Multistate businesses: What to do when state tax apportionment rules are unfair

Editor: Anthony Bakale, CPA

Apportionment is the method by which states divide a multistate taxpayer’s income for taxation among states where the taxpayer has nexus or is doing business. Generally, states use a one- to three-factor formula that measures a company’s property, payroll, and sales. However, every state can require taxpayers to use an alternative method if the state believes the statutory method does not represent a taxpayer’s presence in that state. As discussed below, taxpayers may also request an alternative method if they believe standard apportionment is not equitable in their situation.

By identifying when a state’s statutory apportionment methodology does not accurately represent a company’s presence in the state, identifying a reasonable and acceptable alternative method of apportionment, and knowing the requirements and burdens of proof necessary to use the alternative method, taxpayers may obtain significant tax savings. Some situations in which a business may be able to demonstrate entitlement to an alternative apportionment method involve expanding operations, new revenue from acquired entities, or substantial gain realized from the sale of assets or business interests.

This item first summarizes the constitutional and statutory rules on apportionment, then discusses how to qualify for an alternative apportionment method in a state and, finally, describes some circumstances in which alternative apportionment may be available.

Constitutional and statutory rules for apportionment

Constitutional restraints on apportionment: Article 1, Section 8, Clause 3 of the U.S. Constitution, referred to as the Commerce Clause, gives Congress singular power over interstate commerce. The U.S. Supreme Court has interpreted the clause as prohibiting states from imposing tax rules that place an undue burden on interstate commerce (see Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), and Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983)). To avoid undue burden, the taxation of multistate business must meet the following requirements:

• There must be a sufficient connection between the taxpayer and the state imposing the tax, generally referred to as nexus;
• The state cannot tax more than its fair share of the income of the taxpayer, generally referred to as fair apportionment;
• The state cannot treat out-of-state taxpayers differently than in-state taxpayers (i.e., the tax cannot discriminate); and
• The tax must be fairly related to the services provided to the taxpayer by the state (see Brady, 430 U.S. 274).

Statutory apportionment methods: In 1957, the National Conference of Commissioners on Uniform State Laws, in an effort to create uniformity in multistate taxation and relieve pressure on Congress to intervene, created the Uniform Division of Income for Tax Purposes Act (UDITPA) to assist states in taxing multistate taxpayers.

Under UDITPA, income is classified as either business or nonbusiness. Business income is defined as income received from the ordinary course of a taxpayer’s trade or business. Nonbusiness income is defined as income not resulting from a taxpayer’s ordinary trade or course of business. Business income is apportioned to the states where a taxpayer conducts business, using one or more of the following factors:

• Property — the ratio of a taxpayer’s property in the taxing state compared to the taxpayer’s property everywhere;
• Payroll — the ratio of a taxpayer’s payroll in the taxing state compared to the taxpayer’s payroll everywhere; and
• Sales — the ratio of a taxpayer’s sales in the taxing state compared to the taxpayer’s sales everywhere.

Traditionally, states employed an equally weighted formula, calculating a taxpayer’s property, payroll, and sales factors and then adding the resulting ratios to determine the percentage of the taxpayer’s income apportionable, or subject to tax, within the state.

Nonbusiness income was, and still is, generally allocated to a specific state depending on the nature of the income and the activity that created it. Nonbusiness income allocation is extremely important to many taxpayers. The allocation of this income should be examined closely, and many strategies can be employed to accurately and efficiently source a taxpayer’s nonbusiness income. However, this item focuses mainly on the apportionment of business income received by a multistate taxpayer.

In the 1990s and accelerating since then, businesses have relied less on physical locations, and commerce has exploded through use of the internet and other non–brick-and-mortar means to reach customers in other states and countries. Due to these changes in the commerce formula, states determined that the traditional three-factor apportionment under UDITPA no longer fairly and accurately represented their taxpayers’ activities. As a result, states began weighing the sales factor of their apportionment formula more heavily; the result was a larger burden being placed on out-of-state businesses with sales but no physical presence within a state. At the same time, the tax burden on in-state businesses, which are often owned and operated by individuals living in the state (and part of the voter base for legislators making these decisions), was reduced.

For the 2022 tax year, almost twothirds of the states that impose an income-based tax use a single sales factor to apportion income to their state. The equally weighted three-factor formula is used by only a handful of states, with the remainder of jurisdictions applying different weights to the sales factor in determining the amount of income assignable to the state.

