Opening up shop in a new state or city should feel exciting, like you’re moving one step closer to your business goals. And it is. Until the bills for compliance come rolling in. Most businesses that face regional tax issues end up in hot water, not because they were reckless. They simply used their home-state playbook in a new market that plays by a different set of rules. And they weren’t tipped off to the distinction until that audit letter landed in their mailbox.
The Physical vs. Economic Nexus Trap
The common understanding was that you would owe taxes in places where you had an office, a warehouse, or employees. That went out the window when, in 2018, the Supreme Court ruled in South Dakota v. Wayfair to allow states to require out-of-state sellers to collect and remit sales tax solely based on economic activity.
Almost all states now have economic nexus thresholds (45 of them at last count), and most set the bar at $100,000 and/or 200 – meaning $100,000 in annual revenue sourced to that state or 200 separate transactions sourced to the state. A software company that has no physical presence in a state can easily meet or exceed that threshold, as the test is of course applied retrospectively once it is.
The noose continues to tighten further for companies because every state is different in terms of what the nexus threshold is, how it’s calculated (gross receipts vs. transactions, for instance), and how far back a state can look if you trip the wire. There is no “standard” for all the states, which makes it extra complicated. Some states count sub $1.00 transactions, most count transactions irrespective of size, a few have carve-outs that favor one industry over another.
Municipal-level Tax Overlays
Even if companies are careful about managing their state-level compliance, they often overlook city-level taxes that are not only entirely separate but also not even mentioned on the state filing. NYC’s Unincorporated Business Tax, to use one harrowing example, applies to partnerships and sole proprietorships doing business in the city, unlinked to New York State’s income and franchise taxes. San Francisco has a Gross Receipts Tax that varies by industry and revenue. Philadelphia imposes a Business Income and Receipts Tax. These aren’t incidental costs – they’re real tax liabilities with separate forms that have to be prepared apart from your state filings, separate definitions of taxable income, separate penalties for failure or fraud, and – in many cases – separate audits.
A company that expands into a major metro, opens a satellite office, and hires a local team can quickly find itself owing taxes to three different jurisdictions simultaneously: the federal government, the state, and the city. The city-level obligation is the one that surprises people most, because it doesn’t appear on any state-level registration form and rarely comes up in generic compliance checklists. For businesses operating in or expanding into the New York metro area, working with the best CPA in Queens, NY, who understands not just the state-level obligations but the municipal layers underneath them can make a real difference.
The Remote Employee Payroll Problem
Remote work has actually complicated payroll compliance. Simply by hiring a remote employee in another state, you’ve created nexus, likely triggered state unemployment insurance registration requirements, and almost certainly compelled the company to withhold local income taxes based on the employee’s home municipality. It’s that last part that’s getting missed on a regular basis. Cities such as New York, Philadelphia, and Columbus, Ohio, impose local earned income taxes, and the employer must withhold them. Fail to register for those local payroll accounts, and the employee will owe those taxes at year-end and the employer will face separate penalties for non-compliance with withholding rules.
There’s an even more punitive twist. Some states have adopted a “convenience of the employer” rule in which a remote employee’s wages can be taxed by the employer’s home state even if the employee never sets foot there. New York is the most prominent jurisdiction with this rule on the books. The real-world result is that a business based in New York that has a remote worker in New Jersey could owe payroll taxes in both states at the same time – and receive no dollar-for-dollar credit for one against the other. Double taxation isn’t a hypothetical danger here; it’s already transpired for a number of companies that failed to get their payroll house in order before hiring across state lines.
Fragmented Rules for Digital Goods and SaaS
Software and digital service companies face many challenges when it comes to sales tax. The taxation of a SaaS subscription or a digital download varies from state to state, and in most cases, it even varies within a state due to local county or city rates.
Each state has its own way of treating SaaS for tax purposes. Some consider it a taxable service. Some consider it an intangible asset and exempt it. Some only tax it if the customer has the ability to download the software locally rather than access it via browser. These nuances can be challenging when you have to bill multiple customers in dozens of states.
There are more than 11,000 local sales tax jurisdictions in the US, with their own specific rates, rules and processes (Tax Foundation). When you’re a SaaS company that’s growing nationally, this is not a compliance issue – it’s a compliance infrastructure issue. You can’t keep track of this using spreadsheets and generic tax filing solutions. The regulations change faster than a centralized team can monitor. And mistakes multiply when you’re dealing with a high volume of invoices and already months of delayed tax remittance.
