What Is Apportionment for State Income Tax?

When a business operates in more than one state, state income tax apportionment is the method used to divide its income among those jurisdictions. This process ensures each state can tax its fair share, preventing income from being taxed by multiple states or escaping taxation altogether. The apportionment percentage determines how much of a company’s total income is subject to a specific state’s corporate income tax. For example, if a company has $100 million in income and a state’s formula yields a 15% apportionment, $15 million of its income is taxable by that state.

Determining Which Income is Apportioned

Before apportioning income, a business must classify its earnings as either business or nonbusiness income. Only business income is divided among states using an apportionment formula. Nonbusiness income is allocated in its entirety to a single, specific state.

Business income is earnings from the regular course of a company’s trade or business, a definition evaluated through two tests. The transactional test considers if income comes from a customary business activity, like revenue from a retailer’s inventory sales. The functional test is broader, classifying income as business income if it comes from assets integral to the company’s operations, such as the gain from selling a factory.

Nonbusiness income is all income that does not meet the definition of business income, such as interest from unrelated investments. This income is allocated directly to a specific state, often the company’s commercial domicile or where the underlying property is located.

The Three-Factor Apportionment Formula

The traditional method for apportioning business income is the three-factor formula, standardized by the Uniform Division of Income for Tax Purposes Act (UDITPA). The formula averages three ratios representing a company’s business activity in a state: the property factor, the payroll factor, and the sales factor. The final percentage is calculated by adding the three factors and dividing the sum by three. This percentage is then multiplied by the company’s total business income to find the taxable amount in that state. For example, a business with 20% of its property, 25% of its payroll, and 30% of its sales in a state has an apportionment factor of 25% [(20% + 25% + 30%) / 3].

Property Factor

The property factor measures a company’s physical presence by comparing its in-state property value to its total property value. This factor includes the average value of all real and tangible personal property, such as land, buildings, and equipment, that the business owns or rents. Intangible assets like patents are excluded. Property owned by the business is valued at its original cost without reduction for depreciation. Rented property is often valued by multiplying the net annual rental rate by eight to create a value comparable to owned property.

Payroll Factor

The payroll factor quantifies a business’s labor presence through a ratio of total compensation paid to employees in the state versus total compensation paid everywhere. Compensation includes wages, salaries, and commissions, but not payments to independent contractors. Payroll is assigned to the state where the employee’s service is performed. If an employee works in multiple states, their compensation is assigned to a single state based on a hierarchy of tests, starting with their base of operations or the place from which the service is directed.

Sales Factor

The sales factor represents a company’s market presence and is a ratio of its gross receipts from in-state sales to its total sales. Under the traditional formula, sales of tangible personal property are governed by a destination rule. This rule sources a sale to the state where the property is delivered to the purchaser, regardless of where the order was placed or the shipment originated. For example, if a product is made in one state and shipped to a customer in another, the sale is sourced to the destination state. This rule applies to tangible goods; revenue from services and intangibles is sourced differently.

State-Specific Variations and Sourcing Rules

While the three-factor formula was a historical standard, most states have modified their apportionment rules to advance their economic policies. This has created a diverse landscape of formulas that businesses must navigate. States often adjust their formulas to incentivize local investment in property and payroll, leading to a trend of placing greater emphasis on the sales factor. The goal is to attract and retain jobs by reducing the tax burden on companies with significant in-state employment and capital.

Modified Weighting

A common departure from the traditional formula is modified weighting, where states give greater importance to the sales factor. The most prevalent example is the double-weighted sales factor. In this structure, the sales factor is counted twice and the total is divided by four, making sales account for 50% of the apportionment percentage. Some states have gone further with triple- or quadruple-weighted sales factors. This approach benefits businesses with substantial in-state property and payroll but who make most of their sales elsewhere, shifting the tax burden to companies that use a state’s market without a large physical presence.

Single-Factor Formulas

The evolution of apportionment has led many states to adopt a single-factor formula based exclusively on sales, which is now the predominant approach. This formula eliminates the property and payroll factors, so a company’s apportionment percentage is determined solely by the ratio of its in-state sales to its total sales. The policy is to encourage in-state investment. Under this formula, a company can build factories and hire employees within a state without increasing its state income tax liability, provided its sales are to out-of-state customers. This makes a state attractive for production, as the tax is tied to the market’s location, not the business’s infrastructure.

Sales Factor Sourcing Rules

State-specific variation is significant in the rules for sourcing sales of services and intangible property. While the destination rule for tangible goods is simple, states are divided on services between two methods: cost of performance and market-based sourcing.

Under the cost of performance (COP) method, revenue is sourced to the state where the income-producing activity is performed, based on the costs incurred. For example, if a consulting firm does all its work at its headquarters, all revenue is sourced to that state, regardless of the client’s location.

In response to criticism of COP, a majority of states have adopted market-based sourcing. This method sources service revenue to the location where the customer receives the benefit. For instance, if an architectural firm in one state designs a building for a client in another, the revenue is sourced to the client’s state.

Special Industry Apportionment

Standard apportionment formulas do not always accurately measure the business activity of specialized industries. Sectors like transportation, finance, and media have unique operating models that require tailored apportionment rules to distribute income fairly. States have developed specific formulas for these industries that replace or modify the standard factors with more relevant metrics. These industry-specific regulations are exceptions to the general rules and apply only to companies in those particular business activities.

Transportation Companies

For transportation companies like airlines and trucking firms, a sales destination is difficult to apply, so they often use a revenue-mile factor. A revenue mile is one passenger or one ton of freight transported one mile for a fee. The apportionment factor is calculated by comparing a company’s revenue miles within a state to its total revenue miles, which better reflects its business activity.

Financial Institutions

Financial institutions have business models centered on loans and deposits, not tangible goods. Special rules for this industry replace standard factors with metrics relevant to banking. These can include interest from loans secured by in-state property, receipts from in-state credit card customers, and the volume of deposits in local branches. These factors tie the institution’s income to the location of its customers and assets.

Publishing and Broadcasting

Publishing and broadcasting income comes from advertising and subscriptions tied to an audience, not a single point of sale. For these industries, the sales factor is based on circulation or audience data. For a newspaper, this could be the ratio of in-state to total subscribers. For a broadcaster, it might be the proportion of the audience located in the state, which measures the market penetration that drives advertising revenue.

Construction Contractors

Construction projects can span multiple years, so contractors present a unique case. States often require them to use a percentage-of-completion method to recognize income. Their apportionment factors are modified to reflect the ongoing nature of their work. For example, the property factor may include the value of construction in progress, and the sales factor may be based on revenue recognized in a given year from a long-term contract, sourced to the project’s location.