Importance of State and Local Tax Planning

Various Types of Taxes Levied on Business Review Table 1.1

Various Business Transactions Subject to Taxation Review Illustration 1.1

Disparity of Tax Rates Across Jurisdictions Tax Liabilities Among Multiple Jurisdictions

“Today’s entrepreneurs and managers thus must be well versed in the basics of state and local tax planning…”

Types of Taxes Corporate Income and Franchise Taxes

Simplified Formula: [(Federal taxable income +/- state adjustments) X State rate] – State Credits and Estimated Taxes

Key Issues When is a business subject to a state’s taxing

jurisdiction? How should the corporation split income in a

multi-state operation? Compliance Procedures and Tax Controversies are

some what similar to Federal. 4 year statute of limitations. Amendments filed 90 days of Federal Amendment Appeals process less friendly than federal, use

regular courts rather than tax court.

Individual Income Taxes Residency

Resident—Physically present in the state for other than a temporary or transitory purpose. Taxed on world wide income.

Non Resident—An individual who is not a resident. Taxed only on income sourced within the state.

Part year resident—A resident who moves into (out of the state) during the tax year. Taxed on income received while a resident.

Calculation of base Starts with Federal Taxable Income or AGI, adjustments,

tax rates and credits similar to corporate formula Sourcing of Income

Generally sourced where earned. Rents—By jurisdiction where the property is located Royalties—Where the intangible is being used Services—Where the service is rendered.

Flow Through Entities Generally not taxed on the state level Resident partners/shareholders taxed on their

distributive share of income regardless of jurisdiction

Non resident partners/shareholders taxed (1) in the state of their residence and (2) in the state where the income is earned. The state of residence generally allows a credit for taxes paid to another state.

Non resident partners/shareholders are often permitted to file a composite (group) return.

Many states have withholding or other arrangements to collect taxes owed from non-residents.

Sales and Use Taxes Imposed on the Consumer Rates set at the state level; cities and

counties may levy an additional tax. Based on a percentage of purchase

price. Definitions are very important

Certain types of sales are exempt Tax rate depends on the nature of the

product sold. Definitions determine the difference

between products and services.

Property Taxes Assessed against realty, in many

settings also personalty Local government assesses the tax

in most cases. Valuation methods, tax rates and

Assessment dates vary

Other Taxes Payroll (unemployment compensation) and excise taxes

—very important Capital stock taxes License taxes—important Estate (Inheritance) and Gift Taxes

Estate tax structure was generally uniform until 2001, not varies considerably

Gift taxes are rare Additional Taxes

Transfer Tax Incorporation Severance Telecommunications Tourism Highway Use

Sources of Law U.S. Constitution

Jurisdiction and Nexus are important issues. See next slide. Commerce Clause Due Process

State Constitutions Legislative Law Sources

Statutes are the highest authority Administrative Law Sources

State revenue agency administers the law. The agency issues regulations and rulings, letter rulings.

Counties and cities assess and collect property taxes Specialized agencies collect capital stock taxes, employment taxes,

and public utility taxes. Judicial Law Sources

Only bind states over which the court has jurisdiction. Trial, intermediate appellate, and final appeal courts--> US

Supreme Court

Multistate Law Sources Multistate Tax Commission

Encourages states to adopt tax laws that apply to multistate and multinational enterprises

Over ½ of the states are full or associate members of MTC

UDITPA “Seeks to properly and consistently determine

the state and local tax liability of multistate taxpayers.

Applies primarily to apportionment methods. Most states have adopted UDITPA in whole or

in part.

Generic State and Local Tax Planning Strategies

Shifting and Splitting (Examples 1.1 & 1.3)

Location (Example 1.4) Transformation (Example 1.6) Timing (Example 1.7) Apportionment (Example 1.10)

State and Local Tax Research Scanning the changing state and

local tax environment for (1) non tax changes in the business environment and (2) changes in tax rates and tax credits

Tax Management in Action 1.1 Web Sites

Appendix A

Corporate Income/Franchise Tax

Effective and Statutory Rates (Table 3.1)

Nexus Definition and judicial history differs

from sales tax Four tests for franchise tax purposes. Domestic corporations have nexus with

state of incorporation; foreign corporations must meet the nexus rules.

Definitions Jurisdiction

A State’s Power to Impose a Tax

Nexus A Taxpayer’s

Contact with a State

Elements of Public Law 86-272If a seller from state B has only the followingbusiness activities in state A: Solicitation By an employee or representative Of orders for tangible personal property Sent outside the state for approval, and Filed by shipment or delivery from a point

outside the state.Then the seller from state B owes no income tax to

state A.

