By: Adam Beckerink, Eric Fader, Dakota Newton of Duane Morris LLP
Illinois’ corporate income tax rate is one of the highest in the nation. S corporations and partnerships are also taxed, although at reduced rates, under the same tax law. Yet, new developments in Illinois and across the country may present opportunities to reduce your Illinois income tax liability.
If your Illinois business sells goods or services to customers located outside of Illinois, it’s time to re-visit your business’ Illinois apportionment factor. The apportionment factor is how states divvy up their portion of your business income, which is generally your federal taxable income with state modifications. Since 2000, Illinois generally apportions a company’s business income based on single fraction, the numerator of which is sales in Illinois, and the denominator of which is sales everywhere.
Two businesses operating in Illinois that have the same ratio of in-state and out-of-state sales can have vastly different Illinois sales factor percentages and, thus, different Illinois income tax liabilities. What can be driving this difference? Whether the business is filing income tax returns in other states. That’s because Illinois sources, to Illinois, certain out-of-state sales when the business is not filing an income tax return in the destination state.
With recent court cases, states’ new interpretations of long-stating laws, coupled with changes in business activities (e.g., use of Amazon’s FBA service), filing state income tax returns in even more states – similar to what you may be doing for sales taxes as a result of the 2018 Wayfair decision – may not only reduce your non-filing position tax exposure but also reduce both your Illinois income tax liability and your overall state income tax liability. That’s because you’d be shifting your tax burden to a state with a lower tax rate. Plus, if you make sales to customers in other countries, an Illinois regulation revised on August 24, 2022, may also help reduce your Illinois income tax liability.
A Primer on Illinois’ Apportionment Formula
Prior to 1999, Illinois apportioned business income based on a three-factor apportionment formula comprised of a payroll factor, a property factor, and a sales factor (double weighted). The payroll and property factors gave weight to the origin state, while the sales factor was intended to give weight to the market state.
In years when Illinois used a three-factor formula, Iowa used (and still uses) a single-sales factor formula. Given the two states’ different apportionment methodologies, a business could end up sourcing 100% of its income to Iowa, plus 50% of its income to Illinois if all its payroll and property were in Illinois, and all of its sales were sourced to Iowa. In 1978, the U.S. Supreme Court upheld Iowa’s use of a single-sales factor formula.
Some early adopters of a single-sales factor were Iowa, Nebraska, and Texas. Illinois adopted a single-sales factor for tax years ending on or after December 31, 2000. In 2022, approximately 30 states now use a single-sales factor formula. This broad adoption makes it even more important to properly source your sales pursuant to each state’s laws – your apportionment formula may be solely dependent on it!
Illinois’ Sales Factor: Sourcing Sales of Goods
For businesses that sell goods, the Illinois generally sources such sales to the destination state for sales factor purposes. But, Illinois law incorporates a “throwback rule” that sources such sales to Illinois if the goods are shipped or delivered from Illinois to a customer in another state where you are “not taxable in the state of the purchaser.”
What does “not taxable” mean? That question has been the subject of litigation and currently evolving Illinois regulatory guidance. For example, what if the person has no tax liability in the destination state because (1) there is no income tax imposed (e.g., Nevada, Ohio, South Dakota, Texas, Washington, Wyoming); (2) your business has sales representatives in the destination state, but you are immune from income taxes pursuant to federal law, namely, Public Law 86-272; or (3) you are shipping to a customer overseas and you are immune pursuant to a U.S. tax treaty?
In 1995, the Illinois Appellate Court held that, to avoid throwback, a taxpayer must prove that it filed a tax return and paid tax in the destination state, that is, if the state imposed such a tax. The court reasoned that, with tax compliance being a self-reporting duty, the taxpayer has the power to file returns and pay taxes to avoid throwback. That’s not the rule in all states, though.
What’s new?
In August 2021, the Multistate Tax Commission, a state tax policy agency that various states govern and participate in, adopted a new interpretation of Public Law 86-272. Public Law 86-272 is a federal law enacted in 1959 that provides state and local income tax immunity when a person’s only business activity within a state during the year is limited to the solicitation of orders for sales of tangible personal property, and orders are sent outside the state for approval or rejection and, if approved, are filled by shipment or delivery from a point outside the state.
The MTC’s new interpretation of PL 86-272 provides that post-sale assistance via electronic chat or email can defeat a claim to PL 86-272 immunity. Is that the right answer? California and New York are on board with this new interpretation. In the meantime: would you be better off taking a filing position in states where your goods are shipped? Perhaps your claim to immunity is already in jeopardy if you have inventory held at an Amazon distribution center in the state. The key take-away here: will you ultimately pay less state income taxes by filing in the destination state and avoiding Illinois’ throwback rule?
Another new development is the Illinois Department of Revenue’s change, effective August 24, 2022, to regulation 100.3200 which had required taxpayers to throwback, to Illinois, sales shipped to foreign countries when the taxpayer has no liability because of a U.S. tax treaty. The Department just revised this throwback rule to provide that, for taxable years ending on or after December 31, 2022, if your activities abroad give the country jurisdiction to impose tax, you can avoid throwback, even though you aren’t filing or paying taxes to that foreign country.
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