Posted Thursday, February 20, 2025

With state apportionment and tax return preparation, there are two issues at play- apportionment itself, and then state tax return filings. Apportionment is generally based on sales, property and payroll. For most small business owners, sales and payroll are the most common apportionment factors. Property comes into the mix with buildings and inventory.

Each state determines the importance of each factor. Fine, sure, whatever, right? The problem is two-fold. State tax code and courts govern your business activities, and they can be self-serving. Next, states don’t play nicely between each other, and at times the same dollar can be taxed twice.

The first step is to apportion or allocate or split up, or whatever you want to call it, the revenue you had in each state. You also do the same thing with payroll, and at times you must also consider contractors. If you own property, such as machinery, inventory and buildings in other states, then that needs to be factored in as well.

Sidebar: Apportionment is used to divide a business’s income among multiple states where the business operates. Allocation is used to assign specific types of non-operating or non-business income such as royalties and capital gains to a particular state. While used interchangeably, these two words have specific meanings. Terms of art as they say.

Some of this stuff is also referred to as nexus. Nexus is a Latin word meaning to bind, join or tie. Simply stated, tax nexus is the minimum amount of contact between a taxpayer and a state, which allows the state to tax a business on its activities. Every state defines nexus differently using terms such as physical presence or economic presence- physical is generally property or payroll (people), and economic is generally sales.

In other words, physical presence nexus relies on a tangible connection to the state whereas economic nexus focuses on the volume of economic activity within the state.

Once apportionment is completed, the next challenge, and it is a massive one, is to determine what the filing thresholds are in each state. Several states are clear, and several others are nebulous or squishy with their words. Here is California’s self-serving verbiage–

If you are doing business in California, you are subject to our tax laws. We consider you to be “doing business” if you meet any of the following:

• Engage in any transaction for the purpose of financial gain within California

• Are organized or commercially domiciled in California

• Your California sales, property or payroll exceed the following amounts:

Year	Sales	Property	Payroll
2024	$735,019	$73,502	$73,502
2023	$711,538	$71,154	$71,154
2022	$690,144	$69,015	$69,015
2021	$637,252	$63,726	$63,726

These are also considered bright lines, or bright line nexus. If a business exceeds these thresholds, it is considered to have a nexus, or connection, with the state.

California takes this one step further and slaps on a 25% rule- although your sales, property or payroll might not exceed these hard numbers, if they exceed 25% of your total sales, property or payroll, you are considered doing business (trip nexus). For example, you have $200,000 in sales which is clearly below the limits above. However, $80,000 or 40% of your sales is traced to California customers. You are now considered doing business in California.

Another consideration is the second bullet above. Many states will define doing business merely as being registered. This happens primarily two ways- first, the state requires you to register before they will issue payroll account numbers. Second, the state’s regulatory bodies require registration. For example, if you are an architectural firm who does business in several states, each state will likely require your architectural firm to register with the regulatory body that oversees engineers and architects, which in turn will likely require you to register with the Secretary of State as doing business in that state. Yuck.

Wolters Kluwer publishes a guide titled “What Constitutes Doing Business” which is updated annually. Click here for a copy. The publication helps define “doing business” from a foreign qualification perspective which is part and parcel to state income tax apportionment, but is also a can of worms to be discussed elsewhere.

Nexus and doing business and filing thresholds and a bunch of other words are at times used interchangeably, and each state likes to use terminology that is meaningful to them. The net-net of all this is quite simple- Do I trip the wire, Yes or No?

How do the three factors of payroll, property and sales work together? Here are the three most common-

• An equally weighted three-factor formula that takes payroll, property, and sales into account in equal measure,

• A single sales factor formula, which bases taxes solely on a business’s sales within the state, or

• A three-factor formula in which the sales factor is given different weight from the other elements, such as a double-weighted sales factor.

Recall the mini discussion of business income and non-business income, and the differences between apportionment and allocation above. Keep in mind that apportionment is the assigning of business income to each state. So, what is business income? Each state is different in its definition naturally, but California has a nice write-up on business income apportionment–

Apportionment generally refers to the division of business income among states by the use of an apportionment formula. A trade or business with business income attributable to sources both inside and outside of California are required to apportion such income.

Generally, income earned in your business on a regular basis (transactional) or income earned from property used for your business (functional) is business income.

Business income is income from the regular course of trade or business and/or income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the corporation’s regular trade or business operations.

The critical element in determining whether income is “business income” is the identification of the transactions and activities that are the elements of a particular trade or business. In general, all transactions and activities of the corporation that are dependent on or contribute to the operations of the corporation’s economic enterprise as a whole give rise to business income.

The California Supreme Court held that the definition of business income contains both a transactional test and a functional test and includes income from the sale of a business asset or right, even if the income is derived from an extraordinary event (Hoechst Celanese Corp. vs. Franchise Tax Board, (2001) 25 Cal. 4th 508).

