Diversity in state corporate income tax rules and regulations creates planning opportunities.
By Kurt Fanning and David Joy
Direction for Taxpayers in the Multistate Tax Area
Despite efforts to develop uniform income tax treatment across all states, state corporate tax laws still lack consistency. Given this diversity, many businesses can save substantial state income taxes by properly structuring their interstate operations.
The authors provide a conceptual framework to provide direction for taxpayers in the multistate tax area. This conceptual foundation focuses on eight concepts:
* Identification of nonbusiness and business income
* Partitioning nonbusiness income
* Partitioning business income
* Allocation of Federal tax deductions
* Modification of nonbusiness and business taxable income
* Apportionment of business taxable income
* Computation of state corporate income tax liability
* Effective state tax planning strategies.
The Multistate Tax Commission has repeatedly pursued the objective of uniform income tax treatment across all states. Despite these efforts, state corporate income tax laws still lack congruency. As a result, taxpayers are confronted with the challenge of complying with each individual state's corporate income tax rules. Given the diversity in rules and regulations, it is possible for many corporations to save substantial state income taxes by properly structuring their interstate business operations following eight general concepts.
Identification of Nonbusiness
and Business Income
A few states, such as Louisiana and Minnesota, do not differentiate between business and nonbusiness income. Some states choose to treat specific types of income as nonbusiness income. These include dividends, interest, passive rental and royalty income, and gains and losses resulting from sales of investments yielding such income.
Most states have chosen the approach set forth in the Uniform Division of Income for Tax Purposes Act (UDITPA). The focus of UDITPA is the determination of whether the acquisition, management, and disposition of tangible and intangible property used to produce the income is an integral part of the taxpayer's regular trade or business.
Under UDITPA, rent from real and tangible property is business income if the property is used in the trade or business. For example, UDITPA classifies the rental of one floor of a 10-story office building as business income when the other nine floors are used for business purposes. In contrast, the rental of nine floors out of 10 floors is classified as nonbusiness income. The rental of property during the time period it is not used in the regular course of trade or business is classified as business income, as are car rental fees by a car rental business.
Interest income, dividend income, and patent or royalty income are classified as business income if the intangible with respect to which the income was received arises out of or was created in the regular course of the taxpayer's trade or business. Such income is also classified as business income if the purpose for acquiring and holding the intangible is related or incidental to the taxpayer's trade or business.
Thus, UDITPA classifies interest income as business income if it is derived from notes received from the sale of regular merchandise. Likewise, interest received by banks on loans made to their customers is classified as business income, as is interest earned on money held for escrow purposes or workmen's compensation funds. In contrast, interest income earned from investing excess cash holdings is treated as nonbusiness income.
Using the trade or business criteria, UDITPA classifies dividends received from stock held for investment to meet a specific business objective, such as bonding or obtaining a source of supply, as business income. In contrast, UDITPA classifies dividends from stock held purely for investment or speculative purposes as nonbusiness income.
Royalties received by a taxpayer engaged in the publishing business or from patents resulting from the taxpayer's regular trade or business are classified as business income. Royalties for use of a patent on a type of phonograph needle, for example, are treated as nonbusiness income if the taxpayer does not manufacture or sell phonographs or phonograph components.
Partitioning Nonbusiness Income
After identifying the nonbusiness income, taxpayers should determine which state is entitled to tax the nonbusiness income. Most states have opted to use the following rules established in UDITPA:
* Nonbusiness rents, royalties, and capital gains attributable to real estate are allocated to the state in which the property is located.
* Nonbusiness rents and royalties from tangible personal property are allocated to the state(s) in which the property is utilized.
* Capital gains and losses on tangible personal property are allocated to the state in which the property was used at the time of sale. If this state does not levy a tax on the taxpayer, the gains and losses are allocated to the state where the taxpayer's commercial domicile is. State laws may designate that the commercial domicile may be either the state in which the corporation is incorporated or the state where the home office is located.
* Nonbusiness capital gains and losses and interest or dividends attributable to intangible personal property (stocks and bonds) are allocated to the state where the taxpayer's commercial domicile is located.
* Nonbusiness income from royalties on patents and copyrights is allocated to the state in which the rights are utilized. If the taxpayer is not taxable in that state, the income is allocated to the state where the taxpayer's commercial domicile is located.
The taxpayer should then group three types of nonbusiness income. First, all nonbusiness income allocable solely to the state levying the tax should be allocated to one group. All nonbusiness income not allocable solely to the state levying the tax should be allocated to a second group. The final group would include nonbusiness income for activities that occur in two or more other states, one of which is the state levying the tax. More than one group may be necessary if the investment activities allocable to such groups are unrelated.
