Small change: state and local taxes are taking a bigger bite out of your business. Here's how to fight back

Entrepreneur, March, 1997 by Joan Szabo

State taxes are taking a bigger bite out of small-business owners' bottom lines, and this trend is expected to continue. As Washington moves more responsibility for funding social programs to the states, the drive is on to collect more tax revenue at the state level.

"If the federal government is going to contribute less, then the states must contribute more because the money must come from somewhere," says state and local tax specialist Michael H. Lippman, a Washington, DC, partner with accounting firm KPMG Peat Marwick LLP.

Entrepreneurs are already feeling the pinch. A recent survey of the fastest-growing U.S. companies by accounting and consulting firm Coopers & Lybrand LLP found state and local taxes were the fastest-growing tax burden for these firms. Those surveyed reported a 15.3 percent increase in state and local taxes in the past year.

While most states are not actually increasing corporate or sales tax rates, they are taking less obvious steps to expand their tax base. One strategy, for example, is to subject more services to a state's sales tax, says Sally Adams, an attorney and state tax analyst for CCH Inc., a major provider of tax information in Riverwoods, Illinois.

State governments are also making the tax rules even harder to comprehend, and enforcement efforts are gaining greater muscle, says Joe Donovan, a multistate tax services principal with Coopers & Lybrand in Boston. To boost compliance, Donovan says, many states have opened audit offices in other states, established information exchange agreements among themselves and with the federal government, and refined their strategies for tracking down companies they believe aren't paying the correct amount of taxes.

To collect more revenue, a number of states have expanded their auditing activities, increasing staff by 20 percent to 25 percent, says Jack Cronin, national director of Deloitte & Touche LLP's state and local tax practice. This is a direct benefit to state coffers, he explains, because auditors can generate revenue that would not otherwise be available.

With all this activity directed at getting more tax dollars from you, proper tax planning and a good understanding of state tax regulations are essential. Accountants who specialize in state and local tax issues suggest taking six important steps to put your business in a better tax position.

1. Be sure to collect sales and use tax, not just in your home state, but in the other states where you sell. "Typically, companies collect these taxes in their home state, but they may fail to collect them in the other states where they have customers whom they reach through a local sales force," Donovan says.

States are looking for businesses that neglect to collect these taxes, and companies that come to the attention of state revenue collectors will be required to pay back taxes, as well as interest and penalties. The message here is clear: Don't turn your customers' tax liabilities into your own.

2. Consider doing business in more than one state. (This won't help you if you are conducting business in a state that doesn't have a corporate income tax, such as Nevada.) In many cases, becoming a multistate business can reduce overall taxes, says Lippman. Here's how it works: "If you are taxable in only one state, you must report 100 percent of your income to that state. But if your business is taxable in more than one state, then you can apportion the income and the tax between the states, using a special formula," he explains. "This could result in income that doesn't get taxed in either state." Establishing a business presence in another state can be as easy as having inventory or a single salesperson in a rented office there.

But before undertaking such a move, it is important to check with a state tax specialist who understands each state's rules to make sure it will result in a lower state tax bill.

3. Don't make the mistake of thinking you don't owe any state or local taxes if you have a new company operating at a loss. Although you may not have any state income tax liability, your sales and use tax exposure continues to accrue if you fail to collect and remit these taxes. Getting stuck paying a sales tax of 5 percent to 10 percent of your gross receipts yourself because you didn't collect it from your customers can turn out to be a significant amount, Donovan says.

Keep in mind that state corporate income taxes account for only about 10 percent of a company's state and local tax burden. State and local property and sales and use taxes make up the bulk of your tax responsibility at this level. If you haven't been collecting these taxes properly, many states will allow you to negotiate a settlement. This often involves using the services of your accountant. In this kind of give and take, states have been known to waive penalties and a percentage of the taxes owed.

4. Stay abreast of details concerning the tax incentives, exemptions and credits state governments offer to reduce a company's tax bill. Small to midsized companies are often eligible for such benefits, but many overlook them. In a number of states, items used in manufacturing or in research and development, for example, may qualify for such exemptions and credits.