© Copyright NAPEO 2011
Reproduced with permission of the National Association of Professional
Employer Organizations
State Taxation
A Jigsaw Puzzle for Multi-State PEOs
Ronald J. Morelock, Esq. and Steven A. Pletcher, Esq.
Our old friend, Paul E. Oglethorpe (yes, he is still known as PEO to his friends), is ecstatic. The ace
salesman for his company, Employees R' Us, just signed up ERU's biggest client ever, Everything's
Ball Bearings, a company with manufacturing facilities in six different states, including ERU's home
state. While ERU has never done business outside its home state, as a diligent NAPEO member,
ERU knows that it needs to determine whether it will be regulated as a PEO in these states, and it
becomes registered in the states where it is required. Life is good as PEO rakes in the revenue from
this new client. Then multiple income and sales and use tax assessments start rolling in from the five
new states in which ERU is operating. Where did ERU go wrong?
Similar to other types of businesses, PEOs (not Oglethorpe, but PEOs generally) with multi-state
operations must remain vigilant about the applicability of various state and local taxes to their
business activities. Given the unique and often complex nature of individual state taxing regimes,
complying with state taxes requires a great deal of diligence on the part of PEOs, like any multi-state
business, and their tax advisors. PEOs are potentially subject to a wide variety of state taxes and
must be cognizant of this fact, especially upon entry into new markets.
This article focuses on a few of the more common state taxes potentially applicable to PEOs. 1
Generally speaking, those state taxes can be categorized into two groups: excise-type taxes on
business transactions, including sales, use, gross receipts, privilege, and franchise taxes; and net
income taxes on revenues. A key issue facing PEOs is whether a state tax applies to "full" gross
receipts from client companies, including reimbursements for co-employee payroll, taxes, and related
expenses, or to the "net" amount after allowance for a PEO's business expenses, i.e., the
administrative fee. Obviously, this distinction is of utmost importance in determining the potential tax
liability of PEOs.
Because businesses must be "doing business" in a state to trigger a state business tax, this article
touches upon a state's jurisdiction to impose tax on an out-of-state business, i.e., "nexus," and
identifies the apportionment techniques typically used to source business income to the taxing state.
These issues are particularly relevant to PEOs servicing clients operating in multiple states.
Transaction Taxes
States impose a wide array of excise-type taxes on business transactions, including the common
sales tax or a similar excise-type tax under a different name, e.g., a transaction privilege tax or
retailer's occupation tax. Notwithstanding the various labels, PEOs must be particularly aware of
whether each state in which they serve clients imposes a sales tax on transactions by PEOs.
While state sales tax almost always applies to sales of tangible personal property, to a lesser extent
some states also tax some service transactions.2 Although a detailed analysis is beyond the scope of
this article, most states currently do not impose sales tax on PEOs. In the limited instances where a
sales tax now applies, the nature of the sales tax requires the client company to pay the PEO who,
acting as a collection agent for the state, directly remits the sales tax to the state taxing authority. As
a word of caution, state taxing regimes are subject to rapid change and it is quite possible state
legislatures may look to expand sales tax into new or additional services to bolster state coffers.
Courts have the final say on the breadth of any sales tax. In this regard, it is worth noting that the
Pennsylvania Commonwealth Court recently ruled that a PEO that provided no new or additional
employees to the client company was not providing taxable help supply services, services that are
otherwise subject to Pennsylvania sales tax.3 If this favorable ruling holds up through the pending
appeals process, PEOs with similar operations would also avoid Pennsylvania sales tax.
Most states also impose a "complementary" use tax as "an excise tax on the consumption or use of
property, which is imposed on the user."4 A use tax is designed to prevent otherwise taxable
transactions from "slipping through the cracks" and escaping tax altogether. Basically, if a taxable
transaction occurs within a state, sales tax is typically paid to the vendor, but if the same transaction
occurs elsewhere for a purchaser's "use" in the state, the state use tax may apply to the purchase
price.5 For instance, use tax like this may arise when a PEO purchases tangible personal property
from an out-of-state vendor for use in the state, e.g., office computers or supplies, and the PEO's
state sales tax is not collected by the out-of-state vendor. The PEO is required to self-assess and pay
the state use tax on the purchase price of the items unless an exemption applies. In addition, if a
PEO does not collect sales tax from a client company when required, the client company could be
subject to the state use tax.