Partitioning Business Income
State corporation income tax rules focus on identifying the parameters of an integrated business operation. The essence of this process is the unitary business concept. The Supreme Court first ruled that vertically integrated businesses (such as oil companies that explore, drill, produce, refine, distribute, and sell oil and gas products) are unitary businesses. The Supreme Court later ruled that horizontally integrated companies (such as Wal-Mart, Safeway, and Service Merchandise) with parallel operations benefiting from economies of scale are also unitary businesses. Using this same logic, companies that conduct complementary business operations are most likely unitary businesses. It is very possible that corporations may have two or more unitary businesses.
States usually adopt one of the following three major tests for application of the unitary business concept:
* The three utilities test focuses on the unity of ownership, operation, and use.
* The dependency/contribution test focuses upon whether or not the in-state operations are dependent upon, or contribute to, out-of-state operations.
* The profitability test focuses upon the existence of functional integration, centralization of management, and economies of scale.
In partitioning business income, cost of goods sold should be allocated to the various business income groups identified in this process. The total of all business groups should be added to the total of the nonbusiness groups. This total should equal the total gross income reported on the Federal corporate income tax return.
Allocation of Federal Tax Deductions
The next step is allocating the Federal tax deductions to the various income groups identified in the previous step. The focus of this step should be to determine whether or not the corporation incurred a given expense solely for the benefit of a single income group. Such expenses should be allocated directly to that income group.
Typical expenses that various states do not deem to be directly allocable to a given income group include interest expense, general and administrative expenses, and other business expenses shared by two or more business income groups.
States have adopted different approaches for the allocation of expenses not directly allocable to the various income groups. UDITPA only stipulates that the taxpayer must be able to justify the allocation process in a rational manner. Accordingly, the taxpayer often has considerable latitude in the allocation process. In contrast, other states deny taxpayers this opportunity by requiring the use of specific allocation procedures. For example, New Jersey provides that taxpayers must allocate general and administrative expenses to various income groups using the value of the assets attributable to each group.
The final phase of this determination is calculating the net income for each income group by deducting the expenses from the total gross income allocated to each group. The total of the net income for each group should then equal line 28 of the U.S. Corporate Income Tax Return (taxable income before net operating loss deduction and special deductions).
Modification of Nonbusiness and Business Taxable Income
Having partitioned taxable income before net operating loss deduction and special deductions, the taxpayer should then modify the taxable income of each group subject to tax in the state for which the tax return is being prepared. All states except Alabama, Arkansas, California, and Mississippi have opted to use taxable income for Federal purposes as the initial point for computing corporate taxable income. Thus, the state law for the other states must specifically identify all modifications to Federal taxable income.
Alabama, Arkansas, California, and Mississippi have enacted their own tax rules and regulations for computation of taxable income. However, they have either chosen to incorporate many of the Federal income tax provisions into their state laws or have provisions that are very similar to the Federal provisions.
These modifications may increase taxable income for income taxable at the state level but not at the Federal level or deductions allowed for Federal purposes but not for state purposes. Also, the modification may decrease taxable income for expenses allowed for state purposes but not for Federal purposes. Increases and decreases may also result due to differences between the timing of recognition of income or expenses at the Federal and state levels.
The best approach to work with this scenario is to provide a general outline of the different modifications that exist in the various state income tax laws.
Dividends from Foreign Corporations. Federal tax rules require dividends received from foreign corporations to be increased for foreign taxes incurred by the corporation when the income that is being distributed was earned. To compensate, Federal tax law allows such taxes to be taken as foreign tax credits. Accordingly, the Federal tax law imposes little or no taxes on foreign dividends. On the other hand, state tax laws do not allow any tax credits for foreign taxes. The grossing up of the foreign taxable income becomes taxable at the state level unless the state law specifically provides some form of relief. As a result, some states provide for either total exclusion of dividends received from foreign corporations and subpart F income or a tax deduction for the foreign taxes attributable to such income.
Domestic Dividends. A majority of states recognize the Federal dividend exclusion rule for domestic corporations. Some states, however, allow a 100% exclusion for domestic dividends, while others allow no exclusions for any dividends. Still other states have adopted their own percentage for excludable dividend income.
Interest on Federal Government Obligations. Many states exclude interest from Federal government obligations from their state taxable income. Note that any tax deduction attributable to this interest is not allowed when the interest income is excluded from taxable income.
