Income Tax Basics
Michael J. Fleming is the founder and president of Sales Tax and More, a full-service consulting and solutions firm with a passion for state tax. He is one of the country's leading authorities on sales tax issues such as consulting and research, registrations, returns, nexus, drop-shipping, eCommerce, and service providers.
Michael is a renowned writer and speaker, and he regularly presents on webinars. He is also the host of the Sales Tax and More Podcast, where he shares his wisdom and learnings with his audience in order to help them navigate the tricky world of taxes.
In this episode…
Mike Fleming and Ellie Moffat discuss and answer questions about income tax.
Here’s a glimpse of what you’ll learn:
What is an income tax and who is responsible for paying it?
How is income tax different from a sales or use tax?
Does income tax affect e-commerce sellers? Are they protected by Public Law 86-272?
Have there or will there be any major changes to Public Law 86-272?
What can businesses do to make sure that they’re staying income tax compliant?
Connect with Michael
Episode Transcript - Audio Version
[00:00:00] Welcome to Sales Tax and More your go-to resource for all things state tax related. Now here is your host, Michael Fleming.
Michael Fleming: Hi, Mike Fleming here, founder of Sales Tax and More, and today's co-host of the Sales Tax and More podcast where we talk about everybody's favorite topic, which is of course, sales tax. However, today we're going to divert a little bit and talk about income tax. But first, before we do, let me introduce you to my co-host, Ellie Moffat.
Ellie Moffat: A little bait and switch for everybody today, Mike. So yes, we're gonna be talking about income tax. Great to be here. Quick introduction for Sales Tax and More. We are full [00:01:00] service consulting and solutions firm. We have a really great team here of experienced tax professionals who are very dedicated to fulfilling your state tax and related needs.
So we do a lot of sales tax returns, sales tax registrations, consultations, research, audit, defense, and more. So if you have questions about our services, please reach out. We would love to hear from you and we would love to work with you. And please, please, please like and subscribe to this podcast as well.
So, Mike, what is an income tax and who is responsible for paying it?
Michael Fleming: Okay, good question. Just to let you know, today we're gonna be talking about state income taxes, not federal income taxes. And state income taxes, they're generally gonna be net income taxes. There are other types of taxes, but primarily we're gonna be talking about net income taxes.
And net income is really another way of saying it's a tax on your [00:02:00] profits. So the company is responsible for paying a tax on its profits. Now the follow up question to that should be who does it get paid to? And the way that most states work is they have apportionment formulas and there's, you know, the sales in the state divided by the sales everywhere, and you get a percentage and apply that to your net income or your profits.
And then that is the amount that's used to apply the state's rate to, we're boiling this down way, way low. Or there is a three factor apportionment factor, and that's usually based on property sales and payroll. But you get an apportionment factor and you multiply that by your overall profits.
And then that percentage of the profits is taxed to the state where you may have nexus and have a responsibility or the state thinks that you should be paying them the tax on that apportioned amount of profits.
Ellie Moffat: All right. Thank you [00:03:00] so much, Mike. So how is this different than a sales or a use tax?
Michael Fleming: Well, it's different in a couple of ways. The first way is sales tax generally has a lot more potential exposure. See, sales tax is being paid on your gross sales. So the number's usually a lot higher. For example, if I have a hundred thousand dollars in gross sales, but a 10% profit margin. I'm probably talking about $10,000 or so in net income.
So an 8% rate on a hundred thousand dollars is $8,000, but an 8% rate on $10,000 is only $800. So the potential exposure for sales tax is a lot greater than income tax. And that's why a lot of our clients, they concentrate on the sales tax. They wanna make sure that they got the sales tax down because that's where their biggest exposure is gonna [00:04:00] lie.
That's where their biggest problems will be. And as they grow as they can, you know their potential exposure in these other states becomes meaningful. That's when they start taking care of the income tax in those states.
Ellie Moffat: All right. So does income tax affect e-commerce sellers? Are they protected by Public Law 86-272?
