What “Sourcing” Means in State Income Tax and Why It Matters
Sourcing is the process by which a state determines where income is earned for purposes of its income tax or franchise tax regime. In multistate operations, sourcing governs whether revenue from a sale or service is assigned to State A, State B, or potentially both, which then drives your apportionment percentages and ultimate tax liability. The rules are deceptively simple on their face, but the implementation is nuanced, varied, and often counterintuitive. A single invoice can implicate multiple statutes, regulations, and administrative interpretations in several states at once.
From the perspective of an attorney and CPA, the most common mistake taxpayers make is assuming that where a business is located is where the income is taxed. In practice, the analysis pivots on the customer’s location, the delivery location, where a benefit is received, where costs of performance occur, and whether you have sufficient nexus to be taxed at all. The consequences of misapplying sourcing rules include duplicated taxation, denial of credits, assessments with penalties and interest, and protracted audits. A thoughtful, jurisdiction-by-jurisdiction analysis is required even for small enterprises that make a handful of out-of-state sales.
The Two Principal Paradigms: Market-Based vs. Cost-of-Performance
States generally source receipts from services and certain intangibles using one of two approaches: market-based sourcing or cost-of-performance (often abbreviated COP). Under market-based rules, receipts are assigned to the state where the customer receives the benefit of the service, uses the intangible, or where the end market exists. In contrast, COP assigns receipts to the state where the service is performed or where the greatest proportion of the costs are incurred. The difference is not academic. The same engagement can be 100 percent sourced to the customer’s state under market-based rules, or predominantly sourced to the service provider’s headquarters state under COP.
The complexity deepens because some states use a hierarchical series of “reasonable approximation” tests if the primary rule cannot be applied, and many states assign receipts to the customer’s billing address only after other indicators fail. Moreover, states define “benefit received,” “used,” and “delivered” differently. An architect designing a building in one state for a site in another may be pulled into multiple analyses depending on whether the state looks to where drawings are delivered, where client personnel use the plans, or where the building is ultimately constructed. Failing to identify the correct paradigm and fallback rules for each state is a common source of audit adjustments.
Sourcing Sales of Tangible Personal Property
Receipts from sales of tangible personal property are usually sourced under a destination-based rule: the sale is assigned to the state where the property is delivered to the customer. This seems straightforward until one confronts drop shipments, multi-leg logistics, title passage clauses, and delivery terms such as FOB shipping point versus FOB destination. These mechanics can alter which state treats the sale as delivered within its borders and whether the seller or an intermediary is treated as making the retail sale.
Layered on top are throwback or throwout rules in certain states. If a sale is shipped from State A to a customer in State B where the seller is not taxable, State A may require the receipts to be “thrown back” into its sales factor numerator. Businesses frequently overlook this when they assume that shipping outside a state always reduces that state’s apportionable base. In reality, the seller’s nexus footprint and the destination state’s taxing jurisdiction determine whether throwback applies. Meticulous contract review, shipping records, and nexus analysis are essential to prevent mis-sourced receipts and inflated audit exposure.
Sourcing Services, Professional Fees, and Consulting Engagements
Services often generate the most disputes because their “delivery” is intangible. Under market-based rules, states ask where the customer received the benefit. For a software implementation project, that may be the location of the client’s user base; for a consulting report, it may be the office where decisions are made; for a repair service, it may be the site where equipment is returned to operational status. Some states differentiate between individual and business customers, applying look-through rules that require you to identify the customer’s customer. These distinctions can change results dramatically and require granular client data that many providers do not maintain by default.
Under COP, the emphasis is on where the service provider’s personnel performed the work or where the direct costs were incurred. States may use an “all or nothing” COP rule (source 100 percent to the state with the greatest costs) or a proportional COP rule (source receipts in proportion to costs in each state). Each variation demands distinct cost accounting. Without contemporaneous timekeeping and cost allocation, taxpayers are left arguing from estimates, which auditors routinely challenge. Your chart of accounts, time sheets, and project tracking systems must be aligned with the sourcing standard that applies in each state where you file.
