What CDEs Need to Know About State Tax Issues
Question: What state tax issues does a community development entity (CDE) need to consider and how should they be addressed?
Answer: CDEs make qualified low-income community investments (QLICIs) into qualified active low-income community businesses (QALICBs) under the new markets tax credit (NMTC) program. When a QLICI is made to a QALICB outside of the CDE’s state of commercial domicile, which is the principal state in which the CDE conducts business, the CDE can potentially face myriad state tax issues, most notably related to nexus, tax filing requirements and apportionment.
When considering the states for which a tax filing requirement exists, a CDE needs to consider where it has nexus. Nexus is a connection to a state that gives the state the ability to impose a tax on a taxpayer. Historically, nexus was established through a physical presence test: if the taxpayer had an office or employees in such a state, it would have nexus and need to consider filing a return in that state. However, states have been trending away from the physical presence standard and toward economic nexus. Under an economic nexus regime, a taxpayer would trigger nexus so long as there is an economic presence within the state, even if there was no physical presence within the state. The threshold for economic presence can be very broad (any income sourced to the state will trigger economic presence) or well-defined (income sourced to the state more than a specified dollar amount will trigger economic presence), as the definition varies by state.
Many states have adopted factor presence thresholds, in which nexus is established when the taxpayer meets a quantitative threshold, either through dollar value and/or percentage of property, payroll or sales receipts within the state. Certain states have a provision to adjust these thresholds periodically to account for inflation. While a CDE may have previously only filed a state tax return for its state of commercial domicile, this shift toward economic presence increases the likelihood that a CDE will have a filing requirement outside of its state of commercial domicile.
It can be challenging for a CDE to determine whether it has nexus for a state that asserts nexus based on economic presence rather than one using a bright-line factor presence standard. However, a CDE may be able to determine whether there is sufficient nexus with the state by considering the following factors: a CDE that has made a QLICI in the form of a loan to a QALICB should assess whether the loan is secured, whether that security is real or tangible personal property, where that collateral is located and the QALICB’s geographic market. A CDE that has made a QLICI in the form of an equity investment into a QALICB should assess where the QALICB has nexus and filing requirements.
The next piece to consider once nexus and filing responsibility have been established is to figure out apportionment. For purposes of sourcing receipts from services, states most commonly use the cost-of-performance sourcing approach or market-based sourcing approach. However, certain states also have special apportionment rules for financial institutions. While CDEs may not be a financial institution in a traditional sense (i.e., a bank), certain state tax laws may still define CDEs as financial institutions based on the lending activities undertaken for apportionment purposes. Under cost-of-performance sourcing, a taxpayer will assign receipts to the state where the taxpayer incurred the costs associated with performance of the service. For a CDE that has made loans to a QALICB, the income would typically be sourced to where the solicitation, investigation, negotiation, approval and administration of the loan occurred. Under market-based sourcing, a taxpayer will assign receipts to the state where the customer benefited from the taxpayer’s services. For a CDE that has made loans to a QALICB, the income would typically be sourced to the state where the QALICB’s geographic market is located when using market-based sourcing.
Cost-of-performance sourcing is falling out of favor with states, for a similar reason that states have been moving away from physical presence test: states want to capture tax revenue from businesses that benefit from their state but do not have a physical location or employees within the state. In that regard, states that have adopted market-based sourcing are also transitioning to single sales factor apportionment, in which a taxpayer’s income apportioned to a state is based only on its sales receipts within the state in relation to its total sales receipts, rather than sticking with the traditional three-factor apportionment, which is based on the taxpayer’s proportion of property, payroll and sales receipts within the state in relation to the totals. This shift tends to favor states where a QALICB does business.
Something to be aware of for a CDE with a multistate filing requirement is that there is a possibility that while one state employs market-based sourcing for apportionment, another state employs the cost-of-performance sourcing for apportionment which may result in a “nowhere income” scenario (income is not apportioned to any state because loan originates in a market-based sourcing state while income is attributable to a cost-of-performance state) or a “double taxation” scenario (the same income is subject to taxation in two states because loan originates in a cost-of-performance state while income is attributable to a market-based sourcing state).
Sometimes, it is necessary to determine where the benefits from the taxpayer’s services are received for market-based sourcing before we can assess where nexus and filing requirements are triggered. Suppose a CDE (CDE A), located in State B, has made a loan to a QALICB (QALICB C), that conducts business in both State D and State E. All three states, States B, D and E have adopted the market-based sourcing rules for apportionment. Without knowing the amount or the proportion in which the sales should be sourced to State D or State E, CDE A would be unable to figure out whether its activities have met factor presence thresholds or whether there is sufficient economic presence to trigger nexus and a filing requirement in State D or State E.
Nexus and apportionment rules are varied between states, complex and ever evolving. It will be pertinent for CDEs to assess their nexus and filing responsibility at least annually to determine whether there are any additional filing requirements that have occurred over the prior year. To the extent that a CDE may trigger nexus and filing responsibilities in states that would require withholdings on behalf of partners (if the CDE is taxed as a partnership) or make estimated income tax payments (if the CDE is taxed as a corporation), the assessment on nexus and apportionment should be made more frequently.
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