Multistate Tax Issues for Construction Contractors
Multistate Tax Issues for Construction Contractors
The construction industry is no stranger to change, whether on the macro-economic level or the individual project level: tight margins, project delays, scope changes, skilled labor shortages, materials price increases, and many other challenges all seem to be a normal part of everyday life. However, the past two years have also ushered in a whole new set of changes, including unprecedented expansions in government monetary policy (e.g., PPP loans, EIDL grants, Economic Impact Payments, and the Federal Reserve’s removal of banking reserve limits); large-scale supply-chain issues; the release of new Federal infrastructure funds; and record-setting levels of inflation. As construction and contracting firms struggle to adapt to all these changes, it is imperative they do not forget a vital component of their overall business strategy: taxes.
Like businesses of all types, states have also been changing the way they administer their tax systems. Some offered temporary relief to businesses with remote employees during the Coronavirus Pandemic, but many are now in process of ending that grace period. Some are even providing expanded temporary sales tax holidays or exemptions for different types of goods (e.g., groceries, fuel, tools, energy-efficient appliances, garage doors and windows) or industries (see Tennessee’s Broadband Investment Maximization Act). However, many are simultaneously getting more aggressive in their audit and enforcement activities, as they look to replace or increase revenues lost during the Pandemic.
All these changes carry both silver linings and hidden threats for taxpayers, and construction contractors are especially susceptible, as firms continue seeking more or better work and improved margins by expanding their territory farther from their traditional base of operations. With cross-border moves, a host of state and local tax laws can easily (and unknowingly) be triggered, so it is now more important than ever to know the stakes before venturing out in search of greener pastures. This article deals with a few of the more common areas of concern, with regard to state and local taxes and the contractor.
Triggering Taxes in New States & Localities
First things first: what can trigger new state and local taxes? The short answer is “nexus.” “Nexus” in the context of tax law is a fancy Latin-derived word expressing the idea of a “connection” or “binding together” of a business with a government—a connection sufficient to allow the government to exercise its statutory authority to tax upon the business and its activities. The theory of nexus is simple to understand, but it can be difficult to apply. One reason for this is that there are different standards or nexus for different taxes. For example, in order to impose sales and use tax on a business, a state must show the business has consummated sales totaling $100,000 within the state or else that the business has made 200 separate sales transactions within the state. However, for a state to impose income tax on a business, the threshold may be expressed differently. Examples of things that can create income tax nexus include owning or leasing property (real or personal, tangible or intangible) in a state; having one employee (or, in some cases, one independent contractor) working in the state; or deriving income from a single contract performed in the state. Another reason the principle of nexus can be difficult to apply is that each state has different rules for what constitutes nexus within its jurisdiction; there is not a single, common standard. And, it should be noted that, while having nexus with a state subject the entity to the state’s tax laws and usually means the business is required to file a tax return with that state, it does not necessarily mean that the business will owe any taxes! A simple example of this can occur when a firm has income tax nexus with a state, but that state allows (or requires) it to use a single sales factor apportionment model, discussed later.
Now that we understand better what nexus is and how it works, let’s take a look about three broad types of taxes and why contractors should take note of them.
Multistate Income Tax Issues
Once income tax nexus is established for contractors with a state other than their home state, their income is generally subject to allocation and/or apportionment, which, in effect, is the way a state will try to approximate and tax only the income earned by activities carried on within its borders. “Allocation” is the means of identifying specific types and amounts of income earned within a state, while “apportionment” is the means of prorating via mathematical formula an approximate amount of income earned by a company’s in-state activities.
In practice, apportionment is, by far, the more common method used by firms to divvy up the overwhelming majority of their income among states, and, for contractors, there are two major ways apportionment is applied—to wit, the “multi-factor” model and the “single-sales factor” model. The first of these models is the more traditional approach, which many states take and in which in-state sales, payroll, and property ratios are weighted and combined to produce an apportionment factor; this apportionment factor is then applied to all apportionable income earned by the company, and the tax rate is applied to the result. The second model has become much more widely accepted among the states and is far easier to apply: as you would guess from its name, the “single-sales” model apportions income to a state based solely on the relative amount of gross receipts earned within that state to gross receipts earned in all states; some states tweak this model, using a “double-sales” factor. Still, it is important to understand that different models exist and the basics of how they work, as contractors may be required to use one apportionment model in some states and a different model in others, and the model required will affect what data the contractor needs to track on a job-by-job and state-by-state (or even locality-by-locality) basis. For example, tracking revenue by project and state may be necessary for operations in a single-sales factor state, while tracking equipment rentals, materials and equipment storage, and payroll on a state-by-state basis is also needed for operations in a multi-factor locale. It is also worth noting here, as mentioned previously, that a sales-based factor for apportionment can result in no tax being owed to a state with which a company has nexus; this assumes that in the given year, no significant sales were transacted in or sourced to that state.
And, before we move away from income taxes, we should mention the issue of “conformity.” In the U.S., each state maintains its own level of conformity (or lack thereof) with the Internal Revenue Code (IRC). This conformity may be maintained on a fixed-date basis (where the state legislature votes infrequently on whether to adopt new changes made to the IRC, as those changes are actually made) or on a rolling basis (where the legislature typically votes each year on whether to adopt changes to the IRC). Each state’s level of conformity will affect its apportionable, and thus taxable, amount of income. Common areas where state and Federal tax law conflict are in the timing of §179 expense, bonus depreciation, charitable contribution, and other deductions, as well as in some specific items that should be included in or excluded from taxable income for state purposes.
