The federal government is, by law, exempt from paying state and local taxes. However, this exemption does not apply to organizations with federal or state government contracts, which are designated as agents of the government. In fact, government contractors are subject to specific state and local taxes simply because they are government contractors.
Contractors must be aware of the tax laws specific to the states they operate in, and any localities that impose taxes as well.
Government contractors are subject to three categories of state and local taxes:
- income taxes;
- sales and use taxes; and
- business, professional and occupational license taxes.
Here’s some valuable guidance on these three categories.
State and Local Income Taxes
When determining state and local tax liability, contractors must look at nexus, allocation and apportionment.
Generally speaking, Nexus is defined as a “connection or series of connections between two things”. For state taxes, this means that if a business has a connection with a state, the state can impose its tax laws on the business. A contractor is considered to be doing business in a state if it is legally domiciled, physically present and economically present in the state.
Nexus is an important factor for government contractors to track, as they often work across multiple state lines with the contractor headquartered in one state, the contract located in another state, and the work performed in multiple other states. This potentially makes the contractor liable for paying income tax in every state with which they have even a small connection. (For a more detailed explanation of nexus, refer to the PBMares blog on Operating across state lines presents tax risks—or possibly rewards.)
Contractors should keep in mind that physical presence alone does not trigger nexus. For example, California requires an income tax return to be filed if a contractor derives more than $500,000 or 25 percent of its total sales from the state—even if the contractor does not physically enter the state.
Allocation refers to the division of income among the states a contractor is doing business in, while apportionment refers to the formula that states use to divide federal taxable income among themselves. This formula consists of property, payroll and sales factors. Each factor is evaluated to determine the in-state presence as a percentage of the total (in-state property divided by total property; in-state payroll divided by total payroll; in-state sales divided by total sales). The three factors are averaged to determine the total apportionment for a specific state.
Contractors have three options when determining the amount of service revenue attributable to one state:
- Cost of performance: This method is not uniformly applied by the states, but the common methodology is to attribute revenue to a state if all of the costs of providing services—or all of the costs of performing other income-producing activities—are incurred in that state. If more than one state is involved, revenue is sourced to the state in which the greatest proportion of direct costs were incurred or the majority of the work was performed.
- Pro-rata: This method distributes revenue generated from services performed in multiple states based on the costs incurred or time spent in each state.
- Customer location: Contractors can also look specifically at where the benefit of the service is received or where the customer is located. This method is not frequently followed, but use is growing.
Sales and Use Taxes
Most states impose a tax on the sale or use of tangible property, commonly referred to as a Sales and Use Tax. "Tangible property" consists of any property that can be seen, measured, weighed, felt or touched.
This tax is imposed on purchases made at the in-state point of purchase—that’s the “sales” part—and also on the “use” of taxable items on which sales tax was not paid at the point of purchase (i.e. purchases made on the internet).
The sales and use components are viewed as complementary because they essentially capture taxable items not captured by the other.
If the prime contractor or subcontractor makes purchases under a contract, the contractor cannot claim an exemption from sales or use tax because it is working for the federal government. Instead, any exemption from tax would be the result of a particular state or local law. Therefore, contractors need to stay on top of the sales and use tax requirements that are in effect for every state in which they acquire tangible property.
Business, Professional and Occupational License Taxes
Wherever a company operates, there are federal, state, local and sometimes regional licensing requirements that apply to all businesses. These licenses are necessary to ensure a business has the required permits to operate in a specific location and the business pays the appropriate state and local taxes.
For example, government contractors should be aware that Virginia’s Business, Professional and Occupational License Tax requires all businesses operating in the state’s localities to obtain a license to conduct such activities. The statute provides two methods for determining taxable gross receipts: direct allocation and apportionment by payroll factor.
In order to be considered a place of business in a Virginia locality subject to the BPOL, the office location must be maintained in the locality for 30 consecutive days, a license is required for each definite place of business in the locality, and a license is required for each separate business activity (even in the same location). The BPOL is measured by gross receipts in the locality, and rates are set by each locality for each line of business activity.