Although Israeli companies operating in the US often focus on federal tax concerns, US state and local taxes (SALT) have the potential to significantly increase tax liabilities.
For example, if a company does not collect sales tax from its customers and fails to file any sales tax returns, its obligation to pay the tax can accrue indefinitely – and the liability is based on gross taxable sales, not net taxable sales.
Therefore, it is possible to conduct business at a loss and thus have no federal or state corporate income tax liability, but still owe a substantial sales tax liability because of the company’s failure to collect and remit such taxes. While this is just one example of state tax liabilities exceeding a federal tax liability, many more exist.
There are more than 10,000 state and local taxing jurisdictions in the US with their own rules. This article addresses the top ten SALT challenges Israeli companies may face when doing business in the US.
1. The requisite tax connection, or nexus, for SALT
Where to file
Whether a company is required to file tax returns in a jurisdiction depends on whether the company has a sufficient jurisdictional connection (ie, nexus) in the state. Historically, a physical presence (eg, office or employee) has been required. Nowadays, all that is needed is an economic presence for sales tax purposes and, in many states, for income tax purposes as well.
South Dakota v. Wayfair Inc., a US Supreme Court case decided in 2018, held that states can require out-of-state sellers to collect and remit sales tax, as long as the tax applies to an activity with a substantial nexus with the taxing state. As a result, all states with a sales tax now look to a fixed dollar amount of sales in the state to create “economic nexus.”
While the thresholds differ in each state, most states will require a company to register with the state revenue collecting agency and collect sales tax if the company has more $100,000 of sales to the state and/or 200 transactions in the state. For income taxes, some states will also look at the level of sales to determine whether a company has a filing responsibility.
2. State tax structure
Optimizing structure to reduce state taxes
Companies are encouraged to explore various structuring options for establishing a US parent company or subsidiary, or for expanding operations within the US. It may be particularly important to consider which states to operate in to minimize income tax liability. This can be important for the Flip structure involving Israeli companies – whereby a US domestic corporation owns a former Israeli parent entity – which can lead to increased funding opportunities and provide other benefits in the US for startup founders.
As part of their SALT planning, companies can consider whether the state requires combined reporting of all tax items of a parent-subsidiary or with its affiliates (which is similar, but not identical, to the federal consolidated return rules), or requires each entity to file a separate income tax return to report its own items of income, deductions, and net operating losses.
The location of a company’s operations in the US could also be beneficial from its and its employees’ perspectives since several states do not impose a personal income tax, while some states do not impose a corporate income tax.
3. Sales and use tax imposed on sales and purchases of products and services
Determining whether a sales tax liability exists
Sales taxes currently pose one of the most significant SALT challenges for businesses. This is because the sales tax laws were drafted at a time when certain technological products and services – such as Software, Platform, and Infrastructure as a Service (SaaS/PaaS/IaaS) – were not yet available, and more purchases were made at brick-and-mortar stores.
Some companies find it challenging to determine whether their products are taxable in each state where they have a nexus, especially given that definitions of certain products and services can differ across states. For example, while two states may tax SaaS, the definition of “SaaS” may not be the same in both states.
Companies also often sell more than one product or service to a customer at a time – charging one price for the bundle – when a portion of the bundle is not taxable. Companies are left to determine whether they will charge tax on the entire amount of the sale.
4. Historical tax liabilities
Making corrections
If a company has not sorted its sales tax filing and collection obligations, sales tax will need to be considered if and when the company begins to raise its next round of funding, becomes a target for an acquisition, begins its plans to go public, or is audited. This is because sales tax becomes the company’s liability if it does not collect the tax from its customers. If the sales tax is not passed on to the customer, the liability continues to accrue and cannot be extinguished without payment.
Determining sales tax exposure is now part of the due diligence process for most US investors and bankers, especially in anticipation of a funding round or an exit. DLA Piper assists Israeli companies in the US with determining whether there is exposure, how much the exposure will cost, and how to best minimize the exposure.
The issue of historical liabilities is also relevant to income tax. However, it does not come up as often because many companies are either in loss positions or have losses available to offset income. With that said, there are certainly ways to address any historical income tax liability and liability related to other taxes where historical obligations may exist.
5. State tax credits and incentives
Choosing where to do business
Many states welcome companies that create jobs and make substantial capital investment in the state. Often, they are willing to provide tax credits, property tax abatements, sales tax abatements, and other incentives in exchange for the companies’ presence, employees, and investment in the state.
If your company is looking to enter the US market or expand into another state, the potential for such tax credits and incentives may be an important factor in choosing the states in which to establish your presence or make capital investments.
6. SALT corporate income taxes
Apportionment and allocation
Consider whether your company is apportioning income or allocating certain income to the correct state tax jurisdiction. This is key because, when a company has nexus for corporate income taxes with multiple states, each state vies for its slice of the federal taxable income pie.
States can constitutionally impose their corporate income tax on apportioned net income or certain allocable receipts to the state. States use one or more of the following factors for purposes of such formulary apportionment:
- Property factor compares the value of real and personal property owned or leased in the state to such property located everywhere.
- Payroll factor compares wages paid to employees located in the state to total wages paid to employees everywhere.
