State Taxes That May Go Unnoticed
February 6, 2018
The majority of states impose an income tax as well as a sales and use tax on businesses, but it’s the more unique taxes that can catch many off guard. These taxes are broadly applicable to most businesses and typically come in the form of a gross receipts tax (or modified gross receipts). Businesses that are expanding their physical presence, and more importantly, their customer base to new states, need to be proactive in determining if one of those states imposes this type of tax.
Unlike a typical state income tax—which generally uses federal taxable income as a starting point—a state that imposes a tax based on gross receipts will have no deductions or very limited deductions. Therefore, the fact that a business has a net loss and no tax liability for federal income tax purposes, is largely irrelevant for purposes of a gross receipts tax. Further, states that impose a gross receipts tax tend to have lower thresholds for what constitutes nexus or “doing business” in states for purposes of being subject to the tax.
Here is an overview of a few state taxes that catch many business leaders off guard, whether it be when they are seeking to sell their company and the buyer’s due diligence uncovers a hefty tax exposure, or when the state issues an attention-grabbing estimated tax assessment.
Washington Business and Occupation Tax (B&O)
The B&O tax is Washington’s general business activity tax. Washington does not impose a corporate income tax or an individual income tax on business income from pass-through entities. However, Washington does impose a sales and use tax. The B&O tax is a gross receipts tax with tax rates that vary depending on the particular business activity of the taxpayer. For example, taxpayers falling under the “retailing” classification are subject to a 0.471% rate, whereas service providers generally pay tax at a 1.5% rate. Further, there are over 30 specialized business classifications that have a specific tax rate.
What surprises many businesses about the B&O tax is that it’s imposed on many out-of-state businesses with no physical presence in Washington if the business has more than $267,000 in sales to Washington customers (i.e., the taxpayer has “economic nexus”). This threshold applies to domestic and foreign companies alike. In 2015, the Washington Department of Revenue issued a determination holding that a German pharmaceutical company with no physical presence in Washington was subject to the B&O tax on royalties received that were based on sales of its products in this state because the company royalty receipts were in excess of the Washington sales threshold discussed above. Further, since the B&O is not an income tax, the Department held that the comprehensive tax treaty between the U.S. and Germany did not protect the company from the B&O tax.
Texas Franchise Tax
The Texas Franchise Tax is a modified gross receipt tax imposed on most legal entity types conducting business in the state. Similar to the B&O tax, the Texas Franchise Tax does not follow federal income treatment of pass-through or disregarded entities. Instead, the tax is imposed directly on such entities. Taxpayers subject to the Texas Franchise Tax compute a “taxable margin” that is based on the lesser of following:
- 70% of total revenue
- Revenue less cost of goods sold
- Revenue less compensation
- Revenue less $1 million
Except for smaller businesses, most taxpayers utilize either the revenue less cost of goods sold or revenue less compensation method. Both methodologies require careful attention to what constitutes “compensation” or “cost of goods sold,” as these terms for Texas Franchise Tax purposes do not mirror the federal income tax rules. In addition, taxpayers seeking to use the cost of goods sold method to compute margin, need to confirm they are permitted to do so, as this method is generally limited to sellers of “goods” and a handful of other industries. Thus, most service providers are required to use the revenue less compensation method.
Texas also has unique combined reporting rules. Unlike most state income tax combined reporting regimes, which are usually limited to corporate taxpayers, a Texas Franchise Tax combined reporting group can include varying entity types. Further, incorrectly completing the required affiliate schedule and public information reports will result in forfeiture notices and assessments.
Hawaii Gross Excise Tax
Unlike Washington and Texas, Hawaii does impose a net income tax on businesses. Thus, the Hawaii Gross Excise Tax (GET), which is imposed at a rate of 4.5% when factoring in the 0.5% local tax, is not the only tax broadly imposed on most businesses in the state. Many taxpayers mistake the GET as being similar to a typical state sales and use tax. Although the GET shares some features that are found in many sales and use taxes, there are a number of important distinctions that make the GET more akin to a gross receipts tax (similar to the Washington B&O). These include:
- The GET being imposed on the seller, not the purchaser.
- The GET being imposed on most services.
- There are very few exemptions for sales to the government.
- Sales for resale are subject to tax, albeit at a lower wholesale rate of 0.5%.
Taxpayers providing services in Hawaii need to be proactive in recognizing that their receipts will likely be subject to the GET. Hawaii does allow taxpayers to pass the GET along to customers on an invoice. However, it’s not as simple as charging the customer 4.5% on the purchase price because “gross receipts” are defined to include any tax that the business passes on to the customer. Thus, Hawaii allows taxpayers to charge customers a rate expressed as a percent of the price that is greater than the statutory tax rate on gross receipts. Specifically, the 4.5% tax on gross receipts translates into a maximum visible pass on tax rate of 4.712%.
The taxes discussed above don’t account for all of the unique state taxes business may face throughout the country. Other unique taxes include:
- Ohio’s Commercial Activity Tax
- New Mexico’s Gross Receipts Tax
- Nevada’s Commerce Tax
Certain states also permit localities to impose taxes based on gross receipts. For example, most Virginia localities imposed a business license tax based on gross receipts. Other prominent localities with similar types of taxes include San Francisco and Philadelphia.
To ensure compliance, the best course of action for any business that is expanding into new markets is to be proactive in identifying the taxes that it may be subject to in the applicable jurisdiction.
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