ISC tax issues.
Issues in Formation/Entity Selection
The selection of' the type (and location) of entity to be used as an ISC is perhaps the most important consideration, from both a Federal and state tax perspective.
Generally, an ISC's purpose is to facilitate sales in interstate commerce with a minimum of physical presence or activity in the destination state. Accordingly, state tax concerns tend to overshadow Federal concerns in the selection of the type and form of entity. For this reason alone, the corporate form of operation tends to provide greater flexibility and potential state tax savings.
Benefits of the corporate form of operation include the availability of allocation and apportionment rules and the ultimate burden of state tax at the entity (as opposed to individual, partner or member) level. (A tiered structure with corporate partners or members could provide similar benefit, but nexus issues on behalf of corporate partners can affect the overall benefit of the corporate partner/member form.) In addition, a corporate ISC may also avail itself of favorable "separate return" states, as well as apportionment factor planning in unitary states such as California.
With the availability and popularity of entity alternatives under the check-the-box regulations and in the Small Business Job Protection Act of 1996 provisions affecting qualified subchapter S subsidiaries, passthrough entities have become the choice in many corporate structure plans. In many cases, it is possible to arrange a business structure to take advantage of the benefits of passthrough treatment at the state level, but these situations tend to be more complex than their C corporation counterparts. If passthrough entities are to be considered in an ISC business structure, the expected states of sales and operations must be reviewed, as well as which existing entities and/or parties will be partners/members in the passthrough [SC.
Because of the inherent flexibility in forming and operating a special-purpose entity, there are several other ownership considerations to address in its formation. If the ISC is a corporation, it may be a direct, wholly owned subsidiary of an operating company or "placed" elsewhere within a corporate structure. Liability concerns, other nontax issues or the use of intercompany transactions may dictate the ISC's location within the corporate structure. Percentage ownership of ISC stock is an important factor, especially considering alternatives for Federal consolidated returns and state combined and consolidated return rules. If a passthrough entity is used, special considerations can be made for income and estate tax planning purposes, to meet the needs of other special-purpose owners and to orchestrate the distribution of profits and property.
Issues in Entity Operation
Nexus. The issue of nexus focuses entirely on state sales and use and income taxes. In both cases, however, the ISC should be set up and operated in a manner to limit taxable nexus (i.e., the minimum connection between the ISC's business activities and a state) to the state where the Website is developed, maintained and operated. It is possible to set up and maintain an ISC in Nevada or some other "tax friendly" state, but the practicalities of forming and operating the ISC in a home state do not appear to warrant formation and operation in another tax-friendly state. For instance, if the ISC is operated as a buy/sell entity, it would be unreasonable to require the ISC to also operate a warehouse in another state to store inventory temporarily, merely to avoid nexus in the home state. The effect of nexus in the home state will be collection of home state sales tax on sales of products by and through the ISC to home state residents.
For state income tax purposes, some states may attempt to impose an income tax filing requirement on an "economic nexus" basis. However, most efforts to date in this regard (with respect to ISCs specifically) have not been entirely successful. Generally, the risk of a state asserting nexus on an ISC that limits its activities in the state to Internet access and transactions is relatively small.
Buy/Sell or Commission Basis. In the case of an ISC formed for the purpose of "e-tailing" tangible personal property, the preferred form of operation is a buy/sell entity. This takes advantage of current state and local sales and use tax rules that apply to "retailers" of tangible personal property. Because it is unlikely the ISC will have nexus in any state other than the home state, it will be preferable for the ISC to purchase property from a related supplier and resell the property to purchasers in other states. Under current law, the lack of nexus on the ISC's behalf in the destination state will preclude collection of state use tax.
If the ISC is formed on a commission basis, under which it receives a commission on sales received through its Website, the related supplier would likely be considered the retailer in the destination state. If the related supplier otherwise had nexus (i.e., from other operations or activities in the destination state), it would be required to collect state use tax on taxable sales to residents of that state.
Transfer Pricing/Intercompany Transactions. For Federal and state tax purposes, the issue of intercompany pricing, delivery and other transactions is an important part of an ISC's overall tax planning. Intercompany transactions should be at arm's length and on "reasonable" terms under the prevailing fact,; and circumstances. The ISC should purchase inventory (if a buy/sell) at a reasonable "cost plus" markup, but should also charge the related supplier a reasonable amount for marketing, selling and other general and administrative expenses. Nothing precludes an ISC from charging reasonable amounts to the related supplier for costs associated with the ISC's sales activities. In the "separate" return states where the related supplier may file income tax returns, these intercompany deductions will reduce taxable income on a separate-company basis, while causing no additional taxable income in the ISC's home state. In this fashion, careful maintenance and determination of intercompany pricing can produce state income tax savings for the affiliated group, not just the ISC.
The Advisory Commission on Electronic Commerce and Council of State Governors continues to meet and discuss the issue of state sales and use taxation of Internet sales. In the absence of Federal legislation (or a reversal in the current legal standards applied to remote selling), this issue appears to be one that will continue to be debated for the foreseeable future. In fact, the issue may not be resolved at the state level until a state enacts legislation that may be unconstitutional under prevailing law, a taxpayer challenges the law and the U.S. Supreme Court either refuses to hear the taxpayer's appeal or sustains a state appeal. This process could take many years. At present, the Federal moratorium on new Internet taxes applies; the states must "legislate around" existing authority.
This discussion highlights some of the issues involved in creating, operating and maintaining an ISC for the purpose of facilitating and making sales through and by way of the Internet. Additional operating issues (such as software development and acquisition costs, access charges, other Website development costs and recurring operations costs) may affect any entity carrying on a trade or business, and may offer tax planning considerations. This list attempts to illustrate some of the Federal and state planning ideas or considerations that must be a part of any ISC formation and operation. A taxpayer's specific facts and circumstances will tend to dictate which of these points are worthy of more serious consideration. However, in an ISC's simplest form, planning around destination state sales and use tax, income tax apportionment, separate-return tax planning and the form of operation (i.e., buy/sell or commission) are "essential" issues that will arise in all cases.
FROM TOM DELONG, CPA, ZAINER RINEHART CLARKE DFK, SANTA ROSA, CA
Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA