The surprising benefits of nexus: multistate taxation actually can lower a company's state income tax bill.
A CASE IN POINT
The single business tax (SBT) the state of Michigan imposes on companies that do business there is a good example of a tax that can cause problems for out-of-state enterprises. This tax has been the focus of considerable controversy over the last several years: The Michigan Department of Treasury has begun to apply a nexus standard retroactively in a manner inconsistent with the guidance it previously had provided. Businesses that thought they were exempt now find they have tripped the state's SBT nexus standard. (A business has nexus when it has sufficient presence in a state to allow the state to legally impose a tax.)
One of my clients had a difficult time with Michigan. The state's treasury department contacted the company in the early 1990s and asked it to respond to a standard nexus questionnaire. All the client's property and payroll were concentrated in one location outside of Michigan. As a result all its income was taxed in that one state. The only business presence the company had in Michigan was a sales representative who entered the state a few times each year to call on customers and solicit orders for home office approval. The client claimed protection from Michigan's SBT tax under public law 86-272 and heard nothing in response until the state contacted it for an audit in 2000. (Public law 86-272 generally restricts a state from imposing a net tax on a company's income derived from interstate commerce within its borders if the company's only business activity in the state is soliciting orders it sends outside the state to be accepted--or rejected--and filled. Net income taxes includes a franchise tax based on net income.) Michigan's treasury department officially changed its position on nexus in 1998 and decided to apply a 10-year, look-back period reaching back to 1989 for purposes of assessing SBT tax, interest and penalties.
Although Michigan's SBT tax base begins with net income, companies are not protected by public law 86-272 because technically the SBT is not considered an income tax. Michigan successfully levied this tax on out-of-state companies that solicited only occasional orders in the state. Michigan's voluntary disclosure program provided no relief to the client since the state already had contacted it for an audit. The company did indeed have to pay 10 years of tax, interest and penalties.
This otherwise dark cloud, however, had a Silver lining. The experience motivated the client to ask for a thorough review of possible nexus issues in other states. As it turned out, the company had franchise tax exposure in nine other states. Unlike income taxes, franchise taxes are imposed for the privilege of doing business in a state and are not covered by public law 86-272. The mere fact a company has sales representatives soliciting orders in a state is often sufficient to establish nexus for franchise tax purposes.
SOLVING THE PROBLEM
The client's next step was to contact the nine states and take advantage of voluntary disclosure programs that limited the look-back period to three or four years. The company filed franchise tax returns and paid the appropriate taxes and interest. (In all the voluntary disclosure cases, the states waived penalties and, in one case, interest.) The good news? The client saved $2 million in state income taxes by filing amended returns that apportioned income from its home state into the other states where it had paid franchise taxes. Doing so substantially reduced the company's effective tax rate.
Under the Uniform Division of Income Tax Purposes Act (UDITPA), "any taxpayer having income from business activity which is taxable both within and without this state, other than activity as financial organization or public utility or the rendering of purely personal service," has the right to allocate and apportion net income. The company's home state had adopted UDITPA and also incorporated many of the provisions of the Multistate Tax Commission (MTC) model regulations on income allocation and apportionment.
According to those regulations, "a taxpayer is taxable within another state if it meets either one of two tests:
* "By reason of business activity in another state, the taxpayer is subject to one of the types of taxes specified in article IV. 3(1), namely; a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax.
* "By reason of such business activity, another state has jurisdiction to subject the taxpayer to a net income tax, regardless of whether or not the state imposes such a tax on the taxpayer."
The client's tax savings came from the differences in how the various states weighted the apportionment formulas. The client's home state apportioned taxable income solely on the basis of relative sales shipped to each state with sales "thrown back to the home state" if the company had no taxable presence in another state. Most of the other states used a three-factor apportionment formula based on property location, payroll and sales shipped to each state with the sales factor being double-weighted. Since the client's property and payroll were located substantially in one state, a dollar's worth of income in that state had been taxed at 100% of the statutory rate. But when a dollar of income was apportioned out to another state where the company had no property or payroll, the only remaining element in the apportionment factor was sales. Even though sales were generally double-weighted, the apportionment still effectively reduced the statutory rate in the other states by 50%.
If all the states had used the same formula, the client would have gained no advantage from apportionment. Exhibit 1, below, illustrates this point. For the sake of simplicity, assume the company ships its sales equally to four states and has nexus in each even though all the company's property and payroll are located in the home state. If all four states have the same tax rate and apportion income the same way using the average of property, payroll and double-weighted sales factors, the total tax would be $80,000. This is exactly what it would have been if the home state had taxed all the income at the 8% statutory rate.
Exhibit 1: All States Use Property, Payroll and Double-Weighted Sales Apportionment Formulas State 1 State 2 (Home state) Taxable income to be apportioned $1,000,000 $1,000,000 Property factor 1 0 Payroll factor 1 0 Sales factor 0.25 0.25 Sales factor 0.25 0.25 Average factor 0.625 0.125 Apportioned income $625,000 $125,000 State tax rate 8% 8% Income tax $50,000 $10,000 State 3 State 4 Total Taxable income to be apportioned $1,000,000 $1,000,000 Property factor 0 0 Payroll factor 0 0 Sales factor 0.25 0.25 Sales factor 0.25 0.25 Average factor 0.125 0.125 Apportioned income $125,000 $125,000 State tax rate 8% 8% Income tax $10,000 $10,000 $80,000
Exhibit 2, page 88, illustrates the potential for tax savings. In this case the only change is that the home state apportions income using a single relative sales factor; the other states still use the same three-factor, double-weighted sales formula. As CPAs can see, the overall effective tax rate drops to 5% from 8%.