Michael Fleming: Well, that's really a two part question. So the answer to does income tax affect e-commerce sellers is our favorite answer. It depends. It depends on their specific facts and circumstances. And are they protected by Public Law 86-272? Also, it depends. It depends on the state. And it depends on their specific facts and circumstances. So let's tackle that first one. If you're an e-commerce seller, a lot of times you're gonna have inventory in an Amazon warehouse. Maybe you don't. But if you do, then states will say that, Hey, you [00:05:00] have a physical presence here and you need to be paying our income tax.
California very, very aggressive. And even though the inventories in an Amazon warehouse and Amazon's collecting the sales tax that's still can create nexus for income tax. And California is going after so many people and they're about two and a half to three and a half years backed up. Pretty much in all times.
So if you tried to take care of your past exposure it's gonna take you two or three years before they get to review your returns. Doesn't mean that you don't need to get it taken care of because the penalties and interest can really start stacking up. But it's gonna be a process.
It's not gonna be over tomorrow. So, does income tax affect e-commerce sellers? Absolutely in a state like Hawaii. Hawaii says that if you have a substantial nexus for sales tax you also have a substantial nexus for income tax. [00:06:00] And a hundred thousand dollars or 200 transactions is their thresholds for substantial nexus for both sales tax and income tax.
And therefore there is no protection from Public Law 86-272 as they say it. So it's gonna be very specific as to whether it can impact an e-commerce seller or if they are protected by Public Law 86-272. When it comes to Public Law 86-272, is the state following the current guidelines put out by the MTC or are they looking at the historical guidelines?
Right now there are 23 states that say they're going to adopt the new guidelines. But only less than a handful of states actually have. The protections of Public Law 86-272. Pretty simple. This is a federal law, and the federal law says if the only activities in a [00:07:00] state are solicitation and the orders go outside the state for approval and if they're shipped from outside the state into the state, then the state is not allowed to impose a net income tax on you. Now, there are lots of other types of taxes that may look, smell, or feel like an income tax. You're not protected from them. Only from a net income tax.
And that is the old rules. The problems is the Public Law 86-272 is passed in 1959 and we had a manufacturing based economy back then. We have a service based economy today. So if you are offering any types of services in addition to or instead of selling tangible personal property, then you're not protected.
When it comes to the example I was talking about earlier, you know, if you have inventory in a warehouse in California and that's only 2% of your sales, you don't say, okay, well only 2% of my [00:08:00] sales are subject to income tax. This is all or nothing protection. So once you pierce the protections of Public Law 86-272, you gotta pay all the tax.
So. Very, very limited protections. Now, if all you're doing is selling and you don't have any services whatsoever. You don't have any inventory in the state. I mean, if you're truly a pure, pure economic nexus and it's a state following the old guidelines, then you are protected by Public Law 86-272. If it's a state following the new guidelines like a New Jersey, if you're over a hundred thousand dollars or 200 transactions, then they say you are not protected by Public Law 86-272. If you do one of a list of things and one of those things is use cookies and most websites use cookies nowadays. Also, if you do any post-sale customer service. [00:09:00] Either by email or on your website by chat. So the new guidelines virtually eviscerate the protections of Public Law 86-272.
So you've got New York, New Jersey and California came out. They got their wrist slapped because of the way that they implemented. We think that they're going to continue pushing the new guidance on Public Law 86-272. Even though they got their wrists slapped, but the protections have always been fairly limited, but I think they're gonna become a lot more limited in the coming years here.
Ellie Moffat: And I think, Mike, you touched base on this, but I'll give you a chance to expand if you'd like to. But have there, or will there be any major changes to Public Law 86-272? And I know that you talked about are people evaluating historically, are they looking at the current guidelines. But anything else that you wanna really add to that?
Michael Fleming: Yeah, and you bring up a point I want to make. There's a great distinction between changes to Public [00:10:00] Law 86-272 and interpretations of Public Law 86-272 in light of Wayfair. What I've been talking about with the states are they using the new guidance of the old guidance is the interpretation of Public Law 86-272 based upon the impact of Wayfair and what the Supreme Court said in Wayfair. So the multi-state tax commission put out new guidelines but they're not binding. They're only suggestions on how states can do things. 23 states have said they're gonna accept in whole or in part these new guidelines, but they have not done so yet.