Multistate Sales Tax Issues
As with income tax, different jurisdictions define and apply nexus standards in different ways for sales and use tax. Most have worked through their legislatures and administrative agencies new laws and rules that effectively switch them to an “economic nexus” standard, following the Wayfair decision of 2018. And since then practitioners have been seeing an increase in enforcement activity and litigation on the part of state sales tax auditors, as the new laws are implemented and tested. States have only increased these activities as they look to bolster budgets and replace revenue shortfalls due to the Pandemic and other factors, like the increased migration of taxpayers to lower-tax jurisdictions. These changes in law and increased enforcement activity, in general, highlight the need both for robust tracking of costs and jurisdictional nuances and for diligence in collecting and remitting sales and use tax and filing related reports timely. However, for contractors, they offer even more reasons to take note.
First, contractors should consider the sheer number of sales tax jurisdictions in the United States: by one estimate, there are as many as 11,000 among the 45 states (and the District of Columbia) that impose the tax. This provides a lot of room for error in identifying when a contractor’s activities have created nexus with one of those jurisdictions.
Second, contractors should realize states do not have a single, unified standard for what constitutes a taxable transaction and what does not. As an example, take the end-user laws for the installation of construction materials: in Tennessee, a non-profit entity is allowed to purchase construction supplies for its own use and have a contractor install them without the contractor incurring a requirement to collect or file sales or use tax on the materials; however, in Virginia, this is not the case. As another example, states differ in what sales tax holidays or exemptions may apply to an individual contractor, and an exemption or exempt purchase in one state may not be respected in another state. Different rules among states provide more opportunities to unwittingly run afoul of the rules, incurring costly consequences.
Third, given the nature of many construction companies and their related parties, intercompany transactions and transactions between the companies and their owners are common. And while these might be properly handled at the Federal income tax level, they may be inadequately accounted for at the state or local level for sales tax. For example, equipment owned by one company and rented to a related company may need to have state sales tax charged on it in some locations; similarly, the owner's use of a company credit card may cause the company as the cardholder to incur an unexpected sales tax liability on the owner’s personal charges. States are becoming increasingly aggressive in auditing these related-party transactions, as they look for novel arguments to support new ways to increase the state’s revenues.
Finally, contractors should be aware of the need to watch for even “small” disclosures related to sales and use tax owed on other tax forms, as their answers could be used against them during an audit. Many states have been including checkboxes on non-sales tax returns that require the taxpayer to affirm whether or not it owed sales tax at the time of filing. Don’t sign that return before looking at the checkboxes and making sure it is properly answered!
Payroll Tax Issues
When it comes to multistate operations and payroll taxes, construction firms should be aware of four main issues: how to source payroll to individual states; when they are required to withhold state income tax for their employees; how voluntary withholding of state income taxes for employees may create nexus; and to which state they should pay unemployment insurance contributions.
Generally, payroll is sourced to states based upon where the underlying services are performed. This holds true for most construction projects, especially for purposes of reporting wages for apportionment schedules. However, things are less straightforward when it comes to state income tax withholding for an employee who lives and works in different states. In these cases, the state where services are actually performed is an important part of the equation, but so is the state of the employee’s residence. This is because some states have reciprocity laws in place that formally govern which state has the right to tax the income of an employee who lives in one of the signatory states and works in the other. These reciprocity laws, in turn, determine which state an employer must withhold under. Generally, reciprocity agreements default to make the state of the employee’s residence the one to whom tax is owed and for whom tax should be withheld by an employer. If no reciprocity agreement exists between the states in question, the laws of each state must be examined, and the employer’s nexus with the employee’s state of residence should be considered.
Due to the existence and operation of reciprocity agreements, it is possible for a contractor to find itself in a situation where it is not legally required to withhold state income tax on the wages of an employee but where it may consider doing so voluntarily, out of courtesy to the employee. In this scenario, an employer may consider doing this, so a high-performing employee doesn’t have the administrative burden of making estimated income tax payments to the state. However, before acting on this charitable impulse, businesses should be mindful of the potential “nexus trap” inherent in such voluntary reporting. This is because voluntarily establishing and utilizing a payroll tax account with some states may be enough to establish nexus with those states—sometimes it can also even be enough to open the employer to audit risk and business litigation risk in the state.
The decision process is a bit more streamlined, in most cases, when talking about state unemployment contributions payable by employers: generally, these should be paid to the state where the employee is most likely to look for work or apply for unemployment benefits (usually their home state). However, as you might guess, facts and circumstances will always operate to determine whether the “normal” rules can be followed or whether a more “tailored” or researched solution is needed.
In summary, cross-border contracts can be highly lucrative for construction companies and specialty trade contractors, but multi-state operations can bring potential pitfalls, too, especially in light of the ever-changing legal and enforcement landscape of state and local taxation. Determining the tax implications of accepting a contract in another state can become a complicated and nuanced undertaking quickly, as the states vary in their imposition of taxes, their definitions of terminology, and their application of their laws to those who live and work within their geographical borders. And, it is important to realize that, at the end of the day, it is up to each taxpayer to satisfy his own tax obligations in a given jurisdiction. However, a little planning and forethought can afford business owners a tremendous amount of peace-of-mind, when it comes to taxes and potential penalties! At Brown Edwards, we can help you answer those questions, to see whether your current protocols and planning are still viable and whether you may have some hidden tax exposure.