State Apportionment with Multiple Entities

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 much, since you would probably have a foreign registration requirement in the other state anyway. So, you domicile the entity in Minnesota but also register as a foreign entity in North Carolina. Done, but not quite.

What’s the big deal? States get all bent out of shape over nexus and income apportionment. We have a whole chapter on nexus, but let’s do a quick preview. Generally, there are two types of nexus triggers, economic and physical. Economic nexus is about how much business is being conducted, commonly measured by revenue. Physical nexus is commonly viewed as “boots on the ground,” such as employees or contractors furthering your interests (payroll), or “bricks and mortar,” such as offices (property). So, the three nexus triggers are-

• Revenue or Sales (depending on your vernacular).
• Payroll.
• Property.

What makes it slightly confusing is that some states, including California, attach bright-line dollar amounts to each, so the mere existence of payroll or property doesn’t necessarily trigger nexus unless it exceeds the threshold. Other states use a looser “doing business” standard. With sales tax nexus (as opposed to income tax nexus), the Supreme Court’s 2018 decision in South Dakota v. Wayfair eliminated the physical presence requirement, so enough economic activity alone can create nexus. Again, Wayfair was about sales tax nexus, 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%, 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 it, nexus is automatic without argument or anything else to support it. Does that help?

If you trip the nexus wire, the entity is on the hook for apportioning its taxable income among multiple states based on various formulas, and in most states today the main factor is revenue. As such, if you trip nexus in two states, you must source revenue to each state. Next, each owner will likely have an income tax obligation in multiple states and need to file nonresident tax returns outside their resident state. Yes, there are exceptions and workarounds, such as composite tax returns and pass-through entity tax elections, but multistate filing is generally part of the package. What we can reduce, to some degree, is the friction. 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 (the revenue earned in North Carolina). We find ourselves connecting dots for revenue agents often, since you commonly must report all revenues earned and then split them off to other states. The state starts with everything and makes you defend what isn’t theirs. Yuck.

Solution? At WCG CPAs & Advisors, we usually create an entity in Wyoming or some other “tax-inert” state, and then a baby S Corp in each owner’s resident state. All revenues pour into the Wyoming entity, which in turn pays fees for services to the baby S Corps (Minnesota and North Carolina, in our example). Does this allow the Minnesota owner to avoid North Carolina taxes? No. Here is what doesn’t change-

• Taxable income is still apportioned between the states.
• Each owner still has an income tax obligation in multiple states.
• The Wyoming mothership might still need to register and file in Minnesota and North Carolina. With properly supported fees reducing its taxable income to a nominal amount, the income tax consequences can be modest, but the paperwork doesn’t necessarily disappear.

What does change is that each baby S Corp reports its own revenue under its own state’s rules, rather than every state starting with the whole pie.

It also sidesteps the K-1 problem. Here is a quick version of an example we explored in another section. Your Illinois S Corp owns part of a California multi-member LLC that conducts business in several states. The MMLLC issues a K-1 to your S Corp, and now your S Corp must deal with California’s partnership income and apportionment rules (Cal. Code Regs. tit. 18, 25137-1). California handles it one of two ways-

• If the businesses are not unitary, California apportions the partnership’s income separately, using the partnership’s own numbers.
• If the businesses are unitary, California folds the partnership’s income and factors into your S Corp’s.

Either way, you are reporting the partnership’s business, not your own revenue, and simply owning part of a California LLC can create a California filing obligation. Swap the K-1 for a legitimate fee for service, and your S Corp reports its own service revenue under the sourcing rules applicable to its business. That is the reporting distinction we are after.

California is our favorite punching bag, but it isn’t alone. Other states have similar rules for corporate partners, and plenty of states copy California’s homework.

Sidebar: What does unitary mean? Two businesses are unitary when they really operate as one integrated business, with shared management, shared operations and each one depending on or contributing to the other (Cal. Rev. & Tax. Code 25120 and Cal. Code Regs. tit. 18, 25120). Say your Illinois S Corp is an IT consulting firm that owns 20% of a California restaurant LLC. Different businesses, different management, nothing shared. Not unitary. Now say your Illinois S Corp is a consulting firm that owns part of a California consulting LLC, and the two share staff, clients and leadership. That starts to look like one business wearing two hats, which is likely unitary. Most states that tax corporate partners use some version of this test.

In summary, having the mothership pay fees for services to the partners’ S corporations changes how the income is legitimately reported to each state. Again, we are not doing anything wrong or dodging income tax. Every state with nexus still gets its share. We are simply structuring the relationship so each state sees the business that belongs to it. Why spend a bunch of resources proving your innocence when you haven’t done anything wrong?