Why Does Another State Want Tax Your Very Local Business?
Imagine you own a small graphic design business in Washington. You have three employees, one office, and a loyal group of local customers. You've never opened another location. You don't have salespeople traveling around the country. In fact, you've never really thought of your company as doing business anywhere other than Washington.
Then something good happens. A company in California discovers your work online and hires you for a major project. You handle everything from your Washington office, communicating by email, phone, and video calls. Nobody travels to California. Nobody opens an office there.
The project goes well, the customer is happy, and your business earns some much-needed revenue. Then your accountant delivers some surprising news: You may now have to file an income tax return and pay taxes in California.
Wait. What?
How can another state tax a business that isn't located there?
Most small business owners naturally assume that they pay taxes in the state where their business is located. That seems reasonable. After all, that's where the employees work, where the bills get paid, and where the business operates.
But state income tax laws don't always work that way. Some states can tax a business based on where its customers are located or where those customers receive the benefit of its services—not just where the business has offices and employees.
Tax professionals call the connection that allows a state to tax a business "nexus." That's a technical word for a fairly simple idea: Has your business developed enough of a connection with another state for that state to impose its tax rules?
And here's the surprising part: That connection can sometimes exist even if you've never physically set foot in the state.
One big customer can make a difference
Let's return to our Washington graphic design business.
Suppose the business has $1,000,000 in annual sales. Its California customer accounts for $300,000 of that amount, with the work benefiting the customer's California operations. That's 30% of the business's total sales. Under California's rules, a business can be considered to be doing business in California when its California sales exceed 25% of its total sales, even if those sales are below the state's separate dollar threshold.
In our example, that one California customer could be enough to create a California income tax filing and payment obligation. The company doesn't have a California office. It doesn't have California employees. It isn't a national business or even a regional business. It's still just a small Washington company with one particularly good customer in another state. Yet it may now have tax responsibilities in two states.
Does that mean other states taxe all of the business's income
Generally, no.
States typically have rules for deciding how much of a business's profit is connected to their state. For example, suppose our Washington business earned $100,000 in profit for the year. If 30% of its sales are assigned to California, roughly $30,000 of that profit might be treated as California income under the state's usual allocation formula.
That doesn't mean the company owes $30,000 in taxes. It means that $30,000 could be the amount on which California calculates its income-based tax. The actual tax depends on several factors, including how the business is legally organized. Some businesses may also face a minimum state tax or other fees.
And the business may still have to report its income in Washington, potentially dealing with two sets of tax returns. Rules designed to reduce double taxation may help, but they don't necessarily eliminate the extra paperwork or expense.
Not just a big company problem
When people hear about businesses paying taxes in multiple states, they tend to picture big corporations with warehouses, offices, and employees scattered across the country. But this issue can affect much smaller businesses, including independent consultants, marketing firms, web designers, accountants, and other local service providers.
Sometimes all it takes is landing one significant customer in another state. In other situations, allowing an employee to work remotely from a different state can create tax obligations the business never anticipated.
And here's another important point: Income tax is not the same thing as sales tax.
Many small business owners have heard that selling products online can create sales tax responsibilities in other states. Far fewer realize that earning revenue from out-of-state customers can also create income tax issues.
The two types of taxes have different rules, and complying with one doesn't necessarily mean you've complied with the other.
Does every out-of-state customer create a tax problem?
No, and that's an important distinction. Each state has its own rules for determining when an out-of-state business must file a return or pay income tax. Some states use dollar-based sales thresholds. Others consider what percentage of a business's overall sales comes from within the state. The presence of employees or other business activities can also matter.
There are also special federal protections that may apply to businesses selling physical goods under certain circumstances. Those protections generally don't extend to businesses providing services.
So having a customer in another state does not automatically mean you owe income tax there. But assuming that you cannot owe income tax because you have no physical location there can be an expensive mistake.
What should small business owners do?
The goal isn't to become an expert in the tax laws of all 50 states. It's simply to recognize that certain everyday business decisions can have unexpected tax consequences.
If your company starts earning substantial revenue from customers in another state, takes on a particularly large out-of-state project, or hires someone who will work remotely from another state, it's worth asking your accountant whether any new state tax obligations have arisen.
It's also helpful to keep records showing where your customers are located and, for service businesses, where customers actually benefit from the work.
A little planning can help prevent unexpected tax bills, penalties, interest, or the expense of preparing several years of overdue state returns.
The bottom line
Small business owners have enough to worry about without discovering that they owe income taxes in a state where they've never operated a storefront or employed anyone.
Unfortunately, state income tax rules don't always match our everyday understanding of where a business operates. A company can be entirely local in every practical sense and still be considered to be doing business in another state for tax purposes.
The lesson is simple: Your business doesn't have to cross state lines for its tax obligations to cross them.
And for a small business, discovering that distinction before a state tax agency comes calling can make all the difference.
This information is intended for educational purposes, and is not tax, legal, actuarial, or investment advice. It is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.