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Editor's note: Ms. Boucher chairs the AICPA Tax Division's State & Local Taxation Technical Resources Panel.

If you would like additional informaion about this article, contact Ms. Boucher at

The majority of states that impose a corporate income tax begin the computation of state taxable income with a corporation's taxable income, as reported on either line 28 (taxable income before net operating loss (NOL) 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 addition and subtraction modifications 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 own income taxes be added back to Federal taxable income in computing state taxable income, while other states require that all state income taxes be added back. Several states require 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; in general, however, most states include both kinds of taxes in the statutory, state tax add-back.

In determining deductibility, the most controversial of all of the state taxes is the Michigan single business tax (MSBT). Numerous court cases, including the U.S. Supreme Court's decision in Trinova Corp. v. Michigan Dep't of Treasury, 498 US 358 (1991), have described or defined the MSBT as a value-added tax (VAT), 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, NOLs and partnership income or loss; additional modifications are made for statutory exemptions and, in tax years beginning before 2000, Michigan's capital acquisition deduction. 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 states. While some states permit a deduction for the entire MSBT, other states do not allow a deduction for any portion of it. As a middle road to those approaches, a few states attempt to bifurcate the tax into deductible and nondeductible components. Over the past couple of years, several states have clarified or modified their positions on the deductibility of the MSBT; in a number of states, the change in position was the result of court decisions. However, whether the MSBT must be added back in computing the state tax base continues to be an area of litigation. If a state's statute merely requires the add-back of income-based taxes, taxpayers may argue that the MSBT is not an income tax or tax measured by net income, and therefore there may not be a requirement to add it back to Federal taxable income.


In 1990, the California Franchise Tax Board (FTB) took the position that, to the extent the MSBT is measured by income, it is not deductible and, to the extent the tax is based on labor cost of goods sold, it is deductible (FTB Notice No. 90-2). However, during 1994, the State Board of Equalization (SBE) took a contrary position. In Appeal of Dayton Hudson Corp., 94-SBE-003, the SBE noted that gross income for Federal tax purposes in a manufacturing, merchandising or mining business is defined as gross receipts less cost of goods sold. Although the MSBT does not include material or acquisition cost of goods sold when determining the MSBT tax base, it does include the cost of labor. For that reason, the SBE held that the imposition of the MSBT against a base that included the cost of labor, without exclusion of the labor cost of goods sold, resulted in a tax measured by something other than gross income, and therefore was deductible.

In response to Dayton Hudson, the FTB modified its MSBT position to provide that the MSBT was deductible for California corporate tax purposes (i.e., an add-back modification was 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 was 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 did not allow the deduction.

However, the California SBE rejected the FTB's modified MSBT position. In the Matter of Kelly Service Inc., 97-SBE-010 (5/8/97), the taxpayer asked the SBE to expand its holding in Dayton Hudson to encompass situations in which there is no cost of goods sold in the MSBT tax base for a particular taxpayer. Kelly Service is a service business providing temporary help to a variety of customers. As a service business, it has no inventory costs and thus the MSBT, as applied to Kelly Service, did not "contain an element of return of capital" in its tax base. The SBE affirmed Dayton Hudson and clarified that its holding applies equally to service businesses. Accordingly, the MSBT is deductible for California tax purposes, regardless of the specific components of the MSBT tax base of the taxpayer claiming the deduction.


On March 31,1999, the Indiana Tax Court, in First Chicago NBD Corp. v. Dep't of State Rev., 49T 10-9712-TA00197, held that the MSBT is not an add-back for purposes of Indiana's financial institutions tax. Citing Trinova and other states' decisions on the analysis of the MSBT, the Tax Court held that the MSBT is a type of VAT, rather than a tax based on or measured by income. Although the decision related to the add-back for financial institutions tax now found in IC 6-5.5-12(a)(1)(C), the modification language in IC 6-3-1-3.5(b)(3) for Indiana adjusted gross income tax purposes is identical.


In Directive 99-9, the Massachusetts Department of Revenue announced that it had determined that the following state taxes are disallowed as deductions in arriving at corporate net income: (1) Delaware gross receipts tax (merchants' and manufacturers' license taxes); (2) Indiana gross income tax; (3) Los Angeles city tax; (4) Louisiana franchise tax; (5) Michigan single business tax; (6) New Hampshire business profits tax; (7) New Hampshire insurance premiums tax; (8) Ohio franchise tax; (9) Pennsylvania franchise tax; (10) San Francisco business tax (including the San Francisco payroll expense tax); (11) Texas franchise tax; (12) Washington business and occupation tax; and (13) West Virginia business and occupation tax (emphasis added).


