Colorado Reminds Residents that Credit for Taxes Paid to Other States is Based on Colorado Sourcing Rules

In addition to tax rate differences, variations in state apportionment methodologies can impact the amount of credit a resident will receive for income tax paid to other states.

By Jeff Weinkle, SALT manager

In last month’s newsletter, we summarized an Ohio court decision regarding the state’s ability to tax a nonresident’s gain from the sale of equity in a business operating within that state. To recap, the Ohio Supreme Court ruled that the state’s “Closely Held Statute,” which sources to Ohio certain sales of equity interests in companies that conduct business in the state, did not apply to a particular taxpayer since he did not actively participate in the management of the business nor did he conduct a business that was unitary with the sold business. However, the court did not strike down this law in all cases, and it may still apply to other nonresidents in other circumstances.

On April 12, 2016, Colorado issued Private Letter Ruling PLR-16-006, in which it examines this Ohio tax law as it relates to a Colorado resident’s tax liability and draws attention to another important factor in such a transaction: the taxpayer’s resident state credit for taxes paid to another state.

In the Colorado Ruling, the state affirmed that it computes its resident “credit for taxes paid to another state” based on Colorado’s sourcing rules and not Ohio’s. The taxpayer’s credit is then equal to the lower of the computed Colorado tax on this gain (using Colorado apportionment and sourcing rules) or the actual Ohio tax paid on the gain. [1]

Ignoring state tax rate differences, when states’ sourcing rules are the same or similar to other states’ sourcing rules, there is consistency in the application of credit for tax paid to another state. However, when the sourcing rules of a nonresident state are different from that of the resident state, taxpayers may end up paying tax on the same income in multiple states. Two factors largely affect this impact: the difference between states’ construction of their apportionment formulas and the difference in the sourcing rules for that apportionment.

While Colorado and Ohio use similar rules to apportion the gain by using an average of the business’ prior three periods’ apportionment factors, we end up with different outcomes due to the construction of the states’ apportionment formulas. Colorado’s apportionment factor is comprised solely of a measure of the company’s sales, while Ohio’s takes into account the business’ sales, property and payroll.

Further, the composition of the sales factor within those apportionment formulas can create large differences. For example, Colorado sources revenues from services based on the location where the services were rendered, while Ohio sources revenues from services based on the location where the customer receives the benefit of those services. [2] Had the taxpayer’s prior year revenues been comprised of services performed outside of Colorado for Ohio customers, Ohio’s apportionment formula would have resulted in most of the above gain sourced to Ohio while Colorado would source none to their state. This outcome would result in double taxation between the states: a significant nonresident Ohio tax and no resident Colorado credit to offset it. We addressed a similar issue in New Jersey in our May 2015 SALT Newsletter.

Often, taxpayers think that only rate differences can impact the state tax credit amount. For example, if a resident of State A with a four percent state tax rate has $200,000 of income, of which $100,000 is sourced to State B with a six percent state tax rate, then all else being equal, the taxpayer will receive a $4,000 credit in State A even though he paid $6,000 to State B. What this Colorado ruling addresses is whether that $100,000 is the correct amount of income to source to State B in the first place. If, based on State A’s sourcing rules, that $100,000 was reduced to $70,000, then the credit amount is further reduced to $2,800.

Individuals that plan to conduct income-producing activities in multiple states should understand the state income tax consequences of doing so. Aprio’s SALT practice has experience in addressing these issues and providing potential alternative options for minimizing any unfavorable state income tax effects.

Contact Jeff Weinkle, SALT manager, at jeff.weinkle@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the July 2016 SALT Newsletter. To view the newsletter, click here.

[1] See Colorado Rev. Stat. §39-22-108.

[2] See Colorado Rev. Stat. §39-22-303.5(4)(c)(i) & Ohio Rev. Code Ann. §5733.05(B)(2)(c)(ii).

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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