Nonbusiness income is not subject to apportionment.

Once apportionment calculations are completed, state tax returns must be prepared and filed. If you are a pass-through entity (PTE) such as an S corporation or partnership, there are generally two options-

• File a typical business tax return, and if necessary, pay entity-level income tax withholding on behalf of non-resident owners, or

• File a composite tax return and pay taxes on behalf of the non-resident owners which precludes the need to file state income tax returns on the individual level.

What is entity-level income tax withholding? If there is a state filing requirement, the business entity is required to calculate and “pay” withholding on each non-resident owner. This ensures the state receives cash associated with the taxed activities of the pass-through entity (PTE). From there, each owner is required to file a non-resident income tax return to ultimately reconcile the withholding calculation and the tax liability- this is no different than you filing a 1040 tax return which reconciles your W-2 income tax withholding against your tax liability, and refunds any excess amounts.

What the heck is a composite tax return? According to The Tax Adviser,

“a composite return is an individual return filed by the passthrough entity that reports the state income of all the nonresident owners or, in some cases, the electing members, as one group. Filing the composite return can also relieve the passthrough entity of the withholding requirement that many states impose on passthrough entities with nonresident owners. The state gets its money while the owners’ personal filing obligations are reduced.”

Sounds cool, right? Well, maybe! There are situations where this makes sense, and there are clearly situations where it does not.

The big benefit is this- it lowers tax return preparation fees on the individual tax return level, and more importantly, it shrinks each owners’ tax footprint and risk in a bunch of states. Shrinking your tax footprint and subsequent risk is nice, like real nice.

The big downside is this- composite tax returns tend to overpay taxes to the state since certain credits and deductions on the individual level are not accounted for. Also, not every state allows for composite tax returns. However, this can beviewed as buying down your risk. Yeah, sure, swapping cash for risk might not sit well, but it should.

If you are operating a pass-through entity (PTE) such as a partnership filing Form 1065 or an S corporation filing Form 1120S, and you have multiple owners in multiple states, we should chat.

As you might see, state apportionment calculations and filing thresholds are tricky. Here’s the mud-

• Just because your business has a sales tax obligation does not mean you have a state apportionment and possible income tax obligation. Sales tax and income tax are not the same thing. Having said that, states are aligning their nexus thresholds, bright lines and triggers between sales tax and income tax (makes sense, right? if you have a sales tax obligation, you are likely doing business, and if you are doing business then let’s collect some income tax).

• Just because your business is registered as a foreign entity (foreign qualification) in another state does not mean you have a state apportionment and possible income tax obligation (but it is getting more and more likely).

• Just because your business is deemed to be doing business in another state does not mean you have a state apportionment and possible income tax obligation.

• Just because your business is not registered as a foreign entity in another state does not absolve you from having a state apportionment and possible income tax obligation.

• Just because your business has a state apportionment obligation does not mean you are deemed to be doing business in that state nor does it mean you have an income tax obligation.

Yup! Nutty! What does WCG CPAs & Advisors do? When clear answers present themselves such as California’s sales, payroll and property bright lines above, our hands are tied. There are times where you must register (foreign qualify) in a state to process payroll, and again, our hands are tied. Taking this one step further, there are some states where the Secretary of State shares data with the Department of Revenue, and letters are mailed saying something like, “Hey there, friend, you are registered in our lovely state. Did you forget to file an income tax return? Just trying to be helpful over here.” Whenever someone calls you “friend” it is unlikely they are indeed your friend.

When it is murky or tricky or muddy, then we take a risk-based approach and discuss with you. Sure, we can file in a zillion states… a payroll dollar here, a sales dollar there… but that is insane from a fee and risk perspective.

As mentioned above, this is a two-step process-

• calculate the apportionment and determine filing requirements, and then

• prepare state income tax returns for the business (and possibly the owners too)

This can get messy really fast. Apportionment calcs and determination of filing requirements is usually $100 to $250 per taxing jurisdiction (state or local municipality) where this is material activity. For example, you sell your services all over the country, and you’ve traced $12,000 of revenue to Idaho. You don’t have any property or payroll in Idaho. This clearly does not trip nexus or doing business in Idaho, and we can move along quickly without a fee.

Here is a sample of our workpaper from a client’s recent business activities-

State	Sales	Payroll	Property	Nexus	Filing
CA	38,065
CO	3,673,400	1,814,947		Owner	Common
FL	584,283			NA
GA	537,783	338,497		Both	Composite
IL	293,205			Sales	Composite
IN	112,485	96,923		Both	Composite
MI	223,409			NA
MO	33,500	55,000		Owner	Common
NC	238,715			Sales	Composite
OH	256,280	158,750		Payroll	Composite
PA	176,220	148,100		Payroll	Composite
TX	326,765	326,754		Payroll	Common
WA	8,900
WI	26,075

In this example, we had 14 states where we had to stop, research and determine filing requirements. Some were obvious- some were a bit more challenging. Our fee, for just apportionment calculation and filing requirement determination, was $750. They had good books, and they are cool client to work with.

