Can we talk about something that’s a little bit awkward for small business owners? Specifically, can we discuss the “why file out of state tax returns” issue?
You know what I mean, right? You live and run your service small business out of state “X”. But you also go into and then operate in states “Y” and “Z”.
Or maybe you operate entirely in your home state. But you partner with some other firm—perhaps a giant ecommerce company named after a South American river—and so you own inventory scattered across a dozen states.
In situations like these, do you really need to worry about state income tax returns? Or about state sales tax returns? Gosh, that seems awfully complicated, doesn’t it? Wouldn’t it be easier—just between us chickens—to pretend you’re operating only in your home state? To pretend that you do not need to file out of state tax returns?
Lost of small business owners think the way I’m describing here. But you know what? You have at least three good reasons to follow the letter of the law. And for reasons that go beyond the fact that the law is the law…
Reason #1: A Large Sales Tax Liability Destroys Resale Value
Perhaps the biggest reason to comply with state and local tax laws is this: If you operate a multi-state business that should collect and remit sales taxes and don’t follow the rules, your small business may become unsaleable.
In other words, a small business with a long history of not complying with sales tax laws may create too much risk for prospective buyers.
Let me give you an example to put this all into context. Say you’ve got a sweet, $1,000,000 in revenues small business making, say, $200,000 annually.
Say the business sells stuff all over the country using Amazon’s “Fulfillment by Amazon” service.
A business like this might, on average, be worth $500,000 to a potential buyer. Small businesses often get valued at 2.5 times cash profits. ($200,000 times 2.5 equals $500,000)
If you don’t comply with state and local sales tax laws, however, you’re probably annually under-collecting between $50,000 and $100,000 in sales taxes. So over ten years, this will mean you potentially sidestep $500,000 to $1,000,000 in sales tax collections.
In this situation, you will find it very hard to sell your business for $500,000 if there’s a chance the buyer might get into an argument with a bunch of states about $500,000 to $1,000,000 in unpaid and uncollected sales taxes.
Reason #2: State Income Tax Liabilities Never Go Away for Nonfilers
Another reason to comply with state tax laws. If you operate your business as pass-through entity (so a sole proprietorship, partnership or S corporation) and you don’t calculate and pay the income taxes you owe any states in which you “operate”, you could have some state come back years later and ask for the income taxes you should have paid.
Let’s say, for example, that you do have a business that makes $200,000 and that half of this profit, or $100,000, gets earned and is therefore taxable in other states. This $100,000 of out-of-state profit might be creating an annual income tax bill of $5,000 to $10,000.
Over time, that’ll add up. In ten years, for example, you’re looking at $50,000 to $100,000 in total taxes.
Penalties might be another chunk—as a guess another 25%.
And then you’ll have interest on the taxes and the penalties. And that’ll add another big chunk, as the taxes, penalties and interest start to snowball.
But the real issue here is that old unpaid taxes never move “outside the statute of limitations” if you haven’t filed your state income tax returns.
This problem isn’t as big a problem as the sales tax problem. But over time, as noted, things snowball.
Reason #3: Heads Someone Else Wins Tails You Lose
The final reason to file out of state tax returns is that in a sense when you don’t file out of state tax returns you’re really taking a “heads someone else wins and tails you lose” bet.
But let me explain.
First, remember that your customers and not you pay the sales taxes.
One way to look at the sales tax question, then, is that your customers win if you don’t deal properly with the sales tax (because they avoid sales taxes)… and you and your business lose if your failure later gets spotted by a state (and you have to pay the sales taxes customers should have paid).
Note: One other thing to mention about sales tax accounting. Most and even all of the work for sales tax reporting can be done by outside vendors either for free or at a reasonably low price. Amazon, for example, will collect sales taxes. And the major sales tax return preparation vendor, Avalara, charges about $60 to file out of state tax returns (at this writing). By the way, we have no financial arrangement with Avalara. And our firm’s only arrangement with Amazon is that Amazon sells copies of our book QuickBooks for Dummies.
Second, in a way, state income tax accounting creates a similar “heads someone else wins and tails you lose” predicament.
Here’s why: Probably the income taxes you pay other states will become a credit against the income taxes you owe your state of residence if you deal with all this in a timely manner.
But if you don’t deal up front with the state income tax issue, you may find yourself paying state income taxes twice on the income you earn in other states. You’ll pay state income taxes to your state when you file your original tax returns. And then, if you’re caught, you’ll later pay state income taxes on that same income to the states you should have filed returns with earlier.
The problem here is that if the statute of limitations has expired on the returns you filed with your state–the returns that overallocate income to your state–you won’t be able to get a refund of the taxes you, in effect, paid to the wrong state.
The upshot? You may end up unnecessarily paying two states income taxes on the same income…
Note: Annual state income tax returns can also be easily handled by your CPA at a reasonable cost. Especially if you’re operating as a partnership or corporation.
Summing Up Situation If You Don’t File Out of State Tax Returns
Our digital economy creates lots of opportunity for small business owners who go multi-state. And you and I definitely want to be exploring those opportunities.
However, these digital economy opportunities do burden us with a longer list of tax returns to file. We want to take care of this stuff.
Last comment: Maybe this summer, you should call your CPA and ask about doing the out of state tax return stuff right…
Other Blog Posts You Might Find Useful
Amazon FBA Sales Tax: The Reality Sandwich
Small Business Multistate Taxation: A Short Primer
Multistate Taxation: Avoiding Costs & Hassles
Your argument #1 is a really good one. Any buyer worth his/her salt will check for this out-of-state tax liability during due diligence. If this tax liability is discovered during due diligence, it can only send up a red flag that maybe there are other aspects of your business operation that aren’t up to snuff. So how do the taxing authorities in other states find out? First, they share information across states to an extent you’d never imagine. Second, if you have any employees living in another state, that sets off a trigger that you have “business interests” in their state, and increases their efforts to examine any business revenue that you might have.
And I know firsthand that Steve’s argument #2 is true. For at least five years after I sold my small software company, certain states that focus on retrieving tax revenue from out-of-state businesses (Arizona is one that’s particularly ferocious) continued to send delinquent tax filing statements for at least six years after I sold my business. Worse, the buyer of my company reported my contact information to any inquiring state tax authorities for potenetial tax liabilities in years before they bought my company.
Lastly, by the time you pay any out-of-state tax liabilities that are in arrears, you’ve most likely paid the taxes in your own home state – and now you face the prospect of having paid double taxes, with a real headache on your hands about getting a tax refund from your home state.