Comparing State Taxes When Making Business Decisions

By Haroldene F. Wunder

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Tax Trends

Research strongly indicates that state tax systems are relevant to businesses decisions, including location. Examples of companies selecting states due to favorable tax systems are plentiful. In 2005, Intel built a multi-billion-dollar chip-making facility in Arizona due to its favorable corporate income tax system. In contrast, high-tax-rate California struggles to retain businesses attracted to neighboring Nevada, a low-tax-rate alternative.

One factor contributing to the constant state of flux is that states try to enact legislation that will improve their competitive positions. For example, Michigan repealed its Single Business Tax (SBT), effective January 1, 2008, because of its punitive effect on corporations. In her announcement of the new Michigan Business Tax (MBT) to replace the SBT, Michigan Governor Jennifer Granholm acknowledged that making Michigan’s business climate more competitive was central to her economic plan. Granholm was careful to stress that each component of the new MBT’s tax base is used by a number of other states.

Within this changing climate, trends in state business tax systems are emerging. For example, the state corporate income tax continues to decline as a component of state tax systems, as states increasingly enact gross receipts taxes to replace or complement corporate income taxes as a revenue source. Another clear and rapidly developing trend is away from three-factor apportionment formulas and toward sales as the single apportionment factor.

Businesses should keep informed about current trends in state business tax systems. The authors compiled information about the following aspects of the business tax systems of the 50 states and Washington, D.C.:

• Corporate income tax rates;
• Gross receipts tax;
• Sales and use tax;
• Corporate alternative minimum tax (AMT);
• Taxation of S corporations and limited liability companies;
• Tax credits (investment credit, R&D credit, jobs credit); and
• Adoption of the Multistate Tax Compact Uniform Division of Income for Tax Purposes Act (UDITPA).

Types of Taxes and Tax Rates

The Tax Foundation (a nonpartisan tax research group based in Washington, D.C.; www.taxfoundation.org) has concluded that states which raise sufficient revenue without one of the major taxes (i.e., corporate, individual, or sales tax) will, ceteris paribus, “out-compete those states that levy every tax in the state tax collector’s arsenal” (Background Paper No. 52, 2006). States appear to be marching in the opposite direction, however, as they no longer restrict their business tax provisions to corporate income, franchise, and sales taxes.

Exhibit 1 and Exhibit 2 provide comparative information about state corporate income tax rates and the existence of a gross receipts tax, sales and use tax, and corporate AMT, respectively. The data in Exhibit 1 show that, of the 46 jurisdictions that levy a corporate income tax, 31 levy a flat rate. The 30 states with flat corporate income tax rates are in the mainstream not only in terms of numbers, but also when compared to international trends.

With the replacement of Michigan’s SBT with the MBT, which taxes business income at 1.875%, rates on income now range from this low to Pennsylvania’s 9.99% high. The 1.875% Michigan rate does not take into account the tax imposed on the other two components of the MBT (0.125% for gross receipts, and 0.125% for business assets).

A KPMG report (KPMG’s Corporate Tax Rate Survey: An International Analysis of Corporate Tax Rates from 1993 to 2006; www.kpmg.com) describes the incentive effect that relatively low corporate income tax rates have on business decisions. It concluded that as transport, communication, and trading links improve across jurisdictions, corporations are finding it progressively easier to site their operations wherever they can find the best combination of resources, skills, finance, security, and the effective rule of law. Under those circumstances: 1) taxes effectively become a price that corporations must pay to make use of the goods and services that a jurisdiction can provide, and 2) like any astute consumer, corporations are shopping around “for the best combination of price and value.” This phenomenon is particularly applicable to interstate analyses, because the Department of Labor has concluded that the majority of mass business relocations are from one U. S. state to another, rather than to a foreign location (www.bls.gov/news.release/mslo.nr0.htm).

Exhibit 2 compares jurisdictions with regard to gross receipts tax, sales and use tax, and corporate AMT. Only three states levy neither gross receipts, sales and use, nor corporate AMT: Montana, New Hampshire, and Oregon.

A gross receipts tax is becoming increasingly common. Its proponents praise the steadier flow of tax receipts into government coffers, compared with the fluctuating revenues generated by corporate income taxes. The gross receipts tax appears to be roughly as stable as a retail sales tax (see John L. Mikesell, Gross Receipts Taxes in State Government Finances: A Review of Their History and Performance, Washington, D.C., Council on State Taxation, 2007).

In 2005, Ohio enacted the Commercial Activities Tax (CAT), which applies a 0.26% rate (when fully phased in) to gross receipts in excess of $1 million. Washington State’s Business and Occupation (B&O) Tax applies a multi-rate schedule to gross receipts of Washington businesses. Kentucky, New Jersey, and Texas have also enacted gross receipts taxes, although New Jersey’s Alternative Minimum Assessment was phased out July 1, 2006. Kentucky’s gross receipts tax is an alternative tax; businesses pay either the corporate income tax or the gross receipts tax, but not both. As noted previously, Michigan replaced its SBT with the MBT, the base for which consists of three components: gross receipts, assets, and income (profits).