Interest on State Obligations. Most states require inclusion in taxable income of state bond interest, except for interest on bonds issued by government instrumentalities within the state. However, several states do not provide such an exception. Alaska, New Hampshire, West Virginia, Pennsylvania, Ohio, and Indiana exclude all state bond interest from taxable income.
Capital Gains and Losses. Several states require modifications to the amount of capital gains and losses reported on the Federal return. One reason is differences in basis of the property for state and Federal tax purposes. This might occur for any number of reasons. A few states have adopted their own depreciation rules. Other states require capitalization of intangible drilling costs or the use of cost depletion. Louisiana and Oklahoma allow taxpayers to use percentage depletion in lieu of cost depletion. Other state laws stipulate that the tax basis of property held on the date state income tax laws were initially adopted is fair market value. Alabama, Arkansas, North Carolina, and South Carolina allow all capital losses to be deducted in the year they occur. Other states deny capital loss carrybacks. Several states also do not grant deferral of gain recognition for like kind exchanges or casualty and theft losses unless both the old property and its replacement are located within the state levying the tax.
Federal, State, and Local Taxes. Many states also require modification to the amount of tax deductions for Federal, state and local taxes. For example, approximately half the states allow tax deductions for Federal income taxes. All of these states base this deduction on the Federal income tax expense for the tax year; Arkansas alone, however, bases this deduction on the Federal taxes paid during the tax year. Most of the states deny tax deductions for state income taxes, yet the unique Michigan Small Business Tax is typically deductible unless specifically mentioned in the state income tax rules and regulations. Several states make an exception for their state income tax. Wisconsin also denies a tax deduction for state property taxes.
Bad Debt Expense. Arizona, Arkansas, and Michigan allow the use of the reserve method of allowance for bad debt expenses. In turn, California, New York, and Tennessee allow financial institutions to use the reserve method. West Virginia permits only savings and loan associations to use the reserve method.
Depreciation and Amortization. A few states have adopted their own depreciation and amortization tax rules. Oregon and California provide for a 31.5-year useful life for nonresidential real estate. California provided for different depreciation rules prior to the enactment of the Accelerated Cost Recovery System rules. Pennsylvania requires the use of straight line depreciation for depreciable real estate. Michigan does not recognize bonus depreciation rules for acquisition of any property or equipment. California and Oregon limit this tax deduction to $10,000. Alabama, Oklahoma, and Louisiana allow the use of percentage depletion for oil and gas purposes. Colorado allows the use of percentage depletion for oil shale. Other states require the use of cost depletion or limit the use of percentage depletion to the cost basis of the depletable property.
Charitable Contributions. Several states have adopted different percentages for limitation on the amount of deductible charitable contributions. These states and applicable percentages are as follows: California, five percent; Indiana, zero percent; Minnesota, 15%; and Mississippi, 20%.
Federal Tax Credits. States may or may not modify taxable income for tax credits taken for Federal purposes in lieu of tax deductions. Expenditures that qualify for tax credits, such as the job tax credit, or the research and development tax credit, are those for which some states may provide modification of state taxable income.
State Credits. Some states allow tax credits for certain expenditures in lieu of tax deductions. In these situations, the tax deductions taken on the Federal return must be added back as a modification of the taxable income.
Business Enterprise Zones. Several states, such as Texas and Missouri, have opted to exclude from taxable income earnings attributable to business enterprise zones. For example, Missouri exempts 50% of such income from taxation.
Expenses Attributable to Exempt Income. Expenses attributable to income exempt from state taxation but included in gross income for Federal purposes must be added back. Likewise, expenses attributable to income excluded from gross income for Federal purposes but included in state taxable income can be deducted.
Net Operating Losses. Many states have established their own tax rules for net operating loss (NOL) carryforwards and carrybacks. Several states deny net operating loss carrybacks, and several have adopted their own limits for carryforwards, such as five years, seven years, or 10 years. Moreover, states base the amount of NOL carryback or carryforward on the application of their own tax rules, rather than Federal rules.
Unique Rules. Several states have adopted unique rules for modifying Federal taxable income. For example, Alabama denies a tax deduction for amortization of premiums on purchased bonds. Arkansas denies a tax deduction for amortization for organization expenses and start-up costs South Dakota allows expenditures for meals and entertainment to be deducted in full.
Apportionment of Business Taxable Income
The next step is to apportion the taxable income of the business groups that conduct business activities within the state levying the tax and in other states. UDITPA provides three factors (sales, property, and payroll) to apportion this income and proposes that each factor be weighted equally. The numerator for each factor is the amount attributable to the state levying the tax, and the denominator is the aggregate of that factor either on a U.S. or worldwide basis.