What happens when apportionment is no longer fair?

Alternative apportionment Ground rules for challenging statutory apportionment methods: States have continually and frequently adopted different apportionment methodologies; though they are required to abide by the constitutional requirements that their tax be applied fairly and represent the taxpayer’s presence in the state, the movement to a singles sales factor clearly is intended to export the state income tax burden to out-of-state taxpayers as much as possible. In fact, the entire impact of various states’ modifications to their apportionment regimes has generally increased the burden on out-of-state taxpayers. In its effort to more fairly apply its income-based tax to an ever-changing tax base, when does a state go too far in taxing any specific taxpayer, and what can taxpayers do if they are unfairly taxed?

The answers to those questions are often found in each state’s alternative apportionment rules and application. Almost every state provides that if a state’s allocation and apportionment provisions do not fairly represent the extent of the taxpayer’s business activity in the state, the taxpayer may petition for, or the tax administrator may require (in respect of all or any part of the taxpayer’s business activity, if reasonable), the following alternative apportionment methods:

• Separate accounting;
• The exclusion of any one or more of the factors;
• The inclusion of one or more additional factors that will fairly represent the taxpayer’s business activity in the state; or
• The employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income.

How does a taxpayer successfully challenge unfair taxation? As states continually adjust their apportionment factors to affect out-of-state businesses, it becomes more likely that those rules will create an unfair result for these taxpayers. Consequently, there has been an increase in the number of challenges to statutory apportionment and, lately, in the success of these challenges. However, taxpayers carry a heavy burden when requesting alternative apportionment. Generally, states require taxpayers to show, by clear and convincing evidence, the following:

• That the statutory apportionment method subjects an unfair amount of a taxpayer’s income to the state’s income tax; and
• That the taxpayer’s alternative method is reasonable.

Taxpayers can also succeed in asserting alternative apportionment on the grounds that the state’s method produces a grossly distortive result and thereby violates the Commerce Clause.

Historically, taxpayers were largely unsuccessful in meeting their burden of proof on one or both of the issues required to assert that they qualify for alternative apportionment; however, recently, states have conceded to certain alternative apportionment arguments, and taxpayers are enjoying more frequent successes in obtaining alternative apportionment. Two examples of these successes are found in court cases in Michigan and New York.

In Vectren Infrastructure Services Corp., 981 N.W.2d 116 (Mich. Ct. App. 2021), the issue involved Michigan’s ability to tax gain on the asset sale of a multistate business when much of the value of the gain (i.e., goodwill) was attributed to business activities outside Michigan occurring over many years before the sale. In this case, the Michigan Court of Appeals determined that application of the statutory formula to the circumstances of this case would result in the imposition of a tax in violation of the Commerce Clause.

In British Land v. Tax Appeals Tribunal, 85 N.Y.2d 139 (1995), the issue was whether application of the statutory apportionment formula resulted in an unfair allocation of value from the taxpayer’s business activities outside New York (and before British Land became a New York taxpayer), by apportioning to the state a substantial portion of gain on the sale of real property in Maryland. New York’s highest court held that the taxpayer demonstrated that, in the circumstances here, the statutory formula attributed income to New York State that was out of all proportion to the taxpayer’s activities in the state (British Land, 85 N.Y.2d at 149).

As demonstrated in Vectren and British Land, the key to succeeding in asserting entitlement to alternative apportionment is to provide the state with documentation and support for both prongs of the alternative apportionment statutory requirements. The taxpayer must clearly establish the unfairness of the statutory apportionment formula and must also prove that the proposed alternative method is reasonable.

When does alternative apportionment apply?

Alternative apportionment may apply in a number of factual situations. Often, taxpayers overlook these situations or are not familiar with how to plan, document, and establish with a taxing state that the statutory formula is unfair and that a reasonable alternative method applies.

Classification of income as nonbusiness: Taxpayers frequently receive income from multiple sources in the ordinary course of their business. Occasionally, this income can be classified as nonbusiness, based on statutory or other controlling law in a jurisdiction. As a result, the income may not be subject to the statutory method of apportionment for business income and can be excluded from either the tax base or apportionment.

Taxpayers should be deliberate and examine the rules of each state in which they are subject to tax to determine how each source of revenue and the resulting income is classified for state income tax purposes. While many states have similar definitions of business income, specific items such as interest, gain on the sale or use of intangible property, and goodwill can result in vastly different results for apportionment purposes.

