How Nonresident Business Allocation Works

When a business operates in more than one state, its owners must pay taxes on the income earned within each jurisdiction. States require nonresident owners to determine the portion of their business’s profit generated from activities within their borders. This process, known as allocation and apportionment, is the method used to source income correctly so that states can tax their fair share. Understanding this system is necessary for maintaining compliance across multiple states.

Determining Business and Nonbusiness Income

The first step in allocating income is to distinguish between business and nonbusiness income. Business income is defined as earnings from the regular transactions and activities of a company’s primary operations. This includes revenue from selling goods, performing services, or renting property if those activities are central to the company’s purpose. For a clothing retailer, income from selling apparel is business income.

Nonbusiness income includes all earnings outside a company’s main operations. Common examples are interest from investments, stock dividends, or capital gains from selling an asset not part of the core business. For instance, if a manufacturing company sells land held as a passive investment, the gain is classified as nonbusiness income.

States use two tests to make this distinction: the transactional test and the functional test. The transactional test determines if the income came from an event in the regular course of business. The functional test is broader, examining if the asset that generated the income served an operational function. An asset can meet the functional test even if the income-generating transaction is rare, such as selling a factory.

This classification dictates how income is sourced. Business income is apportioned, meaning it is divided among the states where the company operates using a formula. Nonbusiness income is allocated in its entirety to a single state. For an individual owner, this is their state of residence or, for real property, the state where the property is located.

Information Required for Apportionment

A business must gather financial data related to its activities in every state where it operates. This information is organized into three categories, known as factors, which form the basis of the apportionment formula.

Property Factor

The property factor accounts for all real and tangible personal property the business owns or rents for its operations. For owned property, the original cost is used, not the depreciated value. This includes land, buildings, machinery, and inventory. The business must calculate the average value for the tax year by adding the beginning and end-of-year values and dividing by two.

Rented property is also included in this factor. Its value is determined by multiplying the gross annual rent by a state-set multiplier, which is often eight. This calculated amount is added to the value of owned property to determine the total property value for the factor.

Payroll Factor

The payroll factor consists of the total compensation, such as wages and salaries, paid to employees during the tax year. This calculation does not include payments made to independent contractors. The payroll must be sourced to the state where the employee’s services are performed.

For employees who work in multiple states, their compensation is assigned to their base of operations. If they have no regular base, it is assigned to the state from which their activities are directed. This requires tracking where work is physically performed to assign payroll expenses to each state.

Sales Factor

The sales factor is based on the business’s gross receipts from all transactions, including sales of goods and revenue from services. For sales of tangible personal property, the destination rule is the most common method. This rule sources the sale to the state where the property is delivered or shipped to the purchaser. For services, sourcing rules are often based on where the customer receives the benefit of the service.

Businesses must also be aware of “throwback” or “throwout” rules, which apply to sales made into a state where the business is not taxable due to a lack of nexus. The throwback rule requires the seller to reassign these sales from the destination state to the state from which the goods were shipped. The throwout rule excludes such sales from the denominator of the sales factor.

The Apportionment Calculation

The apportionment percentage determines what portion of the total business income is taxable in a specific nonresident state. The calculation involves creating a ratio for each of the three factors. A factor’s ratio is determined by dividing the amount attributable to the state by the total amount of that factor everywhere.

For example, if a business has $200,000 of its total $1,000,000 in sales delivered to customers in a particular state, its sales factor for that state is 20%. The same calculation is performed for the property and payroll factors to find their state-specific percentages.

The traditional method to combine these factors was the three-factor formula, which gave equal weight to property, payroll, and sales. The three factor percentages are added together and divided by three to find the final apportionment percentage. For example, a business with a 10% property factor, 15% payroll factor, and 20% sales factor would have a 15% apportionment factor for that state.

Many states have moved away from the equally weighted formula to place greater emphasis on sales. A number of states now use a single-sales factor formula, where only the sales factor is used to apportion income. Other states use a double-weighted or heavily weighted sales factor, which gives more influence to the sales percentage in the final calculation.

After determining the final apportionment percentage, it is multiplied by the company’s total apportionable business income. This calculation yields the dollar amount of income earned in the nonresident state, which is the figure subject to that state’s income tax.

Reporting Allocated Income and Tax Credits

The business reports the income apportioned to a nonresident state on its state income tax return. For pass-through entities like partnerships or S corporations, the return includes an apportionment schedule. The apportioned income is then passed to the individual owners on a state-specific Schedule K-1, which details each owner’s share of the income.

Using the state K-1, the owner files a nonresident individual income tax return and pays the tax due. To prevent double taxation, the owner can then claim a credit on their resident tax return for the taxes paid to the nonresident state. This credit offsets the home state tax liability on that same income.

Many states now offer an elective Pass-Through Entity (PTE) tax as an alternative. This system allows a pass-through business to pay state income tax at the entity level. When a business makes this election, it pays the tax directly for its owners. The owners then receive a credit on their resident state income tax return for the taxes paid by the entity, which simplifies their filing obligations.