How are service revenues sourced for state income tax: cost of performance or market?
Edvin Givargis Published 12 minute read
The short answer
It depends on the state, and the answer can differ for the same receipt from one state to the next. States that apportion business income divide it by formula, and most now weight the sales factor heavily or use it alone, so the rule that assigns a receipt to a state's numerator largely decides how much income that state taxes. For tangible goods the rule is familiar: the sale belongs to the destination state. For services and intangibles, two rules compete. The traditional rule, section 17 of the Uniform Division of Income for Tax Purposes Act, sources a receipt to the state where the income-producing activity is performed, and where the activity spans several states, assigns the entire receipt to the one state in which a greater proportion of the activity is performed than in any other, based on costs of performance. The newer rule, market sourcing, looks at the other end of the transaction: to where the customer is, or where the customer receives the benefit of the service, and it treats the provider's own location as irrelevant. A clear majority of apportioning states have moved to market sourcing, and the Multistate Tax Commission's model version of section 17, as revised in 2015, assigns service receipts to the location where the service is delivered. California, for example, sources service receipts to the state to the extent the purchaser received the benefit of the service there. A meaningful minority still applies cost of performance; Virginia is one. Because the two rules look at opposite ends of the same sale, a provider headquartered in a cost-of-performance state that sells into market states can have the same receipts counted twice, and a provider based in a market state that sells into cost-of-performance states can have receipts counted nowhere. Identifying which rule each state applies, for each year at issue, is the first step in any sales factor review for a service or intangible business.
Why receipts sourcing decides the answer
Apportionment divides a multistate company's business income among the states by a percentage, and the percentage comes from factors. The model act used three, property, payroll, and sales, weighted equally. Most states have since moved to a double-weighted sales factor, and a steadily growing number to a single sales factor, in which the sales factor is the whole formula. Even under a three-factor formula, a service or intangible business with modest property and a concentrated workforce finds that the sales factor carries most of the weight.
The sales factor is a fraction: receipts in the state over receipts everywhere. The denominator is the company's total receipts and moves little from state to state. The numerator is where the contest happens. The model act splits it into two rules. Section 16 governs sales of tangible personal property and assigns them to the destination state, with a throwback to the state of shipment when the seller is not taxable at destination or sells to the federal government. Section 17 governs everything else: services, rents and royalties from intangibles, and the other receipts a consulting firm, software company, engineering practice, or asset manager actually earns. For those businesses, essentially the entire receipts base passes through section 17 or the state's own version of it, so the sourcing rule for services is not a detail of the return; it is the return.
Cost of performance and market sourcing
The cost-of-performance rule, as the Multistate Tax Compact carries it in Article IV, paragraph 17, treats a receipt other than a sale of goods as in the state if the income-producing activity is performed there, or if the activity is performed both inside and outside the state and a greater proportion of it is performed in the state than in any other state, based on costs of performance. The operative words are "greater proportion." The model rule is all or nothing: a firm that incurs 40 percent of its performance costs in one state, 35 percent in a second, and 25 percent in a third sources 100 percent of the receipt to the first and nothing to the others. Some cost-of-performance states soften this by assigning receipts in proportion to the costs incurred in each state, or by the time personnel spend performing services in each state, an approach common for personal services. Every version raises the same working questions: what the income-producing activity is, which costs count as costs of performance, whether payments to third-party contractors are included, and in which state a given cost is incurred. The rule structurally favors the provider's home state and disfavors the states where its customers sit, which is precisely why most states abandoned it.
Market sourcing reverses the orientation. The location where the service is performed and where the costs are incurred become irrelevant; what matters is the customer. States have written the test three ways. Some ask where the service is delivered, the formulation the Commission adopted when it revised its model: receipts from a service are in the state if and to the extent the service is delivered to a location in the state, with a reasonable approximation required when the location cannot be determined. Some ask where the service is received; Illinois sources a service receipt to the state if the service is received there, falling back to the customer's ordering office and then its billing office when the place of receipt is not readily determinable (35 ILCS 5/304(a)(3)(C-5)(iv)). Others ask where the benefit is received. California is the leading example: sales from services are in California to the extent the purchaser of the service received the benefit of the services in California, and sales from intangible property are in California to the extent the property is used there (Cal. Rev. & Tax. Code section 25136(a)(1) and (a)(2)). The Franchise Tax Board's regulation defines the place where the benefit is received as the location where the customer "has either directly or indirectly received value from delivery of that service," and assigns receipts from business customers through a cascade that runs from the contract and the taxpayer's books and records, to a reasonable approximation, to the location from which the customer placed the order, and finally to the billing address (Cal. Code Regs., tit. 18, section 25136-2). That regulation was amended in 2025 for taxable years beginning on or after January 1, 2026, and the companion California article in this library works through both versions. Across all three formulations, rules for individual customers usually differ from rules for business customers, and the answer turns on documentation the provider may or may not keep.
Intangibles followed the same path. The traditional approach sourced royalties and license fees under cost of performance, which in practice meant the owner's home state. Market states now source them where the intangible is used, which for a licensed trademark or patent often means where the licensee's own sales occur.
Two numerators or none
The mismatch is easiest to see in numbers. Assume two states, both using a single sales factor. State A uses the model cost-of-performance rule. State B uses market sourcing. The provider has nexus in both.
