The complexities of income tax

In addition to federal income tax, all but six states impose a corporate income tax on companies operating as a C-corporation. Most of these states begin with the federal taxable income reported to the IRS and make various state adjustments. As with sales tax rules, the state laws around what adjustments are required can be tricky. However, with a few exceptions, if a startup is in a loss position for federal income tax, it will likely be in a loss position for state income tax as well, resulting in minimal cash outlay.

Where things get blurry in the income tax space is when states impose a gross receipts tax, either in addition to or in lieu of an income tax. For example, Texas imposes a Gross Margin Tax, which begins with the gross receipts of a company then allows for certain deductions like cost of goods sold. It is typically accounted for like an income tax on the books of the company. Because the Texas Gross Margin Tax does not start with federal taxable income, it typically results in a cash outlay by the company.

In contrast, Washington does not impose a corporate income tax, but it does require corporations to file and pay its Business & Occupation (B&O) tax, which must be filed concurrently with a sales tax return and is calculated based on the gross receipts of a business without deductions. The B&O tax is typically accounted for like a sales tax on the books of a company; however, it is a tax in addition to the sales tax and usually cannot be passed on to customers. Therefore, it is a cash hit to a company like an income tax.

Smaller and newer companies operating as C corps tend to be operating at a loss so that income tax may not be a significant cash expenditure immediately, but simply an administrative filing obligation. However, as more states are looking into gross receipts options, startups need to pay attention to where they may have additional income tax obligations. In Oregon, for example, companies must pay both a corporate income tax and a corporate gross receipts tax.

What is nexus and how does it relate to sales tax and income tax?

Nexus is a connection to a particular state or jurisdiction that rises to a level that triggers an obligation to pay corporate income tax (for C corps) there or collect and remit sales tax there. A startup might have nexus in a state due to a physical presence such as an office or employee there or due to economic activity — a particular volume of and/or dollar amount of sales in the state.

Each state has different rules about nexus. Startups need to track where they have physical and economic presence and compare the details to each state’s regulations. Those rules have changed in many states recently due to the landmark 2018 U.S. Supreme Court decision South Dakota v. Wayfair, which gave states the ability to implement economic nexus rules for sales tax.

Even before the Wayfair decision, which focused on sales tax, states had been putting economic nexus rules on the books to govern when companies had to pay corporate income tax. Companies often challenged these rules, which Wayfair made it much more difficult to do.

The bottom line

Because sales tax is a tax on sales, not a tax on some net income, as a startup you’re much more likely to be responsible for remitting sales tax to one or more states than you are to be required to pay income tax. Therefore, it is much more likely that you may have a sales tax exposure than an income tax exposure in your early years. But in both cases, there are so many variables that you’ll do best with professional advice.

Work with a tax advisor or service to ensure that you’re staying in compliance with all your sales tax and income tax obligations.