What Is State Apportionment and How Is It Calculated?

When a company operates in more than one state, its income must be divided among those states for tax purposes through a process called apportionment. This uses a formula to assign a portion of a business’s income to each jurisdiction where it operates, preventing the same income from being taxed by multiple states. For example, if a business earns $10 million and a state’s apportionment formula determines 10% of the company’s activity occurred there, that state can tax $1 million of the company’s income. This system is how corporate income taxes are administered in a national economy.

Establishing State Tax Nexus

Before a state can require a business to apportion its income, the business must have a connection, or “nexus,” with that state. Nexus is the legal threshold granting a state the authority to impose its tax laws on an entity. Historically, this connection was based on physical presence, but the concept has expanded with the digital economy.

Physical presence nexus is created when a business has tangible ties to a state, such as an office, warehouse, or retail store. Other activities that establish physical presence include employing workers in the state, storing inventory in a local warehouse, or owning property. The presence of sales representatives operating on behalf of the company can also create this connection.

Economic nexus allows a state to assert tax jurisdiction based on a company’s economic activity, even without a physical footprint. This principle was solidified by the 2018 Supreme Court case, South Dakota v. Wayfair. While the case was about sales tax, many states now apply similar economic standards to corporate income tax. The specific thresholds vary, with some states setting revenue requirements at $100,000, while others use thresholds of $500,000 or more. A company with significant remote sales into a state may be required to file and pay income taxes there.

The federal law, Public Law 86-272, limits a state’s power to impose income tax. It prohibits states from taxing the net income of businesses whose only activity in that state is soliciting orders for tangible personal property, provided those orders are approved and shipped from outside the state. This protection does not extend to sellers of services or intangible goods. States now argue that activities like interactive websites and post-sale online support go beyond the law’s protections.

The Three-Factor Apportionment Formula

The traditional method for apportioning business income is the three-factor formula, which considers a company’s property, payroll, and sales. The formula weighs a company’s property, payroll, and sales within a state against its total amounts everywhere. The final apportionment percentage is determined by averaging the three individual factor ratios.

Property Factor

The property factor measures a company’s physical assets within a state, including all real and tangible personal property the business owns or rents for its operations. To determine the property factor ratio, a business divides the average value of its in-state property by the average value of its total property. Rented property is valued at eight times its net annual rental rate to approximate its value as if owned.

Payroll Factor

The payroll factor measures a company’s workforce within a state based on the total compensation paid to employees, including wages, salaries, and commissions. The ratio is calculated by dividing the total compensation paid to employees working within the state by the total compensation paid to all employees. This factor reflects the contribution of labor to income generation.

Sales Factor

The sales factor is based on a company’s gross receipts from transactions. The ratio is calculated by dividing the company’s total sales generated within the state by its total sales everywhere. Sales of tangible personal property are sourced to the state where the goods are delivered to a purchaser, known as the “destination rule.” The sourcing of receipts from services or intangibles is more complex and varies by state.

State-Specific Formula Variations

Many states have modified the traditional, equally weighted three-factor formula, often due to economic policies. By changing how the factors are weighted, states can create a more favorable tax environment for companies with a large physical presence but most of their sales elsewhere.

A common modification is the “double-weighted sales factor” formula, where the sales factor is counted twice. The property and payroll factors are each counted once, and the sum is divided by four to find the apportionment percentage. This method gives greater importance to sales activity, reducing the tax burden on businesses with substantial in-state property and payroll but lower in-state sales.

Another modification is the “single-sales factor” formula, where property and payroll factors are disregarded. A company’s income is apportioned based only on its sales, with the percentage being the ratio of in-state sales to total sales. This method favors businesses based in the state that sell nationally, as it shifts the tax burden to companies with high sales into the state but little physical presence.

Allocating Nonbusiness Income

Not all corporate income is subject to apportionment. States distinguish between business income, which is apportioned, and nonbusiness income. Business income arises from the regular course of a company’s trade or operations.

Nonbusiness income is derived from activities outside a company’s central operations. Examples include interest and dividend income from investments, royalties from patents, or capital gains from selling an asset unrelated to the core business.

Nonbusiness income is “allocated,” meaning 100% of the income is assigned to a single state. This is the state where the income-producing asset is located or where the company is commercially domiciled. For instance, rental income or a capital gain from selling real estate is allocated to the state where the property is located.