Headshot of Joe Hardick tax partner at Dannible & McKee

Challenges of Contractors Crossing State Lines


Undoubtedly, the past two years have proven to be challenging for construction contractors. Given record-setting levels of inflation, coupled with supply-chain issues and historic interest rate increases, contractors are hard-pressed and need the contracts to return solid gross profit numbers to cover these additional costs. This may cause an owner to look to expand into new states and localities to generate these enhanced profit margins. This may seem like a great idea at face value, but one should be very cautious of the challenges one will face by entering new markets.

These challenges can be daunting and must be addressed before you jump into a new market. First, entering new physical locations comes with the challenge of learning and adapting to the business environment. You don’t know who the suppliers are or how they operate. You don’t know the “unwritten rules” of a certain state or region, or even the physical attributes that may impact a job, such as rock density, water table and weather patterns. For example, maybe you have a construction company that has operated in New York successfully for many years, and you hear there is high-profit work down in Virginia and plan on opening a new office there. Do you think, since we have been successful in New York, why not expand into the potentially lucrative new market of Virginia? You then bring your equipment to start your first job in Virginia and go to hire employees only to find that there are no experienced laborers available, and the local unions give preference to the existing contractors, that they have dealt with for years.

Additionally, there is a different taxing regime in every state. The laws regarding a state’s right to impose income or sales tax can be very complex, often with different states imposing different thresholds for what can create tax in each. Meeting these thresholds is called “nexus,” which is a fancy Latin word meaning binding two things together, your business with their tax system. So, if you have an employee in a new state or buy some machinery there, that alone can subject you to sales or income tax. Although these activities may mandate a contractor to file tax returns in that jurisdiction, that does not mean the company will owe taxes there. So, it is imperative that you are aware of the administrative burdens of entering new jurisdictions, as non-compliance can be costly. The same state can have different standards for different taxes, such as income and sales tax. States and localities have been changing the way they administer their tax systems and increasing their enforcement to replenish budgets and replace revenue shortfalls due to the Pandemic.

If a contractor does business in multiple states, they must be aware of how each state computes and allocates its overall net income and, subsequently, how that net income is taxed. If you generated $1M of income in a year, but half your sales are attributable to State A and the other half are attributable to State B, does that mean you are taxed on $500k in each state? Potentially, each state has different rules for computing and allocating income. You may need to track revenue on a job-by-job, state-by-state basis and track the equipment and labor employed in each. How to do this depends on how each state allocates their income and whether they factor in sales, wages and/or property employed in and out of the state.

As previously mentioned, different jurisdictions apply different nexus standards for sales tax reporting and collection. It has been estimated that there are more than 13,000 sales tax jurisdictions in the United States. Each of these jurisdictions applies different rules and definitions for what constitutes a taxable or exempt transaction. Increased enforcement in this area has made it more important than ever to have a sound system in place for ensuring compliance.

Finally, payroll tax and unemployment insurance obligations must be analyzed before accepting a bid to enter a new state or locality. Generally, payroll is sourced to states based on where the services are performed. However, if an employee lives in one state but works in another, the rules become much more convoluted. Some states have reciprocity with other specific states, which govern which state has the right to tax the income of an employee who lives in one but works in another. By default, reciprocity agreements generally make the state of an employee’s residence the one to whom tax should be withheld by an employer. These are very useful but are usually limited to only adjacent states. Regarding unemployment insurance, this should generally be paid to the state where the employee is most likely to look for work or apply for benefits, but there are many exceptions.

These factors, and many others, must be analyzed along with their potential related cost before entering a new market. Tough economic times have drawn more contractors to explore work in new regions in search of new profits. Contractors should think things through and have a detailed plan before entering new markets to maximize their potential for success.

Contributing Author: Joseph A. Hardick, CPA, CCIFP, is a tax partner who has over 38 years of experience in all areas of individual and corporate income tax preparation and planning. Joe specializes in corporate tax and tax planning for manufacturing and construction companies, and he has consulted on numerous areas of income and estate tax planning for high-net-worth individuals.