Deductible or not deductible? The Michigan SBT question.

The majority of states that impose a corporate income tax begin the computation of state taxable income with the corporation's taxable income as reported on either line 28 (taxable income before net operating loss and special deductions) or line 30 (taxable income) of Form 1120, U.S. Corporation Income Tax Return. The selected Federal figure is then adjusted for various state-defined additions and subtractions to determine the corporation's state taxable income.

In determining the corporate tax base, most states require a corporation to add back state income taxes previously deducted in arriving at Federal taxable income. Some states require that only their income taxes be added back to Federal taxable income in computing state taxable income, while other states include all state income taxes. Several states require that all state, local, foreign and Federal income taxes deducted in computing Federal taxable income be added back. The distinction between a direct income tax and a franchise tax measured by income may be significant in this connection; however, most states include both kinds of taxes in the statutory definition of a nondeductible tax.

In determining deductibility, the most controversial of all of the state taxes is the Michigan Single Business Tax (MSBT). Numerous court cases, including the Supreme Court's decision in Trinova v. Michigan Department of Treasury, have described the MSBT as a value-added tax, rather than a tax based on income. The MSBT is levied on the privilege of doing business in Michigan. While Federal taxable income is the starting point for the MSBT, there are significant modifications that must be made in determining the tax base. Adjustments are made for such items as employee compensation, depreciation, taxes, net operating losses, and partnership income or loss. Additional modifications are made for Michigan's capital acquisition deduction and statutory exemptions. Finally, a significant deduction is allowed that limits the tax base to no more than 50% of adjusted gross receipts.

The deductibility of the MSBT varies significantly among the states. While some states permit a deduction for the entire MSBT, others do not allow a deduction for any portion of it. As a middle ground, a few states attempt to bifurcate the tax into a deductible and a nondeductible component. Several states have recently modified their positions on the deductibility of the MSBT. If a state has not specifically addressed the MSBT, it may be possible for taxpayers to argue that the MSBT is not an income tax or tax measured by net income, and therefore is not required to be added back to Federal taxable income.

California: In response to the State Board of Equalization's decision in Appeal of Dayton Hudson Corp. (No. 94-SBE-003, 2/4/94), holding that the MSBT is fully deductible in computing the California corporate franchise/income tax (because it is not a tax measured by income and cannot be bifurcated into deductible and nondeductible portions), the California Franchise Tax Board (FTB) recently modified its MSBT position. Under the modified position, the MSBT is deductible for California corporate tax purposes (i.e., an addback modification is not required) if the taxpayer has incurred and deducted labor costs of goods sold in the year in which the tax is paid or accrued. If there is no return of capital in the form of labor costs of goods sold in the MSBT base (i.e., businesses that exclusively provide services or that do not incur and deduct labor costs of goods sold), the FTB will not allow the deduction.

Georgia, Kansas and Maine: Several states, including Georgia, Kansas and Maine, recently informally announced that the MSBT is deductible for state tax purposes to the same extent it is deductible for Federal income tax purposes. Therefore, no portion of the MSBT must be added back to Federal taxable income in computing a corporation's tax base in these states.

North Dakota: The North Dakota State Tax Department's stated position is that the MSBT is deductible for North Dakota corporate income tax purposes only to the extent that it is not based on income. Accordingly, an addback to Federal taxable income is required for the portion of the MSBT deducted federally that is deemed to be based on income.

South Dakota: South Dakota has informally indicated that the MSBT is an income tax; therefore, the entire amount of the MSBT deducted on the Federal return constitutes an addback in computing South Dakota bank excise income) tax. (Note: South Dakota does not impose a corporate income tax.

Virginia: In a 1994 ruling, the Virginia Tax Commissioner found that the MSBT is not a tax based on, measured by or computed with reference to, net income. Accordingly, the tax should not be added back to Federal taxable income in computing its state corporate income tax.

West Virginia: The West Virginia Department of Revenue's stated position is that the MSBT is deductible only to the extent the taxes paid were calculated using the alternative gross method. If the MSBT paid was calculated using the business-income method (Federal taxable income method), an addition to the corporation's Federal taxable income would be required in computing the West Virginia corporate income tax.

Wisconsin: Legislation enacted during 1994 substantially broadened the list of nondeductible taxes for Wisconsin tax purposes. The modified statute provides that corporations are not permitted to deduct state taxes and taxes of the District of Columbia that are value-added taxes, single-business taxes, or taxes on or measured by net income, gross income, gross receipts or capital stock. Accordingly, no portion of the MSBT will be deductible for Wisconsin tax purposes. Prior to the legislative change, only taxes on or measured by net or gross income, gross receipts or capital stock were expressly disallowed.

Potential refunds

Corporations that incurred significant MSBT liabilities in tax years that are open under the statutes of limitations and that added back such taxes in computing their state tax base in the jurisdictions discussed should consider amending their corporate income tax returns to claim refunds of the overpaid tax.

Impact on individual state taxes

While a state's position that the MSBT is not an income tax typically is favorable for corporate taxpayers, it may have an unexpected side effect for individual taxpayers. Generally, individuals are permitted to claim a credit on their residency state return for "income" taxes paid to another jurisdiction. If an individual who resides in a state that takes the position that the MSBT is not an income tax addback is an owner of a flowthrough entity subject to the MSBT, it is possible that the residency state will not permit the individual to claim a credit for the individual's pro rata share of the MSBT paid by the passthrough entity.

From William B. Curlee, CPA, Los Angeles, Cal., and William H. Labhart II, Minneapolis, Minn.