State gross receipts taxes are similar to sales taxes in that they tax a percentage of the recipient's
gross receipts, though these taxes are often lumped together with the other business income taxes
discussed below. Unlike a typical sales tax, a gross receipts tax is usually levied against the seller of
tangible personal property or services instead of the consumer.6 In addition, while most states provide
many exemptions from sales and use tax, there are relatively few exemptions from gross receipts
tax.7 While gross receipts taxes and net income taxes are tied to the business's income flow, the
difference between the two is the deduction of expenses typically allowed from net income taxes and
the lack thereof in gross receipts taxes.8
In a few states, a gross receipts tax has replaced a net income or franchise-based tax. Examples are
the fairly recently enacted Ohio commercial activity tax and the Texas franchise tax, but both provide
statutory deductions that allow the taxes to resemble a business income tax, at least with respect to
PEOs. Favorably, the Ohio commercial activity tax is limited to the PEO's administrative fee;9 and the
Texas franchise tax is also limited to the PEO's administrative fee. 10
Business Income Taxes
State business income taxes take on many forms, including the traditional net income tax, as well as
a tax based upon a business's worth, measured through a capital stock tax, and a corporate franchise
tax. Under the various state business income taxes, the type of legal entity can greatly impact the
manner in which a PEO is taxed, not only within its home state, but also in any other state in which it
is "doing business." Depending on the type of entity, certain PEOs may be subject to a business
income tax, while others may pass income untaxed through to their owners, who themselves may
become subject to a personal income tax in the state.
Without sufficient minimum contacts with a state, i.e., nexus, a PEO will not be subject to a state
business income tax. When subjecting out-of-state businesses operating within their respective states
to business income taxes, the majority of states establish nexus criteria by statute, though
jurisdictional requirements under the U.S. Constitution also factor into the equation. PEOs should
examine individual state jurisdictional standards before engaging in business within the state to
determine whether, in fact, the state would consider the PEO subject to its taxing authority. Although
a detailed analysis is beyond the scope of this article, generally speaking, most states will likely
conclude that maintaining co-employees within the state is sufficient to establish nexus.
Once a PEO determines it has nexus for a state's business income tax regime, the next issue is to
determine how the state calculates business income. Nearly every state imposes some form of net
income tax on businesses established as corporations or similar to corporations in operation. State
business income tax statutes generally begin with some variation of federal taxable income with a
variety of state-specific modifications, i.e., additions and subtractions. Unlike a gross receipts tax,
PEOs structured in a manner subject to a state net income tax may typically deduct expenses such
as wages and related taxes, rent and equipment expenses, and depreciation from income to calculate
taxable net income.
A state is limited to taxing business income earned within its borders. Nearly every state has adopted
an apportionment formula to measure the level of the taxpayer's business activity within the state. 11
This formula generally consists of a business's property, payroll, and sales within and without the
taxing state, and is designed to satisfy constitutional requirements. Using these factors, a ratio is
created comparing, for example, property held by the business within the state to property held
everywhere, payroll within the state to payroll everywhere, and sales within the state to sales
everywhere.12 A majority of states use a modified three-factor formula with a double weighting of the
sales factor and some states have created specific apportionment rules for service businesses. To
properly calculate its net income tax liability, it is important for a PEO subject to a state business
income tax to determine whether the standard or a special apportionment rule applies. In addition,
some states consider the co-employees' wages and related expenses to be included in the formula,
while others exclude those amounts.13 Determining an appropriate apportionment formula and, even
the amount subject to tax, may be difficult for a PEO, as these formulas tend to vary from state to
state.
As Paul E. Oglethorpe learned the hard way in the area of state business taxes, it is vital that PEOs
consult with their tax advisors prior to engaging in operations in any state to assure knowledge of and
compliance with the tax laws of all jurisdictions in which PEOs operate.
Ronald J. Morelock's professional experience includes five years as a manager in multi-state tax
services for Deloitte, and five years as a hearing officer for the Indiana Department of Revenue.
Steven A. Pletcher counsels clients on employee benefits issues relating to the Employee Retirement
Income Security Act (ERISA), the Multiemployer Pension Plan Act, and various state laws. Morelock
is an attorney and Pletcher is a partner with Scopelitis, Garvin, Light, Hanson & Feary, Indianapolis,
Indiana.
This article is designed to give general and timely information on the subjects covered. It is not
intended as legal advice or assistance with individual problems. Readers should consult competent
counsel of their own choosing about how the matters relate to their own affairs.
1 Excluded from this article are state payroll and unemployment tax reporting schemes, a tax
subject worthy of a stand-alone article.
2 Casser, 259 PLI/PAT 251; See, e.g., Conn. Gen. Stat. CH 219 Sec. 12-407.
3 All Staffing, Inc. v. Commonwealth, 325 F.R. 2006 (December 2, 2010).
4 Corpus Juris Secondum, 85 C.J.S. Taxation § 1992 2004.
5 Id.
6 Id.
7 Id.
8 1610 Tax Mgmt. State Portfolio.
9 ORC § 5751.01(F)(2)(x).
10
Tex. Tax Code 171.1011(k).
11
1820 Tax Mgmt. State Portfolio, supra.
12
Id.
13
1991 WL 153363 (Ill. Dept. Rev.)