Have you noticed a growth spurt in your state tax bill? Is it consuming more and more of your company's revenue? If so, the good news is there are steps you can take to gain control of this often overlooked tax liability.
State taxes are taking a bigger bite out of small-business owners' bottom lines, and this trend is expected to continue. As Washington moves more responsibility for funding social programs to the states, the drive is on to collect more tax revenue at the state level.
"If the federal government is going to contribute less, then the states must contribute more because the money must come from somewhere," says state and local tax specialist Michael H. Lippman, a Washington, DC, partner with accounting firm KPMG Peat Marwick LLP.
Entrepreneurs are already feeling the pinch. A recent survey of the fastest-growing U.S. companies by accounting and consulting firm Coopers & Lybrand LLP found state and local taxes were the fastest-growing tax burden for these firms. Those surveyed reported a 15.3 percent increase in state and local taxes in the past year.
While most states are not actually increasing corporate or sales tax rates, they are taking less obvious steps to expand their tax base. One strategy, for example, is to subject more services to a state's sales tax, says Sally Adams, an attorney and state tax analyst for CCH Inc., a major provider of tax information in Riverwoods, Illinois.
State governments are also making the tax rules even harder to comprehend, and enforcement efforts are gaining greater muscle, says Joe Donovan, a multistate tax services principal with Coopers & Lybrand in Boston. To boost compliance, Donovan says, many states have opened audit offices in other states, established information exchange agreements among themselves and with the federal government, and refined their strategies for tracking down companies they believe aren't paying the correct amount of taxes.
To collect more revenue, a number of states have expanded their auditing activities, increasing staff by 20 percent to 25 percent, says Jack Cronin, national director of Deloitte & Touche LLP's state and local tax practice. This is a direct benefit to state coffers, he explains, because auditors can generate revenue that would not otherwise be available.
With all this activity directed at getting more tax dollars from you, proper tax planning and a good understanding of state tax regulations are essential. Accountants who specialize in state and local tax issues suggest taking six important steps to put your business in a better tax position.
1. Be sure to collect sales and use tax, not just in your home state, but in the other states where you sell. "Typically, companies collect these taxes in their home state, but they may fail to collect them in the other states where they have customers whom they reach through a local sales force," Donovan says.
States are looking for businesses that neglect to collect these taxes, and companies that come to the attention of state revenue collectors will be required to pay back taxes, as well as interest and penalties. The message here is clear: Don't turn your customers' tax liabilities into your own.
2. Consider doing business in more than one state. (This won't help you if you are conducting business in a state that doesn't have a corporate income tax, such as Nevada.) In many cases, becoming a multistate business can reduce overall taxes, says Lippman. Here's how it works: "If you are taxable in only one state, you must report 100 percent of your income to that state. But if your business is taxable in more than one state, then you can apportion the income and the tax between the states, using a special formula," he explains. "This could result in income that doesn't get taxed in either state." Establishing a business presence in another state can be as easy as having inventory or a single salesperson in a rented office there.
But before undertaking such a move, it is important to check with a state tax specialist who understands each state's rules to make sure it will result in a lower state tax bill.
3. Don't make the mistake of thinking you don't owe any state or local taxes if you have a new company operating at a loss. Although you may not have any state income tax liability, your sales and use tax exposure continues to accrue if you fail to collect and remit these taxes. Getting stuck paying a sales tax of 5 percent to 10 percent of your gross receipts yourself because you didn't collect it from your customers can turn out to be a significant amount, Donovan says.
Keep in mind that state corporate income taxes account for only about 10 percent of a company's state and local tax burden. State and local property and sales and use taxes make up the bulk of your tax responsibility at this level. If you haven't been collecting these taxes properly, many states will allow you to negotiate a settlement. This often involves using the services of your accountant. In this kind of give and take, states have been known to waive penalties and a percentage of the taxes owed.
4. Stay abreast of details concerning the tax incentives, exemptions and credits state governments offer to reduce a company's tax bill. Small to midsized companies are often eligible for such benefits, but many overlook them. In a number of states, items used in manufacturing or in research and development, for example, may qualify for such exemptions and credits.
"Competition among states to attract new businesses is growing," says Cronin, "and states are offering property tax abatement, job and investment tax credits, and manufacturing equipment exemption credits." In some cases, these benefits are also offered to encourage companies to continue operating within a given state.
"There is a myth out there that only large companies can land these tax benefits," says Lippman. "But states are offering all types and sizes of companies benefits for either locating facilities in a given state or moving headquarters into those states."
In Massachusetts, for example, there is a program designed to generate business development and new jobs, which may be activated if your company establishes just one new job in a location dubbed an "economic target area." "If your company meets the requirement," says Donovan, "you are eligible for special financing or credits that apply to the acquisition of property."
Major accounting firms' state and local branches can identify exemptions and credits for small companies. In addition, every state and most major cities have economic development councils that provide low-cost assistance in determining the tax incentives that apply to your business.
5. Minimize unemployment taxes by making sure former employees collecting unemployment benefits are actually eligible to do so. "Very often when employees leave a company, they claim unemployment tax benefits, even though they were discharged or leave on their own accord," explains Lippman. "Employers should document the reason for termination and then actually go to the unemployment office and provide proper documentation to substantiate it." This way, only individuals who are truly eligible receive the benefits, and a tax charge is not made against your account. "This is often overlooked, but it's a very easy way to minimize unemployment taxes."
6. Keep track of your firm's personal property and its worth. The personal property you report as yours should actually be something you own. If you have scrapped a piece of equipment, for example, eliminate it from your personal property total.
Remember, there are three different types of property that can be taxed: real property, which is made up of land and any improvements to land; tangible personal property, which can include business personal property, inventory, supplies, machinery and equipment; and intangible personal property, such as stocks, bonds, mortgages and intellectual property.
While there is no way to eliminate the tax man's bite entirely, following these six steps can put your business on the road to substantial savings on your state and local tax bill.
Even with all the IRS' recent efforts to clarify the controversial issue of independent contractors (including the amnesty program we mentioned in the January "Tax Talk" column), some courts are getting tougher in their rulings. For example, a recent decision by the U.S. Court of Appeals for the Ninth Circuit reversed a lower court's ruling and found that hundreds of independent contractors working for Microsoft Corp. were regular employees and thus eligible to participate in the company's 401(k) and stock purchase plans.
In light of this trend, more companies are shying away from independent contractors and instead are using employment agencies or professional employer organizations. By going this route, a company can sidestep the tax and legal problems associated with independent contractors because these agencies put workers on their own payrolls, pay the appropriate taxes, and do all the paperwork.
If you are concerned about the independent contractor issue, you may want to look more closely at employment agencies or employee leasing options to avoid potential tax snags.
CCH Inc., 2700 Lake Cook Rd., Riverwoods, IL 60015, (847) 267-2482;
Coopers & Lybrand LLP, 1 Post Office Sq., Boston, MA 02109, (617) 478-5097;
Deloitte & Touche LLP, 1000 Wilshire Blvd., Los Angeles, CA 90017, (213) 688-6969;
KPMG Peat Marwick LLP, 2001 M St. N.W., Washington, DC 20036, (202) 467-3802.
Joan Szabo is a writer in McLean, Virginia, who has reported on tax issues for more than 11 years.