Independent Contractor Classification Across State Lines
Businesses using contractors often try to force a one-size-fits-all approach to classifying those workers regardless of where the work is taking place. The federal common-law rules were designed to give employers a fair amount of wiggle room to treat workers as contractors when the economic realities merit that classification. Many states viewed that wiggle room as too generous and passed their own much more rigid standards. Under all of those laws, businesses have to apply the strictest rule – the state level standard – when determining whether a specific worker is an employee or a contractor.
California’s AB5 law is the most famous example. Using an “ABC test,” it says a worker is assumed to be an employee unless a business can show the worker is: a) free from their control; b) does work that’s outside the usual course of the company’s business; and c) is engaged in an independently established trade, occupation, profession, or business. If even one of those is not true, the worker must be treated as an employee. This creates a large, unfortunate unintended consequence for companies wanting to do business in other states.
Several of them have adopted their own version of the ABC with different, often more stringent requirements and different industry exceptions. In some, even if the federal standard would uphold a contractor finding, the worker could be classified as an employee and expose your company to tax liabilities, claims for unpaid benefits, and back wages from the start of the business relationship.
Business Licensing and Franchise Tax Deadlines
Registration as a foreign corporation in a new state is a one-time thing, but continued good standing in that state depends on annual reports and sometimes minimum franchise tax payments. These are not triggered by any income or activity – just the registration’s existence.
When a company fails to file an annual report or to make a minimum franchise tax payment, the Secretary of State can administratively dissolve or revoke the foreign corporation. Contracts are potentially voidable, the company’s right to sue in that state ceases, and in some states directors or officers can be held personally liable for corporation debts arising during that period.
This is a common failure mechanism for fast-growing businesses, because the registration happens at the same time as a lot of other things and nobody takes charge of renewals. The reinstatement fee is the least of it.
Why Localized CPA Expertise Matters More Than National Scale
Local CPAs are experts in the nuance that separates compliance from optimization. The Unincorporated Business Tax, for instance, can be particularly unfair to businesses with substantial New York City payrolls even if they structure their corporate entity as a partnership to take advantage of pass-through treatment. As the most common structure for hedge funds, professional service firms, and real estate funds, that’s information that most state-level accounting workflows are just never going to flag down as potentially relevant for your business.
Audits in New York City are more common than any other place in the state. New York City’s audit rate for the state’s major corporate tax is consistently north of 5% and the city’s independent audit is so pervasive that one-fifth of all the state’s corporate overcharge issues stem from New York City audits alone. A local CPA can bring specialized knowledge about prior audit adjustments that the city is known to target, and can tell you about proposed regulatory changes being floated specifically to curb perceived abuses in the city even before those rules go final.
Aggressive State Audit Targeting of Mid-market Businesses
Large multinationals have big tax and legal teams who slow walk auditors. Small businesses aren’t big enough to show up in the administration’s budget analysis due to revenue alone. Mid-sized businesses who are expanding operations, opening different locations, and reporting revenue growth without a corresponding payment to a new state are right in the crosshairs of very aggressive state tax departments.
NY, CA, and IL particularly, have dedicated audit divisions whose only job is to find businesses like yours. They get your federal returns, your registration information to obtain payroll taxes in another state, and see the payments your roster of 3rd party payment processing vendors make to you. Once they realize you’ve crossed that threshold there is no getting around it. What starts as an innocuous letter questioning your principal business office location can quickly spiral when the auditor realizes that if they come to an agreement on the current year’s liability they’re also entitled to the last three closed years.
The penalty and interest schedules in these states are absolutely brutal for companies that didn’t realize what they were getting themselves into. It’s because “I was never told to file in your state before” is not a reasonable defense. Voluntary disclosure programs can mitigate some of the exposure but if you think your company is going to have a hyper growth year next year that impairs business and foresight planning you’d much rather spend on revenue generating activities.
Relaxing these states’ statutes of limitations for these decisions is also not an ideal route. Often the language grants the administrative ability to go back all the way to inception if the current and penultimate years aren’t filed on a full income basis. Which most likely will be the case after they catch you in year seven.
Regional compliance isn’t a back-office problem. It’s a growth risk that scales with the business, and the companies that manage it well treat it that way from the moment they start crossing state lines.