WCG CPAs & Advisors uses Thomson Reuters Checkpoint and Bloomberg Tax for our research tools ($25,000 annual cost for these… not trying to complain, but damn!). We then throw it into Copilot and ChatGPT to keep these overly expensive research tools honest. Why not, right? Two men say they’re Jesus, you know one’s lying.

Back to our example above. We had state income tax returns to prepare and file. Similar to apportionment calculations, this varies between $100 to $250 per taxing jurisdiction. In our example above, we are filing 8 state tax returns- Two of these tax returns are routine since the owners live in Colorado and Missouri. However, the other six state tax returns had a combined fee of $1,200.

Our total fee was $1,800 for the base S Corp tax return (Form 1120S), plus $750 and $1,200 for a total of $3,750. Yes, there might be additional state tax returns for the owners requiring increased tax return preparation fees. Hey, we didn’t make the rules.

It’s a crummy deal. The internet has allowed us to pursue opportunities all around the world. However, our founding fathers and mothers in the late 1700’s never envisioned interstate commerce the way it is today. To make matters worse, each state has their own way of doing business and defining terms. It is not easy. Not one bit.

Sidebar: We mentioned taxing jurisdiction twice. Most taxing jurisdictions when it comes to tax returns means a state, however, cities and even counties at times can come into play. City of Portland and Multnomah county comes to mind (not to mention Tri-Met which adds Clackamas and Washington counties). New York City is another.

Apportionment does not necessarily apply to rental property activities since each building is normally contained within a taxing jurisdiction and reported as such. However, we briefly mention a few things here-

You live in Colorado and have a rental property in California. You will need to file a California non-resident tax return even if the rental loses money. You have an income-generating asset in their state. Also, please consider that a taxing jurisdiction has the right to inspect your books and records to ensure your loss is truly a loss.

If we prepare a tax return with a rental property, WCG CPAs & Advisors has two possible add-on fees for additional tax returns: $125 for streamlined (in addition to your resident state) and $200 for complex where the state or taxing jurisdiction requires separate business or gross receipts filings. Keep in mind that some states and cities consider rental properties to be business ventures like any other, and more are focusing on short-term rentals as well. What makes things worse is that some taxing jurisdictions will impose an income tax based on gross rental receipts regardless if the activity is profitable.

While we have your attention or perhaps even your interest, please read our State Problems With Your Rental Property section from our book “I Just Got A Rental, What Do I Do?“

We primarily discussed state apportionment from a business entity perspective. For those businesses taxed as an S corporation or partnership, apportionment information for each shareholder, member, owner, etc. will be detailed on the K-1. A K-1 is a tax document generated in the process of preparing Form 1120S or Form 1065 (including Form 1041), and details the allocated income or loss to each recipient. However, the K-1 will also detail the apportioned state income or loss.

There are two general paths-

• Prepare and file the state income tax return as a resident or non-resident depending on your residency and the state, and should you exceed filing thresholds requiring a state income tax return.

• Skip filing the state income tax return since the business entity filed a composite tax return partly on your behalf.

At times it is silly to file a state tax return just to receive a refund. For example, your business entity did entity-level tax withholding and submitted these taxes to the state on your behalf. After reviewing the state income filing thresholds, you determine that you are not required to file a state tax return. However, $225 was paid by the entity as income tax withholding. Is it worth the pain, risk and tax preparation fees to grab this $225. Maybe, maybe not. Free money to the state.

What’s an example of a filing threshold? For 2024 California Form 540NR tax returns, an example, if you are single and have California adjusted gross income under $17,818 for the 2024 tax year, you are not required to file. Colorado? $5,500 in gross income. Who wants more? For the 2024 tax year, non-residents of New York must file a state tax return (Form IT-203) if their New York adjusted gross income exceeds the New York standard deduction which is $8,000 for singles.

Keep in mind the pass-through entity tax deduction to avoid state and local tax limits of $10,000 (SALT). States got creative, and created a state tax that was deducted on partnerships and S corporations (otherwise called pass-through entities, or PTE for short) resulting in lower federal taxable income. This tax was in turn credited to the small business owner resulting in lower state income taxes being reported on Schedule A. This is a workaround to the SALT limit, and nearly all states have enacted legislation to do just that.

What does this mean to you? If your business entity elected into the pass-through entity tax (PTET) system, and paid this tax on your behalf, you might have a reason similar to entity-level tax withholding above.

Do you have questions about filing in multiple states? Not sure if you should foreign qualify as doing business in another state? We can certainly help with state apportionment and determining your filing obligations.

WCG CPAs & Advisors is a full service consultation and tax return preparation firm, and we look forward to working with you!