Sourcing Service Receipts

By Scott Salmon, CPA, M.Acc.

Co-Author: Deborah Rood, CPA, MST

Past items in TTA have discussed state taxation of service providers. However, with the advent of telecommuting and the explosion of electronic commerce, “sourcing” a taxpayer’s receipts to a particular state has become much more challenging. While the terms “duty days” and “games played” have become common among practitioners when sourcing services of professional athletes, “sourcing” receipts of other service providers (e.g., systems consultants, architects, outsourcing agencies and trainers) has challenged tax advisers, due to a lack of formal guidance and states’ inconsistent positions. 1


When it comes to the apportionment and allocation of income, many states have adopted the general provisions of both the Uniform Division of Income for Tax Purposes Act (UDITPA) and the Multistate Tax Commission (MTC) regulations interpreting them. Accordingly, practitioners often use these provisions as general guides to the multistate income tax treatment of personal and professional services. However, as is discussed below, a growing minority of states employ several other methods for sourcing service income.

Sourcing Service Revenue

The UDITPA provision on the sourcing of service income is short and straightforward. It simply provides that sales, other than sales of tangible personal property, are in a state if the income-producing activity is performed (1) in the state; or (2) both in and outside the state and a greater proportion of the income-producing activity is performed in the state than in any other state, based on costs of performance. 2 This is often referred to as the “greater of costs of performance” rule or the “all or nothing” rule.

Example 1: Consulting firm X collects $200,000 from a client in state A, for services provided by an X employee, M, solely in A. X would assign the $200,000 to the A numerator.

Example 2: M from Example 1 has a home office in state B, while X’s main office is in state C. Several employees in C worked on the project ($80,000 associated payroll and project costs); M spent 60% of her project time in B, with $34,000 associated payroll and project costs. In providing the consulting service, M spent only 40% of her time in A; approximately $26,000 in payroll travel, meals, lodging, etc. was related to the project in A. Including project costs, X’s entire costs of performance were $140,000. Using the all-or-nothing rule, X incurred more than 50% of the costs of performance in C ($80,000/$140,000); thus, the $200,000 in sales receipts would be assigned there.

Defining income-producing activity: The UDITPA does not define “income producing activity.” The MTC regulations provide only a general definition of the term. MTC Regulation IV.17(2) defines an “income producing activity” as applying to “each separate item of income” and meaning the “transactions and activity directly engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profit.”

Individual or aggregate evaluation: As noted above, the definition of income-producing activity found in the MTC regulations is not specific. One area of confusion is how strictly the phrase “each separate item of income” should be interpreted. Two states have addressed this general issue in the last year, with very different results.

In July 2006, the Massachusetts Appellate Tax Board (ATB) held 3 that a Massachusetts-based company that assembled vacation packages was required to source all its receipts to that state under the state’s costs-of-performance rule. The state did not conform to the MTC regulations in this case, but implemented substantially similar provisions. The ATB rejected the taxpayer’s argument that each separate vacation package should be treated as a separate income-producing activity, finding that the relevant activity was the overall operation of a business that sold tour packages, the costs of which were incurred in Massachusetts. The ATB stated that the taxpayer was engaged in the activity of marketing vacation packages, and its receipts should not be fractured into mini-transactions for purposes of defining income-producing activity. This decision was consistent with a 2003 ATB ruling that ultimately was upheld by the state’s Supreme Judicial Court. 4

In contrast, the Michigan Department of Treasury (MDOT), in late 2006, released guidance on the proper application of the costs-of-performance rule. 5 Although Michigan does not adopt the MTC regulations, sales of other than tangible personal property are attributed to the state if a greater proportion of the income-producing activity is performed there, based on costs of performance, and many of the core provisions are functionally similar. The guidance clarified that the costs-of-performance analysis does not apply to the taxpayer’s total business activity, but to each separate sale transaction.

Lost in this confusion are the potentially significant ramifications of the use of one method over the other.

Example 3: X Co. provides information technology consulting services in several states. It has two significant contracts, one for $500,000 and the other for $1 million. The first contract is performed more than 50% in state A, approximately 30% in state B and approximately 20% in state C. The second contract is performed wholly outside A. Assuming A conforms to the UDITPA and MTC rules, $500,000 of gross receipts would be sourced to A if it takes the position that each contract is a separate income-producing activity. Alternatively, if A takes the position that the income-producing activity is information technology consulting services as a whole, no gross receipts would be sourced to it.

