Apportionment Rules for Service-Based Sales

Written By: Cortney Das

When our economy began to shift from manufacturing to service based, the state law had to revise its apportionment rules in order to address this change.  The apportionment formula was established in the late 20′s and early 30′s.  At this time the economy was dominated by manufacturers and therefore the original rules did not address services.  The new rules, however, lack uniformity or clarity thus creating many challenges for taxpayers to comply.

States have employed a variation of two general rules:

                            A.            Cost of Performance Approach

                             B.            Market-Based Sourcing Approach

Cost of Performance Approach

The “cost of performance approach” was introduced by UDITPA.  Using this approach, service-based income is sourced to the state in which the “income producing activity” is performed.  If the income producing activity is performed in two or more states, this may get complicated. 

States that have taken a cost of performance approach have adopted one of three methods for sourcing sales from services.  MOST states employ the “all or nothing” concept and attribute the sale to the state in which a greater proportion of the income producing activity is performed than in any other state, based on the “costs of performance.”  Other states employ a greater-than-50% test and source the sale to the taxing state if more than 50% of the income-producing activity is performed there.  Finally, some states employ the pro-rata cost-of-performance approach in which gross receipts derived from the performance of a service are prorated among multiple states based on the cost of performing the service in each state.

Additional guidance and examples of the terms “income producing activity” or “costs of performance” are provided by MTC Reg. IV.17

Market-Based Source Approach

UDITPA was drafted in 1957.  During this time, interstate commerce was rare.  Therefore, the cost of performance and the benefit received from a service often occurred in the same state.  Today it is standard for service providers and their customers to be located in two different states.  The sales factor is intended to measure the taxpayer’s customer base within a given state.  The “Cost of Performance” is not an accurate measure of a service company’s customer base (the original intention of the sales factor) therefore more and more states are beginning to adopt the “Market-Based Source Approach.”

The “Market Based Source Approach” attributes the sale of a service to the state in which the benefit is received.  In other words, the service income is sourced to the state in which the customer is located.  This is similar to the sales factor of manufacturing companies in which sales are sourced to the destination of the sale and not the origin. 

The states that have adopted a market-based approach for sales of services include Georgia, Illinois, Iowa, Maine, Maryland, Michigan, Minnesota, Ohio, and Wisconsin.  Illinois and Michigan were new to this list in 2008 and this list will continue to grow.

Given the non-uniformity of the states, it is necessary for most multistate service companies to gather the data for both methods.  This involves determining the costs associated with the activity, as well as the states in which those costs were incurred and the state in which the benefit was received. 

To make matters more complicated, Illinois employs a throw-out rule to its factor.  If the taxpayer is not taxable in the state in which the services are received, the sale is excluded from both the numerator and the denominator of the sales factor. 

While I have attempted to provide a brief overview of the concepts, this area of state law is more profound and always changing.  It is as the economy continues to make the shift towards the service-based economy, it is important for corporate taxpayers to understand and apply the related state apportionment concepts and mechanics. 

Congratulations to the Dave O. from Vandalia, MI, he is the winner of the autographed copy of The Truth About Paying Fewer Taxes by Kay Bell. Click on the link to buy your copy.

I have received a copy of “Stand up to the IRS” written by Tax Attorney Frederick Daily. After tax season I will be holding another book giveaway to this title. Mr. Daily has generously agreed to sign a copy and send to the winner. Be sure to look for that after tax season. While you are waiting please visit Mr Daily’s web site. The Tax Law Offices of Frederick W. Daily III

Special Thanks to my guest post author, fellow tweeter (Quornball) and tax professional Cortney Das. This is a great post and a greater help to me during the busy season. Thank you.