Chapter 10 Notes
Multi-state Business Expansion
State taxation of business income
Business must be incorporated in state
or
Have sufficient business activity to create nexus
The amount of activity or connection that is necessary to create nexus is defined by state statute or case law and tends to vary from state to state. Generally, nexus requires a physical presence in the taxing state but the amount of physical presence varies from state to state. In addition, some states take the position that earning income from intangible assets within the state is sufficient to create nexus even with no physical presence.
The Determination of a Corporation’s Taxable Income
Allocation and Apportionment
The most common method for companies to determine how much of their income is subject to tax in each state is called allocation and apportionment. Under this method, certain types of income are traced to their geographic source or other connection with a state and attributed solely to that state. Other types of income are apportioned among the states in which the corporation is doing business.
In most states, income classified as nonbusiness may be specifically allocated to a jurisdiction while business income is apportioned.
A few states (Ohio, Connecticut, New Jersey) do not differentiate between business and nonbusiness income. In these cases, all income is apportionable. The definition of business and nonbusiness income varies from state to state.
The calculation of state taxable income for multi-state corporations (4 step process)
The majority of states piggyback onto the Federal income tax base in some way. In more than 40 of the states that impose a corporate income tax, the starting point is taxable income as reflected on the Federal Corporate income tax return (Form 1120).
(A) Calculate the state tax base (usually starting with Federal taxable income) adjusted for various modifications
(B) Adjust for allocable (usually nonbusiness) income or loss to arrive at apportionable income
(C) Multiply apportionable (usually business) income by state’s apportionment percentage
(D) Assign or trace allocable income or loss directly to state to arrive at state taxable income
Common modifications include:
(A) Adding back interest on state and muni obligations if not exempt for state purposes (net of expenses)
(B) Subtracting interest on U.S. obligations which is taxable for Federal purposes but not state purposes (net of expenses)
(C) Adding back state income taxes deducted in computing Federal taxable income
(D) Subtracting refunds of state income taxes
(E) Subtracting Federal income tax paid (a limited deduction is allowed in five states)
(F) Adding back Federal depreciation, amortization and depletion in excess of that allowed by the state
(G) Subtracting state depreciation, amortization and depletion in excess of Federal
(H) Adjustments of gain or loss on asset dispositions due to depreciation differences
(I) Adjustments for differences between Federal and state NOLs
(J) Adding back dividends received deduction and subtracting dividends included in income
Example 1:
Fowle Corporation is commercially domiciled in State A and is subject to tax in both state A and state B. Both states start with Federal taxable income in computing the state tax base. Both states exempt from tax their own municipal obligations and dividends from in-state corporations and disallow a deduction for all state income taxes. Both states distinguish between business and non-business income. Assume the apportionment factor for state A is 70% and state B is 30%.
Sales $1,500,000
Interest on Federal obligations 100,000
Interest on muni obligations of state A 50,000
Interest on muni obligations of state B 50,000
Dividends from 50% owned state A corporations 100,000
Non-business rental income – A 60,000
Non-business rental income – B 80,000
Total income $1,940,000
Expenses related to Federal obligations $ 5,000
Expenses related to state A munis 2,000
Expenses related to state B munis 2,000
State income tax expense – A 30,000
State income tax expense – B 40,000
Depreciation allowed for Federal purposes 300,000
(state A adopts Federal law but state B’s
allowance is only $250,000)
Other allowable deductions 1,200,000
Total deductions $1,579,000
Assuming that the interest and dividend income is business income and that the rental income is nonbusiness income calculate Federal taxable income and income subject to tax in state A and state B.
Under formula apportionment, there is no attempt to trace apportionable income to the state in which the income was generated. Rather a formula is used to arrive at an approximation of a business’s income that should be attributed to a particular state.
Historically, the method used most often has been a three-factor equally weighted formula that considers the ratio of in-state property, payroll and sales to overall property, payroll and sales.
However, at present only 11 states use an equally weighted three-factor test while 20 states utilize a three-factor formula with sales double-weighted, 2 states utilize a three-factor formula with sales triple weighted and 4 states utilize a one-factor sales formula. Other states allow companies to choose among formulas or require different formulas depending on the type of company involved – financial vs. manufacturer for example.
