Apportioning Income:A Review of the Basics… and More

The states have been hit hard by the economy over the last few years.  They’ve found themselves in budget shortfalls and are under pressure to enhance existing funding or create new sources of funding.  To alleviate these problems, states are becoming aggressive in how they administer taxes.  While this obviously creates concerns for taxpayers, it also presents opportunities.  One way is through the right to apportion income for income tax purposes.

A taxpayer generally pays tax in each state based on activity within that jurisdiction.  When business is conducted entirely within one state, that state usually has the right to tax all of the taxpayer’s income.  However, a taxpayer with business activity in several states generally must divide income among those states in determining overall state income tax.  This division of income is called apportionment.

To apportion income among the states in which a taxpayer does business, the taxpayer must calculate a percentage based on the business done in each state.  This percentage is multiplied by the taxpayer’s modified federal taxable income to arrive at state taxable income.  For many states, this percentage is a weighted average of the property owned and rented, compensation paid, and sales made within each state.  However, many states have begun to base this percentage solely on the sales attributed to each state.  This determination is much more complex than it might seem, as states differ in how sales within the state are determined.  While the complexity may seem daunting, it presents special opportunities for taxpayers.

To apportion, a taxpayer must meet certain requirements.  These requirements vary from state to state.  Under the Division of Income for Tax Purposes Act (“UDITPA”) which has been adopted at least in part by many states, a taxpayer must be “taxable both within and without this state”.   There are two ways states apply this.  First, a taxpayer must actually be subject to income tax in another state.  The second is the “notional” or “hypothetical” standard.  Under this concept, if another state has the right to tax the taxpayer, income may be apportioned, regardless of whether the other state actually subjects the taxpayer to a tax.

For example, Florida applies the hypothetical standard.   Incorporation, possibly registration to do business with another state, may satisfy this requirement, even if the taxpayer is not actually subject to tax in the other state.   Actual business operations may not be required.  On the other hand, New Jersey applies a quite different requirement.  There, a taxpayer will be permitted to apportion only if that taxpayer has a regular place of business in another state.   Whether a taxpayer is, or could be, subject to tax in another state is not a factor.

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