July 8, 2013

By Joe Haberzetle, JD, LLM

If you are a Washington-based professional services business with at least some of your clients located outside the state, how do you know whether (or to what extent) you’re required pay the state’s business and occupation (B&O) tax on your income from those clients?

That is a complicated question, and one that has frustrated businesses for many years. To try to alleviate this confusion (and to shift some of the tax burden to out-of-state companies, as explained below) the 2010 Washington legislature enacted significant reforms to the so-called “apportionment rules” for businesses earning income from services and intangibles. The new rules went into effect on June 1, 2010. These rules apply not only to professional service providers (such as lawyers, accountants, business consultants, architects, engineers, doctors and dentists), but also to personal service providers (e.g. hairdressers and personal trainers) and to franchisors, authors, musicians and other royalty recipients.

Before June 2010, it was difficult for these types of businesses to determine how much of their receipts from customers located outside of the state were subject to B&O tax. The State required the use of a complex cost apportionment method that was byzantine, often misunderstood, and very difficult for most businesses to apply. It was based on a percentage of costs inside and outside the state and required the use of different methods for sourcing each kind of cost. Most businesses were confused and dissatisfied with how this apportionment method worked.

What the New B&O Tax Apportionment Means

The central concept of the 2010 law change is that receipts from services and intangibles are now taxed based on where the customer receives the benefit of the service or uses the intangible. For example, consider a law firm that does work for a client located outside Washington. In general, revenue from that work would not be subject to B&O tax under the new law because the client receives the benefit where it is located. Likewise, a franchisor would generally be subject to B&O tax only on royalties received from Washington franchisees. The impact, which was anticipated by the new law’s proponents, is to shift some of the burden of the B&O tax away from Washington-based service providers and onto companies based outside of the state (but with a substantial Washington customer base).

The “Throw-Out Rule”

Unfortunately, the new law contains provisions that add considerable complexity to its operation. Foremost among these is a “throw-out rule” that says if an entity does not file tax returns in the jurisdiction where the customer is located and would not have a “taxable presence” there under Washington standards, its receipts from customers in that state must be spread pro rata among the jurisdictions where it does have such a presence (including Washington). For this purpose, a “taxable presence” is determined using the same rules Washington applies to decide whether a non-Washington business is subject to B&O tax. Thus, for states in which a business does not file tax returns, it must generally have at least $250,000 in annual receipts from customers in the state – or at least 25 percent of its total receipts there – in order to avoid paying B&O tax on at least some portion of those receipts. The worst case scenario under the new law exists for Washington based service businesses that have non-Washington customers and don’t file tax returns or exceed any of the above thresholds in any other state or foreign jurisdiction. In that case, the business would pay B&O tax on 100% of its receipts despite the new apportionment rules.

The ostensible purpose of the throw-out rule is to avoid the situation where a company has receipts that are not being taxed by any jurisdiction. This is why a company that does file business tax returns in a state is not subject to throw-out on its receipts from customers located there, even if it doesn’t exceed the receipts threshold. However, the rule undeniably adds a layer of complexity to an apportionment method that was intended to simplify the calculation of B&O tax for Washington taxpayers.

Questions to Consider

Also, although these new rules are more straightforward for most taxpayers than what previously existed, there can be significant uncertainty in determining where a customer receives the benefit of a service. For example, if a customer headquartered in Oregon has stores in 10 different states, does the customer receive the benefit in Oregon or in proportionately at all of its stores or is the entire benefit received at the headquarters? If the receipts from this customer must be spread among the 10 states where it has stores, should they be allocated pro rata to each store or should the locations with greater sales be more heavily weighted? What if the seller isn’t privy to the information it would need to allocate its receipts in this manner?

The application of the new rules can be markedly different for different types of businesses – and although a regulation applying the new rules was finally issued in late 2012, it appears that the Washington Department of Revenue is still grappling with how these rules should apply in various circumstances. Given this uncertainty, a letter ruling from the state may provide some relatively inexpensive insurance (and possibly a refund opportunity, if the business has been paying B&O tax since 2010 on a larger proportion of receipts than it should have been).

Like most tax law changes, there are winners and losers under the new rules. Those who take the time to understand the nuances of the new law will give themselves the best chance to be among the former rather than the latter.

© Clark Nuber PS, 2013.  All Rights Reserved

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.