© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comprehensive Volume Chapter 24 Multistate Corporate Taxation

The Big Picture (slide 1 of 3) LocalCo has customers in most U.S. states. –It does not employ a traditional sales force. –Instead, it sells its products exclusively through Internet solicitations and its elaborate website. LocalCo has two product lines: –Cell phone accessories, which it manufactures in Alabama, and –Various sports-themed apparel items, all produced in California.

The Big Picture (slide 2 of 3) LocalCo has been quite profitable in the past. –It holds a sizable investment portfolio, made up chiefly of U.S. Treasury securities. Banking, payroll, and other administrative operations are located in rural New York State, where the entity is incorporated. –LocalCo’s rank and file employees receive compensation packages that are below the national median, –Its top 10 executives are very highly paid.

The Big Picture (slide 3 of 3) In an effort to ‘‘go green,’’ LocalCo wants to hold down its shipping costs. –Thus, it is considering the construction of a sizable new multifunction building. Ideally, the new facility would have access to both: –Interstate highways, and –A reliable airport with excess capacity for freight operations. How will LocalCo’s expansion decision be affected by state and local tax considerations? Read the chapter and formulate your response.

Overview 46 states and District of Columbia impose a tax based on corp’s taxable income –Majority of states “piggyback” onto Federal income tax base Essentially, they have adopted part or all of the Federal tax provisions In more than 40 of those states, the starting point in computing the tax base is taxable income as reflected on the Federal corporate income tax return (Form 1120)

Computing Corporate State Income Tax Liability

State Modifications Federal taxable income generally is used as the starting point in computing the state’s income tax base –State adjustments or modifications often are made to Federal taxable income to: Reflect differences between state and Federal tax statutes Remove income that a state is constitutionally prohibited from taxing

Common State Additions (slide 1 of 3) Interest income on state/municipal obligations and other interest income exempt from Federal income tax –May exclude interest income on obligations within that state to encourage investment in in-state bonds

Common State Additions (slide 2 of 3) State income taxes deducted on Federal return –Includes franchise taxes based on income Federal depreciation in excess of amount allowed by state (if depreciation systems differ)

Common State Additions (slide 3 of 3) State gain in excess of Federal gain on assets; Federal loss in excess of state loss on assets Adjustments to amounts under Federal elections Federal net operating loss deduction

Common State Subtractions (slide 1 of 3) Interest on U.S. obligations to extent included in Federal taxable income –States cannot impose income tax on income from U.S. obligations, but may assess income-based franchise tax State depreciation in excess of Federal (if depreciation systems differ)

Common State Subtractions (slide 2 of 3) Federal gain in excess of state gain on assets; State loss in excess of Federal loss of assets Adjustments to amounts under Federal elections

Common State Subtractions (slide 3 of 3) State Net Operating Loss Deduction Dividends received from certain out-of-state corps to extent included in Federal return Federal income taxes paid

UDITPA and the Multistate Tax Commission Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law relating to assignment of income among states for multistate corps Many states have adopted UDITPA either by joining the Multistate Tax Compact or modeling their laws after UDITPA

Nexus for Income Tax Purposes (slide 1 of 2) Nexus is the degree of business activity which must be present before a state can impose tax on an out-of-state entity’s income Sufficient nexus typically exists if: –Income is derived from within state –Property is owned or leased in state –Persons are employed in state –Physical or financial capital is located in state

Nexus for Income Tax Purposes (slide 2 of 2) No nexus if only “connection” to state is solicitation for sale of tangible personal property, with orders sent outside state for approval and shipping to customer (Public Law ) Sales tax can still apply

Independent Contractors May generally engage in the following activities without establishing nexus for the company: –Solicit sales –Make sales –Maintain sales office Source: Public law

Allocation and Apportionment of Income (slide 1 of 3) Apportionment is the means by which business income is divided among states in which it conducts business –Corp determines net income for the company as a whole and then apportions some to a given state, according to an approved formula

