The Future of State Taxes

The landscape of state taxes is poised for significant transformation in the new year. Businesses must prepare for the evolving interpretations of state tax laws, groundbreaking court decisions and new approaches to managing prospective and historical tax liabilities. This article explores three major areas of change in state taxes: the future implications of Public Law 86-272, emerging trends in service revenue sourcing for income tax purposes and innovative strategies for addressing both prospective and prior-year tax exposures.

1. The Changing Interpretation of Public Law 86-272

Public Law 86-272, enacted in 1959, provides that states cannot impose a net income tax on businesses whose only activity within the state is soliciting orders for sales of tangible personal property, provided these orders are approved and fulfilled outside the state. While this law has long provided clear guidance, recent developments have led to its evolving interpretation.

With the rise of digital and remote business activities, states are reevaluating the scope of PL 86-272. For example, electronic communications with customers, online services and other digital interactions are increasingly scrutinized. The Multistate Tax Commission proposed guidance concerning PL 86-272 for states to consider adopting. States like California, New Jersey and New York have issued new guidelines indicating that certain online activities may exceed the “mere solicitation” standard for PL 86-272’s protections and subject businesses to state income tax despite historical protections under PL 86-272. These guidelines have been challenged in various ways in these and other states.

Businesses must stay informed of these changes and regularly reconsider their nexus footprint to ensure compliance with state tax obligations. Expanding state interpretations are expected in the coming years.

2. Recent Cases Impacting the Sourcing of Services for Income Tax Purposes

Sourcing of service revenues for state income tax apportionment purposes has always been complex, and recent court cases have further influenced this area. Historically, states followed either a cost-of-performance or market-based sourcing method to determine where service revenue should be taxed.

Several cases recently helped to interpret the sourcing rules in Florida and Texas. Also, California and New York recently published proposed and final regulations regarding the application of their market-based sourcing rules. Depending on the company's operations, these rulings and regulations may change how taxpayers have historically sourced sales in these states.

These shifts can lead to substantial tax liability changes for service providers. Businesses must stay updated on the specific sourcing rules in each state to report and allocate service revenue accurately.

3. Strategies for Addressing Prior-Year Tax Exposure

Businesses that exclusively focus on prospective tax exposure and neglect potential liabilities from prior years open themselves to significant risks and financial penalties. This is commonly seen with taxpayers making business decisions that address prospective sales tax compliance.

States are increasingly vigilant in identifying and pursuing past tax liabilities, with many having enhanced their audit capabilities and conducting more frequent and comprehensive audits. We have seen an increased likelihood of audits for clients who decide not to address historical tax liabilities and file only on a prospective basis. However, voluntary disclosure programs (VDAs) are available in most jurisdictions, allowing businesses to come forward and address past non-compliance with reduced penalties.

It is crucial for businesses to conduct regular nexus reviews and consider historical liabilities as part of their overall tax strategy. Businesses can mitigate risks and ensure compliance by addressing prospective and prior-year exposures, avoiding unexpected financial repercussions. A taxpayer's actions can hinder their ability to enter into VDA agreements, so fully understanding the exposure before actions are taken is critical.

Conclusion

The landscape of state taxes is undergoing significant changes, driven by evolving interpretations of laws like PL 86-272, critical court cases and new regulations affecting the sourcing of service revenues and states' proactive measures to address historical non-compliance. Businesses must remain vigilant, stay informed of these changes and adopt comprehensive tax compliance strategies encompassing current and prior-year obligations. By doing so, they can navigate the complexities of state tax requirements and minimize potential risks.

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