Example 2:
A company has nexus in State A and State B with the following percentages of sales, property and payroll allocated to each state:
State A State B Total
Sales 80% 20% 100%
Property 70% 30% 100%
Payroll 75% 25% 100%
If both A and B use an equally weighted 3-factor test, what proportion of business income is apportioned to State A and State B?
If State A double-weights sales, what proportion of business income is apportioned to State A and State B?
Why would a state double-weight sales or use sales as the only apportionment factor?
Generally, an increase in the weight on sales and the simultaneous reduction of the weights on payroll and property decreases taxes on in-state companies that export to other states and small in-state companies with little presence in other states while increasing taxes on companies selling into a state from an out of state location.
Example 3:
Shockley Products (located in state B) has $600,000 of taxable income from product sales in both state A and state B and has sufficient nexus to warrant income taxation in each state. The company’s sales, property and payroll in each state are as follow:
State A State B Total
Sales $600,000 $1,400,000 $2,000,000
Property - 4,000,000 4,000,000
Payroll - 1,500,000 1,500,000
If state A uses an equally weighted three-factor formula, how much taxable income is apportioned to A?
If state A uses a three factor formula but double weights sales, how much taxable income is apportioned to A?
If state A uses a single factor (sales) to apportion income, how much taxable income is apportioned to A?
The sales factor
- Ratio of sales in state to total sales
- Sales of tangible personal property are generally assumed to take place at the point of delivery
- What if purchaser picks up the product at the seller’s location (dock sales)?
- What if sale is to U.S. Government, a purchaser in a foreign country, a state in which nexus has not been established, or to a destination state that does not have an income tax?
Example 4
Connell Computers is a manufacturing company located in Missouri with sales in Missouri, Kansas and Oklahoma (all throwback states utilizing a equally weighted 3-factor formula). Sales in Kansas are obtained by an employee who also does training and repairs. Residents of Oklahoma can purchase the product if they arrange to take delivery at Connell’s shipping dock in Missouri. No other activities are performed in Oklahoma. The company’s sales are as follow:
Sales to residents of Missouri $ 800,000
Sales to residents of Kansas 500,000
Sales to residents of Oklahoma 100,000
$1,400,000
What is the sales factor in Missouri, Kansas and Oklahoma?
The payroll factor
- Ratio of payroll within state to total payroll
- Includes wages, salaries, commissions but only related to production of business (apportionable) income
- Excludes payments to independent contractors
- May exclude compensation of officers
- May include payments on behalf of employees to 401(k) plans
- What if employee performs services in more than one state?
- What if employee’s time is spent on both business and non-business (rental) activities?
Example 5
Greystone Brick Company has sales offices and manufacturing plants in both state X and state Y. X defines payroll as all compensation including salaries for officers and contributions to 401(K) plans. Y includes only compensation to employees other than officers.
State X State Y
Compensation to employees $400,000 $200,000
Salaries to officers 200,000 100,000
Contributions to 401(K) plans 30,000 20,000
Calculate the payroll factor for state X and state Y.
What is the impact of moving all officers’ salaries to state Y?
The property factor
- Ratio of property owned/rented and used in state to total property
- Includes machinery and equipment, buildings etc. but also land and inventory
- What about mobile equipment?
- What about leased or rented property?
- How is equipment valued?
- When is it valued?
- What about property used in producing non-business income?
Example 6
RGS Inc. has a manufacturing plant, distribution center and warehouse in state C and a smaller distribution center in state D. Both states utilize an equally weighted three-factor apportionment formula. State C has a 9% corporate tax while state D has a 3% tax. RGS has apportionable income of $500,000.
State C State D
Sales $700,000 $300,000
Property 400,000 50,000
Payroll 300,000 40,000
What is RGS Inc.’s tax liability in C and D?
If the distribution center and warehouse in state C have a cost of $200,000 with $100,000 of related payroll expense and are moved to state D, what is the impact on RGS Inc.’s total tax liability?