Digital Products, SaaS, and Streaming: The New Frontier
Digital products, software as a service, platform access, and streaming subscriptions introduce unique sourcing questions. Many states treat SaaS as a service subject to market-based sourcing, asking where the customer uses the service. Others treat it as the license or use of an intangible, applying usage-based or billing address heuristics. Still others look to the location of the user’s devices, seats, or IP addresses. Because business customers may deploy seats across multiple states, a single enterprise contract can produce multi-state usage that requires allocation among jurisdictions.
Streaming and content platforms face additional complications when end users are mobile, consume content while traveling, or permit family plans with household members in different states. Some states permit reasonable approximation when precise user-location data is unavailable, but “reasonable” is evaluated against what your systems could capture with commercially reasonable effort. Implementing data fields to identify bill-to, ship-to, primary use location, and seat distribution is not merely good operations hygiene; it is critical evidence in a sourcing audit. Absent such data, tax departments are left with inference and negotiation, which increases risk and can lead to double taxation.
Pass-Through Entities, Withholding, and Composite Returns
Partnerships and S corporations do not pay entity-level income tax in most states, but they are typically required to apply sourcing rules to determine the state-sourced distributive share of each owner’s income. Mis-sourced receipts at the entity level flow through to partners and shareholders, who may then face nonresident filing obligations, underwithholding, and underpayment penalties. Many states require pass-through entities to withhold tax on nonresident owners or to file composite returns on their behalf when state-sourced income exceeds a threshold.
Owners often assume their Schedule K-1 will reflect only their home state activity. In reality, state K-1 equivalents are driven by the entity’s apportionment and allocation computations in each state where it has nexus. A pass-through with market-based sourcing may generate state income for owners in the customer’s state even when the owners never visited or did business personally in that jurisdiction. This is a frequent and costly surprise for investors, private equity funds, and professional service firms. Properly designed owner agreements, withholding procedures, and composite election strategies can mitigate administrative burdens and penalties.
Remote Workers, Payroll Factor, and Wage Sourcing
Employee location affects both nexus and apportionment. While many states have shifted to single-sales-factor apportionment for income tax, payroll sourcing still matters for franchise taxes, gross receipts regimes, and industries that use three-factor formulas. The location where an employee performs services can change the payroll factor and influence whether a state asserts nexus for income or withholding taxes. Temporary or remote work arrangements, particularly in a hybrid environment, complicate determinations of where wages are sourced.
States employ various payroll sourcing rules, such as “where the service is performed,” “base of operations,” or “place of direction and control.” Some states adopted temporary COVID-era telework guidance that has since expired, yet many businesses still follow those outdated assumptions. Incorrect payroll sourcing can cascade into incorrect wage withholding, unemployment insurance contributions, and apportionment percentages. Employers should implement robust telework policies, track days worked by location, and periodically reconcile HR and payroll systems to reflect the realities of hybrid work.
Allocation vs. Apportionment and the Business vs. Nonbusiness Distinction
Not all income is treated the same. States distinguish between apportionable (often “business”) income, which is divided among states using apportionment formulas, and allocable (often “nonbusiness”) income, which is assigned to a specific state. Historically, items such as interest, dividends, and gains from sales of intangible property were allocated to the commercial domicile, while operating income was apportioned. Many states have narrowed the nonbusiness category, but the distinction still exists and can materially affect tax exposure.
Taxpayers frequently misclassify gains on the sale of a business division, sale of goodwill, or sales of partnership interests. Depending on the state, these gains might be fully apportionable as operational in nature, or partially allocable to the state of commercial domicile. The analysis turns on your facts: integration into the unitary business, frequency and regularity, and the statutory definitions in each state. The wrong classification alters both sourcing and credit computations, and it is a common trigger for assessments in mergers and acquisitions. Early, transaction-specific planning is indispensable.
