State Income Tax Challenges in a Technology World
July 14, 2023
Contributing Author: Peter Baisch, Senior Manager, State & Local Tax Services
Over the last few decades, the technology industry has been booming with new technology startups. Many of these startups are set up as pass-through entities (PTEs), which provide an easy conduit for one layer of flow-through taxation and often retain favorable exit opportunities from a tax perspective. As these startups grow and take on investors, it’s important that financial managers understand the state tax ramifications of growth. Sales tax has been a hotbed issue in the technology world, especially since the South Dakota v. Wayfair, Inc. U.S Supreme Court decision back in 2018.
More and more states treat software-as-a-service (SaaS) or platform-as-a-service (PaaS), hosting services and other data-processing services as taxable services and subject to sales tax, which shouldn’t be ignored. However, state income tax issues for PTEs generally receive less attention in the technology industry.
State taxing authorities have increasingly become much more aggressive in asserting income tax nexus, even with no physical presence. Nexus is simply the minimum contact needed with a state to become subject to taxation. As often seen, technology companies may only have one office location, which means the sourcing of receipts can be the focal point for how states conclude whether nexus exists. This, coupled with the growing popularity of hiring remote workers, can add additional challenges to navigate nexus.
Prior to the internet age, most services were performed on site, so the sourcing of receipts was generally easier to ascertain. However, in the modern economy, most states have gravitated toward a market-based sourcing regime for how revenue from the sales of services or intangible assets should be sourced among the states. You would think that the states would have a uniform approach in how these market-based rules are applied, but this is generally not the case.
States have varying approaches on how they define market-based sourcing which can include (among other factors):
- Where the service was delivered
- Where the benefits of those services are ultimately received
- Where the customer was located
It is important to also note that because states all have varying rules, these rules can be different based on entity choice. In New York for example, partnerships follow personal income tax rules, not the corporate tax rules for apportionment. Taxpayers must take note of these distinctions for state compliance purposes.
Growing Pains
As technology companies grow and become profitable, additional state income tax compliance complexities begin to take shape for PTEs, especially when the company has a multistate tax footprint or has many owners. The reason for these complexities is due to how states tax PTEs. Unlike federal treatment where the income passes through to the owners and the owners are then responsible for remitting the tax, most states require a PTE to withhold state tax on nonresident owners. This nonresident withholding tax (NRW) requires the entity to remit tax on the nonresident owner’s behalf.
The justification behind this makes a lot of sense. It is much easier for a state to collect the tax owed to it by putting the tax collecting responsibility on the PTE, as opposed to chasing down all business owners. States also understand that this creates additional compliance burdens for nonresident owners to file tax returns in each jurisdiction. This is what led to many states allowing – and some requiring – the filing of a composite tax return. The composite return allows the PTE to file a group return on behalf of some or all the nonresident owners. The composite tax return relieves the owners from the burden of having to file a tax return in that jurisdiction. One consequence for filing a composite return is, in many cases, states with a progressive system will tax income at the highest marginal tax rate. When evaluating which states in which to file a composite return, the resident state of the owners along with other factors play a significant role in that decision-making process.
Owners of a PTE, particularly owners that are other entities, may not want to be withheld on or be allowed to participate in a composite return. There are various reasons why owners may want to opt out of these NRW requirements, including controlling their own internal tax planning process or other administrative reasons. Due to this, some states may not have NRW requirements for certain types of owners or offer a waiver from NRW requirements. These waivers, also called affidavits or consent forms, are signed documents which specify that the nonresident owner agrees to be subject to the state’s income tax, remit estimated tax payments and file returns. A valid waiver will remove the NRW requirement on the entity for that specific owner.
PTE Tax Elections
Over the last couple of years, another big opportunity for many technology clients has been around PTE tax elections. These elections were created by states to circumvent the federal limitation on state and local tax deductions of $10,000 that was imposed on individuals under the federal Tax Cuts and Jobs Act. This allows a taxpayer to make an election to impose the tax at the PTE level, making it fully deductible for federal tax purposes for the PTE. The pass-through ordinary income amounts on the PTE federal K-1s are effectively reduced by the state tax deductions, therefore bypassing the state tax deduction limitation. This can result in significant tax savings for many PTE owners.
A Technology-Enabled Solution
As you can imagine, PTEs can have complex state income tax issues that require significant planning and diligence. With the myriad of nexus, sourcing and state income NRW tax methodologies that are required or available in the various states, Cherry Bekaert can help technology companies navigate these challenges through internally developed, technology-enabled solutions. Cherry Bekaert’s state tax and digital teams have partnered to create a state income tax nexus tool which provides companies with a high-level understanding of their state nexus footprint. Our state tax team works with many technology companies to address nexus and remediation options to get compliant and assist with PTE tax election research and eligibility. Cherry Bekaert also has a new service offering tool that assists with the process of collecting withholding, composite and waiver options, and providing owners with statements listing their multi-state tax information on an individual partner basis.
Let Us Guide You Forward
Contact your Cherry Bekaert advisor or a member of the Firm’s State and Local Tax team today to learn more about how we can use these tools to help your technology company tackle its state income tax issues.