The effect of differential sales tax rates is often apparent when crossing the border from a high-tax state to a low-tax state; a “vast expanse of shopping malls has sprung up along the border in the low-tax jurisdiction” (Tax Foundation, Background Paper No. 52, 2006). Such a phenomenon occurs on both coasts. For example, Oregon, Arizona, and Nevada—whose sales tax rates are zero, 5.6%, and 6.5%, respectively—poach commercial activity from California, whose base 7.25% sales tax rate can reach a maximum rate of 8.75% in certain counties (e.g., Alameda County). On the East Coast, Delaware—with no sales tax—attracts businesses and shoppers from across the mid-Atlantic region, and its relative advantage increases whenever a neighboring state raises its sales tax rate (Tax Foundation, Background Paper No. 52, 2006).

Forty-six jurisdictions impose sales and use taxes (Exhibit 2), taxes that raise so much revenue that states cannot afford to repeal them without enacting new or expanding existing taxes. Even Wyoming, which the Tax Foundation concluded had the best business climate in 2007, levies a 4% sales tax.

Evidence shows that AMTs have no redeeming features. An AMT does not improve fairness in any significant way; it nets insignificant amounts of revenue for state governments; its compliance costs in some years are larger than collections; and it encourages businesses to reduce or shift their investments.

Eight states currently levy some form of AMT (Alaska, California, Connecticut, Florida, Iowa, Maine, Minnesota, and New York). Kentucky recently replaced its AMT with a limited liability entity (LLE) tax levied on corporations for taxable years beginning on or after January 1, 2007; the LLE tax incorporates the former $175 AMT. Connecticut levies a flat $250 AMT. The remaining seven states with AMTs apply rates ranging from 2.5% (New York) to 18% (Alaska) on some measure of AMT income. Although Virginia does not impose a broad-based AMT, its telecommunications companies pay a minimum tax at the rate of 0.5% of gross receipts if the 6% income tax is less than the minimum.

Taxation of S Corporations and LLCs

State recognition of pass-through business entities enables multistate business entities to legally shift income from the state in which it was earned to one with a lower rate, or to a state that does not impose tax on income derived from intangible assets (ownership of an LLC qualifies as an intangible asset).

The vast majority of states treat S corporations as exempt, although three states (Arkansas, New Jersey, and New York) also require a separate S-corporation election in addition to the federal election. Only nine jurisdictions (California, Kentucky, Louisiana, Michigan, New Hampshire, New Jersey, Tennessee, Vermont, and the District of Columbia) treat S corporations as taxable entities. California S corporations pay a franchise tax of 1.5% of net income (minimum $800). Effective January 1, 2007, Kentucky S and C corporations are subject to the Limited Liability Entity (LLE) tax. Louisiana, Michigan, Texas, and the District of Columbia tax S corporations in the same manner as other corporations. New Hampshire S corporations are required to pay a business profits tax. Vermont S corporations are liable for income taxes imposed on nonresident shareholders. All of the statutes that recognize S corporations contain restrictions or conditions so that an exempt S corporation may be subject to tax under specific circumstances (e.g., certain capital gains).

Empirical data show that the advent and growth of LLCs have been one important cause of the decline of state corporate tax revenues (William F. Fox and Leann Luna, “Do Limited Liability Companies Explain Declining State Corporate Tax Revenues?,” Public Finance Review, 33(6), 690–720, 2005). In some respects, the treatment of LLCs is identical across jurisdictions. All have enacted LLC-enabling legislation; permit both domestic (formed in-state) and foreign (formed out-of-state) LLCs; and either follow the federal income tax treatment of LLCs or have enacted state statutes explicitly describing when LLCs are treated as partnerships. (A minor exception is Tennessee, which subjects LLCs to a Tennessee franchise/excise tax unless specific exemption exists.)

The similarity across jurisdictions with respect to LLCs is largely illusory, as state-specific features matter significantly. The following are the top 10 states, ranked by the number of LLCs created, in 2006:

• Florida: 130,251
• Delaware: 97,942
• California: 73,334
• Texas: 65,116
• New York: 55, 762
• New Jersey: 55,614
• Arizona: 51,832
• Colorado: 50,367
• Ohio: 49,253
• Michigan: 48,905.

In just those 10 states, 678,376 new LLCs were created in 2006 (International Association of Commercial Administrators; www.iaca.org).

