My Top 10 State Tax Concerns for Middle Market Companies

Good morning. It's February. The weather can't decide if it's still winter or spring (at least in Tennessee). The seesaw begins. The roller coaster. The uncertainty of when winter will end and spring will begin. One certainty is that change is in the air. The same goes for state and local taxes (SALT) as state legislatures are in session or will be in session and Governor's have already proposed changes. Over the next few months we will learn what changes get passed and those that won't. Regardless of what may or may not happen, there are trends that middle market companies should be concerned about.

1. Economic nexus is still a big concern for sales tax purposes. However, it is becoming even more important for state income tax purposes. (Economic nexus is simply defined as having a taxable presence in a state even when you don't physically enter the state).

2. State conformity to the Internal Revenue Code and the One Big Beautiful Bill Act (OBBBA) will make state income tax returns more complicated this year. States will continue to slowly conform or not conform (decouple).

3. Sales sourcing is likely the most important factor that middle market companies should be focused on getting right. Where and how a company sources their sales not only determines economic nexus, it impacts how much income gets taxed by a state for income tax purposes and where or when sales tax collection obligations occur.

4. Speaking of sales sourcing, knowing when and when not to use "look-through" sourcing (i.e., sourcing your sales to your customer's customer location versus your customer's location or "ship-to" state) is a growing challenge and complexity.

5. Sales tax on additional services continues to expand state by state.

6. Sales tax on digital goods and services continues to expand state by state.

7. The question of whether you are selling software or a service continues to be litigated or challenged. States leaning to treat these types of transactions as the taxable sale of software or SaaS.

8. The great federal law of 1959 (P.L. 86-272) that protects certain companies from state income tax continues to be whiddled away and its protections challenged and litigated. Companies should take this protective stance thoughtfully and carefully and well documented. It should not be taken lightly with assumptions. States are aggressively auditing companies that take this position.

9. Residency audits are on the rise as individuals attempt to move from high tax states to no tax states while maintaining a residence in the high-tax state. Several states are proposing higher tax rates (or new taxes) on "wealthy" taxpayers.

10. Pass-through entity tax elections (PTET) remain a viable option for owners of partnerships, S corporations and other pass-through entities despite the increase in the SALT CAP (federal individual itemized tax deduction). Knowing when to make an election still requires careful analysis.

Those are my top 10 trends or concerns for middle market companies. Trust me - there are many more, but these are the big bucket items, depending on your situation.

If you have questions or concerns on any of the above or other state tax issues, feel free to reach out. Don't wait for problems to arise (i.e., notices, audit assessments, additional tax, interest and penalties).

Stay safe. Stay warm. Stay sharp.

Don't let the past dictate your future. Free your company so it can move forward with confidence.

a problem is a terrible thing to waste

I gave a SALT (state and local tax) update at Frazier & Deeter Atlanta CPE day this week and spoke about sales tax problems (opportunities) that companies are facing. I entitled it, "A Problem is A Terrible Thing to Waste."

I deal with problems every day - work, clients, home, etc. But how do you look at problems? Are the problems really opportunities?

From a sales tax standpoint, problems (opportunities) are created by business changes and tax law changes (and the lack of uniformity among the states, and clarity among existing laws).

Sales tax can be more painful than income tax. How you ask? Because a company's obligation to collect can become their obligation to pay (out of their own pocket). Something that a company was supposed to collect from somone else will become their expense if they can't prove the customer already paid it or obtain some type of exemption certificate from the customer.

Economic nexus (Wayfair US Supreme Court Case in 2018) changed the sales tax world dramatically. Caused companies that were filing sales tax returns in 2 states to start filing in 30 states. Playing the "wait and see game" has truly come to an end.

In decisions in Texas, the Comproller asserts that a company licensing software to customers in Texas has a physical presence in Texas. The Comptroller contends that computer software programs are the equivalent of physical property in the state. Thus, the lease, license or rental of software means the seller owns property in the state that is being used by a customer.

Sales sourcing is a mess if you don't sell tangible property. Companies generally use the shipping address; however, when you sell services or digital goods, SaaS, etc. you don't have a "ship to" address. You have a "billing address." Unfortunately, companies who source sales according to the billing address are likely sourcing sales incorrectly. This could create a problem (opportunity). Sales of services, digitial goods and SaaS are generally sourced to where the service is received, or the digital goods and SaaS are used. Consequently, if a buyer has users in multiple states, the sale should be sourced to multiple states, not one.

When selling digital goods, services and/or SaaS, the question becomes "what is the customer actually buying"? What is the "true-object" or "primary purpose" of the transaction? The problem (opportunity) with these transactions is that they are usually bundled together. Thus, if one item is taxable, the whole transaction may be taxable. However, if you can prove that the true-object is the nontaxable item, then the whole transaction may be nontaxable. Tennessee has several rulings that reflect this analysis.

Is AI (artificial intelligence) taxable? No one is looking at this. No one is talking about this. This will sneak up on the states similar to when SaaS took over tangible sales of software. AI could be a nontaxable service, information service, data processing, SaaS, custom software, or something else. Chicago has said they are taxing ChatGPT.

Marketplace facilitators are facing an attack from Texas. Texas is asserting that everything is data processing (taxable). This includes the commission/revenue share or "marketplace provider commissions (MPC) or fees.

Procurement companies are still a great idea for sales tax deferral, cash flow benefits and paying sales tax (use tax) to the correct state, but accurate implementation is key. Transactions between entities must be legit and papered. There must be substance and actual transactions between the entities.