What Is the Apportionment of Taxes for Businesses?

When a company operates across state lines, its income must be divided among those states for tax purposes through a process called tax apportionment. States use this method to assign a portion of a multistate corporation’s taxable income to the jurisdictions where it conducts business. The goal is to ensure each state can tax a fair share of a company’s profits while preventing the same income from being taxed by multiple states.

A state’s apportionment formula determines the percentage of a company’s income subject to its corporate income tax. For example, if a company has $10 million in apportionable income and a state’s formula results in a 10% apportionment factor, then $1 million of that income is taxed by that state.

Differentiating Business and Nonbusiness Income

Before apportioning income, a company must distinguish between its business and nonbusiness income. Business income is subject to apportionment among multiple states, while nonbusiness income is allocated, or assigned in its entirety, to a single state. This distinction is foundational to multistate tax calculations.

Business income arises from transactions and activities in the regular course of a company’s trade or operations, such as revenue from selling its primary products or services. To define it, states apply two tests: the transactional test and the functional test. The transactional test considers whether the income-generating activity is one the business commonly engages in.

The functional test looks at whether the asset that generated the income served an operational function in the business. For example, if a manufacturing company sells an old factory, the gain from that sale is considered business income because the factory was an integral part of its operations. This test broadens the scope of what qualifies as business income beyond daily sales.

In contrast, nonbusiness income is all other income not directly tied to the company’s central operations. Common examples include interest from an unrelated investment, dividends from non-subsidiary stock, or capital gains from selling land never used in business operations. Proper classification is important, as mischaracterizing income can lead to it being incorrectly taxed.

The Three-Factor Apportionment Formula

Historically, the standard method for apportioning business income was the three-factor formula, giving equal weight to a company’s property, payroll, and sales within a state. The final apportionment percentage is the average of these three factors. This percentage is then applied to the company’s total apportionable income to find the amount taxable by that state.

The property factor compares the value of a company’s real and tangible personal property in a state to its total property everywhere. This includes assets like land, buildings, machinery, and inventory, which are valued at their original cost. To calculate the factor, businesses use the average property value for the tax year to account for major changes. For example, if a company’s average property value is $2 million in a state and $20 million everywhere, its property factor is 10%.

The payroll factor measures the proportion of a company’s total compensation paid to employees within a state compared to its total compensation everywhere. Compensation includes wages, salaries, and commissions, and is sourced to the state where the employee performs the service. If an employee works in multiple states, their pay is often assigned to their base of operations. If a company pays $1 million in compensation in a state and has a total payroll of $10 million, its payroll factor is 10%.

The sales factor compares a company’s total sales generated within a state to its total sales everywhere. For tangible personal property, sales are sourced to the destination state. For services, states use different sourcing methods, with market-based sourcing becoming increasingly common. Under market-based sourcing, revenue is assigned to where the customer receives the benefit of the service, as opposed to the cost-of-performance method, which sources it to where the work is done. Some states also have “throwback” rules, which require a company to include certain out-of-state sales back into the sales factor of the shipping state.

State Variations and the Shift to Sales Factor Weighting

While the equally weighted three-factor formula was once standard, most states have moved away from it to attract business investment. By reducing the emphasis on property and payroll, states can lower the tax burden on companies with a large physical presence. This creates a more favorable tax environment for businesses that invest in local facilities and employees.

A common modification is the double-weighted sales factor, which gives sales more influence in the calculation. The formula is the sum of the property factor, the payroll factor, and twice the sales factor, with the total divided by four. For example, a company with a 10% property factor, 10% payroll factor, and 50% sales factor would have a 30% apportionment factor: (10% + 10% + (50% x 2)) / 4.

A more significant departure is the single-sales factor apportionment formula, which an increasing number of states have adopted. This approach removes the property and payroll factors entirely. A company’s tax liability is determined solely by its proportion of in-state sales, which favors businesses with a large physical presence but most of their sales in other states.

The lack of uniformity among states creates a complex compliance landscape. A company might use a different formula in each state where it operates, requiring careful tracking of data and knowledge of each state’s rules. These differences can result in more or less than 100% of a company’s income being subject to state taxation.

Allocation of Nonbusiness Income

Nonbusiness income is not apportioned; instead, it is allocated based on rules that assign the income to a single state. The rules for allocating nonbusiness income depend on the type of property that generated it. Income from tangible property, like real estate or equipment, is allocated to the state where the property is physically located. For instance, rental income earned from a building is allocated to the state where the building stands.

Allocation rules for income from intangible property, such as stocks and bonds, are different. This income is allocated to the state of the corporation’s “commercial domicile,” which is the principal place from which the business is managed. For example, if a company with its commercial domicile in one state earns dividends from unrelated stock, that income is allocated to and taxed by its home state.