Still, many states have adopted different apportionment procedures. For example, Iowa, Texas, Nebraska, and, recently, Illinois, have adopted a single factor of sales. Other states have adopted a four-factor procedure that gives a double weight to sales and single weights to property and payroll. Other states give varying weights to each of the three factors. States such as Missouri allow taxpayers to choose between two different apportionment alternatives, such as the single factor of sales or the four-factor apportionment procedure described above.
Various states have also defined these three factors differently. In addition, some states include only the gain from property sales, whereas other states include the gross sales price for property sales in the sales factor. In the event of sales to customers in other states, all states except Louisiana attribute the sale to the state in which the property that is sold will be used rather than where the title of the goods is transferred. Louisiana allocates its sales based upon where the title to the goods is transferred.
UDITPA proposes that sales made in different states that either do not or cannot impose an income tax on the taxpayer will be treated as sales in the state from which the goods were shipped, commonly referred to as the throwback rule. Many states apply a throwback to sales made to U.S. government agencies. Massachusetts chose to not apply the throwback rule to sales made to U.S. government agencies.
UDITPA defines the property factor as the average original cost of tangible property for the tax year. In addition, UDITPA includes six times the amount of lease payments in the property factor. The numerator includes the property located and leases paid for use of property within the state levying the tax. Louisiana does not include lease property in the definition of property; some states require a different multiple for leased property. California and Nebraska include some intangible property related to oil and gas. A few states use the net book value of the property rather than the original cost. Other states use the value of property held at either the beginning or the end of the year.
UDITPA defines payroll as the compensation included in the employees' W-2 as taxable compensation plus contributions to IRC section 401(k) plans. However, Delaware, Mississippi, New York, North Carolina, Oklahoma, South Carolina, and Vermont exclude officer's compensation from their definition of payroll. Arkansas, Maryland, Mississippi, New Jersey, New Mexico, North Dakota and Tennessee exclude 401(k) contributions from their definition of payroll.
Computation of State Corporate Income Tax Liability
The preceding steps provide the net income for the nonbusiness income allocated directly to the state levying the tax and the amount of net income from each unitary business apportioned to the state levying the tax. The aggregate of these components is the taxable income subject to state income taxes.
Most states have adopted a flat income tax rate. However, several states have adopted a progressive tax rate structure with two or three different tax rates. These rates range from as low as three percent to as high as 12%.
Most states provide for tax credits. A number of states have enacted tax credits to attract businesses; their use is now extremely popular. This trend is the exact opposite of what has occurred at the Federal level.
Some of the more popular tax credits that states have chosen to allow for expenditures made within the state include the following:
* Property, plant, and equipment
* Initial employment of residents of the state or specifically identified groups of individuals such as young workers, ex-convicts, and welfare recipients
* Investments within economically underdeveloped or other specific areas
* Research and development
* Protection of the environment
* Purchase of resources produced within the state, such as coal
* Support of certain government activities, such as public education
* Handicapped-accessible structures, rehabilitated historical structures, or low income housing
* Conservation of land, fish, wildlife, or forests
* Solar energy or conservation facilities
* Commuter vehicles
* Investment in new small businesses
* Taxes on certain purchases, property, or activities
* Certain employee benefits.
The amount of the tax credit can vary from a small percentage to 100% of the expenditure over a given time period. Accordingly, the benefits from tax credits vary substantially from state to state.
Effective State Tax Planning Strategies
Given the vast array of state tax laws, state taxation of interstate commerce can vary substantially depending upon where a company carries on various components of its operations. Some opportunities for substantial tax savings include the following:
* The location of manufacturing and warehousing operations in states that use a single factor of sales
* The location of home offices in states that exclude dividends from both domestic and foreign corporations and other investment income from taxable income
* The location of production facilities in states where there is no throwback for sales made in states where no income taxes are imposed on the sales activity or on sales to U.S. agencies
* The location of a home office in states that do not include officer compensation in the definition of payroll for apportionment purposes
* The construction of new production facilities in states that use original cost rather than net book value for the definition of property for apportionment purposes
* The conduct of business in states with lower tax rates
* The conduct of business in states that provide incentives to taxpayers such as exclusion of income earned in industrial enterprise zones or tax credits.
As various states offer different tax benefits, proper tax planning should use quantitative tools that enable the taxpayer to identify the optimal locations for various business operations. This will surely require the use of computer programs that incorporate the tax rules of various states in which management may wish to conduct its business operations. *
Kurt Fanning, PhD, CMA, CPA, is an assistant professor of accountancy and David Joy, PhD, CPA, a professor of accountancy, both at Central Missouri State University.
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