Strategies to minimize state and local taxes.
State and local governments are faced with significant budgetary shortfalls, and many jurisdictions are taking aggressive steps to add to their revenues. A number of state and local governments are increasing the size and the level of experience of their audit staffs to step up their enforcement of tax law. Most states have installed sophisticated computer systems to cross-match information on their taxpayers, and many states have entered into agreements with other states to share information on taxpayers.
As a result, state and local taxes constitute an increasingly greater share of a company's cost of doing business, and companies need to review their operations carefully to make certain they have considered all state and local tax planning opportunities available to them. Here are some general guidelines a company should consider to minimize its state and local taxes. (This article is limited to a discussion of income and franchise taxes. The company should balance these strategies with strategies for other state and local taxes, such as property taxes.)
1. Do not assume that state and local taxes follow established Federal guidelines. Executives often assume that state and local taxes are the stepchild of the Federal tax and that their plans to minimize Federal tax will result in a comparable minimization of state and local taxes. This is not necessarily the case. So the company's first step in developing a strategy is to conduct a thorough review of its tax posture from the perspective of state and local taxes.
2. Consider combined/unitary reporting. If a group of affiliated companies reports on a combined or unitary basis, the companies are treated as though they are a single entity. This method of reporting can produce significant tax savings. Perhaps the greatest advantage is that the company using this method can offset the losses of unprofitable affiliates with the income of those that are profitable. Combined reporting can also create a tax benefit for companies operating in a number of states as a result of the impact it has on the states' apportionment formulas. (The apportionment formula defined by each state determines how a company apportions its income to those states in which it does business. The formulas typically include three factors equally weighted: property, payroll, and receipts.) If the group of affiliates computes its apportionment formula as a unitary entity, rather than as separate companies, it may reduce the group's overall apportionment.
In order to file on a combined basis, a group of affiliated companies must conduct a unitary business. The determination of what constitutes a unitary business is generally based on a subjective evaluation of the relationship between the companies-so subjective, in fact, that it has been the subject of considerable litigation. The factors generally considered in determining if a group of affiliates is a unitary business are the similarity of their businesses, common management, centralized services, and the extent of intercompany transactions.
Note that certain states require a group of affiliated companies to request permission to file on a combined basis, Failure to do so in those states generally results in the loss of the benefit.
3. Look at the location of your business facilities. The next area to explore in state and local tax planning is the location of the business facilities. Corporate tax strategists should review all of their company's activities to determine if shifting any of these activities to another state will minimize the company's overall state and local tax burden.
The location of inventory, for example, can have a significant impact on taxes. A company may be able to reduce its corporate income or franchise tax by understanding the methodology each state uses in determining the receipts factor of its apportionment formula. For example, New York, unlike several other states, does not employ "sales recapture." Sales of tangible personal property shipped from New York to another state in which the company is not subject to tax is not considered a sale in New York and is, therefore, not taxed at all. So locating inventory in New York can reduce the overall receipts the company reports to all the states in which it does business.
The location of the group's headquarters can also have tax implications. Some jurisdictions-again New York is an example-don't consider general executive officers in their computation of the payroll factor. By locating its general executive officers in such a state, the company can reduce its overall payroll factor.
A company should also consider relocating its entire facilities to a state that has a more favorable tax structure.
The cost of relocating can be less than the amount of tax savings that result from the move. A number of companies are considering relocating their corporate headquarters to other states to save on their corporate tax as well as to reduce their employees' personal income tax. Indeed, many companies have already made the move.
4. Establish an investment subsidiary or intangible holding company. Companies that have significant amounts of passive income can benefit from transferring investments generating such income to a separate investment subsidiary located in a state, such as Delaware, that gives favorable tax treatment to such entities. Having the subsidiary allows a business to convert certain types of passive income, including interest and capital gains, into dividend income for the operating companies, to which most states give favorable tax treatment. The investment company can also make loans to its parent; generally, the interest the parent pays for the loan is a deductible expense.
The formation of an investment subsidiary must be carefully planned and implemented, however, in order to achieve the desired state and local tax benefit. in setting up an investment subsidiary, a company should establish a bonafide office with appropriate personnel; have all decisions relevant to the subsidiary's activities made in that office; and operate the subsidiary autonomously.
Companies that have valuable intangible property such as patents or trademarks should consider setting up an intangible holding company in a state such as Delaware. By transferring the intangible assets to the holding company and charging a fee to the operating company for the use of the patent or trademark, the company creates a deductible expense for the operating company while freeing the income from taxes.
It should be noted that some states may insist that the holding company is unitary with the operating company and require the company to file a combined return, in which case the benefit of locating the holding company in Delaware would be eliminated.
5. Minimize taxes with management fees. Another method companies have used successfully to minimize state and local taxes is to have the parent company charge a management fee to the subsidiaries for the services the parent provides.
A management fee creates income for the parent, which may be operating at a loss, and creates a deductible expense for the subsidiaries, which may be generating profits, thus making the management fee an extremely beneficial tax strategy. In determining the amount of the fee, the company should consider what is appropriate based on the services the parent provides to the subsidiaries.
Many companies assume that since charging a management fee does not have any effect on a federal consolidated return, it has no effect on state returns. But, since most companies file state returns on a separate-company basis, they may miss this opportunity for tax savings. Depending upon where the parent and the subsidiary operate, the tax savings can be significant.
it should be noted that, as with the investment subsidiary or intangible holding company, in the event the state determines that the parent and subsidiary should be filing on a combined or unitary basis, the benefit of the management fee would be eliminated.
6.File returns in the appropriate states. Surprisingly, some companies file returns in states in which they don't need to because they don't have enough activity there. In fact, certain companies even report more than 100 percent of their income to the various states in which they file returns. This happens most often when companies have filed returns in certain states for so many years that, even though the operations have changed and the company no longer conducts business in the state, it continues to file returns. It is extremely important to review periodically your operations in all states in which you file to make certain that you really do need to file in those states.
The bottom line-planning:
While multistate companies clearly benefit from developing a strategy for state and local taxes, companies with operations in only one state should also give serious consideration to state and local tax planning. For example, a company currently operating in one or two states may benefit from setting up an intangible holding company and from carefully reviewing the states' apportionment formulas.
Companies of all sizes need to examine periodically their planning for state and local taxes. A well-planned strategy can give their bottom lines a boost that may be badly needed in the uncertain times ahead.
This article is adapted from Mr. Genetelli's interview on Financial Management Network in September.
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|Author:||Genetelli, Richard W.|
|Date:||Jan 1, 1991|
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