Introduction

State income tax apportionment remains a complex and evolving area, especially as states refine their approaches for various entity types and types of income. This article outlines key principles of income characterization, evolving apportionment and sourcing methods, and highlights both uniform and divergent state approaches in the taxation of different types of entities. In this article, we give special focus to the Tri-State Area, compliance challenges for tiered entities, and practical planning considerations for multistate businesses.

Fundamentals of Income Characterization

Traditionally, income for state tax purposes has been classified as either business income (also referred to as apportionable or operational income)  or nonbusiness income (also referred to as allocable or nonoperational income).

Business income arises from transactions and activities in the regular course of the taxpayer’s trade or business, including income from tangible and intangible property, if such activities are integral to operations. Business income is apportioned among jurisdictions using formulas based on property, payroll, or sales factors.

Nonbusiness income (i.e., all other income) is allocated to a specific location. As an example, dividends may be sourced to the taxpayer’s commercial domicile or property sales to the asset’s location.

It must be noted that, over time, it has become less likely that income will be classified as nonbusiness income because states generally take the position that taxpayers use nonbusiness income to avoid apportioning income to the state. Thus, the definition of business income has been narrowed over time in most states.

While states generally apply similar rules to corporations and pass-through entities (PTE) in determining business vs. nonbusiness income, the determination of whether income is business or nonbusiness income for a PTE may be determined at either the partnership or the partner level, following either the entity theory or aggregate theory.

Apportionment Overview

State income tax apportionment determines how multistate businesses divide their apportionable income among states for tax purposes. The apportionment process relies on a formula that typically includes one or more of the following factors: property, payroll, or sales (receipts). Over time, many states have revised their apportionment formula to one that relies more and more on the receipts factor, with most states now using an apportionment formula consisting solely of a receipts factor.

Sourcing Methods

States use different methodologies to assign receipts to a state:

• Market-Based Sourcing: Assigns receipts to the state where the customer receives the benefit of the service or intangible. This approach has become the dominant trend, with over 30 jurisdictions now using market-based sourcing for services, intangibles, or digital property. Since 2014, many states have shifted from cost of performance to market-based sourcing, following changes in the Multistate Tax Commission (MTC) model rules.
• Cost of Performance (COP): Assigns receipts to the state where the income-producing activity occurs. Historically, this was the standard for sourcing sales other than tangible personal property (TPP), but it is now less common.
• Destination Sourcing: Used primarily for TPP, this method assigns receipts to the state where the property is delivered or the sale is consummated.

Trends and Challenges

• Market-Based Sourcing Dominance: The shift to market-based sourcing reflects a broad state tax trend to source income to the location of the customer, rather than the location of the service provider or where the cost of performance occurs.
• Complexity and Compliance: States interpret sourcing rules differently, leading to compliance challenges for multistate businesses. Key questions include how to define the “market,” determine where services are received, and identify the customer for sourcing purposes.
• Variability Across States: Some states apply uniform apportionment rules across all entity types (e.g., single sales factor and market-based sourcing for corporations, S corporations, and partnerships), while others maintain distinct rules for PTEs, leading to further complexity.

Summary Table of Sourcing Methods

Sourcing Methodologies for PTEs

States attribute a partner’s distributive share of partnership income to a particular state or states using one of two main approaches:

• Entity Level: The partnership’s apportionment factors are used to allocate the partnership’s income, with that income then attributed to the partners based on their distributive share of the partnership’s income.
• Partner Level (or Aggregate Method): Partners combine their share of partnership apportionment factors with their own factors, with such combined apportionment formula then applied to the combined income of the partner, including its distributive share of the partnership income. This method is commonly known as “flow-through” or “flow-up” apportionment. This is the majority rule among the states.

Below is a table summarizing three possible outcomes for PTE income sourcing[1].

Uniform Rules Across Entities

Several states achieve uniformity among entities by applying corporate apportionment formulas to PTEs. Other states achieve uniformity in apportionment across entity types through a single tax regime covering all business entities.