- Sales factor compares receipts from sales of tangible goods, from services, and for specific types of income sourced to the state versus total income from everywhere; states also differ on whether to source to the state or elsewhere income/fees earned from providing services based on (i) the cost/place of performance in the state or (ii) market-based sourcing to the state in which the customer derives the benefit of such services.
Interestingly, apportionment should be considered even when choosing which state to operate in. As an example, if a company chooses to be based in a state with a three-factor apportionment formula – as opposed to a state that only looks to sales in the state for apportionment purposes – it will be penalized because property and payroll will be considered as part of the tax base. Apportionment is one of the most contested areas of tax and cannot be overlooked as an issue to consider.
7. State conformity to federal law
Income protected under a federal income tax treaty and treatment of foreign source income
If a foreign entity earns income that is exempt from US federal income taxation, there is the question of whether a state or locality will follow suit.
Some states have specific legislation or guidance that provides whether the state will or will not conform to the federal income tax laws. In particular, some states exempt income from corporate income tax if such income is exempt from US federal income tax (i) under a federal income tax treaty or (ii) because the income is classified under the federal tax laws as not effectively connected (non-ECI) with a trade or business of the foreign taxpayer in the US.
For other states, one must note whether the state corporate income tax rules adopt federal taxable income as the starting point for the state corporate income taxes, thus implicitly adopting a similar exemption from state corporate income taxes.
In addition, states vary in their conformity to the special federal tax rules (eg, global intangible low-taxed income, or GILTI, and foreign-derived intangible income, or FDII) that were enacted into law in the 2017 Tax Cuts and Jobs Act, as well as other principles of federal tax law applicable to special deductions – such as dividends – and net operating losses.
8. Public Law 86-272
Protecting certain sellers of tangible personal property from state income tax
Public Law 86-272 is a federal law that protects companies from being subject to a state’s corporate income tax if the only in-state activities are related to the solicitation of tangible personal property sales or de minimis activities.
While the parameters of this protection are relatively narrow, the impact could be substantial if the business activities are solely limited to the sale of tangible personal property.
Recently, several states have tried to limit the scope of PL 86-272 protection (eg, by issuing guidance that having cookies installed when visiting a website exceeds the PL 86-272 protection).
Moreover, some states (eg, California) take the position that foreign companies are not afforded the protection of PL 86-272 altogether because the statute says “interstate” as opposed to activities between the US and another country. To the extent your company sells tangible personal property, it is worth analyzing how to structure the business to take advantage of the protections of PL 86-272.
9. Miscellaneous taxes
More than 10,000 state and local taxing jurisdictions
While our “top ten” has primarily focused on sales tax and corporate income tax, states impose many other taxes that may be considered when doing business in the US. While this list is not exhaustive, other taxes relevant to businesses include the below:
- Employment tax: Employers are required to withhold a percentage of the employee’s wages in trust to be provided to the state. Employment taxes may become difficult to navigate when there is a remote workforce because the states’ threshold to withhold income from the take-home pay of employees varies, with virtually no uniformity across states.
- Real estate transfer tax: A tax on the transfer of real property, with some states imposing the same or a similar tax on the transfer of a controlling interest in an entity that owns real property.
- Property tax: An annual tax for owning property in the state. These taxes are based on the value of the property itself, and the valuations are often subject to debate. There are also ad valorem taxations in states that are imposed based on the value of tangible personal property located in the state.
- Unincorporated business tax: Several localities impose a separate income tax on unincorporated entities. As an example, New York City imposes its unincorporated business tax on non-incorporated entities doing business in the state. Complying with each locality’s rules can become complicated and make tax planning even more complex.
- State and local gross receipts taxes: Certain states (eg, Ohio and Washington) and certain localities impose a gross receipts tax based on total revenue, but typically at a lower tax rate than an income tax. For example, San Francisco imposes its gross receipts taxes on all entities conducting business within the city. Gross receipts taxes are burdensome on businesses that have not yet generated taxable income because no taxable income is needed to be subject to the tax. Understanding the nuances of gross receipts taxes can help companies reduce the tax burden.
10. Abandoned/unclaimed property
The requirement to give customer property back to the state
While not technically a “tax,” most state rules for escheating (ie, returning) abandoned and/or unclaimed property to the state operate in a similar manner. The main difference is the tax rate on unclaimed property is 100 percent.
The purpose of these rules is to give abandoned property to the state after a prescribed dormancy period so that the rightful owner of such property can reclaim it directly from the state at a later date. Common items of unclaimed property include uncashed checks, unused gift cards, and abandoned account payables, among other items.
Most states look to the address of the potential claimant of the property to determine where money should be escheated, but, if the address of the claimant is not known or is in a foreign country, the property is required to be escheated to the state of incorporation of the entity that holds the unclaimed property.
Complying with these requirements for a holder can be complex and, if not done properly, can result in significant amounts of interest and penalties imposed on the holder.
Moreover, if an unclaimed property return is never filed, the statute of limitations does not begin, and the historical liability can become material, as the full value of the property is required to be returned to the state. There are also voluntary disclosure programs to address unclaimed property matters with the state.
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