For certain taxpayers, attempting to measure income-producing activities on a transaction-by-transaction basis could be an enormously complex compliance burden. Another practical consideration could be whether each activity, even if abundant in numerical terms, is relatively homogeneous or completely unique. When a taxpayer has thousands (even millions) of transactions per year, analyzing the location of the greater costs of performance could be overwhelming; but, as illustrated above, the differences in results could be stark.

Use of independent contractors: Interestingly, the definition of income-producing activity under MTC Regulation IV.17(2) excludes “transactions and activities performed on behalf of a taxpayer, such as those conducted on its behalf by an independent contractor.” Thus, payments to independent contractors generally are ignored in determining the costs of performance for a particular income-producing activity.

Example 4: S, a construction contractor based in state A, obtains a project in state B. Generally, S would use its own employees to perform the contract and the receipts would be taxed in B. However, S instead opts to use independent contractors in B for this project and will plan and manage the project exclusively from A. The costs related to the independent contractors in B generally would not be considered an income-producing activity and would not be a cost of performance when sourcing receipts from the contract.

Recently, this provision has been the subject of increased scrutiny, on account of both its perceived fairness and its potential for manipulation. In 2004, the Virginia Supreme Court ruled 6 that a regulation interpreting its financial corporation apportionment provisions exceeded the scope of the governing statute, by excluding from costs of performance costs incurred in activities performed on the taxpayer’s behalf. Although neither the Virginia statute nor the interpreting regulation defined or addressed “income producing activity” (the exclusion was provided in the regulation’s definition of costs of performance), a similar conclusion could be drawn regarding the relationship between the UDITPA provision and the exclusion provided in the MTC definition of income-producing activity. 7 Notably, the MTC is currently in the process of a uniformity project that would address the independent contractor exclusion (often referred to as the “on behalf” rule) by generally including such costs in the definitions of both income-producing activity and costs of performance. 8

In addition, the California Franchise Tax Board (FTB) recently ruled on the application of the “on behalf of” rule to sourcing receipts in a unitary combined report. 9 The ruling provided that when a taxpayer provides services to a third party and subcontracts with a unitary affiliate to provide a portion of the services, the unitary subcontractor/affiliate’s activities should be included in the measure of income-producing activities, because they contribute to the unitary group’s business income. The ruling explains that the “on behalf of” exclusion would not be triggered, because the subcontractor’s activities would be considered “directly engaged in by the taxpayer.” However, it also notes that, if the subcontractor is not a combined-group member, the “on behalf of” exclusion would apply.

Defining costs of performance: Under MTC Regulation IV.17(3), “costs of performance” means the direct costs determined consistently under generally accepted accounting principles and compliant with accepted conditions or practices in the taxpayer’s business industry group. Neither the MTC regulations nor comparable state provisions have historically provided much support on how to calculate or determine the components of costs of performance. Similar to many issues in this area, very little guidance has been issued, and that which has been provided can be contradictory.

For example, the aforementioned MDOT guidance also clarified the direct costs used in calculating costs of performance. It stated that direct costs include only costs directly related to the activity performed for the client, and do not include fixed costs unrelated to the provision of services or remotely related costs (such as human resource management, accounting, advertising or activities conducted to maintain the business, but not to provide the business activity in question). However, in the Massachusetts decision previously mentioned, the ATB approvingly noted that the overhead costs of operating the taxpayer’s home office should be included in determining the taxpayer’s overall costs of performance. 10

Special rule for personal services: MTC Regulation IV.17(4)(B)(c) provides a special rule for the assignment of gross receipts from the performance of personal services. Initially, the regulation espouses the general “all or nothing” approach, stating that “if services relating to a single item of income are performed partly within and partly without this state, the gross receipts from the performance of such services shall be attributable to this state only if the greater proportion of the services was performed in the state, based on costs of performance.”

However, the regulation then abruptly changes course, essentially providing that the general rule really is the exception in the area of personal services:

where services are performed partly within and partly without this state, the services performed in each state will constitute a separate income producing activity; in such cases, the gross receipts from the performance of services attributable to this state shall be measured by the ratio which the time spent in performing the services in this state bears to the total time spent in performing the services everywhere. Time spent in performing services includes the amount of time expended in the performance of a contract or other obligation which gives rise to such gross receipts.

