The Hidden Tax Risks of Expanding your Business from California into Other States

Key Takeaways

• Nexus drives obligations: Any physical presence, economic activity, or affiliate connection in another state can trigger tax responsibilities, even without a California office.
• Understand apportionment rules: Market-based and cost-of-performance sourcing affect how states divide income for taxation; your revenue may be taxed where your customers are, not just where work is performed.
• Monitor sales and use tax: Economic nexus thresholds, marketplace facilitator laws, and varying rules for digital goods and SaaS mean that remote sales can quickly create filing requirements.
• Payroll and employment taxes matter: Adding employees in new states triggers withholding, unemployment, and compliance obligations; misclassification or cross-state work can create double taxation risks.
• Small actions can trigger multi-state obligations: Contractors, delivery routes, drop shipments, and even minor operations can create nexus in multiple states, the “domino effect.”

Thinking of expanding your business outside of California?

What seems like a growth milestone can quickly become a compliance nightmare if you’re not prepared. Multi-state expansion introduces a web of income, sales, payroll, and employment tax rules, and even small actions. These include hiring a remote employee or using a drop-shipper, can create costly obligations in multiple states.

As state laws evolve quickly, companies that rely on federal safe harbors often face audits or penalties due to outdated assumptions. In this blog, we’ll guide you through what you need to know when expanding your business from California, so you can rest assureIn this blog, we’ll walk you through the often-overlooked tax risks of expanding your business from California and how to protect your bottom line.d that you’re compliant. 

Understanding Nexus When Expanding Your Business from California

“Nexus” is the term for a connection between a business and a state. It’s basically the way in which a state has the legal authority to impose certain tax obligations (sales tax, income tax, withholding, etc.) on your business. Nexus is what “crossing state lines” activates: you don’t have to physically move your headquarters, but certain activities can create that taxable connection.

There are several different types of nexus, and states use one or more of them. This means that if you’re expanding your business from California into other states, you need to understand them all.

Here are the main nexus types, what triggers them, and their implications for your business. 

Income Tax Considerations 

States tax only a portion of a multistate business’ income, and it’s usually the portion that the state says is “sourced” there. Apportionment takes your company’s total taxable business income and divides it among jurisdictions using a formula (commonly a sales factor, payroll factor, and property factor, or some weighted combination). The result is the fraction of income each state can tax your business.

Apportionment can be either market-based, or cost-of-performance sourced. 

• Market-based sourcing: income from services and many intangibles is sourced to the state where the customer receives the benefit (the market). This focuses on where the customer is located or uses the service rather than where work is performed.
• Cost-of-performance (COP): income from services is sourced to the state where the seller performs the income-producing activity (where costs are incurred). Under this method, the location of the service provider’s personnel, facilities or subcontractors often matters.

How California fits in

California has historically applied market-based sourcing for receipts other than tangible personal property. But the state has been actively updating its sourcing regulations to clarify how to determine where the “benefit” is received.

That means for many service and intangible receipts, California looks to the customer/location of benefit rather than strictly where the work was done.

This means that under COP, if your business has remote delivery (work performed in California but customers elsewhere), you might avoid tax in the customer’s state.

Sales and Use Tax Risks When Expanding Your Business from California

When expanding from California into other states, your business may encounter diverse sales and use tax obligations. Understanding the nuances of these is crucial to mitigating compliance risks.

This is particularly important if you use marketplace facilitators like Amazon or eBay. Laws around using these facilitators effectively shift the responsibility of collecting and remitting sales tax from you as an individual seller to the marketplace platforms that facilitate the sales. These laws are in effect in nearly all states with a sales tax. Most states now require marketplace platforms to collect and remit sales tax on behalf of your business once certain thresholds are met, typically $100,000 in sales or 200 transactions in a calendar year. But you, as the seller, still need to comply with tax obligations for sales made outside of the marketplace platform, such as sales through your own websites or physical locations.

And then there’s taxation of digital goods and Software as a Service (SaaS). This varies significantly across states; some states impose sales tax on these services, and others do not. 

Payroll and Employment Tax Triggers 

Expanding your business from California into other states can introduce significant payroll and employment tax obligations. 

Let’s start with withholding obligations when you add staff in new states. When hiring employees in other states, our business must adhere to each state’s specific payroll tax regulations. This includes registering with the state’s tax authority, withholding state income taxes, and contributing to unemployment insurance and workers’ compensation programs. The general rule is that employers must withhold income tax for the state where the employee performs their work. However, this gets complicated when your employees work in multiple states or live in one state while working in another. In these cases, you may need to withhold taxes for both states, unless a reciprocal agreement exists between the states involved.

And what about worker classification? Determining whether an individual is an employee or an independent contractor varies significantly across states. While the federal government provides guidelines, many states have adopted stricter criteria. For instance, California utilizes the “ABC test,” which presumes a worker is an employee unless you can demonstrate that:

• The worker is free from control and direction in performing the work.
• The work performed is outside the usual course of the hiring entity’s business.
• The worker is customarily engaged in an independently established trade, occupation, or business.

But other states can apply different tests or standards, leading to potential misclassification risks.

The Domino Effect of Multi-State Expansion

Expanding your business from California into new states can inadvertently trigger a cascade of tax obligations across multiple jurisdictions. This “domino effect” occurs when a single business activity, like hiring employees or establishing delivery routes, creates nexus in a state.

That’s why there are a number of common oversights businesses make when expanding across state lines, and establishing nexus. These include hiring independent contractors in a new state, operating delivery routes that cross state lines, or using drop shippers located in different states. 

And remember that failing to recognize and address the obligations of establishing nexus can cost you. You risk:

• Penalties and interest: States may impose penalties and interest on unpaid taxes, increasing the financial burden on your business.
• Audits: Non-compliance can trigger audits, which may uncover additional liabilities and lead to further scrutiny.
• Reputational damage: Ongoing compliance issues can damage your company’s reputation with customers, investors, and regulators.

Thankfully, there are a few easy ways to help mitigate these risks. It just requires some proactive strategy. Here’s how to ensure you stay compliant when expanding your business from California:

• Conduct a nexus and tax exposure review: Before entering new markets, assess where your business activities establish tax obligations. 
• Track revenue and payroll by state: Maintaining detailed records of revenue and payroll is essential for accurate tax reporting and compliance. 
• Register with state tax agencies: When establishing nexus in a new state, you must register with the state’s tax authority to fulfill all your tax obligations. Delaying this can result in penalties and interest on unpaid taxes. 
• Work with tax professionals familiar with multi-state operations: Consulting tax professionals experienced in multi-state operations is invaluable. 

Worried you’ve already triggered multi-state tax obligations?

At Fusion CPA, we can provide you with guidance on nexus determinations and help navigate the complexities of varying state tax laws. So if you are expanding your business from California into other states, get in touch! Book a free discovery call with Fusion CPA to assess your exposure and avoid penalties.

Schedule a Discovery Call

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This blog does not provide legal, accounting, tax, or other professional advice. We base articles on current or proposed tax rules at the time of writing and do not update older posts for tax rule changes. We expressly disclaim all liability regarding actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.