The law is still the law that has not changed. Just the interpretation of how the law applies based upon the new environment that we're looking at here. So a couple of things could happen. Congress may step in and they may clarify the law. Or the Supreme Court may step in and they may clarify the law.
[00:11:00] We're just talking about the interpretation of the law by a third party. And the states are saying we believe the Multi-State Tax Commission, which comes from a quasi-governmental agency itself. It's a compact. So, the law itself has not yet changed. The law has been the same since 1959.
It's just how we interpret it that is in sway right now. But Congress passed it in 1959 as a temporary law. Maybe they're finally getting around to making some of it permanent and making some changes while they're at it. I mean, it's been 66 years since they last visited this. And they flat out said, Hey, this is temporary till we can get our arms around nexus, because nexus is so confusing.
We gotta get it right. And here we are 66 years later, we still had this antiquated, wasn't great protection back then. Really not great protection [00:12:00] now. But it's the only thing that we have. So maybe Congress will step in, maybe the Supreme Court will step in. But if they don't, I see more and more states pushing forward with this new guidance from the MTC.
Ellie Moffat: Alright. Thank you so much, Mike. And what can businesses do to make sure that they're staying income tax compliant?
Michael Fleming: Again, the states say that you should be compliant from dollar number one. What we say is just like in sales tax is just because the state says you should do something does not necessarily mean that it makes good business sense to do so.
A state, like Virginia, they have an economic nexus of $1 when it comes to sales tax, they say any positive apportionment factor and sales is one of the apportionment factors. So if you have a dollar of sales, in theory, you could have nexus and be required by Virginia to file an income tax return in Virginia.
But you know what's the penalty and interest gonna be on [00:13:00] $1? So I think we need to use common sense when we're looking at this. Just 'cause the state says we should do it. Do we need to do it? And you know, if it's gonna leave a mark, if it's gonna really hurt if the state finds you, then by all means we need to be tax compliant.
But if the cost of compliance, in other words, if it costs more to do your taxes than the amount of tax you're gonna get paid. Hey I say let the state come and find you. That's not the answer the states want to hear. They probably give me a hard time when they hear that. However, to me, that just makes better business sense to take care of this when the numbers are material, at least when they're more than the cost of compliance. So that's the first part of that question there is we've gotta look at materiality. The second part you said, how can businesses make sure they're staying income tax compliant?
Well, number one staying abreast of which states are applying the old guidance on Public Law [00:14:00] 86-272, and which states are applying the new guidance. And then just doing, just like for sales tax, doing an income tax nexus review. Whether you do it yourself or whether you hire someone like us to do it you gotta know where your nexus footprint is, where potentially could you have a responsibility to file income tax. And sometimes that's not all negative because maybe a state where you have nexus has a lower tax rate than the state where you live. And a portion of your profits that's apportioned to this other state are usually removed from your own state.
So you could end up paying less money by paying income tax in more states. Now, again, what's the cost of compliance in multiple states? You gotta take that into effect. But in general, the tax is generally not paid to two states. There are certain instances where the same [00:15:00] tax may be apportioned to both states depending on how they do their apportionment factors.
And throwback rules and throw outs and everything else, it gets really, really complicated. But the point I'm trying to get to is it's not always a negative. Sometimes it's an actual positive. And there are firms that do a heck of a lot of tax planning out there when it comes to state income tax to lower your tax burdens.
So, that's not a big part of our business. We're primarily sales tax, but we do dabble in income tax when our clients require it.
Ellie Moffat: All right. Well thank you so much, Mike, for your time in answering these questions. And you know if you're listening and you have sales tax needs, we offer many solutions and services.
We also have an entire website full of free resources for you as well. You can reach out to me directly with any questions. My email is. [00:16:00] E-M-O-F-F-A-T at salestaxandmore.com and our website is salestaxandmore.com. So thank you so much for listening today and you can close us out here, Mike.
Michael Fleming: Okay, thank you everyone for joining us today and I promise next episode we'll be back to talking about sales tax 'cause I know that's your favorite topic.
Hope to see you then. Bye-bye.