Three State and Local Tax Issues Tech Companies Need to Address Now

ROB SCHWARZMANN: Welcome everyone to the latest installment of a podcast series we've put together that focuses on state and local tax issues specifically for technology companies. My name is Rob Schwarzmann. I'm a tax partner with Cherry Bekaert's Technology Group, and I'm joined today by Cathie Stanton, who leads our state and local tax practice, and Tony Konkol, a manager in our state and local practice. Cathie, Tony, thanks for joining.

CATHIE STANTON: Thanks for having us, Rob.

ROB SCHWARZMANN: As a firm, we serve a large number of technology companies. To kick things off, our listeners would love to know the state tax issues you're seeing most that affect these companies.

CATHIE STANTON: Technology companies make up a large portion of our SALT work. State tax statutes were often written decades ago, long before computers and the internet, so states are behind in addressing disruptive technologies. They typically wait until technologies are more developed, observe what other states are doing, and then issue assessments.

CATHIE STANTON: We do have some framework to work with now. The three areas we see most in the technology space are nexus, sourcing of revenue, and pass-through entity elections. Nexus is simply whether you have enough connection with a jurisdiction to be subject to its tax structure. Every state has different taxes and many lack uniformity, so you must be aware of each state's rules.

CATHIE STANTON: Sourcing of revenue is the second area. With cloud-based services or mobile use, it can be unclear where revenue should be sourced. Wayfair changed nexus rules and shifted focus away from physical presence. States are moving from domicile-based taxation to source-based approaches—asking where the revenue and customers are and where the benefit is received.

ROB SCHWARZMANN: Wayfair really turned sourcing and revenue on its head. At one point people thought no physical presence meant no filing requirement. That is out the window.

CATHIE STANTON: Exactly. States are changing statutes on income tax sourcing. It used to be where services were performed or where intangible property was located. Now it's where the benefit is received and where the users are located. If a customer buys multiple licenses, the question becomes where those licenses are actually used. Sourcing can be granular, and it affects nexus determinations.

CATHIE STANTON: We often have to do a sourcing review before a nexus review because economic nexus thresholds are based on sourced revenue in a state. It used to be we performed nexus reviews first, then further state and local tax projects. Now sourcing often comes first.

ROB SCHWARZMANN: Tony, any additional thoughts or client examples related to nexus and sourcing?

TONY KONKOL: Some states have look-through provisions that consider the customers of your customer. The question is whether a state allows you to look through and attribute activity to those downstream customers.

CATHIE STANTON: To sign a tax return, an accounting firm needs substantial authority and a reasonable possibility of success, which is roughly a one-in-three chance. We need statute, regulation, or case law as authority. The move to source-based distribution adds gray areas. Benefit-received approaches can be more of an art than a science, which sometimes allows us to develop favorable positions for clients, particularly pass-through entities owned by individuals in no-tax states.

ROB SCHWARZMANN: What do you tell early-stage or growth-stage technology companies that are currently at a loss and say they'll worry about state tax when they're profitable?

CATHIE STANTON: Entrepreneurs often prioritize product development over tax compliance, which is understandable. If you have nexus but no tax due, penalties are generally based on tax, so it may not be a big issue. However, establishing net operating losses (NOLs) in states where you operate can be valuable because you can carry them forward when profitable. States have become more stringent on how many years back they'll allow returns to establish NOLs, so delaying filings can result in lost NOLs.

CATHIE STANTON: In technology, defining what you're selling is crucial. Something that seems like "software as a service" might be treated differently by some states—data processing or professional services—and that affects sourcing. The third major area is pass-through entity elections, which has been very active legislation-wise and can offer significant benefits for profitable entities or large sale events.

CATHIE STANTON: The PTE election stems from the federal SALT cap that limits individuals to a $10,000 deduction for state and local taxes. States have enacted legislation allowing a pass-through entity to elect to pay state tax at the entity level, converting non-deductible individual taxes into deductible business expenses at the federal level. The IRS has indicated that this approach is acceptable, though regulations are not finalized.

TONY KONKOL: The mechanism reduces owners' ordinary income by allowing the entity to take a deduction for state tax paid at the entity level. That reduces the owners' reported income on their individual returns.

ROB SCHWARZMANN: Scenario: My roommate and I started a company in college. Last year we sold 80% to a private equity group but remained a partnership. Can we take advantage of this election?

CATHIE STANTON: You'd want the partnership itself to recognize the gain so the income is at the pass-through entity level. This election is at the entity level, so the gain must reside in the partnership and flow through K-1s. If the gain is taxed directly to individuals, they're subject to the individual SALT cap.

ROB SCHWARZMANN: If in year three we sell while partnered with private equity, can we use the election then?

CATHIE STANTON: It depends on the structure. States adopted different qualification requirements and tax bases; there was no uniform approach. Some states disqualify entities with corporate blockers or certain corporate owners, so restructuring may be necessary. Election dates and qualification rules vary by state.

ROB SCHWARZMANN: Tony, what nuanced issues should people be careful of?

TONY KONKOL: Non-resident owners complicate filing requirements. Entities that previously filed composite returns for non-resident partners may find they can't both make the PTE election and file a composite return in certain states. Some states allow one or the other but not both, and some disallow the owner credit on composite filings, which can result in double taxation.

CATHIE STANTON: For example, if you had 200 partners and it costs $1,000 per return, that's $200,000 in preparation costs. In a state like California, a pass-through entity tax could be imposed at 9.3% with non-resident withholding at 7%, and you might have to wait until filing to get refunds.

ROB SCHWARZMANN: So if you're organized with entities and individuals as owners, there are opportunities, but it depends on organizational structure and where you do business. Is there a scenario where the PTE election is a no-brainer?

CATHIE STANTON: Generally, if a pass-through entity's owners are all in one state, most apportionable income is in that state, and that state offers the election, it's usually beneficial. Problems arise when owners live in states that don't allow credits for tax paid at the entity level—then you can double tax and negate any federal benefit. In multi-state situations, you must ensure no owners are harmed. Review partnership agreements to confirm who can make tax elections and whether votes are required.

TONY KONKOL: It's important to analyze who benefits and who could be harmed and to document the authority for making elections to avoid disputes.

ROB SCHWARZMANN: If you're in a multi-state setting with a complex capital structure, get assistance before proceeding. For simpler single-state structures, the opportunity is easier to calculate and may benefit all members.

CATHIE STANTON: This ties back to nexus and sourcing. If we can source more revenue in a state that offers the election—income you'd be paying tax on anyway—you can make that tax deductible federally. That may motivate planning to shift more income or create nexus in certain states to take advantage of the deduction.

ROB SCHWARZMANN: Lots to consider. This is definitely the new focus area in state and local tax. Thank you, Cathie and Tony, for joining and sharing your insights. For everyone listening, subscribe to Cherry Bekaert's podcast series to keep up with our industry teams and specialists, and visit CBH.com to learn more or ask questions.

CATHIE STANTON: Thanks for having us, Rob.

ROB SCHWARZMANN: Thank you.