A case for updating P.L. 86-272.

P.L. 86-272, the Interstate Income Tax Act of 1959, was passed by Congress nearly 45 years ago to prevent states from dissuading interstate commerce by asserting nexus toward out-of-state businesses, thereby casting them into a web of compliance issues. Its passage has raised two common concerns. First, its narrow scope in protecting sellers of tangible property has become a contentious issue. Second, its limit to state income taxes leaves a gaping loophole in the law, which Congress needs to address. Several states impose business activity taxes not based on income, and, thus, not subject to the P.L. 86-272'S constraints.

P.L. 86-272 essentially extends greater protection to certain taxpayers, above and beyond the Constitutional protections (the Due Process and Commerce Clauses), afforded to all taxpayers. It applies only to taxpayers that sell tangible property, and only to income taxes.

In addition to the existing Constitutional protections, P.L. 86-272 provides that no state can assert income tax nexus on the basis of mere solicitation. However, the courts have construed "mere solicitation" very narrowly.

The Problem

Although many taxes like the business activity tax were in place when Congress passed EL. 86-272, two recent developments in state taxation demand Congressional action in closing the loophole. With increasingly powerful technology, states can easily find taxpayers operating within their borders, but just outside of the very slight Congressional protections. This alone creates the burden on interstate commerce that P.L. 86-272 was supposed to avoid. The courts have ruled that as little as two days of mere solicitation in a state in which substantial sales result, can create nexus in absence of P.L. 86-272 protection; see Michigan Sugar Co. v. Michigan Dep't of Treasury, MI Tax Tribunal, No. 220328 (5/21/97).

The growing trend for states to weight the sales factor more heavily in their apportionment formulas is bolstering a call for Congress to act. It is common knowledge that one court-approved way for states to favor in-state taxpayers is either to rely on the sales factor in calculating the tax due or to weight it more heavily. However, applying a sales-heavy apportionment formula to a nonincome tax base usually produces large liabilities for out-of-state taxpayers.

In considering both the administrative burden on interstate commerce noted above and the economic burden caused by applying a heavily weighted sales-factor to nonincome taxes, it is easy to see that conducting interstate commerce is becoming increasingly burdensome.

The Michigan SBT. This state's single business tax (SBT) is one of the most burdensome taxes falling outside P.L. 86-272. Enacted in 1976, it is probably the most notorious of the nonincome taxes. The Supreme Court, in Trinova Corp. v. Michigan Dep't of Treasury, 498 US 358 (1991), found that the SBT is not an income tax, but a value-added tax. Consequently, P.L. 86-272 affords no protection against SBT nexus.

Generally, Michigan taxes an entity's economic activity, 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 tax base is then multiplied by an apportionment formula, weighted 90% for sales. It is easy to imagine how the aggregation of the tax base, when apportioned essentially by sales, can cause out-of-state taxpayers having very little contact with Michigan to have high tax liabilities.

Perhaps most disturbing, however, is that the Michigan Department of Treasury reversed the position that it would voluntarily follow P.L. 86-272 (enunciated after Trinova), and, in 1993, took up a case against Gillette Company.

In Gillette Co. v. Dep't of Treasury, 198 Mich. App. 303 (1993), the Michigan Court of Appeals derided that the SBT'S nexus standard should be the same as that described in Quill Corp. v. North Dakota, 504 US 298 (1992) (i.e., merely Constitutional protections). After Gillette, Michigan announced that it would apply the Quill standard retroactively to 1989. This drew many complaints, including due process arguments. However, the courts consistently found in Michigan's favor; see, e.g., Syntex Labs. v. Dep't of Treasury, 590 NW2 612 (MI 1998).

Since that time, Michigan has become very aggressive in tracking down out-of-state entities, asserting nexus and levying large assessments against taxpayers with very little connection to the state.

Texas Corporation Franchise Tax

The other notoriously burdensome tax is the Texas corporation franchise tax. It was originally enacted as a net-worth tax, and far pre-dates P.L. 86-272. However, in 1991, the state legislature added the earned-surplus component of the tax, essentially an income tax with an addback for officer's and director's compensation. Generally, taxpayers pay the higher of the calculated net-worth tax or the earned-surplus tax. Apportionment is weighted 100% toward sales.

Although some tax advisers question the Constitutionality of a single sales factor in apportioning a net-worth tax, the courts, to date, have not provided guidance.

In any event, the question is whether any protections exist above and beyond the Constitution. The answer is yes and no.

For the net-worth part of the tax, only Constitutional protections apply; see Decision of the Comptroller of Pub. Accts., Hearing No. 21,502 (6/25/87). However, P.L. 86-272 does apply to the earned surplus part of the tax; see Texas Administrative Code, Title 34, Part 1, Chapter 3, Subchapter V, Rule [section] 3.546(b).This means that taxpayers that have violated Constitutional standards, but have not exceeded P.L. 86-272's provisions, would pay the net-worth tax, and not be subject to the earned-surplus tax.

Like Michigan, Texas is very aggressive in finding and assessing taxpayers who have very little contact with the state.

Conclusion

Clearly, Congress's intent in enacting P.L. 86-272 was to remove the barriers that state taxation posed to interstate commerce. Unfortunately, many states have discovered that they have the right to levy their nonincome taxes against out-of-state entities when minimal contact exists, and, in so doing, have been creating the administrative and economic barriers to interstate commerce that Congress intended to dismantle. It is time to level the playing field. Congress needs to mandate one nexus standard for income taxes, as well as proxies for income taxes, because the current Constitutional provisions do not go far enough to protect interstate commerce.

FROM SCOTT MUDFORD, CMA, CFM, CPA, REHMAN, RONSON, PC, FARMINGTON HILLS, MI