Throwback and Throwout Rules, and the Limits of P.L. 86-272
Throwback rules require sales of tangible personal property shipped from a state to a jurisdiction where the seller is not taxable to be included in the origin state’s sales factor numerator. Throwout rules, in contrast, remove such sales from the denominator entirely. These rules can swing apportionment outcomes dramatically. Whether you are “taxable in the destination state” depends on the destination state’s nexus standards, not merely whether you filed a return. Economic nexus thresholds, filing positions regarding protection under federal law, and trailing nexus periods complicate the analysis.
P.L. 86-272, a federal statute, protects sellers of tangible personal property from a state’s net income tax if their in-state activity is limited to solicitation of orders that are approved and shipped from out of state. However, the scope of “solicitation” is narrower than many believe, and it does not protect services, digital goods, or non-income taxes. Modern state interpretations, including those addressing post-sale customer support, internet cookies, and virtual interactions, can remove protection and render you “taxable in the destination state,” thereby defeating throwback. A careful, activity-by-activity review is required for each state.
Credits for Taxes Paid to Other States and Avoiding Double Taxation
When two states both claim the same income through conflicting sourcing rules, taxpayers typically rely on a credit for taxes paid to other states to mitigate double taxation at the individual or corporate level. Unfortunately, credits are not a panacea. States may deny credits if they view the other state’s tax as a different type of tax, if the income is classified differently, or if the tax was paid by an entity that the state does not recognize for credit purposes. Timing mismatches are also common when one state taxes income in Year 1 and another taxes the same stream in Year 2.
Business owners routinely assume that filing everywhere and claiming credits will “wash out” exposure. In practice, optimizing credits requires aligning sourcing positions across returns, documenting the precise income streams at issue, and sometimes litigating or negotiating with revenue departments. Failure to coordinate owner-level credits with entity-level apportionment creates stranded credits and unrelieved double taxation, especially in pass-through contexts. A proactive, unified strategy is essential.
Common Myths, Misconceptions, and Audit Triggers
Several myths repeatedly lead to adverse audit outcomes. One is the belief that billing address equals sourcing location. In many states, billing address is a last resort, not a primary rule. Another is the assumption that if no physical presence exists, no state can tax the income. Economic nexus standards, especially for services and digital businesses, often confer taxability at low revenue thresholds. A third misconception is that the same rule applies in every state. In reality, states apply a patchwork of definitions, hierarchies, and tie-breakers that must be evaluated individually.
Auditors focus on predictable weak points: undocumented approximations, inconsistent application of rules across years, mismatched customer location data, and unexplained spikes in sales factor numerators. Mergers, expansions into new markets, and new product lines can trigger scrutiny, particularly if they change your fact pattern in ways your returns do not reflect. Proactive risk management includes documented methodologies, board-approved policies, and contemporaneous evidence supporting your sourcing positions.
Data, Documentation, and Systems You Actually Need
Effective sourcing is ultimately a data problem. You must design systems that capture the attributes regulators care about: ship-to addresses, service location, benefit location, number of user seats by state, IP-based usage, employee timesheets by state, project codes tied to client sites, and cost-of-performance ledgers. These are not merely operational preferences; they are the evidentiary foundation for your filing positions. Without them, you will rely on rough allocations that auditors will challenge and courts may reject.
Practical steps include building a state attribute schema in your CRM and billing platforms, enforcing required fields for customer onboarding, integrating ERP and timekeeping systems with state codes, and implementing periodic data integrity checks. Create written sourcing policies by revenue stream, specify fallback hierarchies, and train client-facing teams to collect the right information at the outset. Lastly, maintain a defensible audit file each year: a snapshot of your methodology, data extracts supporting allocations, and reconciliations from financial statements to returns.
Industry-Specific Nuances That Alter Outcomes
Industry context changes the sourcing calculus. Advertising firms may have to look through to the location of the audience rather than the advertiser’s office. Financial services providers often face special rules for interest, fees, and trading receipts that depart from general service sourcing. Construction and engineering firms encounter situs-based rules tied to project locations, permitting, and real property situs. Transportation and logistics businesses often apportion using mileage or revenue miles, while broadcasters face audience-based rules that turn on ratings data and subscriber counts.