Unitary theory
The unitary theory developed in response to the early problems that states faced in attributing the income of a multistate business among the states in which the business was conducted. Originally, the theory was applied to justify apportionment of the income of multiple operating divisions of a single company. Over the years however, it has been extended to require the combined reporting of certain affiliated corporations including those outside the U.S.
Basically an issue of substance over form. If a U.S corporation has a manufacturing facility in State A, warehouses its inventory in State B and sells through a sales division in State C, a corporation would calculate its apportionment percentage for State A taking into account all of its factors in States A, B, and C.
However, what if the nonmanufacturing activities are incorporated in a new U.S. subsidiary. Now, the parent corporation manufactures in State A, sells its inventory to its subsidiary in State C which warehouses and sells the product?
States that calculate the taxable income and apportionment percentages of the parent and ignore the taxable income and factors of the subsidiary (over which they have no nexus) are called separate entity states.
States that ignore the formal corporate structure and treat subsidiaries as if they were divisions or branches of the parent are known as combined reporting or unitary states. Combined reporting permits a state to include in the unitary tax base the income of members of the combined group who on a stand-alone basis are not subject to the state’s taxing jurisdiction.
- Applicable in about half the states
- Most states allow water’s edge election
- Income of unitary group is apportioned to states in which at least one member has nexus
- Can increase or decrease total tax paid but usually results in a larger portion of the corporation’s income being taxed in states where the compensation, property values and sales prices are high relative to other states.
- Can be beneficial when losses of unprofitable affiliates may be offset against the earnings or profitable affiliates.
- Eliminates many planning techniques including the use of passive investment holding companies.
What is a unitary business?
Operates as a unit and cannot be segregated into independently operating divisions. The operations are integrated and each division depends on or contributes to the operation of the business as a whole.
It is not necessary that each unit operating within a state contribute to the activities of all divisions outside the state.
Consolidated and Combined Returns
A combined return is required to be filed in every unitary state in which one or more unitary members have nexus. The computations reflect apportioned and allocated income of the unitary members resulting in a summary of the taxable income of the entities in each state.
Required combined returns in unitary states and elective consolidated returns for affiliated groups are not the same thing!
Several states allow affiliated corporations to file a consolidated return if such a return is filed for Federal purposes. Usually only corporations that are subject to tax in the state can be included in a consolidated return unless the state specifically permits the inclusion of corporations without nexus.
Example 7
RGS Inc., a subsidiary of RBS Inc., has taxable income of $750,000, all apportioned to state F. RBS Inc. has $1,300,000 of taxable income and does business solely in state G. Both are combined reporting states (unitary states) and use an equally weighted three-factor apportionment formula. State F has a tax rate of 10%, while state G has a tax rate of 4%.
RGS Inc. RBS Inc.
Sales $4,000,000 $12,000,000
Payroll 2,000,000 5,000,000
Property 3,500,000 6,500,000
If RGS Inc. and RBS Inc. are not part of a unitary business group, what is their tax liability in F and G?
If they are members of a unitary group, what is their tax liability in each state?
Other types of state taxes
The Michigan Single Business Tax (SBT)
The Michigan SBT was enacted in 1976 and is basically a value added tax rather than an income tax. As such it is not subject to P.L 86-272 and out of state companies with very little connection to the state can find that they owe the tax.
Basically, Michigan taxes an entity’s economic activity as measured by Federal taxable income or loss, adjusted by adding back cash basis wages, employee benefits, depreciation, interest expense and state taxes and by subtracting interest and dividend income. This value added base is then multiplied by an apportionment formula weighted 90% for sales.
Capital stock or net worth taxes
Typically, a capital stock tax is an excise tax imposed on a domestic corporation for the privilege of existing as a corporation or imposed on an out of state corporation for the privilege of doing business or for the actual transaction of business within the state. The annual tax is usually based on the book value of the corporation’s net worth, including capital, surplus and retained earnings.
Most capital stock taxes are apportioned if the corporation does business or maintains an office in another state. For corporations based in other states, the tax is imposed only on the capital that is employed in the state as determined by an apportionment formula.