Wisconsin Department of Revenue vs. William F. Wrigley, Jr. Co. (1992)_ Solicitation of chewing gum orders Stock of display racks and gum Distribution of gum samples Replacement of stale gum Retail display racks Rental of storage space Administrative and personnel-related

issues

Wrigley DecisionThe U.S. Supreme Court: Rejected a narrow construction of

“solicitation” Concluded de minimus exception is

applicable under Public Law 86-272 Decided Wrigley’s non-immune

activities were neither ancillary to requesting orders or de minimus.

Wrigley DecisionThe U.S. Supreme Court: Rejected a narrow construction of

“solicitation” Concluded de minimus exception is

applicable under Public Law 86-272 Decided Wrigley’s non-immune

activities were neither ancillary to requesting orders or de minimus.

Multistate Tax Commission—Interpretation of PL 86-272 Only solicitation to sell personal property

is protected Intangibles are not protected Sale or delivery and their solicitation are

not protected unless it is either: Ancillary to solicitation From the protected list

In-state activity limited to solicitation (exceptions; de minimus and independent contractor activities)

Multistate Tax Commission—Interpretation of PL 86-272 Only solicitation to sell personal property

is protected Intangibles are not protected Sale or delivery and their solicitation are

not protected unless it is either: Ancillary to solicitation From the protected list

In-state activity limited to solicitation (exceptions; de minimus and independent contractor activities)

State C Corporation Income Tax Formula

Federal corporate income tax base± State adjustments= Total corporate income tax base - Non-business income= Total apportionable state incomeX State apportionment percentage= State apportioned business income+ Allocated non-business income= State income tax baseX Statutory Income tax rate= State income tax- Credits= Net State Tax

State C Corporation Income Tax Formula

Federal corporate income tax base± State adjustments= Total corporate income tax base - Non-business income= Total apportionable state incomeX State apportionment percentage= State apportioned business income+ Allocated non-business income= State income tax baseX Statutory Income tax rate= State income tax- Credits= Net State Tax

State Adjustments Interest income on Federal general obligations State and local interest income (same state) Federal income tax (AL,IA,LA,MO,ND) State income taxes (usually an add-back) Foreign income taxes (1/2 of the states) NOL’s (tax management in action 3.1) Dividends received deduction (0 or limited to domicile) Depreciation (non conformity, disallowance of bonus & §

179) , depletion and amortization Foreign Dividends and Subpart F income Deductions foregone because of a federal credit Charitable contributions (different limits)

Business v. Non-business Income

Business income—apportioned Transactional test—”transactions and

activities in the regular course of the tax payer’s trade or business”

Functional test—”acquisition, management, and disposition of the property constitute integral parts of the regular trade or business.”

MTC Compact examples Non-business income—allocated

Example 3.6

Allocating Non-business Income

Non-business income sourced to a particular state Examples 3.7 & 3.8 Table 3.2

Shannon Properties—business and non-business income components

Apportionment Rules for Business Income

Taxable in Another State Net income tax Franchise tax measured by net

income Franchise tax for privilege of doing

business Corporate stock tax in another state

Apportionment Rules for Business Income--Continued Unitary Taxation

Generally states west of Mississippi river. Tax management in action 3.3 provides a list of unitary and

separate reporting states. Combined returns available

Similar to consolidated returns but with foreign affiliates Business income partitioned among the jurisdictions in

which the group operates based on a rough approximation of the companies’ presence there.

Usually uses a three factor formula: sales, property and payroll.

States only apportion the business income of a unitary business or part of a multistate business that constitutes a unitary business (all activities of a single business entity)

Parts of the same groups of companies—whether incorporated or not—are usually considered unitary are they are consolidated for GAAP purposes.

Review Example 3.10

Apportionment Rules for Business Income--Continued Separate Accounting

Each corporation doing business in a state files a separate return even if it a member of a group that files a federal consolidated return.

However states do allow consolidated returns for corporations domiciled in that state and in some instances for foreign corporations that are members of an domestic affiliated group.

Review Tax Management in Action 3.4 & footnotes

Three-Factor Apportionment Formula

Table 3.3 Apportionment Factor Weighting by State Review IA & MN apportionment factors

Property Factor Property included if it is owned or rented and used by the

taxpayer during the tax period. Usually does not include intangibles Mobile property is sourced to each state based on a ratio of

either time spent or miles traveled. Property in transit is sourced to the buyer’s destination

state. Owned property is generally valued at original cost usually

averaged at the beginning and end of the year. The net rental cost of the property rented for the year

multiplied by eights becomes the property factor component. Businesses may reduce state income taxes by shifting

property or payroll to a low income tax state. Citibank example.