Allocation and Apportionment of Income (slide 2 of 3) Allocation is a method used to directly assign specific components of a corp’s income, net of related expenses, to a specific state Allocable income generally includes: Income or loss from sale of nonbusiness property Income or losses from rents or royalties from nonbusiness real or tangible personal property

Allocation and Apportionment of Income (slide 3 of 3) Typically, allocable income (loss) is removed from corporate net income before the state’s apportionment formula is applied –Nonapportionable income (loss) assigned to a state is then combined with income apportionable to the state to arrive at total income subject to tax in the state

Apportionment Procedure Business income is assigned to states using an apportionment formula –Business income arises from the regular course of business Integral part of taxpayer’s regular business Nonbusiness income is apportioned or allocated to the state in which the income- producing asset is located

Apportionment Factors Apportionment formulas vary among states –Traditionally, states use a three-factor formula that equally weights sales, property, and payroll –Many states use a modified formula where sales factor receives a larger weight Tends to pull larger amount of out-of state corporation's income into the state May provide tax relief to corps domiciled in the state

Sales Factor (slide 1 of 3) Sales factor is a fraction –Numerator is corp’s sales in the state –Denominator is corp’s total sales everywhere Most states follow UDITPA’s “ultimate destination concept” –Tangible asset sales are assumed to take place at point of delivery, not where shipping originates

Sales Factor (slide 2 of 3) –Dock sales occur when delivery is taken at seller’s shipping dock Most states apply the destination test to dock sales –If purchaser has out-of-state location to which it returns with the product, sale is assigned to purchaser’s state

Sales Factor (slide 3 of 3) –Throwback rule If adopted by state, requires that out-of-state sales not subject to tax in destination state be pulled back into origination state Treats such sales as in-state sales of the origination state Also applies if purchaser is U.S. government

Payroll Factor (slide 1 of 4) Payroll factor is a fraction –Numerator is compensation paid within a state –Denominator is total compensation paid by the corporation

Payroll Factor (slide 2 of 4) Compensation includes wages, salaries, commissions, etc –Amounts paid to independent contractors are excluded –Some states exclude amounts paid to corporate officers –Some states require that deferred compensation amounts be included in the payroll factor (e.g., 401(k) plans)

Payroll Factor (slide 3 of 4) Compensation of an employee is usually not split between states (unless employee is transferred or changes positions) –Usually allocated to state in which services are primarily performed If more than one state, attribute to: –Employee’s base of operations, or, if none, –Place where work is directed or controlled, or, if none, –Employee’s state of residency

Payroll Factor (slide 4 of 4) Only compensation related to production of apportionable income is included in payroll factor –In states that distinguish between business and nonbusiness income, compensation related to nonbusiness income is not included –Compensation related to both business and nonbusiness income is prorated between the two

Property Factor (slide 1 of 3) Property factor generally includes average value of real and tangible personal property owned or rented –Numerator is amount used in the state –Denominator is all of corp’s property owned or rented

Property Factor (slide 2 of 3) Property includes: –Land, buildings, machinery, inventory, etc –May include offshore property, outer space property (satellites), and partnership property Property in transit is included in numerator of destination state

Property Factor (slide 3 of 3) Property is typically valued at average original or historical cost plus additions and improvements –Some states allow net book value or adjusted basis to be used Leased property, when included in the property factor, is valued at eight times its annual rental payments

Allocation, Apportionment Example Total allocable income (State A) $100,000 Apportionable income (States A and B) 800,000 Total income $900,000 All sales, payroll, and property is divided equally between states A and B. Both states use identical apportionment formulas. Taxable income: State A State B. 1/2 Apportionable income $400,000 $400,000 Allocable income 100, Total state taxable income $500,000 $400,000

Apportionment Example (slide 1 of 2) Americo, Inc. operates in three states with the following apportionment systems: W’s factors: average of four factors, sales double-weighted X’s factors: average of three factors, equally weighted Y’s factors: sales factor only State: W X Y Total. Sales:$400,000$100,000$500,000$1,000,000 Factor 40% 10% 50% Payroll: 90, ,000 60, ,000 Factor 30% 50% 20% Property: 120, ,000 40, ,000 Factor 30% 60% 10%

