tend to think of state income tax as an equal sum game. They often believe if you have $1 million in federal taxable income the business should have $1 million of state taxable income. This is not always the case; a business may find itself in the situation when operating in multiple states where State A taxes you on $800,000 and State B taxes you on $900,000 of the same income, it could blindside the business and the total state taxable income could well exceed the total federal taxable base.

Again, often understanding the subtleties in state law may allow a business to avoid this situation and potentially reverse it. In other words, the business could pay state income tax on less than 100 percent of its federal taxable income. To achieve the best taxable result the business will have to conduct the up front efforts to plan and structure in line with the most favorable state laws.

Don't put tax before business considerations

With all of this said, don't put tax considerations in front of your business objectives. If you want to move into Montana because you're going to sell all the cowboy hats bought in that state, then by all means open operations there. Tax considerations are secondary to sound business strategy.

Take everything - taxes included - that will impact your costs into consideration before expanding. It's painful to do the analysis up front but you can save a lot of risk and expense on the back end that could occur if you get an audit and assessment from a state for not paying the proper taxes. 

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William Mueldener, CMI, is a tax principal in the Denver office of Hein & Associates LLP, a full-service public accounting and advisory firm with additional offices in Houston, Dallas and Southern California. He leads the firm's state and local tax practice, specializing in state income/franchise tax, sales/use tax, other transactional/excise taxes and incentives. He can be reached at wmueldener@heincpa.com or 303.298.9600.

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