Editor: Lori Anne Johnston, CPA, J.D.
State tax planning has been surrounded by uncertainty since 2017's federal tax reforms in the law known as the Tax Cuts and Jobs Act, P.L. 115-97. The COVID-19 pandemic, the economic downturn resulting from it, and a changing U.S. political landscape have only increased the ambiguity. The concept of "new normal" has permeated every area of life since the beginning of the pandemic. As practitioners and taxpayers address 2021 tax year changes, uncertainty and change seem the most prominent themes in both personal and business environments, reminding them that while many things feel "new," none of them quite feel "normal."
Though many elements of the economic climate remain in flux, businesses can proactively respond to and address cash flow management, existing state tax risk, and the changing work environment to help anticipate future state tax issues, increase cash flow, and minimize existing risk. This discussion offers some thoughts, best practices, and recommendations to businesses in each of these areas to help them best manage their state tax function while maintaining flexibility for whatever the future may offer.
Maximizing cash flow
For many companies, the adage "cash is king" is a way of life. In an economic climate that makes the next sale or customer collection uncertain, cash flow takes on an additional level of importance. From a state tax perspective, companies can take several steps to maximize cash flow in these uncertain times.
Refund opportunities: A company that has paid income, franchise, capital gain, or sales/use taxes in prior years could have opportunities to claim refunds of those taxes. Often referred to as a reverse audit, a review of prior returns can identify errors, overpayments, overlooked elections, or available state tax credits that may decrease tax liability and offer a cash refund.
From a sales tax perspective, companies that are capital-intensive, have made substantial recent capital purchases, and qualify for special sales tax exemptions (e.g., manufacturing or medical-related equipment) may be able to retroactively claim these exemptions and associated refunds for sales or use tax originally paid. A review of purchase orders, invoices, and prior tax return filings often identifies overpayments that are eligible for refund.
From an income tax perspective, the many areas of potential opportunity include state modifications to federal taxable income, apportionment factor computation, filing methodologies, and the treatment of capital gains. Growing complexity in the Code resulting from the TCJA and last year's Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, has also increased the complexity of state conformity to certain federal provisions. The necessary state modifications to taxable income are increasingly complex, and certain nuances are often missed or misunderstood; thus, reviewing the treatment of these items may identify refund opportunities. Apportionment opportunities may include single sales factor elections, the treatment of throwback sales, and revenue sourcing alternatives.
Businesses with recent significant transactions or capital gains should also consider whether those gains have been appropriately treated as apportioned, as opposed to allocated, income. Consolidated or combined filing elections are an often overlooked opportunity available in some states that default to separate-entity reporting. Depending on the state and the taxpayer's facts, such elections may allow companies to offset taxable income of one entity with current losses or loss carryforwards of another.
Legal entity restructuring or simplification: Many businesses have grown through acquisitions and/or conduct their business through many subsidiary entities. While this structure may have been beneficial in the past, a complicated operating structure that results in onerous state tax compliance may no longer be the most advantageous way to operate. Businesses can streamline their legal entity structure to reduce compliance and accounting-related costs and potentially offset profits of one entity with losses of another. For example, a parent company might operate at a loss due to corporate debt, while its operating subsidiary is profitable. Merging the subsidiary into the parent or converting it to a disregarded entity could reduce overall cash income taxes and eliminate the need for both entities to file separate tax returns in the same states.
Tax credits: Statutory tax credits are a way for states to encourage investment in capital, hiring employees, or making other types of investments, such as in research and development. Ideally, taxpayers should identify tax credit opportunities prior to filing original returns, but many states allow tax credits to be claimed on amended returns for prior periods for which refunds can be issued. The primary considerations when identifying retroactive credit opportunities include the types of investments that have been made in prior years, the amount of tax previously paid, whether specific states allow credit claims retroactively, the ability to offset taxes other than income tax (e.g., payroll taxes), and the administrative process required to claim credits (e.g., the need for approval from the state).
Establishing a defensive posture to existing risk
In an economic climate where many things are unpredictable, getting a clear picture of any outstanding state tax risk can reduce the possibility of unexpected issues and assessments. With states more aggressively enforcing compliance due to their own budget shortfalls, businesses can prepare by fully understanding and minimizing risk associated with their state tax liabilities.
Nexus studies and exposure reduction: While the concept of nexus — the minimum level of activity or connection required for a state to be able to impose a tax — is at the core of a state's ability to tax, this concept has been anything but stable and consistent over recent history. Requiring physical presence to trigger state tax has been replaced by myriad "economic nexus" rules and interpretations that allow taxation of businesses with only a few substantial customers or transactions within the state. The only constant has been change, through states' guidance releases and litigation, thus redefining how businesses must think about their state tax footprint.