Apportionment Rules for Business Income--Continued Payroll Factor

Exclude payroll related to non-business income Payroll Sourcing Rules (employee services within state)

Source wages to the state where a majority of the services are performed, if only incidental services are performed outside the state.

If the services outside the state are more than incidental sources wages to the state that is the base of operations for the employee

If the employee has no base of operations, source wages to the state from which the employer exercises direction and control, but only as long as some services are performed in that state.

If the employee’s wages cannot be sources under the first three criteria, use state of residence.

Payroll Formula: Payroll nexus state/Total compensation everywhere

Planning: Locate management in states that do not include

executive compensation in the payroll factor.

Apportionment Rules for Business Income--Continued Sales Factor

All gross receipts from transactions and activities conducted in the regular course of the taxpayer’s business.

Gross receipts = gross sales – returns and all. + interest charges + service charges + federal and state excise (sales) taxes + commissions + rental income + royalties + proceeds from disposition of tangible and intangible assets (business income)

Non business income is excluded Sales of a significant asset are included

Apportionment Rules for Business Income--Continued Sourcing Rules for Sales

Tangible Personal Property Sourced at state of destination State of origin for purchaser is US government or

taxpayer is not taxed at state of destination (throwback rule)

Review Table 3.4, Throwback rule creates “nowhere states’

Planning technique—create warehouse or production facility in a state that does not have the throwback rule

Double throwback rule applied in some states for drop shipments

Foreign sales—general rule is if purchaser pay income tax in foreign country, sale is foreign source

Apportionment Rules for Business Income--Continued

Receipts Other Than Tangible Personal Property

Includes employee services, rentals, licensing or other use of intangible personal property

Sourced to location of income producing activity

If activity takes place in more than one state, apportionment is based on the cost of performance.

Apportionment and Consolidated or Combined

Tax Returns Combined Returns

Mandatory Includes the pooled information of the corporation and

other members of the unitary group Members of the unitary group are treated as a single

corporate entity for purposes of apportionment. The combined factor is applied to the unitary group’s combined income

Consolidated Returns in a Unitary State The Unitary group and the affiliated corporations may be

the same. However, a consolidated group may include corporations

that are not members of the same unitary group. To apportion income the group may use one of two methods:

Separate method—company by company basis Consolidated method apportions the groups aggregate

income.

Combined Returns: Sales Factor Sourcing and the Throwback

Rule The separate entity approach

Each unitary group member’s sales are subjected to the throwback rules before the numerator of the group’s combined sales factor is determined.

The unitary approach All sales into the state are sourced to it

regardless of the status of the members. Sales into other states that would be thrown

back are not thrown back if any member of the unitary group is taxable in the other state.

Combined Returns and Unitary Taxation

What constitutes a unitary business? The three unities test

Unity of ownership Unity of operation Unity of centralized executive force and system of operation

The functional integration test Contributions to income result from functional integration,

centralization of management, and economies of scale. Contribution dependency test

The member makes a contribution to, or depends on,l other members of the unitary group./

Multistate Compact Unitary Business Regulations Unitary Checklists (TMA 3.5)

Worldwide Unitary Business Water’s edge unitary group—domestic corporations and

foreign corporations with more than 20% of their activity in the U.S.

Water’s edge election available in many unitary states

Apportionment and Consolidated or Combined Tax Returns--Continued

Consolidated Returns Voluntary Pools the operations of affiliated corporations

operating in a non-unitary state or non-unitary corporations operating in a unitary state.

Beneficial if affiliates having NOL’s are combined with profitable affiliates

Used in both unitary and non unitary states. A group of affiliated corporations that files a

consolidated return is called a consolidated group.

Alternative Apportionment Formulas

Single factor sales Detrimental to out-of state business Used in Iowa/Texas Missouri election

Two Factor Election Colorado, Hawaii

Industry specific formulas Railroads, Financial Institutions, Radio,TV

broadcasting

Taxation of Flow-Through Entities

Partnerships For corporate partners

Partnership must separate business and non-business income based on the relationship between the asset-yielding income and the partnership income.

The partner must then also separate business and non-business income based on the relationship between the partnership’s business and the corporate partner’s business

Apportionment Methods for corporations On the partnership level—allocated to the specific

partner Flow through methods—flows through to the

corporation and is combined with other corporate activities.

Corporate level—stand alone factors are multiplied by the distributive share of partnership income

Example 3.32

Taxation of Flow-Through Entities

Limited Liability Companies Florida, Texas and Pennsylvania tax as

corporations Can use check the box regulations to elect

flow through status (partnership, Subchapter S or in some cases proprietorship)

Subchapter S Corporations Not taxed in most states, five states have a

“toll charge”