Startups Must Consider Several State Tax Traps to Avoid Scrutiny

Because startups are still in the early stages of business, they may not focus significant efforts on state tax considerations at a time when growth takes priority. However, state tax matters have both immediate and future impact.

A startup could also find itself unnecessarily weighed down by audits for state tax and unclaimed property matters or other disputes with taxing authorities, such as requests to enter into voluntary disclosure agreements or compliance programs, or imposition of penalties and interest for late-filed or unfiled reports.

Among other priorities, startups should consider nexus and remote workers, gross receipts taxes, and unclaimed property when looking to stay ahead of potential regulatory challenges.

Nexus and Remote Workers

Given that startups and companies more generally are moving toward a remote workforce, companies now understand that they have income tax withholding obligations on behalf of their remote employees in states that impose a personal income tax. This applies even if the company doesn’t have a permanent office in the state.

However, startups may be surprised to learn their remote workers may trigger entity-level income tax filing obligations for the company itself. Under the US Constitution, a state can impose tax on a company if it has “substantial nexus” with that state, which includes having employees who perform services there.

Although any nexus determination is inherently a facts and circumstances analysis, states may consider a startup to have “substantial nexus” even if it has one employee working remotely depending on the extent of that employee’s presence.

Accordingly, startups must carefully analyze the states where their remote employees will work or may work in the future to determine, on a state-by-state basis, whether any income-tax filing obligations may have arguably been triggered.

Gross Receipts Taxes

Startups often determine they have no state income tax filing obligations because the company has no federal taxable income. However, startups’ entity-level compliance efforts shouldn’t stop at entity-level state income taxes.

Certain states, such as Ohio, Nevada, Texas, and Washington, have entity-level taxes that are calculated based on a company’s gross receipts, rather than net income. As a result, startups with substantial revenue but no federal taxable income will likely have filing obligations in states with gross receipts taxes.

Gross receipts taxes are also imposed at the local level. For instance, San Francisco imposes a gross receipts tax on all taxable business activities attributable to San Francisco. Similarly, Philadelphia imposes its business income and receipts tax on all entities engaged in business within the city.

In addition, gross receipts tax systems often use filing due dates that differ from the usual March 15 and April 15 filing deadlines that apply to income-based taxes.

For example, Nevada’s commerce tax has an Aug. 14 due date, and Ohio’s commercial activity tax has a May 10 due date for annual filers.

Due dates for cities’ gross receipts taxes may also run on different filing deadlines. For instance, the due date for San Francisco’s gross receipts tax is Feb. 28.

Unclaimed Property

Unclaimed property laws provide a mechanism to return property to owners that is in the possession of a company—the “holder” of the unclaimed property. Holders of unclaimed property are required to turn these balances over to states if they are unable to find the owner once the applicable dormancy period has expired (usually three to years).

Although unclaimed property isn’t a tax, states use the proceeds from unclaimed property as a revenue source, similar to tax revenue. For example, unclaimed property revenue is Delaware’s third-largest revenue source behind personal income tax and corporate franchise/LLC tax. Unclaimed property can also feel like a tax to the extent a company has written off a balance or taken a liability into income but is later required to report and remit that balance to a state.

States also have become increasingly aggressive in enforcing their unclaimed property laws, often using contingent fee audit firms, threatening the imposition of substantial penalties and interest for companies that have failed to report property, and creating burdensome and expensive appeals processes. States often seek to assess holders for property dating back several years, and many audits use 15-year (or longer) lookback periods.

Startups must determine whether they are holding any property that is or could later be considered escheatable, which must be turned over to states once certain conditions are met. The following types of intangible property are all potentially escheatable to states if unclaimed by owners for the applicable dormancy period:

• Employee wages
• Accounts payable (such as vendor payables)
• Accounts receivable credit balances
• Refunds
• Customer credits
• Employee benefits

Holders in certain industries may also encounter issues related to gift cards or customer financial accounts, including virtual currency and brokerage accounts. Startups must take the time to invest in gaining an understanding of these laws and adopting an unclaimed property compliance process as early as possible.

Doing so early in a company’s existence will help mitigate future unclaimed property exposure and defend against state audits and examinations. Companies may be surprised to learn this can include any state where the property owner is located, not just states where the business has operations.

Understanding unclaimed property laws can also be a source of opportunity. For example, companies may be able to use various exemptions or unique provisions in these laws to recognize revenue on amounts booked as liabilities. A company may also be owed unclaimed property by another party and can recover such amounts that have been reported to states. This type of “found money” could be crucial to a startup.

All this doesn’t comprehensively address every state tax trap startups should note. However, after reviewing the issues presented, we hope that startups will be armed with enough information to at least identify potential state tax traps.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Michael Giovannini is partner in Alston & Bird’s global tax services group, providing creative strategy in multistate tax and unclaimed property planning issues.

Josh Labat is a senior associate in the same practice, helping clients navigate complex tax controversy matters.

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