This is referred to as the “time spread” method. The MTC regulation offers two examples:

Example 5: P, a road show, gave theatrical performances at various locations in states X and Y during the tax period. All gross receipts from performances given in Y are attributed to it. 11

Example 6: R Corp., a public-opinion survey corporation, conducted a poll via its employees in states X and Y, for $9,000. The project required 600 hours to obtain the basic data and prepare the survey report. Of the 600 hours, 200 were expended in Y. The receipts attributable to Y are $3,000 ((200/600) × $9,000). 12

What is a personal service? The regulation does not define the type of service that is a “personal service.” The activities illustrated by the examples are somewhat diverse and provide little guidance. The question remains as to the types of services to which this rule applies.

Although the term “personal service” is not expressly defined in the Internal Revenue Code, regulations related to the Secs. 269A, 441(i) and 448(d)(2)(A) personal service corporation provisions provide some guidance. In providing the principal activities in which a personal service corporation must be engaged, Regs. Sec. 1.441-3(d)(3) notes that any activity involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting will qualify.

However, the FTB has taken a more expansive view, in its Legal Ruling 2005-1. 13 The ruling finds that limiting the definition to services performed by one individual for the personal benefit of another would be, as indicated by Examples 5 and 6 above, too narrow. However, the ruling opines that the term should not be construed too broadly, such that virtually all services are considered “personal services.” Ultimately, the ruling concludes that “personal services” are not limited to professional services or to specialized services performed by an individual, but are limited to services in which capital is not a material income-producing factor.

Example 7: B Corp., a heavy-equipment construction company located in California, enters into an earth-moving contract with a customer located in another state. B prepares the bid for the contract in California and performs the service in state S. B rents heavy equipment in S. B’s employees spend 25% of their time in California estimating and preparing the bid, and 75% of their time performing the construction activities in S. Employee costs are $800,000 and the equipment rental cost is $5 million, dedicated entirely to a single earth-moving contract in S. Because capital is a material income-producing factor in this situation, the special time-spread rule does not apply. Thus, considering both personnel costs and heavy-equipment costs, the standard costs-of-performance rule would assign the receipts to the state with the greater costs of performance (i.e., to S).

Legal Ruling 2005-1 is instructive in that it provides a definition of personal services that is broader than traditional analysis, which would limit it to the “professional services” enumerated above. Currently, it is not clear how pervasive this interpretation may become.

Differing State Tax Treatments

A number of states either have not adopted or do not strictly conform to either the UDITPA provisions or the MTC regulations as to the sourcing of sales of other than tangible personal property. The variations can be placed into three general buckets: states employing a (1) “percentage costs of performance” method; (2) “greater than 50% costs of performance” method or (3) “market sourcing” method.

Percentage costs of performance: This variation essentially applies the “time spread” method applicable to personal services to all sales other than those of tangible personal property. Essentially, it sources gross receipts based on where the costs of performance were incurred (generally, where the services were performed), regardless of whether the greater costs of performance occurred in one state or another. Currently, this method is used in states such as Connecticut, New Jersey (as a general rule), New York, South Carolina and Texas. 14  For example, the New York regulation addressing receipts from compensation for services provides:

[w]here a lump sum is received by the taxpayer in payment of services performed within and without New York State, the portion of the sum attributable to services performed within New York State is determined on the basis of the relative values of, or amounts of time spent in performance of, such services within and without New York State, or by some other reasonable method. Full details must be submitted with the taxpayer’s report. 15

Greater-than-50% costs of performance: Illinois is unique in that it sources gross receipts from sales other than of tangible personal property to the state only if “a greater proportion of the income-producing activity is performed within [Illinois] than without [Illinois], based on costs of performance.” 16 Accordingly, gross receipts from services will be sourced to Illinois only if more than 50% of the costs of performance are in that state.

Market sourcing: This approach to sourcing service receipts differs greatly from the costs-of-performance approaches discussed above. It sources receipts to the predominant market state (i.e., customer location). Under market-based sourcing, states look to the market for the service or where the benefits of the service were received, rather than to where a company is incurring costs to provide it. This method is being used by a growing number of jurisdictions, currently including Georgia, Iowa, Maryland, Minnesota and Ohio. 17 Some commentators view this method as maintaining a theoretical consistency with the original intent of the sales factor as a market-based or “destination” factor that balances against the role of the property and payroll factors as “origination” factors. 18

Potential for Inequitable or Advantageous Results

The variations between the UDITPA’s “all or nothing” rule and other states’ rules can create situations in which some income-producing activities are taxed more than once, while others are not fully taxed.

