Additional Taxes.

Nonprofits have state and local issues

Believing they are protected by their federal tax-exempt status, many organizations learn about state and local taxes the hard way. If you want to avoid unanticipated liabilities accompanied by costly interest and penalties, you have to address the issues before a state auditor does it for you.

Multi-state operations are quite common for nonprofit organizations. While most state jurisdictions extend some tax relief to organizations that are exempt from federal income tax, they are often required to register and may be subject to some taxes.

State and local jurisdictions typically impose taxes on income, on real and personal property and on certain transactions; e.g., sales and use taxes. Other requirements include remitting unclaimed property and employment and withholding taxes.

This article is the first in a two-part series and will focus on taxes based on income and sales and use taxes. The second part of this series, which will run next month, will focus on state and local property taxes, withholding-tax issues, charitable registrations, and unclaimed property.

Income taxes

Most state and local jurisdictions only impose income taxes on your nonprofit organization's unrelated business income. This parallels the federal income tax exemption rules. Therefore, if you report unrelated business income to the Internal Revenue Service on Form 9904, you are normally required to file a state income tax return as well. If your organization has operations in more than one state, you may be required to file income tax returns with each of those states even if you have a taxable loss.

However, before a state can impose its income tax filing requirements on your organization, there must be a physical presence or an income tax nexus. That is, if you have a physical presence (e.g., workers, equipment, property, inventory or sales activities) within a state, you should determine whether you have the required nexus that allows the state to impose income taxes and filing requirements.

If your nonprofit organization has an income tax nexus in multiple states, you are required to allocate your federal taxable income or loss among those states using an apportionment formula. The three-factor method is one of the most popular apportionment formulas. This formula computes a percentage based on three factors.

In general, the sales, payroll, and property attributable to a specific state are used to develop the numerator and the total of these factors is the denominator. The resulting percentage is applied to total taxable income to determine the portion that is subject to that state's income tax.

Paying sales and use taxes

Many states impose sales and use taxes on your organization's purchase of tangible personal property and certain taxable services unless you have a sales and use tax exemption certificate issued by the state. While some states exempt certain categories of nonprofit organizations, others, such as California and North Carolina, impose sales and use taxes regardless of an organization's for-profit or nonprofit status.

If your organization has obtained a sales and use tax exemption, in most cases, it will be entitled to purchase items such as computers, furniture, and supplies without paying tax. However, some jurisdictions grant only limited exemptions; that is, the organization may only be allowed to claim the exemption for items used directly in its exempt purpose. For example, if a, nonprofit hospital purchases dressings, thermometers, or bandages, the hospital may not be required to pay sales and use tax on them if they are used in treating its patients.

Use tax generally applies to the same transactions as sales tax, but is imposed when you purchase tangible property or services outside your state. If the vendor does not charge you sales tax, your state, to protect sales tax revenues, will impose a use tax on your organization.

Sometimes a nonprofit organization assumes that the special treatment afforded tax-exempt entities under federal and state income tax law extends to taxes in general. You could face an unpleasant surprise if you do not have a sales and use tax exemption and you are not calculating and paying the required state use tax.

You will find that state revenue departments are very aggressive at collecting their sales and use taxes, and can charge interest and penalties for noncompliance. On the other hand, if your organization is eligible for an exemption but has not applied for it, you may be paying these taxes needlessly. Both errors can be a very costly waste of your funds.

Collecting sales taxes on sales

As previously noted, sales tax is imposed on the retail sale of tangible personal property and selected services within a particular state or local jurisdiction. You should not confuse an exemption from paying sales and use tax with an exemption from charging sales taxes on sales you make.

Most jurisdictions require a nonprofit organization to collect sales tax on retail sales of items like books, videos, manuals, compact discs, tapes, t-shirts, hats, pens, cups, etc. Therefore, one of the most prevalent state and local tax issues for your organization is the duty to collect and remit sales tax and on your taxable sales. If you are not aware of the state nexus rules, you could be in for a very costly lesson.

If you have a sales tax nexus with several different states, each one can require you to collect and remit sales taxes on your sales to consumers within that state. Therefore, the paramount inquiry in ascertaining sales tax liability is determining whether you have nexus in a particular state. The term, nexus, is defined for tax purposes as the necessary amount of activity or presence in a state to subject an entity to tax in that state.

Although states may define nexus differently, there are some common factors. Some factors that may result in a sales tax nexus include having property, maintaining an office, having employees or independent contractors or warehousing books or other inventory within the state. Some states consider nexus established if you merely have a meeting there.

Nexus for sales tax collection purposes may not automatically result in an income tax nexus. Federal law requires a higher standard of nexus before a state is allowed to impose its income tax on an organization. That same federal law does not apply to, sales taxes. Generally, states have taken the very aggressive position that any hint of presence is enough to create a sales tax nexus; and therefore, the duty to collect its sales tax. Consequently, it is possible for your organization to have "substantial nexus" for sales tax purposes, but not for state income tax purposes.

Currently, 45 states impose sales and use taxes on the retail sale of tangible personal property and selected services. With each state having its own sales and use tax rules, regulations, and statutes, it is not surprising that this area of state and local taxation is often a source of consternation for many nonprofit entities.

Each state has subtle nuances and unique rules concerning the definition of taxable sales and its standard for nexus. Yet, by examining the nature of your transactions and exploring the nexus rules you may be able to take advantage of some planning opportunities that could reduce your costs and reporting requirements.

Other exemptions

Even if your organization has a specific exemption from sales and use taxes on purchases, you must usually collect and remit sales taxes on your retail sales. if you are not aware of this potentially disparate treatment of your purchases and sales, you may not be collecting the required sales tax (or you may be collecting the tax when it is not due) on certain of your retail sales.

For example, some jurisdictions specifically provide sales and use tax exemptions on sales to or by certain specified nonprofit, educational, and religious organizations provided the sale by or to the organization is made to conduct certain exempt activities. Additionally, most jurisdictions provide exemptions for casual or isolated sales of goods or services.

Once your organization has the required sales or income tax nexus with a particular state, you have an obligation to register with that state's revenue department. In addition, organizations having a nexus within a state may be subject to use tax there.

Don't wait for the state to send a nexus questionnaire; you should proactively review your specific situation and determine your risk to costly assessments for state and local taxes.

In some situations, states may negotiate under voluntary disclosure programs. Successful representation and negotiation may result in a settlement agreement that limits the look-back period for tax assessments and interest and reduces or eliminates penalties.

D. Greg Goller, CPA, is a tax partner in Grant Thornton, LLP's Washington, D.C, office where he specializes in tax issues for nonprofit organizations. Jeffrey M. Rhines, CPA, MT is a senior tax manager and Marc Grossman, JD, L.L.M. is a tax manager; both are located in the Grant Thornton's Philadelphia office and specialize in state and local tax issues.