The early years of a startup are challenging as you navigate financing, hiring, development and managing operations. If state tax considerations are one of the last things on your business’ to-do list, you’re not alone. With the finite resources that come with starting a company from the ground up, state tax opportunities can easily go overlooked.
However, as your business grows, so will your state tax liabilities and related filing requirements. Staying on top of your business’ state and local filing obligations is more than just compliance. This area of tax offers opportunities for savings, as well as fewer surprises when contemplating a future exit event. Understanding state net operating losses (NOLs), apportionment, and sales and use taxes will be key from the beginning.
Operating losses are characteristic of a startup’s early years. At the federal level, NOLs create a future tax benefit, as you can carry them forward to offset a portion of taxable income down the road. The same can be true at the state level for states in which you file during a loss year. Your state NOL creation may only occur when you timely file a state tax return, as some states and local jurisdictions require a timely filed income tax return to secure an NOL carryover.
Another significant consideration in state NOL creation is the company’s apportionment factor, and understanding how each jurisdiction in which you are doing business assigns income to their state. While many states have moved to single sales factor apportionment — in which only the sales factor is used to determine how much income should be attributed to each state for tax purposes — there is also a three-factor apportionment formula that considers payroll, property and sales. Depending on the state, this formula may assign equal weight to the three factors or may weight them differently. Ultimately, your apportionment percentage in a state will drive that state’s NOL creation, but it is not the sole determinant of state compliance.
If you have nexus in a state, regardless of apportionment, that state has the power to tax your business. Your business activities in a state could give rise to nexus if you have a physical presence there, via personnel or property, or if you have receipts in that state above a certain threshold, known as economic nexus.
Filing in states where you anticipate having significant and ongoing apportionment allows for the creation of NOLs in that state, and, depending on the magnitude of the federal loss, this future tax benefit may be significant. As your company eventually turns profitable, you’ll be glad to have created a pool of prior NOLs from which you can reduce your state taxable income and tax liability.
Staying compliant with state and local filing obligations doesn’t begin and end with annual income and franchise tax returns. Your business’ activity in a state can subject you to additional taxes and give rise to other required filings, such as those related to sales and use taxes. It is critical to understand your business’ sales and use footprint, and it is much easier to create a compliance process in the early stages of your company rather than playing compliance catch up later on. A nexus study — an analysis of each aspect of your business activities for purposes of determining your state tax footprint — will help you understand where risk is likely to arise and in what magnitude. Without a periodic evaluation of your multistate activities, you may be absorbing the sales tax liabilities of your customers. Ultimately, a nexus study will help identify these otherwise unknown liabilities, which is important not only to financial statement disclosures, but also in a future exit event.
The sale of your company is the culmination of immense expertise and years of hard work, the value of which should be maximized and preserved. Unfortunately, sales and use liabilities are a common downward purchase price adjustment, which may catch you off guard if you are not proactively evaluating and mitigating risk in this area.
The early years of your company are critical to its longevity, from hiring the right people and developing the best systems and processes, to maximizing long-term tax savings and positioning your company for a successful exit event. While you work hard to grow your business, lean on your tax advisers to keep you not just compliant, but forward thinking and ahead of risk.
Contact Maddie MacStudy or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.