REG CPA Practice Questions Explained: Nexus and State Income Apportionment

Nexus and State Income Apportionment

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In this video, we walk through 3 REG practice questions teaching how nexus and state income apportionment work for C Corporations. These questions are from REG content area 5 on the AICPA CPA exam blueprints: Federal Taxation of Entities.

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Calculating Nexus and State Income Apportionment


Nexus refers to a business’s connection to a state that is substantial enough to subject it to the state’s taxes. This is a fundamental concept in state taxation law because a state can only tax a business if it has nexus there. Nexus is traditionally established through physical presence, such as having an office, employees, or property in the state. However, recent developments in U.S. tax law, particularly the Supreme Court’s decision in South Dakota v. Wayfair, Inc. (2018), have allowed states to assert nexus based on economic activity, such as reaching a certain level of sales or transactions in the state, even without physical presence.

Examples of Activities that Would Cause Nexus:

  1. Physical Presence:
    • Having an office, store, warehouse, or other physical location in the state.
    • Employing workers in the state.
    • Owning or leasing property (real or personal) in the state.
  2. Economic Activity:
    • Generating a certain level of sales within the state, even without physical presence.
    • Regularly soliciting business in the state through employees or other agents.
    • Providing services in the state.
  3. Other Activities:
    • Attending trade shows where sales are made or orders are taken.
    • Holding a significant amount of inventory within the state.

State Income Apportionment

State income apportionment is a method used by multi-state businesses to allocate their income among different states for tax purposes. When a company has nexus with more than one state, it must apportion its income so that each state can tax a fair share. This is done using an apportionment formula, which can vary by state but often involves a combination of factors such as the proportion of a company’s sales, payroll, and property in each state. Some states may use a single sales factor or a weighted formula that gives more significance to one factor over others.

Example of Calculating State Income Apportionment with a Typical Formula:

Let’s assume MultiState Corp, a company with operations in three states, has the following figures for a fiscal year:

  • Total Sales: $10,000,000
  • Total Payroll: $2,000,000
  • Total Property: $3,000,000

Here’s how MultiState Corp’s operations break down in each state:

  • State A:
    • Sales: $4,000,000
    • Payroll: $800,000
    • Property: $1,200,000
  • State B:
    • Sales: $3,000,000
    • Payroll: $600,000
    • Property: $1,500,000
  • State C:
    • Sales: $3,000,000
    • Payroll: $600,000
    • Property: $300,000

If each state uses an equal-weighted three-factor apportionment formula, the apportionment percentage for each state would be calculated as follows:

For State A:

  • Sales Factor= 4,000,000 / 10,000,000 = 0.4
  • Payroll Factor = 800,000 / 2,000,000 = 0.4
  • Property Factor = 1,200,000 / 3,000,000 = 0.4
  • Apportionment Percentage = (0.4 + 0.4 + 0.4) / 3 = 0.4 or 40%

For State B:

  • Sales Factor = 3,000,000 / 10,000,000 = 0.3
  • Payroll Factor = 600,000 / 2,000,000 = 0.3
  • Property Factor = 1,500,000 / 3,000,000 = 0.5
  • Apportionment Percentage = (0.3 + 0.3 + 0.5) / 3 ≈ 0.3667 or 36.67%

For State C:

  • Sales Factor = 3,000,000 / 10,000,000 = 0.3
  • Payroll Factor = 600,000 / 2,000,000 = 0.3
  • Property Factor = 300,000 / 3,000,000 = 0.1
  • Apportionment Percentage = (0.3 + 0.3 + 0.1) / 3 ≈ 0.2333 or 23.33%

Now, if MultiState Corp needs to determine how much of its $10 million in income to apportion to each state, it would multiply the total income by each state’s apportionment percentage:

  • State A: $10,000,000 * 40% = $4,000,000
  • State B: $10,000,000 * 36.67% ≈ $3,667,000
  • State C: $10,000,000 * 23.33% ≈ $2,333,000

Nonoperating Income

Nonoperating income is revenue that is not generated from a company’s primary business operations. It includes items like:

  • Dividend Income: Earnings received from holding stock in other companies.
  • Interest Income: Earnings from interest on bank accounts, notes receivable, and other financial instruments.
  • Capital Gains: Profits from the sale of assets not used in the company’s primary operations, such as investment securities or real estate.
  • Rental Income: If the company is not in the real estate business, rental income from property is often considered nonoperating.

Apportionment of Nonoperating Income

Nonoperating income typically does not get apportioned among the states in the same way as operating income. Instead, each type of nonoperating income is allocated based on specific sourcing rules. For example:

  • Dividend and Interest Income: Generally sourced to the company’s commercial domicile, which is usually where the company’s principal office is located or where the management activities are centered.
  • Capital Gains: Sourced to the location of the capital asset or where the sale occurred.
  • Rental Income: Sourced to the location of the property.

The rationale behind this approach is that nonoperating income is not directly generated from the multi-state business activities that the apportionment formula is designed to capture. Instead, this income has a specific geographic source that can be directly tied to a particular location.

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