Apportionment Example (slide 2 of 2) Taxable income for year (all states) $100,000 State W X Y. Sales 40% 10% 50% Sales 40% N/A N/A Payroll 30% 50% N/A Property 30% 60% N/A Total 140% 120% 50% Average 35% 40% 50% Taxable income to each state $35,000$40,000$50,000 Total taxed in all states: $125,000 N/A = not applicable

Apportionment Example Revisited (slide 1 of 2) Americo, Inc. moves most personnel and property to state Y. State: W X Y Total. Sales:$400,000 $100,000$500,000$1,000,000 Factor 40% 10% 50% Payroll: 30,000 30, , ,000 Factor 10% 10% 80% Property: 40,000 40, , ,000 Factor 10% 10% 80% W’s factors: average of four factors, sales double-weighted X’s factors: average of three factors, equally weighted Y’s factors: sales factor only

Apportionment Example Revisited (slide 2 of 2) Taxable income for year (all states)$100,000 State: W X Y Sales: 40%10%50% Sales 40% N/AN/A Payroll: 10%10%N/A Property: 10%10%N/A Total 100%30%50% Average 25%10%50% Taxable income to each state $25,000 $10,000 $50,000 Total taxed in all states: $85,000 N/A = not applicable

Unitary Taxation (slide 1 of 2) Theory: operating divisions are interdependent so cannot be segregated into separate units –Each unit deemed to contribute to overall profits –Unitary theory ignores separate legal existence of companies: all combined for apportionment

Unitary Taxation (slide 2 of 2) For multistate apportionment, all divisions or entities are treated as single unitary base: –Larger apportionment base (all companies’ activities) –Smaller apportionment factors (each state’s %)

Other Multi-Entity Considerations (slide 1 of 2) Multinational operations: If state uses Unitary system, it may require inclusion of worldwide activities in determining apportionment Most unitary states allow Water’s Edge election so only U.S. operations are included –Cost of election may include: Specified number of years before revocation Additional tax for privilege of excluding foreign entities

Other Multi-Entity Considerations (slide 2 of 2) Combined reporting –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 Consolidated returns –Some states allow (or require) consolidated return if filed for Federal

Taxation of S Corporations (slide 1 of 2) Majority of states with corporate income tax have special provisions that govern S corporations –Only a few states do not provide special treatment for S corps In non-S election states, S corps are taxed the same as C corps –Must have valid S corp election at federal level to get S corp treatment in states

Taxation of S Corporations (slide 2 of 2) Multistate S corps must apportion and allocate income in same manner as regular corp –Must file a state tax return in each state with nexus –Must inform shareholders of their share of income for each state so their tax returns can be prepared S corp may be allowed to file a single return and pay tax for all shareholders

Taxation of Partnerships and LLCs (slide 1 of 2) Most states treat partnerships, LLCs, and LLPs in a manner that parallels Federal treatment –Entity is a tax-reporting, not a taxpaying, entity –Income, loss, and credit items are allocated and apportioned among the partners according to the terms of the partnership agreement

Taxation of Partnerships and LLCs (slide 2 of 2) Some states: –Require entity make est. tax pymts. for out-of-state partners –Apply an entity-level tax on operating income –Allow composite returns to be filed for out-of-state partners Generally, an in-state partner computes the income tax resulting from all of the flow-through income from the entity –Partner is allowed a credit for income taxes paid to other states on this income

Sales and Use Taxes (slide 1 of 2) Sales tax: Consumers’ tax on tangible personal property acquired for use or consumption –In several states, selected services are subject to tax –Vendor acts as collection agent –Generally, not assessed on goods purchased for shipment out-of-state Use tax complements sales tax –Consumers bringing purchased goods into state pay tax to state in which property is used –States have difficulty enforcing use tax

Sales and Use Taxes (slide 2 of 2) A majority of states exempt certain sales including, for example: –Sales for resale –Casual or occasional sales –Most purchases by exempt organizations –Sales of targeted items –Sales to manufacturers, producers, and processors

The Big Picture – Example 27 Tax Planning - Unitary Operations (slide 1 of 2) Return to the facts of The Big Picture on p LocalCo already operates in both unitary and nonunitary states. –Application of unitary corporate income tax rules can make tax planning more difficult. Subjecting certain LocalCo activities to the unitary theory could either increase or decrease the combined Federal corporate income tax liability of the affiliates. –Depends on the apportionment formulas applied in the unitary states.