• Market-Based Sourcing & Single Sales Factor: Examples include California, Connecticut, Georgia, Idaho, Illinois, Kansas (effective 2027), New Jersey (effective 2023), and Massachusetts (effective 2025).

• Cost-of-Performance & Three-Factor Formula: North Dakota applies cost-of-performance sourcing and the traditional three-factor apportionment formula uniformly.

• Uniformity via Single Tax Regime: Hawaii applies cost-of-performance sourcing and the three-factor formula uniformly across corporations, S corporations, and partnerships for its income tax. Tennessee applies single-sales-factor apportionment and market-based sourcing uniformly across corporations, S corporations, LLCs and LPs for Franchise & Excise tax purposes (GPs are exempt); transition completed in 2025. Texas uses gross receipts sourcing under its franchise tax for all entity types.

Divergent Rules in the Tri-State Area and Other States

Other states impose distinct rules for PTEs, including but not limited to:

New York State applies personal income tax sourcing rules for partnerships, which requires use of a three-factor formula with receipts sourced based on where a sale was negotiated or consummated, while corporations and S corporations use a single sales factor and market-based sourcing.

New York City taxes C corporations under the Business Corporation Tax (BCT) regime, S corporations under the General Corporation Tax (GCT) regime, and partnerships under the Unincorporated Business Tax (UBT) regime, resulting in different sourcing rules for each type of entity. In New York City, all entity types use a single sales factor for apportionment. However, sourcing rules for service receipts differ: C corporations apply market-based sourcing, while S corporations and partnerships source such receipts based on the place of performance.

New Jersey historically used three-factor apportionment for the sourcing of income by individuals pursuant to the Gross Income Tax (GIT) (the New Jersey personal income tax), while the Corporation Business Tax used a single sales factor, causing mismatches. As of Jul. 3, 2023, New Jersey retroactively adopted single-sales-factor apportionment and market-based sourcing for GIT taxpayers with New Jersey Assembly Bill A5323 (2023).

North Carolina, Arkansas, Louisiana, Mississippi, and Oklahoma impose unique sourcing rules, often presuming that a corporate partner’s distributive share is nonbusiness income.

Practical Pitfalls and Planning Considerations

States may apply different apportionment formulas and sourcing methodologies to corporations and PTEs, which can lead to significant compliance challenges. For example, New York State uses a three-factor formula for partnerships and a single-factor formula for corporations, with different methods for sourcing receipts between partnerships and corporations—such as market-based sourcing (for corporations) versus sourcing services based on the office where the sale was negotiated or consummated (for partnerships). This complexity can cause substantially different tax treatment for income generated by different types of entities.

Investors in tiered PTEs often face difficulties obtaining apportionment data from lower tiers, as many operating PTEs do not provide state-specific apportionment schedules. This lack of standardized reporting complicates compliance, especially for minority owners in PTEs. Investors should proactively request apportionment schedules from their PTEs and, if necessary, consider alternative apportionment petitions if the standard approach results in distortion in a specific jurisdiction. Common methods for allocating income include using the state K-1 or treating PTE income as an additional receipt in the receipts factor.

Conclusion

State income tax apportionment is a dynamic field, with states continually refining their approaches for different entity types. Understanding the nuances of income characterization, apportionment methodologies, and state-specific rules is essential for effective tax planning and compliance.

Alysse McLoughlin, Esq., is a partner at Jones Walker LLP. Alysse provides broad-ranging state and local tax counsel to clients across the country. With years of experience in private practice, as in-house tax counsel at leading financial institutions, and as an attorney in the Chief Counsel Division of the Internal Revenue Service, she understands the goals and priorities of businesses and tax authorities. Alysse draws on this knowledge to help clients make effective tax-planning decisions and resolve tax disputes. She can be reached at 646-768-7228 or amcloughlin@joneswalker.com.