In a 1994 ruling (P.D. 94-313, 10/17/94), the Virginia Tax Commissioner found that the MSBT was 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 the Virginia corporate income tax.


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 VATs, single business taxes or taxes on (or measured by) net income, gross income, gross receipts or capital stock. Accordingly, no portion of the MSBT is 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. As a result of this legislation, the MSBT must be added back to Federal taxable income in computing the Wisconsin corporate franchise (income) tax base.

The Wisconsin Tax Appeals Commission (TAC) addressed the deductibility of the MSBT in tax years prior to the 1994 legislative amendment. In Delco Electronics Corp. v. Dep't of Rev., No. 95-I-112 (6/16/97), the Wisconsin TAC ruled that the MSBT was not deductible in computing the Wisconsin franchise (income) tax liability. For the years at issue, the Wisconsin statute disallowed a deduction for state taxes on (or measured by) "all or a portion" of net income, gross income, gross receipts or capital stock. The TAC concluded that the MSBT was "measured by net income" within the unambiguous meaning of the Wisconsin statute, because net income was a clearly defined, distinct and essential component of the MSBT total tax base. The TAC noted that the taxpayer might have prevailed had the statute applied only to taxes measured "solely or exclusively" by net income.

The TAC also held that the MSBT was a tax on (or measured by) all or a portion of gross receipts and therefore was not deductible from gross income by a corporation under Wisconsin law. Because the TAC concluded that the statutes in place during the period under review already excluded the deduction of the MSBT, the TAC rejected the taxpayer's argument that the 1994 amendment clearly demonstrated that the statute (as it existed prior to the change) did not apply to VATs generally or the MSBT specifically. The TAC viewed the clarification as providing guidance to taxpayers and removing all uncertainty about the law.

On appeal, a Wisconsin circuit court reversed the TAC and held that the MSBT was deductible for years prior to the 1994 legislative change (Wisconsin Circuit Court for Dane County, Branch 6, No. 87-CV-1980 (3/20/98)).

However, in 1999, the Wisconsin Court of Appeals reversed the Wisconsin circuit court decision and held that the MSBT was not deductible for the years prior to the 1994 legislative change, specifying that single business taxes and VATs are not deductible in computing the franchise tax base (Delco Electronics Corp. v. Dep't of Rev., No. 98-1708 (5/13/99)). Given the TAC'S experience in interpreting the franchise tax laws and exemption statutes, the Court of Appeals accorded the TAC'S decision due weight deference and concluded that the TAC's determination that the MSBT is a tax "on or measured by all or a portion of" gross receipts was not less reasonable than the interpretation in Delco. Accordingly, the court reversed the decision of the circuit court, thereby affirming the TAC.

Potential Refunds

Corporations that incurred significant MSBT liabilities in tax years open under the statutes of limitations and that added back such taxes in computing their state tax base should closely review the statutory language to determine whether the MSBT is among the taxes required to be added back to Federal taxable income. If the add-back was not required, the corporation should consider amending its return and claiming a refund of tax improperly paid. As noted, if the MSBT was added back in California, Indiana or Virginia, corporations should consider amending their corporate income tax returns, claiming 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 resides in a state that takes the position that the MSBT is not an income tax add-back for corporate income tax purposes, 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 that was paid by a passthrough entity.

Ohio. In Ardire v. Tracy, 674 NE2d 1155 (Ohio 1997), the Ohio Supreme Court, relying on Gillette Co. v. Michigan. Dep't of Treasury, 198 Mich. App. 303 (Ct. App. 1993), determined that the MSBT was not a tax "measured by" net income for purposes of eligibility for Ohio's resident tax credit. Accordingly, an Ohio resident S shareholder was not permitted to claim a credit for taxes paid to other states for the MSBT paid by the S corporation. Ardire deferred to the Michigan court's view in Gillette that, even though Federal taxable income was the starting point for computation of the MSBT, the many addition adjustments prevented a conclusion that the MSBT was a tax "measured by" net income.

Karen J. Boucher, CPA Principal Arthur Andersen LLP Milwaukee, WI
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Article Details
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Author:Boucher, Karen J.
Publication:The Tax Adviser
Date:Dec 1, 2000

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