Background
There has been much debate over how income should be fairly apportioned to the states where a taxpayer has nexus. For many years, states by and large adopted the Uniform Division of Income for Tax Purposes (UDIPTA), better known as the “three-factor formula.” This formula apportioned income to the state based on the taxpayer’s overall property, payroll, and sales attributable to the jurisdiction over its presence everywhere.
Initially, all three factors carried equal weight. Over the years, states gave more and more weight to the sales factor, and many moved towards sales as a single measure. The shift has been driven in part by politicians seeking to make their home states more attractive to in-state businesses. Removing the property and payroll factor allows the state to shift tax liability outside the state of domicile.
Recent Legislative Changes
Although not intended to be an exhaustive list, the states below represent a few examples of jurisdictions that have recently embraced the single sales factor.
Massachusetts.
On October 4, 2023, Governor Maura Healey signed into law Bill H.4104, which makes substantial changes to how taxpayers calculate their state income. One of the most impactful items in the legislation is the implementation of a single sales factor effective January 1, 2025. With some exceptions, Massachusetts currently requires taxpayers to apportion income using a three-factor double weighted sales formula. The change is a welcome relief to Massachusetts-based taxpayers but could have a negative impact on out-of-state businesses.
Tennessee.
The Tennessee Works Tax Act (House Bill 323) was signed into law by Governor Bill Lee on May 11, 2023. The legislation transitions the state to a single sales factor over a three-year period. The phase in is as follows:
- For tax years ending on or after December 31, 2023, but before December 31, 2024, the numerator of the apportionment formula is the property factor plus the payroll factor plus five (5) times the receipts factor, and the denominator of the fraction is seven (7)
- For tax years ending on or after December 31, 2024, but before December 31, 2025, the numerator of the apportionment formula is the property factor plus the payroll factor plus eleven (11) times the receipts factor, and the denominator of the fraction is thirteen (13)
- For tax years ending on or after December 31, 2025, a single sales factor is used.
Unlike Massachusetts, the transition allows Tennessee taxpayers to feel the impact gradually. Prior to the legislation the standard apportionment formula, with some exceptions, was a three-factor formula with triple-weighted sales.
New Jersey.
On July 3, 2023, New Jersey Governor Phil Murphy signed into law A.B. 5323, enacting comprehensive law changes. The New Jersey Division of Taxation issued TB-107 to summarize the more substantial provisions. Although the legislation largely focused on the Corporation Business Tax (CBT), there was a significant impact on partnerships. For tax years beginning on or after January 1, 2023, partnerships will use a single sales factor calculated using market-based sourcing. Under prior law, partnerships were required to determine state-source income using an equally weighted three-factor formula; in addition, service revenue was determined using a “home office” rule as opposed to market-based sourcing. The change will allow consistency in the reporting between partnership and corporate taxpayers who are already using a single sales factor and market-based sourcing methodology. It should be noted that partnerships will now face increased complexity when determining how service revenue should be sourced. Furthermore, taxpayers should consider how the change in formula and sourcing will impact both income and cash flow. The impact for New Jersey–based taxpayers as well as for service providers could be significant.
Vermont.
Signed into law May 31, 2022, but effective for tax years beginning on or after January 1, 2023, S.B. 53 also implements a single sales factor. Under prior law, a three-factor, double-weighted sales factor formula was required.
Overall Impact
The above states are just the latest to join the majority of others in using a single sales factor; only a handful of states remain dependent on the once traditional three-factor formula. It is likely just matter of time before all states make the move. This overall trend is in line with the shift in focus from physical to economic nexus determinations. Whether or not this will result in a more equitable distribution of income is a debated topic better left to another discussion.
For now, increased reliance on the sales factor is the current landscape and one that brings with it much nuance and complexity. As the apportionment formula has evolved, so has the methodology for how states define sales in their jurisdiction. The change has by and large been focused on sales rather than tangible property. More and more states are adopting market-based sourcing, including the four states discussed above. Market-based sourcing requires looking to the customer’s location in lieu of the once common cost of performance measure (i.e., where the service providers are based). Although this may appear straightforward, states’ definitions of “market” and “customer” can vary widely, and on-point guidance remains limited. Accordingly, this is an area where a tax professional’s expertise is most critically needed; with that need comes tremendous opportunity to help businesses remain compliant while identifying planning opportunities. Needless to say, CPAs must be aware of these changing rules in order to properly advise their multi-state taxpayers.
