Market-based sourcing for individual filers

Market-based sourcing has become a significant tax issue for individual filers, particularly those providing services across state lines.

States like New York and California have implemented rules that source income to their jurisdiction based on where the "benefit" of a service is received rather than where the service is performed.

For remote workers, independent contractors, and self-employed professionals, this can lead to unexpected tax liabilities and compliance headaches.

Let’s dive into how market-based sourcing works, why it matters, and what you can do to protect yourself.

What is market-based sourcing?

Market-based sourcing is a method used by states to determine how income from services should be allocated for tax purposes.

Traditionally, states taxed service income based on the cost-of-performance method – essentially where the work was done. However, with market-based sourcing, the focus shifts to where the customer receives the benefit of the service.

This shift has significant implications, especially in an age where remote work and digital services are more common than ever.

The shift from cost-of-performance to market-based sourcing

In the old days – like, pre-2010 old – most states used the cost-of-performance method. If you were a consultant living in Georgia, providing services to a client in New York, your income was taxed based on where you performed the work (Georgia).

But under market-based sourcing, New York may assert that they have the right to tax the income because the benefit of your services is being received in New York.

The impact on individual filers

For individuals, particularly nonresidents working remotely or providing services across state lines, market-based sourcing can result in multiple states claiming the right to tax the same income.

Here’s a closer look at some of the key impacts:

1. Double taxation risk

If you live in Texas but provide consulting services to a client in California, you could face tax bills from both states – California for where the benefit is received and Texas for where the work is done.

While most states provide a tax credit for taxes paid to other jurisdictions, this isn’t always straightforward.

Some states have a "convenience of the employer" rule that can override these credits, resulting in double taxation.

2. Complex compliance requirements

Each state has its own set of rules and thresholds that trigger a filing requirement.

For example, New York has a "convenience of the employer" test that applies to nonresidents who work for New York-based employers. If your employer is in New York and you work from home in another state, you might still owe taxes to New York as if you worked in the state.

California takes a similar approach, sourcing income based on where the client receives the benefit, regardless of where the service provider is located.

3. Impact on independent contractors

Independent contractors aren’t off the hook either.

In the recent case of Loober v. Franchise Tax Board (FTB), a Washington-based CPA who provided services exclusively from her home state, was assessed California taxes simply because one of her clients had a California address.

Despite having no physical presence or property in California, the state used market-based sourcing rules to claim its share of her income.

Recent case: Loober v. FTB

This landmark case illustrates the growing reach of state tax authorities.

Here’s a breakdown of the facts:

• The CPA was a Washington resident who performed all her services in Washington.
• She had no tangible or real property in California and did not advertise there.
• Her 1099 forms showed income from clients with California addresses.
• The California FTB issued a proposed tax assessment, and the court ruled in the FTB's favor, concluding that she owed taxes to California.

The decision was upheld on appeal, highlighting that income from services is taxable in California if the client is based there – even if the work is performed entirely out of state.

This case sets a worrying precedent for other nonresident service providers with clients in market-based sourcing states.

Strategies to manage market-based sourcing challenges

The changing tax landscape can feel overwhelming, but there are steps you can take to manage your tax obligations more effectively:

1. Know your state tax responsibilities

Familiarize yourself with the tax rules in each state where you work, have clients, or where your employer is located. States like California, New York, and others with market-based sourcing rules have specific tax requirements that can differ greatly.

2. Keep detailed records

Make sure to keep clear records of where your clients are located, where you perform services, and any correspondence that identifies where the benefit of your services is received.

These documents are essential if a state tax authority questions how you sourced your income.

3. Be prepared to file in multiple states

If you are a remote worker and your employer is located in a market-based sourcing state, or if you are self-employed and have clients in those states, you may need to file nonresident individual state tax returns in those market-based sourcing states.

While this can make your tax situation more complicated, it may help you avoid penalties and interest on taxes you didn’t know you owed.

4. Seek professional tax advice

Navigating multi-state tax rules is not for the faint of heart. Consulting with a CPA or EA who understands these rules can save you time, money, and stress. They can also help you identify opportunities to minimize your tax liability through planning and strategy.

Bottom line

Market-based sourcing is a growing trend that is reshaping the tax landscape for individual filers and service providers.

As states like New York and California continue to assert their tax authority based on where the "benefit" of services is received, taxpayers need to be proactive in understanding and managing their state tax obligations.

The recent Loober v. FTB case is a stark reminder that even if you don’t set foot in a state, you might still owe taxes there. Stay informed, keep meticulous records, and don’t hesitate to consult with a tax expert to protect yourself from unexpected tax liabilities.