Florida’s experience is instructive in demonstrating the significance of state-specific conditions. Three factors contributed to the large number of LLCs created in Florida. First, during its 2006 boom in real estate, investors created separate LLCs for each of their properties. Second, Florida permits foreign individuals to own an LLC interest; they cannot be S corporation owners. Third, LLCs have been used as a vehicle to avoid certain Florida taxes, such as the documentary stamp tax, which is imposed at the rate of $0.70 per $100 of selling price when transferring real property. Instead of selling real property, businesses put the property into an LLC and then sell their interest in the LLC. Since no deed is transferred, the documentary stamp tax is not assessed (Michael Sasso, “Florida Leads the Way in Limited Liability Companies,” Tampa Tribune, May 8, 2007).

Business Tax Credits

Exhibit 3 compares the 51 jurisdictions with regard to jobs credit, R&D tax credit, and investment tax credit. The data show that the three business tax credits are widely represented in state tax systems.

A jobs credit, R&D tax credit, and investment credit are offered by 41, 39, and 41 states, respectively. Twenty-eight states offer all three tax credits; California and Oregon offer only the R&D credit; and Washington, D. C., offers only a jobs credit. (For more detail on state R&D credits, see B. Anthony Billings, “States’ Tax Credits for Company-Financed Research: A Current Comparison,” The CPA Journal, February 2007). Interestingly, 41 states offer an investment tax credit, even though the federal government does not currently offer an investment tax credit for capital expenditures. The increasing popularity and generosity of state investment tax credits has been attributed to competitive pressures; states enact the credits at approximately the same time as their neighboring states (Robert S. Chirinko and Daniel J. Wilson, “State Investment Tax Incentives: What Are the Facts?,” Federal Reserve Bank of San Francisco Working Paper No. 2006-49, available at ssrn.com/abstract=1007816).

Although the three tax credits are well represented in state tax systems, by no means are their provisions identical. California’s experience provides a relevant example. Although the California statute contains only one of the three credits (R&D), California has been aggressive in its attempt to use tax credits to support particular industries. Recently a separate tax credit package bill to benefit motion picture studios, biotech companies, and other high-tech firms was approved by a vote of 51–19; however, it was not joined to the recent budget provisions.
State-specific nomenclature often masks the nature of tax provisions. One feature of the Michigan Business Tax (MBT) is the new Michigan Economic Growth Authority (MEGA) credit. The new tax credit will be available to an established Michigan business to help fund R&D innovation and development at a partnering Michigan small business. The credit is capped at $500,000. The MBT continues the existing MEGA compensation (i.e., jobs) credit.

Multistate Tax Features

The adoption of the Uniform Division of Income for Tax Purposes Act (UDITPA) is touted as facilitating multistate enterprises’ doing business in and relocating to adopting states. Exhibit 4 compares the 51 jurisdictions with regard to their adoption of UDITPA, which brings some degree of apportionment and allocation uniformity.

Only 20 states have adopted UDITPA, either formally or informally. The relatively small number of adoptions is not particularly significant, however, because states are free to model their apportionment formulas after UDITPA without adopting the act itself. For example, although Illinois has not formally adopted UDITPA, it considers itself a “UDITPA state” because its provisions are consistent with the act (Illinois Department of Revenue spokesperson). Businesses must obtain information from the states themselves in order to understand the nuances of specific state statutes as compared to UDITPA. The online information of the Federation of Tax Administrators (www.taxadmin.org) is a good starting point; however, it does not distinguish the states from one another except at a rather superficial level.

The vast majority of apportionment formulas described in Exhibit 4 are either the traditional three-factor formula (sales, property, and payroll, equally weighted), double-weighted sales, or sales only. The states that deviate from this generally employ some other paradigm to weight sales disproportionately; for example, Pennsylvania triple-weights sales.

The most significant finding to take away from the apportionment data is the trend toward sales-only apportionment. In 2005, only three states (Illinois, Iowa, and Nebraska) apportioned using only sales. By 2007, six states use only sales (Illinois, Iowa, Kentucky, Nebraska, Oregon, and Texas), and Michigan’s new MBT changes the apportionment formula to the single sales factor. Michigan’s rationale for the change in apportionment is to prevent business’ tax base from increasing when jobs or investment are added in Michigan; that is, to make the state a more attractive location for out-of-state businesses.

California pursues a similar course of action. California Governor Arnold Schwarzenegger’s campaign pledge to bring more businesses into the state was followed by two unsuccessful efforts to change California’s apportionment formula from three-factor (with sales double-weighted) to sales-only. A similar bill is again pending in the state legislature.

Significantly, five more states are phasing in sales-only apportionment (Georgia, Indiana, Minnesota, New York, and Wisconsin). Arizona and Ohio use three factors, but weight sales 60%; Arizona will increase the sales weight to 70% in 2008. Pennsylvania uses three factors but uniquely triple-weights the sales factor. A total of 35 states weight sales disproportionately.

Constantly Changing Competition

State business tax systems are in a state of flux as states scurry to enact provisions to compete with other states to attract business. Business should be aware of which elements of state business tax systems are relatively static and which are the subject of recent, current, or expected legislative activity. Minding the tax effects of business location decisions is an integral part of a business strategy.

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