Healthcare, biotech, and life sciences companies frequently deliver services across state lines, from remote diagnostics to telemedicine, raising patient-location and licensure overlays. Technology platforms may need to distinguish between license fees, maintenance, implementation, and support, each of which can be sourced differently. Even retailers encounter complexities when extended warranties, installation, and training are bundled with product sales. Unbundling revenue streams and mapping them to the appropriate state rules is critical for accuracy.
Planning Opportunities and Risk Mitigation
While the rules are complex, there are legitimate planning opportunities. Restructuring contracts to clearly delineate deliverables, usage locations, and seat counts can improve documentation and reduce ambiguity. Configuring ERP and CRM systems to capture benefit location at the line-item level creates defensible positions. In COP jurisdictions, tracking and aligning project costs with physical work locations can reduce over-sourcing to a single state. For tangible goods, evaluating shipping terms, fulfillment footprints, and nexus exposure can mitigate throwback and balance sales factor exposure.
Where historical noncompliance exists, voluntary disclosure and amnesty programs can cap lookback periods and reduce penalties. Prospective compliance agreements with revenue departments, while not always available, can secure a methodology for difficult-to-measure usage. For pass-throughs, revisiting owner agreements, implementing nonresident withholding procedures, and using composite filings strategically can reduce owner-level risk. The overarching theme is to transform ad hoc decisions into documented policy implemented across contracts, systems, and returns.
How Mergers, Expansions, and New Offerings Change Sourcing
Corporate transactions routinely change your sourcing profile. Acquiring a target with different customer demographics may shift you from COP-dominant states to market-based states overnight. New product lines, especially subscriptions and SaaS, pull you into usage and audience-based rules you have never applied before. Entering a new state with a distribution center can transform throwback exposure and create franchise or gross receipts tax obligations even if income tax apportionment remains sales-factor only.
Pre-transaction due diligence should therefore include a rigorous review of target-state sourcing methodologies, data capabilities, and potential exposures. Post-close integration plans should prioritize harmonizing contract terms, billing systems, and compliance calendars. Failing to address these items promptly can lead to inconsistent positions on combined or consolidated returns, stranded credits, and audit exposure that surfaces years later when documentation has gone stale.
When to Involve a Professional and What to Expect
Because state sourcing rules vary widely and change frequently, self-help approaches often result in overlooked exposures, overpaid taxes, or both. An experienced professional can survey your revenue streams, map them to the controlling statutes and regulations in each jurisdiction, and design a practical data collection framework. Expect a phased approach: diagnostic review of contracts and systems, identification of high-risk revenue streams, prioritization of states by exposure, and development of a written sourcing policy with clear hierarchies and fallback positions.
Implementation typically involves cross-functional teams from tax, finance, sales operations, and IT. The professional can also assist with voluntary disclosures, ruling requests where appropriate, and audit defense. The most cost-effective engagements occur before an audit and before system changes, when methodologies can be standardized and embedded into your processes. The alternative—reconstructing usage and benefit locations after the fact—is expensive, imprecise, and often unsuccessful.
Key Takeaways to Guide Your Next Steps
First, recognize that there is no single sourcing rule; outcomes depend on the specific state, type of income, and the facts of delivery, use, or performance. Second, invest in data: design systems and contracts that capture benefit location, user distribution, and cost geography. Third, align entity structure, owner agreements, and withholding procedures to minimize pass-through friction and double taxation. Fourth, monitor developments, including changes to economic nexus thresholds, interpretations of P.L. 86-272, and industry-specific guidance.
Finally, treat sourcing as a governance issue rather than a mechanical afterthought. Codify your positions, train your teams, and audit your data periodically. When the rules are unclear, document your reasonable approximation and why more precision is not feasible. The jurisdictions you operate in will not harmonize their rules for your convenience, so the burden of clarity falls on you. An experienced advisor can help you turn this complexity into a repeatable, defensible process that reduces risk while supporting growth.
