Employing Consultants in Multiple States- A Practical Approach to Balancing Tax Compliance Costs & Risk
There was a time when interpreting the Internal Revenue Code was a relatively simple affair. When a company had a single manufacturing facility in a single state, and all its employees worked in the plant or office there, calculating payroll and income taxes was very clear. Even when the company manufactured products that were shipped to customers in different states, sales taxes were easy enough to comprehend.
In our industry, things have become more complex very quickly. A staffing company with an office in one state can commonly find itself working with a client whose HQ is in another state, on behalf of a division of the client company located in a third state. The contractor performing the work could conceivably live and work in a fourth state – or more, if multiple contractors are working remotely.
Tax obligations can vary significantly from one state to another, and tax legislation is constantly changing. You want your business to remain compliant, mitigating legal risks. You also want to minimize your tax exposure to protect your balance sheet. How, then, does a business manage these two priorities?
Derek Wiggins and Ibby Michalik, with UHY Advisors, recently delivered a presentation for a TechServe Alliance webinar, to help staffing industry leaders understand the complexity of the tax landscape and make informed decisions to protect their legal and financial interests.
The federal tax code, printed, is over 19,000 pages long, and approximately 20 inches thick. Additionally, there are over 11,000 state taxation jurisdictions. Wiggins, a Manager with UHY and a state and local tax specialist, says this is why definitions matter. Definitions for the IT Staffing industry’s work differ between jurisdictions. Wiggins says, “Knowing where you’re doing business, and how those regions define the work you do there, is important.”
To illustrate the complexity, the majority of the states, all except five, charge sales tax, but most don’t apply this to services. The states that do apply sales tax designate it to specific services only. Again, Wiggins says: definitions matter.
“Computer services are the ‘wild west’ of tax law. Are you writing code, is that code software, is it software modification or implementation, or are you doing software consulting? Is it hardware design, hardware consulting, hardware implementation, or some other IT-related service?” It’s critically important that a business understands how each jurisdiction defines its services, so it can make an informed decision about its tax obligations.
Payroll taxes are equally complicated. They are usually incurred in the jurisdiction where the employee performs the service this is increasingly important with more remote workers). However, there are exceptions. Seventeen states have reciprocity agreements with bordering states, as does Canada. To remain compliant, you need to know the specific rules in the states where you do business.
That would be challenging enough if tax legislation stayed the same, which it doesn’t.
Changes and Trends
Recently, there have been significant changes in the way taxes are calculated. The Tax Cuts and Jobs Act of 2017 were the most changes since 1986, taking the United States from one of the highest taxed jurisdictions worldwide to the middle of the rankings.
Sales taxes underwent the most significant changes since 1992, with the Wayfair decision in 2018. This act began the shift in determining tax obligation from a ‘physical presence’ standard to a ‘substantial nexus’ standard. The definitions of ‘substantial nexus’ are still being finalized.
The increase in remote work, due in part to a generational dynamic and COVID, has been the catalyst for change in the ways states deal with payroll taxes, too. Where it was once a matter of where the employee resided/ worked, states with large numbers of remote workers are understandably seeking change.
Alongside those considerable changes in recent years, there is also, ongoing evolution in legislation following every election cycle, when the new administration applies their own policy changes. Due to all of these factors, it is necessary to know where your company has tax exposure. The next question is, how much exposure and where?
Ibby Michalik, a Senior Tax Manager with UHY Advisors, explains apportionment as the computation to determine the percentage of a company’s profits attributable to each jurisdiction to determine the tax liability in that area.
There are several ways that calculation is done, depending on the jurisdiction. A three-factor formula takes into consideration property, payroll, and sales. Another type of this three-factor formula puts added weight on sales. Some states employ a single-factor sales formula. A growing number of states are moving in the direction of a market approach, where the considerations more closely align with the way business is being done today. This approach considers where the benefit and the service are received, where the service is delivered, and where the customer is located.
“Applying these methods can be complicated,” Michalik says, “resulting in double taxation, being taxed twice, or not being taxed at all. The lack of uniformity can result in sourcing the revenue to multiple states, or to no states at all.”
To illustrate, Michalik gives this example: If a company performs services in Montana, and the benefit of those services is in North Dakota, there would not be allocation of revenue (this is a ‘nowhere sale’). However, if the reverse were true – with the service performed in North Dakota and the benefit received in Montana – the revenue would be allocated to both states, incurring double taxation.
While these differing and conflicting rules can be confusing, both Wiggins and Michalik agree the most important thing for companies is to track all of the business activity in each jurisdiction. Also, ensure your data is complete and retain knowledgeable counsel to make informed decisions with that data.
Every company that does business across multiple tax jurisdictions ultimately has to make a decision balancing the need to remain compliant, with the need to invest time and effort wisely. Registering in different states to fulfill tax obligations can be an arduous task and a costly one. There are often multiple agencies to register with: the state itself, the Department of Labor, the Department of Revenue, etc. In some cases, this effort doesn’t make business sense. Especially, if the company isn’t planning more work in that jurisdiction. If the potential tax exposure is in the hundreds of dollars, but the administrative process for reporting is going to cost thousands of dollars, it may be the sensible business decision to not report.
Wiggins stresses, the key is to be fully informed to avoid surprises. That said, in business, things can change. For instance, a company may decide not to register because they don’t plan more work in that jurisdiction.
When Things Change
If a business generates more revenue in a certain area than expected and then reverses a decision not to register in that area, it is possible to do this – protecting both the legal and financial interests of the company. To do this use a Voluntary Disclosure Agreement (VDA), reporting revenue several years after it is earned. As with everything related to taxes, there are pros and cons of VDAs to be considered.
With a VDA, a company can limit its exposure. Generally speaking, there is three to four years of visibility, potentially limiting a company’s tax liability and penalties. This can lead to significant savings compared to revenue that may be found during an audit. In short, a VDA offers the opportunity to ‘come clean’ and avoid the risk of forcible tax compliance.
Companies using this method must ensure that they have all the information they need to complete the filing. Through the process, a company could discover additional liabilities. Worse yet, missing details can render a VDA null and void.
A Voluntary Disclosure Agreement is a question of balancing the risk of non-compliance with the need to make the best business decisions for your company.
Wiggins acknowledges how complicated these scenarios are for any business leader to figure out. “If any of us made it this difficult for our customers to pay us,” he says, “none of us would be in business very long.”
The key takeaway is this: if you’re doing business that crosses state lines, you may be incurring tax obligations, including some you are not aware of. Knowing this, Wiggins and Michalik both advise working with a trusted professional who can help you make informed decisions for your company. Allowing you to focus on growing your business … instead of the 19,000-page tax code.