Episode Summary: "Various State and Local Income Tax Issues"

Podcast: How Tax Works
Host: Matthew Foreman (Co-Chair, Falcon Rappaport & Berkman LLP Taxation Practice Group)
Date: September 30, 2024

Main Theme

In this episode, Matthew Foreman discusses a range of common state and local income tax issues frequently encountered during due diligence for mergers and acquisitions, business sales, purchases, and capital raises. The episode is an accessible tour through challenging territory for accountants, lawyers, business owners, and anyone wanting to better understand how state and local taxes (SALT) affect business structures, compliance, and real-world transactions.

Key Discussion Points & Insights

1. Sourcing and Registration (Nexus)

• Definition of Nexus:
  Nexus is the connection that obligates a business to register and file taxes in a given state. Often misunderstood, nexus can be created through:
  • State of formation (where business was formally created)
  • Physical presence (office, employee, inventory)
  • Economic presence (business relationships without physical presence)
  • Remote employees (even a single out-of-state worker can trigger nexus)
• Common Pitfalls:
  • "Business owners often forget that just having a remote worker in another state can trigger a filing requirement." (05:38)
  • Registration can be required both with the Secretary of State (for non-tax purposes) and the tax authority, and doing one doesn’t always satisfy the other.
• Solicitation Exception (PL 86-272):
  • Public Law 86-272 protects businesses from income tax obligations if their only activity in a state is the direct solicitation of orders for tangible personal property. However, the threshold for losing this protection is surprisingly low and:
    • “PL 86-272 only applies to tangible personal property—not real property, and most definitely not intangibles.” (10:13)
• Economic Nexus:
  • Increasingly, states like Pennsylvania assert “economic nexus” — requiring tax filings based on sales or other economic connections, regardless of physical presence.
  • “Every state can have its own rules…51, 52 different approaches. It’s bonkers, and a headache.” (13:45)

2. Convenience of the Employer Test

• Concerns arise when employees claim to work in a lower-tax state, but their employer’s location is in a higher-tax jurisdiction (e.g., New York).
• "A lot of people think they can just avoid NY taxes by working remotely, but New York is aggressive and doesn’t really allow that." (15:59)
• Important for matching individual and business filings — discrepancies can cause compliance headaches.

3. Pass Through Entity Tax (PTET)

• PTET is a workaround for businesses to bypass the $10,000 SALT (state and local tax) deduction cap via entity-level taxes.
• Often elective and varies considerably by state (e.g., NJ’s BAIT, NY’s PTET).
• “You must make the election, and you must do it right…If you create an entity on March 16, you cannot make a PTET election for that year in New York.” (20:10)
• The IRS currently allows deductibility, which surprises many practitioners:
  “People always think the IRS is trying to fight you. And this way, the IRS went entirely the other.” (19:05)

4. Issues with Multiple Entities

• Multiple entities, commonly for franchises or family businesses, create complex apportionment and compliance situations.
• Apportionment (dividing income and expenses among entities and states):
  • “People say, well, I own all the entities, so what does it matter? It matters.” (25:22)
• Transfer Pricing:
  • Related entities must transact at arm’s length prices, even for state tax purposes.
  • “If you have S corporations versus partnerships in different states, transfer pricing can really matter.” (29:41)
  • Maintaining state losses can be strategic—“Don’t dismiss state filings just because you’re losing money—you might want those NOLs later.” (31:28)

5. Conformity and Decoupling from the Internal Revenue Code (IRC)

• Most state income taxes start with the federal rules, but many decouple (partially or fully) in key areas:
  • Depreciation & Amortization:
    • “Federal returns can show $4 in income, but due to state decoupling, state returns can show $17 million.” (34:17)
  • IRC 280E (Cannabis):
    • States like New York have decoupled from federal disallowance of deductions for cannabis businesses.
  • State S Elections:
    • States can require separate S elections (notably NY), sometimes resulting in the same entity being an S-Corp federally and something else (partnership, C-Corp, etc.) at the state level.
    • "I literally saw this once: for federal purposes they were an S-Corp, for New Jersey purposes a partnership, and for New York, a C-Corporation." (37:08)

6. Gross Receipts Taxes and Quirky Local Regimes

• States like Texas and Washington forgo traditional corporate income tax in favor of low-percentage gross receipts taxes, but these can function similarly — often with fewer nexus protections.
  • “Texas has a very large exclusion—most businesses never hit the threshold, but once you do, rules get weird.” (41:30)
• Ohio is singled out for its multitude of complex and sometimes conflicting local business tax regimes.

7. Local Income Taxes

• Notable focus on New York City’s unique approach:
  • NY City ignores S elections; S-Corps pay as C-Corps for city purposes.
  • GCT: 8.85% on corporations for city-sourced income.
  • UBT: 4% on unincorporated businesses, but with an exemption/crediting mechanism under $135,000.
  • "People who don't live around here have no idea they exist." (46:00)
  • Real estate rents get different treatment depending on entity type and tax (UBT vs. GCT).
• Other cities and counties may have unique taxes, adding another layer to compliance and planning.

8. Sourcing and Sub-Sourcing

• Even within a state, different taxes can require different sourcing methods (“sub-sourcing”).
• Large urban areas levy their own taxes because “you really can’t leave the large metropolitan areas … that’s the easiest way to get a whole lot of customers.” (49:52)

9. Expense Deductions and Compliance Check

• Local jurisdictions might question deductions tied to non-registered locations.
• “If you’ve got an office you never use, is it really a business expense? … Are you actually doing business there?” (52:06)
• Returns need to “match” business operations and realities.

Quotes & Memorable Moments

• “It wouldn’t be a podcast by a lawyer if I didn’t say, ‘it depends.’” (04:16)
• “I really wonder how we have such a successful economy really, despite ourselves in some ways.” (13:58)
• “Sales tax became a big issue after Wayfair; it’s calmed down a bit, but income tax can be just as much of a headache.” (54:20)
• “That’s why a lot of people kind of poo-poo state and local tax. I like a lot of it because … the complexity can be really interesting.” (53:28)

Timestamps for Key Segments

| Segment | Timestamp | |----------------------------------------|-------------| | Intro & Rationale for Topic | 00:00–04:25 | | Sourcing & Registration (Nexus) | 04:26–15:58 | | Convenience of Employer Test | 15:59–17:15 | | Pass Through Entity Taxes (PTET) | 17:16–22:15 | | Issues with Multiple Entities | 22:16–32:42 | | Conformity / State Decoupling | 32:43–41:29 | | Gross Receipts Taxes & Local Regimes | 41:30–45:59 | | Local Income Taxes (NYC, others) | 46:00–52:05 | | Sourcing, Deductions, Compliance | 52:06–54:40 | | Closing Thoughts | 54:41–End |

Style and Tone

Matthew’s tone is conversational, energetic, and practical — shaded with humorous asides and candid observations. He demystifies topics while cautioning listeners about real-world pitfalls, always encouraging proactive compliance and strategic planning over shortcut-seeking.

Takeaways

• State and local income tax complexities are unavoidable and material for businesses operating in more than one jurisdiction.
• Key issues include nexus, proper entity registration, electing into specific tax treatments on time, navigating different state and local rules for entity classification, apportionment, transfer pricing, and unique gross receipts and local taxes.
• Strategic attention to entity structure, state-specific elections, and proper expense allocation is crucial.
• Proactive planning and continual review help avoid costly surprises in compliance and tax liability.