Quick overview
Multi-state sourcing of income determines which state (or states) has the legal right to tax specific wages or business receipts when work, sales or operations cross state lines. State rules differ: wages are typically sourced to the state where the work is performed, while businesses use apportionment, sales-sourcing rules, or special sourcing formulas. Getting sourcing wrong can mean double taxation, missed credits, penalties or audits.
Why sourcing matters and who should care
Anyone who lives, works, hires employees, or sells to customers in more than one state needs to understand sourcing. That includes remote or hybrid employees, traveling salespeople, consultants, freelancers, multistate corporations, and e-commerce sellers. In my practice advising over 500 clients, poor tracking of state work days or sales locations is the most common driver of unexpected state tax liabilities.
Authoritative context: the U.S. federal government does not set most state income sourcing rules; states do. For general federal guidance and background about how tax rules coordinate with state systems see the IRS website (irs.gov). The Consumer Financial Protection Bureau offers plain-language consumer guidance on state tax topics and cross-border financial issues (consumerfinance.gov).
How wage sourcing typically works
- Primary rule: wages are usually sourced to the state where the employee physically performs the work. If you are physically present in State A for work days and State B for others, each state may tax wages earned while working there.
- Employer withholding: employers generally must withhold state income tax based on the employee’s work location or the employer’s withholding rules. Some states have reciprocity agreements allowing residents of neighboring states to pay taxes only to their home state — check state-specific rules.
- Remote work complications: telecommuting from a different state than your employer introduces complexity. Certain states use convenience-of-the-employer rules (notably New York and some others historically) to tax income based on employer location when employees work remotely for their own convenience. These rules vary and are litigated frequently; confirm current rules on the state tax agency website.
Practical tip from my practice: track your work location daily. A simple time log that records the state where work was performed cut a client’s audit exposure in half and produced documentation that avoided an overcollection of tax.
How businesses source income
Businesses determine state tax exposure using a combination of nexus (whether the state may tax at all) and sourcing rules for receipts that feed into apportionment formulas.
- Nexus: states assert the right to tax a business only if it has sufficient connection — physical presence (office, employees, inventory) or economic presence (sales thresholds after the Wayfair decision). See our guide on state nexus for more detail: Multistate Nexus: When Remote Work Creates State Tax Obligations (https://finhelp.io/glossary/multistate-nexus-when-remote-work-creates-state-tax-obligations/).
- Sales-sourcing vs. market-based sourcing: many states use market-based sourcing for service and intangible receipts (taxed where the customer receives the benefit), while goods are often sourced where they are shipped or delivered. States differ — consult each state’s instructions.
- Apportionment: states apportion a multi-state company’s income using formulas (single sales factor, payroll and property factors, or weighted formulas). The apportionment determines how much of the company’s federal taxable income is attributed to the state for tax.
- Sales tax vs. income tax: remember that sales tax nexus and income tax nexus are distinct concepts. You may owe sales tax collection duties in states where you have economic nexus after South Dakota v. Wayfair (2018), while income tax focuses on nexus and apportionment rules.
Useful internal reading: our summary on nexus and sales tax after Wayfair explains economic thresholds and remote seller obligations: Nexus and Sales Tax for Remote Sellers After Wayfair (https://finhelp.io/glossary/nexus-and-sales-tax-for-remote-sellers-after-wayfair/).
Documentation and tracking: the frontline defense
States will expect detailed records to support sourcing claims. Recommended documentation includes:
- Daily or weekly work-location logs for employees and contractors.
- Time-stamped calendars, location-based entries, or project time-tracking tied to state locations.
- Sales reports showing customer delivery destinations, billing addresses, and shipping documents.
- Payroll and benefits records segmented by state.
- Contracts and invoices that show where services were provided or where the benefit was received.
In my experience, contemporaneous records (created at the time of activity) carry far more weight during state audits than reconstructed spreadsheets created months later.
Common mistakes and misconceptions
- Assuming residence alone determines tax: residency matters for personal taxation, but states generally tax income based on where it was earned. Residents may still claim credits for taxes paid to other states to avoid double taxation.
- Ignoring small or sporadic activity: even limited activities can establish nexus in some states (e.g., attending trade shows, short-term employees, inventory stored in a third-party warehouse).
- Overlooking reciprocity and withholding rules: some states have unique withholding or reciprocity agreements; employers must follow the employee’s withholding election when applicable.
- Treating sales tax and income tax as identical: they are separate obligations with different nexus and sourcing outcomes.
Credits, credits coordination and residency issues
If two states tax the same income, many states provide a credit for taxes paid to the other state to prevent double taxation. Credits are not automatic; taxpayers must claim them and supply the required documentation. Additionally, state residency tests (domicile and statutory residency days) affect whether you file as a resident, part-year resident, or nonresident — see our state residency checklist for details: State Tax Residency Checklist for Remote and Hybrid Workers (https://finhelp.io/glossary/state-tax-residency-checklist-for-remote-and-hybrid-workers/).
Example: If you are a resident of New Jersey but work in New York 120 days in a tax year, New York may tax the income attributable to those New York workdays; New Jersey will allow a credit on your resident return for taxes paid to New York, subject to NJ rules.
Practical multi-state sourcing checklist
- Map activities: list states where you live, work, sell, or store inventory.
- Track time/location: for employees and principal owners, keep daily logs or use geofenced timekeeping.
- Review contracts: note where services are performed and where customers receive the benefit.
- Check nexus thresholds: for each state, confirm physical and economic nexus thresholds for income and sales tax.
- Apply sourcing rules: for each type of income (wages, services, goods, royalties) apply the state’s sourcing rule.
- Claim credits: where appropriate, compute and claim credits for taxes paid to other states.
- Engage a CPA: if you cross more than two states, consider a multi-state tax specialist.
When to seek professional help
- You operate in more than two states and have complex apportionment issues.
- You store inventory in third-party warehouses in multiple states (marketplace or fulfillment centers create nexus in many jurisdictions).
- You received an audit notice from a state revenue agency.
In my practice, a targeted engagement (1–2 days) to set up documentation templates and initial apportionment calculations usually prevents the most costly mistakes and limits future audit exposure.
Real-world example (anonymized)
A consulting client split time between California and New York, billing clients in both states. By implementing day-by-day time logs, using market-based sourcing for services and claiming a credit on the home state return, we avoided duplicate income inclusion and reduced withholding by optimizing where payroll taxes were paid — saving the client roughly $3,000 in the tax year and preventing an expensive audit.
Resources and further reading
- IRS — general tax information (https://www.irs.gov). While the IRS does not set state income sourcing rules, it provides useful federal background.
- Consumer Financial Protection Bureau — consumer guides on tax issues (https://www.consumerfinance.gov).
- FinHelp guides: Multistate Nexus: When Remote Work Creates State Tax Obligations (https://finhelp.io/glossary/multistate-nexus-when-remote-work-creates-state-tax-obligations/) and State Tax Residency Checklist for Remote and Hybrid Workers (https://finhelp.io/glossary/state-tax-residency-checklist-for-remote-and-hybrid-workers/).
Final notes and disclaimer
This article is educational and general in nature and does not constitute personalized tax or legal advice. State rules change frequently and differ by jurisdiction; check the relevant state revenue department website or consult a licensed CPA or tax attorney for guidance specific to your situation. In my practice, confirming current state regulations before making payroll or withholding changes has proven essential to avoid collection issues.
Last reviewed: 2025 — readers should verify the most recent state rules and thresholds before relying on this content.