Example 8: V, a contractor based in Texas (a percentage state), is working on a client’s home in New Mexico (a UDITPA state). While 80% of the costs of performance occur in Texas, 20% occur in New Mexico. Only 80% of the receipts are sourced to Texas; the remaining 20% escape allocation entirely.

Example 9: T, a systems analyst based in Colorado (a UDITPA state), has a client in Georgia (a market state). About 70% of the costs to provide the consultation are incurred in Colorado and 30% in Georgia. All receipts are sourced to Georgia, because the customer is located there. All receipts are also sourced to Colorado, because the greater costs of performance were incurred there. In total, 200% of the gross receipts are included in the taxpayer’s sales-factor numerators.


In early 2007, the National Conference of Commissioners on Uniform State Laws announced the formation of a study group to review the UDITPA Section 17 rules, in response to a request from the MTC. The MTC’s concerns focus on the differences between the “modern” economy, with its service-driven emphasis (along with accompanying issues surrounding software, various new technologies and intangible assets that have become significant revenue-drivers for many companies), and the issues relevant in the mid-1950s (when the UDITPA was drafted).

Accordingly—and consistent with many areas of state and local taxation—the landscape surrounding the methods used by taxpayers to source service receipts for apportionment purposes is constantly evolving. Taxpayers should proactively review their activities and the apportionment provisions in all of the states involved, to become more familiar with how the inconsistencies among the states affect their operations. If this is done before a taxpayer begins providing services in a particular state, it may be possible to take measures to better manage potential state tax exposures.

Mr. Salmon is the chair, and Ms. Rood is a member, of the AICPA Tax Division’s State & Local Taxation Technical Resource Panel. For more information about this column, contact Mr. Salmon at


1 See, e.g., Schmutter and Lazaar, Tax Clinic, “State Taxation of Professional Athletes and Entertainers,” 35 The Tax Adviser 85 (February 2004).

2 UDITPA Section 17.

3 Interface Group v. Comm’r of Rev., MA ATB, Dkt. Nos. C266670-76, C266680 and C266677-79 (7/18/06).

4 Boston Prof’l Hockey Ass’n, Inc. v. Comm’r of Rev., MA ATB, Dkt. Nos. F250820-23 and F250978-81 (6/30/03), aff’d in part, 820 NE2d 792 (MA Sup. Jud’l Ct. 2005).

5 MDOT, Intern’l Pol’y Dir. 2006-8 (9/29/06).

6 General Motors Corp. v. VA, 602 SE2d 123 (VA Sup. Ct. 2004).

7 Although New Jersey does not conform to the MTC regulations generally, it specifically includes the direct costs of subcontractors in determining costs of performance; see NJ Admin. Code §18:7-8.10(a).

8 See Draft Amendment to MTC Regulation IV.17 (November 2006).

9 CA FTB, Legal Ruling 2006-02 (5/3/06).

10 Interface Group, note 3 supra, citing Boston Prof’l Hockey Ass’n, note 4 supra.

11 See MTC Regulation IV.17(4)(c), Example (i).

12 See MTC Regulation IV.17(4)(c), Example (ii).

13 CA FTB, Legal Ruling 2005-1 (3/21/05).

14 See CT Gen. Stat. §12-218(c)(3); NJ Admin. Code §18:7-8.10(a); NYCRR, tit. 20, §4-4.3(a), (f); SC Code Ann. §12-6-2280(C)(2) and Lockwood Greene Engineers v. SC Tax Comm’n, 361 SE2d 346 (SC Ct. App. 1987); and 34 TX Admin. Code §§3.549(e)(38) and 3.557(e)(33).

15 NYCRR, tit. 20, §4-4.3(a), (f).

16 35 IL Comp. Stat. 5/304(a)(3)(C).

17 GA Code Ann. §48-7-31(d)(2)(C); IA Admin. Code r. 701--54.6(1); MD Regs. Code, tit. 3, §, (D); MN Stat. §290.191, subd. 5(j); and OH Rev. Code Ann. §5733.05(B)(2)(c)(ii).

18 See “Formulary Apportionment in a Service Economy: After 50 Years, Is UDITPA in Need of an Overhaul?” 14 Multistate Tax Rep’t 117 (3/7/07), p. 119.

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