Companies from around the world sell their products and services into the U.S. market, either directly or through a US subsidiary. These businesses are continually looking for better ways to understand the tax and overall business climate. Many companies investing in the US need to better understand Federal as well as state income taxes. Each state is able to apply its own different tax rules and regulation to businesses that have a taxable presence within their jurisdiction.
This article will highlight the differences between federal and state taxes in the United States.
Essential Facts
- Taxes are levied both at the state and federal level.
- Each state has its own rules and rates regarding corporate income tax, which can vary significantly.
- Low corporate tax does not mean a particular state is the best location for starting or operating a business and there are other types of taxes levied on businesses that they need to be aware of.
What are U.S. State Taxes?
Every U.S. state has the authority to impose its own tax rules and rates, including a corporate net income tax applied to both foreign and domestic businesses. As a result, individual companies will need to register separately and file tax returns in each state where they have a taxable presence. This taxable presence is known as a ‘nexus’ and is determined by various factors. It is not uncommon that states base their tax system on the federal tax code, but many also implement their own system.
U.S. State Tax vs. Federal Tax
For foreign businesses looking to operate in the U.S., usually, the greatest consideration is how the entity’s income will be taxed at a federal level. Since it is being levied by the Federal government, it applies to every business regardless of which of the 50 states it operates in.
On the other hand, individual U.S. states will then apportion taxable income according to their own rules to companies that have nexus in that state.
An important thing to keep in mind is that just because a state has a favorable (or even 0%) corporate income tax rate, this does not necessarily make it the best place to do business. Foreign businesses need to take into account all tax issues at both federal and state-level to determine how their total income will be taxed, including sales tax and property tax.
If you are looking to start with a broader understanding of the different tax issues inbound businesses face in the United States, take a look at our recent post: U.S. Corporate Taxes: What to Look Out for When Entering the U.S. Market.
Who Has to Pay U.S. State Tax?
Generally, a business must have ‘nexus’ in a given state to become subject to its net income tax. Nexus is defined as a business’s presence within a jurisdiction, determined by how a business maintains a physical presence but also includes other factors like how much sales or commercial activities occur in that state. If a business is determined to have a nexus, whether it is a domestic or foreign entity, the state has the legal right to impose its own US state tax upon the business.
Paying Tax in Multiple States
If a company has nexus in more than one state, it is subject to the tax code of many states. If this is the case, the company’s overall taxable income will be apportioned among the states, based on property, sales, and payroll in each state. Since each state has different rules, you may not be taxed in any state or may be double taxed in certain cases.
Penalties for Non-compliance with U.S. State Tax
Non-compliance with U.S. tax laws both at the federal and state level may bring a range of consequences for both the foreign company and its employees. In general, a company can expect to pay back taxes, as well as relevant fines and penalties for non-payment.
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Other State Tax Issues
Although many states impose an income tax based on the net income a number of states also impose a franchise or gross receipts tax either as a replacement of the net income tax or in addition to it. Foreign businesses should be aware that even if they are not subject to corporate net income tax in a specific jurisdiction, they may still need to pay franchise, sales, or gross receipts tax as part of their U.S. state taxes obligation.
While some states do not choose to impose a corporate income tax at the state level, this does not mean that a state necessarily has the most favorable tax climate when it comes to doing business there. For instance, property tax, sales tax, gross profits tax, and individual income tax rates could be high even if the corporate tax is low.
Businesses must conduct a careful state-by-state analysis to accurately determine how income from a foreign company will be calculated and taxed.
While some states do not choose to impose a corporate income tax at the state level, this does not mean that a state necessarily has the most favorable tax climate when it comes to doing business there.
Gross Receipt Tax (GRT)
A gross receipt tax (GRT) is a state tax on the gross receipts of a business, which is often imposed in lieu of a corporate income tax or sales tax. Generally, the gross receipt tax is based on a taxpayer’s total gross receipts earned within a specific state.
While gross receipt taxes look similar to sales tax, however, they are designed to tax sellers, not consumers.
Franchise Tax
Many states also levy a franchise tax instead of, or in addition to, a net income tax. Generally speaking, the franchise tax is a levy paid by certain companies and entities that want to do business in certain states and is determined based on a company’s apportioned net worth.
Sales Tax
A sales tax is a type of consumption tax imposed on the sale of goods and services that is levied at the point of sale to consumers. In most of the world, value-added tax (VAT) schemes have been adopted as an alternative, but the US still retains its conventional sales tax system that each state imposes based on its own rules.
Whether a business must pay sales taxes to a particular jurisdiction will depend on the way the state defines nexus. As mentioned earlier, this can be created by a physical location (warehouse or office), employees located in that state, or sales thresholds, or other factors depending on the specific US state tax laws in each jurisdiction.
Whether a business must pay sales taxes to a particular government will depend on the way that the state defines nexus.
Tax Treaties and U.S. State Tax
Foreign companies entering the U.S. often seek to limit their tax exposure by applying international tax treaties that help reduce the federal government’s ability to impose taxes on them. However, a common misconception many companies have is that federal tax treaties between the United States and foreign countries apply to state taxes.
Regardless of the tax treaty applying at the federal level, certain states will treat it as being taxable in that state. Essentially, a non-U.S. company under the protection of a federal tax treaty may be at risk of non-compliance with its U.S. state tax regulations, if it assumes wrongly that it is covered by international tax treaties between two nations.
Certain states will allow specific protections for non-U.S. entities by default, due to the application of international tax treaties. The reality is that many businesses find it difficult to fully understand the nuances of the U.S. tax system when it comes to navigating federal and state taxes. Professional tax advice and guidance is prudent when doing business in the U.S.
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State Subsidies
Many U.S. states offer programs for companies that choose to do business in their jurisdictions. For instance, specific states provide tax credits that lower the effective tax rates for certain industries, such as agriculture or energy.
When evaluating whether or not to take advantage of a corporate subsidy, such as tax breaks, cash breaks, or tax refunds, always remember to check how it factors into a broader assessment of whether a particular state is suitable for long-term business growth.
U.S. State Tax Strategies for Foreign Businesses
Foreign businesses investing in the US must pay close attention when operating within the U.S. in regards to potential exposure to federal and state taxes. To many nations like Japan, the federalist system is unfamiliar and the way that taxes are imposed through multiple authorities and at different tiers can seem overly complicated.
It is up to individual companies and organizations of various shapes and sizes to understand where they have a taxable presence and how it interacts with their business.
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