Taxpayers doing business in more than one state generally use state mandated apportionment formulas to calculate the portion of their income that is subject to tax in each state. For service businesses, the apportionment formulas historically were pretty much the same in all states. But state taxation is dramatically changing in this area. The interplay of new and old rules in various states may have a dramatic impact on your overall state tax burden.

Cost of Performance vs. Market Based Sourcing

Traditionally, state apportionment formulas required taxpayers to source receipts from services based on where the costs were incurred to generate the receipt. Receipts were sourced either based on the percentage of costs incurred in a particular state or in full to the state which incurred the most costs.

Driven by the need to increase tax revenues, states have been moving towards an apportionment approach which instead looks to where the benefit of the service is received. Referred to as “Market Based Sourcing”, receipts are generally sourced based on the location of the taxpayer’s customer. States which have changed their apportionment law, and the year of the change, include:

• California - 2013
• Massachusetts - 2014
• Pennsylvania - 2014
• Rhode Island - 2015 (Limited to Subchapter C Corporations)
• New York - 2015

The Massachusetts Department of Revenue has issued a working draft of a Regulation to implement Market Based Sourcing. The DOR has been receiving comments from taxpayers and practitioners and is expected to publish a revised Proposed Regulation by the end of September, 2014.

Opportunity for Unexpected Tax Results

Assume a law firm has offices in Boston and New York and during 2014 a client located in Massachusetts is serviced by attorneys in New York. For state apportionment purposes, Massachusetts will claim 100% of the receipts generated from this Massachusetts client. New York, however, will also require that a portion of this same revenue be sourced to New York, based on the percentage of the costs incurred in New York to service the client. The end result is that the same revenue is counted twice and the taxpayer may be “double taxed”. The result would be reversed for a client located in New York and serviced from Boston. These receipts would not be sourced to either state.

Any taxpayer engaged in a multi-state service business should be evaluating the potential impact of market based sourcing. Aside from the tax effect, there are also issues to address regarding the ability to collect the required data to source receipts using market based sourcing. The time to complete this analysis is now, while opportunities still may exist to plan for the changes taking place in 2014. For more information about these new apportionment provisions, or for help analyzing how your business may be affected, please contact us.