A Very Short Primer on Tax Nexus, Apportionment, and Throwback Rule

March 28, 2016

We get a lot of questions from legislators and journalists about nexus and apportionment, two important concepts in state tax policy that affect what multistate corporations pay in taxes, and which states they pay it to.

The best run down of these concepts can be found in our 2015 edition of Location Matters: The State Tax Costs of Doing Business. I’ve pasted the relevant section here:

Nexus is the legal term for whether a state has the power to tax a business. The historical rule that remains mostly in force is that a state only has power to tax a business if the business has property or employees in the state, a concept known as “physical presence.”

Some states, however, have adopted aggressive nexus standards in recent years seeking to expand state taxing power to businesses operating in other states.

Firms with nexus in more than one state must use state rules to apportion their profits, determining how much of their income each state may tax. Historically, profits were apportioned among states in the ratio of the company’s property and payroll in each state.

For example, if 50 percent of a firm’s payroll was based in Colorado and 50 percent of a firm’s property was in Colorado, Colorado would be able to tax 50 percent of the firm’s profits. Long the historical standard, this property-and-payroll formula was unsuccessfully recommended by the congressional Willis Commission to be the uniform national standard in 1959.

States resisted this recommendation and instead as a whole adopted the Uniform Division of Income for Tax Purposes (UDITPA), also known as the “three-factor formula.” This formula apportions profits based on each state’s share of the firm’s overall property, payroll, and sales (each of the three “factors” is averaged equally). For example, if 50 percent of a firm’s payroll was based in Colorado and 50 percent of the firm’s property was in Colorado, but only 1 percent of the firm’s sales were in Colorado, Colorado would be able to tax approximately 34 percent of the firm’s profits if it used a three-factor formula.

Over the past few years, many states have increased the weight of the sales factor, with some relying on it completely. This change has had the effect of reducing tax burdens for businesses that have most of their property and payroll in the state but only a small proportion of their national sales in the state, while increasing tax burdens for out-of-state companies that have minimal property or payroll in the state but a large proportion of their national sales in the state. For example, if 50 percent of a firm’s payroll was based in Colorado and 50 percent of the firm’s property was in Colorado, but only 1 percent of the firm’s sales were in Colorado, Colorado would be able to tax approximately 1 percent of the firm’s profits if it used a single sales factor formula.

Since many businesses make sales into states where they do not have nexus, businesses can end up with “nowhere income,” income that is not taxed by any state. To counter this phenomenon, many states have adopted what are called “throwback” or “throwout” rules to identify and tax profits earned in other states but not taxed by those states.

Under “throwback” rules, such profits are taxed by the state where the sale originated. Under “throwout” rules, such profits are ignored in calculating the state’s share of total profits, by subtracting them from the apportionment denominator. For example, if Colorado has a single sales factor formula and a throwback rule, a firm with only 1 percent of its sales in Colorado and 75 percent of its sales in a state where it is not subject to an income tax would see those sales “thrown back” to Colorado. Colorado would thus be able to tax 76 percent of the firm’s profits.

Experts disagree on what the ideal apportionment formula should be. Some economists, favoring a consumption tax, prefer single sales factor apportionment, as the tax then falls on consumption (albeit clumsily). The most notable version of this argument comes from Charles McLure, but others have written good things on this as well.

On the other hand, some, like David Brunori of Tax Analysts, remind us that taxes are supposed to adhere to the benefit principle, so a formula based on property and payroll (similar to the Willis Commission recommendations), would more closely match the benefits a company and its employees receive from government services.

My finding is that these policies are usually made in line with public choice theory, and special interest pressure drives the decision on this issue. Regardless of what is right or wrong, when a state moves from three factor apportionment to single sales, it is often because they are trying to reduce taxes on businesses with a large footprint in their state, and extend more taxes on corporations with sales in the state but without a headquarters.

As a result, most states have been going the direction of single sales factor apportionment in the last few decades.

The Federation of Tax Administrators has the 2016 apportionment formulas for each state listed here.

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