If a business has not recently performed a nexus study, it may be wise to do so sooner rather than later. As part of their enforcement, states frequently send out nexus questionnaires to businesses that have not previously filed tax returns in their state. Being contacted by a state generally precludes a company from participating in voluntary disclosure agreements and often results in additional tax, penalties, and interest. Proactively identifying prior exposure by performing a nexus analysis and participating in voluntary disclosure agreements can provide peace of mind and the opportunity to reduce prior exposure through a limited lookback and, potentially, penalty waivers.
Actively managing audits: Another way for states to raise revenue is through the audit process. Since the pandemic began, there has been some slowdown in audit progress due to remote working and headcount reduction at the state taxing authorities. This enables taxpayers currently under audit to negotiate, settle, and close ongoing audits, as many states have an incentive to collect what they can and move on to other taxpayers. Businesses should consider the current climate around the audit process as an opportunity to reduce the risk of future assessments, negotiate statute closures, establish favorable filing methodologies, and otherwise reduce the company's overall state tax risk profile.
Assessing the impact of a remote workforce
As a result of the COVID-19 pandemic, an unprecedented number of employees are working remotely. Most are simply working from home, but many have taken the opportunity to visit family, work from vacation homes, and generally capitalize on the new ability to work from anywhere with a Wi-Fi connection. What was first imagined as a temporary situation is phasing into a more permanent way of life as many businesses have closed offices or allowed employees to work remotely on a permanent basis.
Nexus issues: One of the largest issues surrounding the new remote workforce is its effect on nexus. In general, an employee working in a state creates nexus for the employer for income, franchise, capital gain, gross receipts, sales/use, and other types of taxes. Over a dozen states have issued guidance providing relief from nexus and associated taxation related to telecommuters temporarily working from within their state's borders in connection with the pandemic.
If a state has not provided specific relief, a remote worker in the state may create nexus for multiple tax types. Even states providing relief guidance leave many questions unanswered — including at what point workers are no longer considered to be temporarily remote and whether the guidance affects the protections of P.L. 86-272 (Interstate Income Tax Act of 1959). At a minimum, companies should try to evaluate their current remote workforce landscape, identify states where they may have nexus risk, and assess available guidance on remote-worker relief provisions. While the risk may be low — and a business decision to decline or defer full compliance may be prudent — gathering all the facts is a crucial step. Customers and daily business operations may proceed normally, even if an employee is working from another state, but it could create unexpected state tax exposure.
Pitfalls with payroll withholding: Payroll withholding presents another potential issue for companies with a remote workforce. In general, a company withholds tax in the state where an employee performs his or her work. If the company is based in State A but an employee works in State B, the company would withhold tax on wages for State B. However, if the employee is now working in State C as a result of the pandemic, does the company continue withholding State B taxes, or does it now need to withhold State Ctaxes?
Some states have provided specific guidance on this issue, but the guidance falls short of addressing all concerns for affected businesses. For example, in July 2020 (and updated in December 2020) Massachusetts adopted an emergency rule (830 Code Mass. Regs. §62.5A.3) addressing nonresident withholding. The rule established that nonresidents working in Massachusetts prior to the pandemic who changed their physical work location to another state must still have Massachusetts tax withheld from their wages. This rule is in effect until 90 days after the governor ends the COVID-19 state of emergency.
While the rule would provide clear guidance on how the employer should handle Massachusetts withholding, it obviously does not address the issue that the employer may also technically have a withholding responsibility in the employee's new, post-pandemic work location state. Businesses with employees working remotely in a new location as a result of the pandemic should carefully evaluate the rules in those states to ensure proper withholding. They should also consider whether the remote employees will return to their original work location or remain remote after the states of emergency have been lifted. All of these factors and others could determine which states will require payroll withholding and whether a business chooses to do so.
Commercial domicile: With some businesses permanently closing offices and their employees working in different states post-pandemic, some companies are considering a change in commercial domicile. Commercial domicile is an important factor in state tax filing obligations and the state tax treatment of certain types of income, such as interest and capital gains. The ability to change commercial domicile may have a beneficial effect when considering a business's footprint, its customer base, and the location of its employees. Companies should evaluate the impact of a change in commercial domicile and the related state tax implications.
Although the current climate of change can create uncertainty in how best to respond to state tax issues, business have the opportunity to proactively approach cash flow management, existing state tax risk, and the changing work environment. The best practices and recommendations outlined in these areas can help businesses manage their state tax function while maintaining the flexibility they need.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.