The Big Picture – Example 27 Tax Planning - Unitary Operations (slide 2 of 2) LocalCo needs to make projections of the profitability of its operations in the new multifunction building. Then LocalCo should determine the income tax effects of expanding its operations into several target states, including both unitary and nonunitary jurisdictions, and Compare how the unitary rules (and all associated compliance costs) affect its after-tax profits.

The Big Picture – Example 28 Tax Planning-Apportioning Income (slide 1 of 2) Return to the facts of The Big Picture on p Most corporate taxpayers consist of a parent corporation and perhaps one or more existing subsidiaries. Given its expansion plans, LocalCo has the opportunity to determine ‘‘from scratch’’ in which states it wants to create nexus for the operations in the multifunction building. The tax professional needs to offer advice to LocalCo’s board of directors, in an effort to provide optimal tax consequences.

The Big Picture – Example 28 Tax Planning-Apportioning Income (slide 2 of 2) Nexus issues to be considered include the following. –Is income tax nexus created with the target state? –Is sales/use tax nexus created with the target state? –How are the income tax apportionment factors affected by the expansion plans e.g., whether the target state uses a property factor in the apportionment formula and, if so, how is it weighted? –Would a building like that planned by LocalCo receive any special computational treatment for the target state’s property factor (e.g., in averaging the building’s costs or applying accumulated depreciation)?

Refocus On The Big Picture (slide 1 of 5) LocalCo holds a competitive advantage with the states and localities in negotiating where its new facility should be located. –Politicians like to attract new facilities to their jurisdictions as a way to create construction jobs and to expand the income and sales/use tax base. LocalCo’s top management should work with the governors and development executives of the states that are final candidates for the location of the proposed new building.

Refocus On The Big Picture (slide 2 of 5) LocalCo’s agenda for these negotiations should include the following items. Many states offer targeted tax incentives to attract and retain ‘‘clean’’ businesses like LocalCo. –Such incentives might include property tax abatements, research and investment credits, and tax waivers for the state and local income and payroll taxes on new jobs. –The company should determine whether it qualifies for any existing incentives. LocalCo should also ascertain how the potential locations apply income and sales/use taxes to Internet sales. Currently, LocalCo’s manufacturing operations are split between a very low tax state (Alabama) and a very high-tax state (California). –Under a relocation plan that makes good business sense, nexus might be eliminated with California and shifted to a low-tax jurisdiction.

Refocus On The Big Picture (slide 3 of 5) California applies the unitary theory of income taxation. LocalCo should determine whether unitary rules increase or decrease its total tax burden. Corporate headquarters currently are located in New York, another high tax jurisdiction. –If the new facility is located in a corporation-favorable, low tax state, the company should consider moving its headquarters there. Relocating the corporate headquarters would also benefit the entity’s highly paid executives. –The individual income and sales/use tax burden of employees should be a factor in LocalCo’s decision.

Refocus On The Big Picture (slide 4 of 5) In any event, shifting the entity’s investment income to a low-tax jurisdiction appears advisable. –Use of a passive investment company will carry out this tax planning objective. States often assess special taxes on trucking and airport functions and might even apply different income tax apportionment formulas to these operations. –LocalCo’s tax department and its outside advisers should research these features of the various relevant tax systems to avoid any unexpected surprises.

Refocus On The Big Picture (slide 5 of 5) What If? If LocalCo did not have a history of strong profitability, some of these state and local tax recommendations might be different. In that case, the company would consider such issues as how a state applies loss and credit carryovers. In addition, if there is no state income tax liability to pay, income tax credits and deductions would be less attractive, so the negotiations might focus on property and payroll taxes instead.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 57 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta