State Apportionment with Multiple Entities
By Jason Watson, CPA
Posted Tuesday, July 6, 2021
Imagine you and another person want to form a business together, but you live in different states such as Minnesota and North Carolina. Where do you put the entity? In the end, it doesn’t matter since you would probably have a foreign filing registration requirement in the other state. So, you domicile the entity in Minnesota but also file as a foreign entity in North Carolina.
What’s the big deal? States get all bent out of shape on nexus and income apportionment. We have a whole chapter on this nexus stuff, but let’s do a quick preview. Generally, there are two types of nexus triggers, either economic or physical. Economic refers to how much “business” is being conducted commonly based on revenue. Physical nexus is commonly viewed as “boots on ground,” such as people or contractors (payroll), furthering your interests or “bricks and mortar,” such as offices (property). What makes it slightly confusing is that most states attach a dollar amount to payroll and property; as such the mere existence doesn’t necessarily mean you trigger nexus unless it exceeds a dollar amount.
So, the three nexus triggers are revenue, payroll and property. With sales tax nexus (as opposed to income tax nexus), the recent Wayfair decision has upheld the concept of “substantial” economic presence where essentially enough economic activity equals physical presence. Again, the Wayfair decision was about sales tax nexus, and not income tax nexus.
Sidebar on Nexus: This is similar to driving under the influence (DUI). Let’s say your state has a 0.08% blood alcohol limit. You can still be considered driving under the influence even if you have less than 0.08%. However, if you are over 0.08% then the state automatically presumes you are driving under the influence no matter how well you walk the line or touch your nose. This is called a “bright line.” States may argue you have nexus even if you do not cross the bright line, but if you do cross the bright line then it is automatic without argument or anything else to support it. Does that help?
If you trip the nexus wire, then the entity is on the hook for apportioning the taxable income among multiple states based on various formulas. One of the factors is naturally revenue, so if you trip nexus in two states, you have to source revenue to each state. Next, each owner now has an income tax obligation in multiple states and is required to file non-resident tax returns in each state outside of his or her resident state. This is unavoidable, but what is avoidable to some degree is the scrutiny. How’s that?
Using our Minnesota and North Carolina example, if the entity is domiciled in Minnesota, you might have to convince Minnesota that a big chunk of the taxable income is not theirs (i.e., the revenue earned in North Carolina). We find ourselves having to connect dots for revenue agents often since you commonly must report all revenues earned, and then split them off to other states. As such, states get to peer into your world and then make you defend it. Yuck.
Solution? We usually create an entity in Wyoming or some other “tax-inert” state, and then also create entities in each resident state of the owners. All revenues pour into the Wyoming entity which in turn pays out revenues as fees for services to the other entities (Minnesota and North Carolina, in our example). Does this allow the Minnesota owner to avoid North Carolina taxes? No. Taxable income is still apportioned between states, and each owner has an income tax obligation in multiple states. What this does, however, is reduce the scrutiny triggers since you only need to “show the cards” that are pertinent to each state.
This also avoids the discussion of K-1 income as well. K-1 income is generally considered investment or passive income, but if you materially participate in the generation of that income it might be considered non-passive income or for some limited purposes, earned income (like for use with foreign earned income exclusion). What are we getting at here?
Let’s run through an example (we explored this earlier, so this might be duplicative to some readers)-
Your Illinois S Corp is part owner of a California multi-member LLC that conducts business in several states. The MMLLC issues a K-1 to the S Corp for the pro rata ordinary business income, and then also apportions that income among the various states. California might argue that all the income to the S Corp is California income since the MMLLC is in California. But in reality, all the income came from other states and only made a pitstop in California. California might want to change the genesis of the revenue based on this alone.
Furthermore, California might consider the K-1 income to not be revenue or sales income at all. In other words, they might consider it investment, passive or non-passive income. Anything but revenue! Having it not be revenue or sales income prevents you from apportioning the revenue among several states, and possibly dipping below the economic nexus thresholds.
In summary, having the multi-member LLC issue payments for services provided to the partners’ S corporations reduces the visibility that states have. Again, we are not doing anything wrong or dodging income tax; we are simply controlling the narrative. Why spend a bunch of resources to prove your innocence (unless you’re O.J.)?
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