Leveraging statutory exclusions from the tax base or the treatment of allocable nonbusiness income can often avoid the burdens of proof required for application of alternative apportionment statutes.

Expansion of filing footprint or change in in-state activity: A common fact pattern in which taxpayers do not recognize the potential application of alternative apportionment occurs when a taxpayer acquires another business or increases business activities late in a tax year. Often, the acquired business may have a vastly different state filing footprint than that of the acquiring entity, resulting in a change in apportionment that may not reflect the acquiring business’s activity in the state for the tax year.

Example 1: Buyer has a 2% apportionment factor in State A and acquires Target 11 months into the tax year. Buyer’s 12-month taxable income, excluding Target’s income, is $9 million. Target has an apportionment factor in State A of 25% and post-acquisition state taxable income of $1 million. The blended apportionment rate in State A post-acquisition is 10%. Buyer’s combined post-acquisition state taxable income is $10 million, and the State A combined apportioned taxable income would be $1 million, using the blended apportionment factor. But on a separate-business basis, Buyer’s State A apportioned income would have been $430,000. (See the chart “Apportionment of Income in Example 1,” below).

The result is a more than doubling of taxable income due to the addition of one month of increased activity. This creates a strong argument for unconstitutional gross distortion and qualifying as unfair under a state’s alternative apportionment statute. Once the apportionment is established as unfair, the taxpayer must establish a reasonable alternative methodology and, most importantly, support its position with the state. One method available in some states is using a “split factor” for the tax year: apportioning pre-acquisition income with the taxpayer’s pre-acquisition factor and apportioning post-acquisition income applying the new factor. This would result in substantially less income being apportioned to the state for the first 11 months of the tax year while giving the state more income in the one month post-acquisition.

This planning method can be even more effective when available to an acquiring entity that does not have nexus with a state and is required to file and apportion its income to a new state following an acquisition. Using a split factor here could result in a large amount of the taxpayer’s income being excluded from state tax until nexus is created post-acquisition. Of course, relevant tax rates between states in which the income is apportioned need to be considered as well.

Apportioning the gain from the sale of assets or business: When a taxpayer sells a significant portion of its business or assets, a large amount of gain is typically recognized. This gain should be classified properly through purchase price allocation; for federal and state income tax planning purposes, this allocation can be one of the most important elements of a sale. One asset that often generates a substantial amount of gain but is not historically an asset of the selling entity is goodwill.

Most states consider gain on goodwill from the sale of a business or assets as apportionable business income. However, the apportionment of a taxpayer’s goodwill often can be unfairly apportioned to the “operating states.” Taxpayers should examine closely how the value in the sold business or assets was created and compare this allocation of value to the company’s operating apportionment. Once the goodwill has been properly considered, a case can often be made for the application of a state’s alternative apportionment rules.

Example 2: Assume that Company A, headquartered in Michigan and with historic operations only in the Northeastern states for the past 35 years, acquires Company B in Arizona, which has a high apportionment rate in Arizona and other Western states. One year after the acquisition, Company A sells a large part of its historic operations operating in the Northeastern states to a third party. A large amount of the goodwill from the sale of these assets likely would be subject to tax in Western states due to the recent acquisition of Company B when applying the statutory apportionment formulas.

Distortion and unfairness may be established if the taxpayer can show how Company A built the value of the sold assets over a 35-year period in which it had no connection to any particular Western state. This is similar to the argument successfully asserted in the Vectren case. Once unfairness can be demonstrated, the taxpayer must present a reasonable alternative that it can show fairly taxes the income of the taxpayer in the state.

Methods that can be considered include split apportionment, discussed above. Additionally, the taxpayer, similar to the Vectren case, could argue that historical apportionment factors should be leveraged using an average of factors over a given period. Alternatively, taxpayers could apply a “supply chain” approach, where they demonstrate that the drivers of the value of the assets sold were located outside the taxing jurisdiction. This analysis would result in the creation of an apportionment formula applicable to the goodwill or other applicable income from the sale.

Whatever alternative apportionment method is selected, the keys are to demonstrate that the statutory apportionment method is unfair to the taxpayer and that the proposed alternative method is reasonable. The more details and specific facts that can be shown, the better.

Editor Notes

Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Bakale at tbakale@cohencpa.com. Contributors are members of or associated with Cohen & Company Ltd.