Firm X is an engineering firm with every employee, office, and dollar of performance cost in State A. It earns $10 million of service receipts: $4 million from customers in State A and $6 million from customers in State B. Its apportionable business income is $2 million. State A asks where the income-producing activity was performed, finds all of it in State A, and places the full $10 million in its numerator: a 100 percent factor and $2 million of income. State B asks where its customers received the service, finds $6 million of receipts in State B, and applies a 60 percent factor: $1.2 million of income. Firm X reports $3.2 million of taxable income on $2 million of actual income. The $1.2 million excess is the same receipts taxed twice, and neither state's rule is misapplied.
Reverse the geography. Firm Y performs all of its work in State B and earns the same $10 million, $6 million from State B customers and $4 million from State A customers. State B places only its own customers' $6 million in the numerator: 60 percent, $1.2 million. State A finds no income-producing activity in State A and places nothing in its numerator. The remaining $800,000 of income is taxed nowhere. The pattern is not hypothetical. Virginia still assigns service receipts to the state where the greater proportion of the income-producing activity is performed, based on costs of performance (Va. Code section 58.1-416(A)), so a firm whose service staff sit in a market-sourcing state and whose customers sit in Virginia can find those receipts in neither state's numerator.
Throwback does not close the gap the way practitioners sometimes assume. In the model act, throwback is a rule for goods: section 16 pulls a sale back to the state of shipment when the seller is not taxable in the destination state, and section 17 needs no counterpart, because under cost of performance a service receipt already sits where the work was done. Market sourcing reopened the question, and states answered it differently. The Commission's revised model excludes from the denominator any receipt assigned to a state where the taxpayer is not taxable, or whose state cannot be determined or reasonably approximated. Illinois excludes a service receipt from both numerator and denominator when the taxpayer is not taxable in the state where the service is received. A few states extend throwback or throw-out treatment to service receipts in their own terms. The interplay produces a counterintuitive result in the Firm Y example: if State B applied a throw-out rule and Firm Y were not taxable in State A, State B's factor would become $6 million over $6 million, or 100 percent, and the nowhere income would move into State B's base. Firm Y's taxable presence in State A, a state that taxes none of those receipts, is what keeps its State B factor at 60 percent.
How auditors use either rule
Each rule gives an auditor a way to reach receipts. In a cost-of-performance state, the examination usually centers on the income-producing activity and the cost pool: whether on-site personnel, in-state subcontractors, or in-state support functions tip the greater proportion into the state; whether the activity should be measured contract by contract rather than across the business as a whole; which costs are direct costs of performance and which are overhead. The statutory label is not always the end of the analysis. In Synthes USA HQ, Inc. v. Commonwealth (2023), the Pennsylvania Supreme Court read a statute written in cost-of-performance terms, for the 2011 tax year, to source service receipts to the customer's location where the benefit of the service is received, adopting the Department of Revenue's reading over the plain cost-of-performance reading the Office of Attorney General urged. The taxpayer there sought the benefit-received reading to support a refund, but the holding cuts both ways: a state can administer a cost-of-performance statute as a market rule, and a return prepared on the statute's text alone can be wrong in either direction.
In a market state, the examination moves to the customer. Auditors test whether the benefit is received where the contract or billing address says, or somewhere the customer's own operations or the customer's customers are located; California's definition expressly reaches value received "directly or indirectly." They challenge approximation methods that default to billing address when the provider's records could support something more precise, and they treat the absence of records as the provider's problem. Under both rules, the receipt itself can be recharacterized: a transaction a provider treats as a service may be framed as a license of intangible property, or a bundled offering as a sale of goods, when a different category moves the receipt into the state's numerator. States do not coordinate these positions, and a sourcing conclusion accepted in one state binds no other.
Practice notes
The working tool is a matrix: for each state where the company files, and for each open year, the sourcing rule for services and for intangibles, the customer-type distinctions, the approximation hierarchy, and the throwback or throw-out treatment, because states continue to move from cost of performance to market sourcing and from weighted formulas to a single sales factor, and the rule in effect for the year at issue controls. Providers based in cost-of-performance states should model the double-count against their market-state receipts before assuming that current filings are neutral, and providers based in market states should understand which of their receipts are presently landing nowhere and whether a throw-out rule or a change in nexus posture could move them. Market sourcing rewards documentation; capturing where customers actually receive the benefit at contract and billing, rather than reconstructing it on audit, is usually the difference between the provider's method and the auditor's. Open years deserve a second look for refund opportunity as well as exposure, since receipts sourced to a home state under a cost-of-performance reading that the state does not apply, or to a market state on a billing address the records contradict, overstate a factor that can still be corrected by amended return or refund claim before the limitation period closes. Where the combined effect of two states' rules is severe double taxation, the alternative apportionment provisions most states carry are worth evaluating, recognizing that the party seeking to depart from the standard formula bears the burden. G&G State Tax Group provides multistate apportionment and receipts sourcing reviews alongside its state and local tax practice.
This article states the law as of September 26, 2026
Statutes, rates, thresholds, and agency practice change, and a different set of facts can change the answer. Before acting on anything discussed above, contact G&G State Tax Group, or another state and local tax adviser, to confirm what has changed since this was written and how the rules apply to a specific situation.
This publication is informational in nature and is not, and should not be considered, legal, accounting, tax, or other professional advice for any person or situation. Correct application of tax law depends heavily on the facts and circumstances in each case, and G&G State Tax Group, LLC assumes no liability in connection with the use of this information, and is not obligated to inform any reader of changes in the law or other factors that could affect the information contained herein.