Exhibit 2: Home State Uses Single-Sales Apportionment Formula All other states use three-factor, double-weighted sales apportionment formula. State 1 State 2 (Home state) Taxable income to be apportioned $1,000,000 $1,000,000 Property factor n/a 0 Payroll factor n/a 0 Sales factor 0.25 0.25 Sales factor n/a 0.25 Average factor 0.25 0.125 Apportioned income $250,000 $125,000 State tax rate 8% 8% Income tax $20,000 $10,000 State 3 State 4 Total Taxable income to be apportioned $1,000,000 $1,000,000 Property factor 0 0 Payroll factor 0 0 Sales factor 0.25 0.25 Sales factor 0.25 0.25 Average factor 0.125 0.125 Apportioned income $125,000 $125,000 State tax rate 8% 8% Income tax $10,000 $10,000 $50,000
The taxes in this example are income-based, whereas franchise taxes often are based on capitalized average income or some other valuation of owner's equity. Franchise tax rates also are generally low relative to income tax, but since retained earnings are a part of owners' equity, any income a company retains gets taxed again and again in perpetuity. These differences aside, apportionment factors for franchise taxes are very similar to those for income taxes and when there are variations from state to state, there is potential for companies to save significant taxes.
As often is the case in taxation, things that work against you can also work in your favor. The result in exhibit 2 was favorable because the home state used a single-sales-factor apportionment formula while the other states used a three-factor formula. However, if the home state had used a three-factor formula with the other states apportioning income on the basis of sales alone, then CPAs would find the outcome unfavorable, with the effective tax rate increasing to 11% from 8%. This is illustrated in exhibit 3, below.
Exhibit 3: Home State Uses Three-Factor, Double-Weighted Sales Apportionment Formula All other states use single-sales apportionment formula. State 1 State 2 (Home state) Taxable income to be apportioned $1,000,000 $1,000,000 Property factor 1 n/a Payroll factor 1 0 Sales factor 0.25 0.25 Sales factor 0.25 n/a Average factor 0.65 0.25 Apportioned income $625,000 $250,000 State tax rate 8% 8% Income tax $50,000 $20,000 State 3 State 4 Total Taxable income to be apportioned $1,000,000 $1,000,000 Property factor n/a n/a Payroll factor 0 0 Sales factor 0.25 0.25 Sales factor n/a n/a Average factor 0.25 0.25 Apportioned income $250,000 $250,000 State tax rate 8% 8% Income tax $20,000 $20,000 $110,000
A TAX-SAVING FORMULA
The nexus standards for state franchise taxes are much broader than for income taxes. Companies that otherwise are exempt from paying income tax by virtue of public law 86-272 may in fact have a franchise tax liability if they do business in a state. If a state has adopted the relevant clauses of the MTC regulations, then paying franchise taxes in other states can be the basis for a company to apportion income out of that state. In general CPAs will find a company with its principal business location in a state that apportions income using a single-sales-factor formula stands to gain from apportionment to states where it has a taxable presence for franchise tax purposes when those states use a multiple-factor formula. The converse is true of companies in states that use a three-factor apportionment based on property, payroll and sales.
Not only can franchise taxes add up to substantial amounts of money but taxpayers often are unaware of their exposure to them. CPAs can serve their employers and clients by reviewing a company's interstate activities to see if it has established nexus for franchise tax purposes. If so, CPAs should advise the company to proceed with voluntary disclosure programs in those states. Under most programs, negotiated look-back periods generally are limited to three years. Companies then can file amended state income tax returns that take into account the franchise taxes paid to other states. If the differences in apportionment formulas are favorable, the company could end up with significant tax savings.
* THE FRANCHISE OR BUSINESS PRIVILEGE TAXES SOME states impose on nonresident companies that have an economic presence in the state can be difficult for small businesses to handle on their own. However, in the right circumstances, CPAs may be able to help clients and employers achieve overall tax savings.
* UNLIKE INCOME TAXES, FRANCHISE TAXES ARE IMPOSED on companies for the privilege of doing business in a state. The mere fact a company sales representative solicits orders in a state is often sufficient to establish nexus for franchise tax purposes.
* POTENTIAL TAX SAVINGS CAN RESULT FROM DIFFERENCES in how states weight the apportionment formulas used to determine how much income is taxed in a state. If all states used the same formula, apportionment would yield no advantage. However, if a company's home state apportioned income using a single relative sales factor, for example, and the other states where the company does business used a three-factor, double-weighted sales formula, the company might be able to reduce its overall effective tax rate.
* THE NEXUS STANDARDS FOR STATE FRANCHISE TAXES are much broader than they are for income taxes. This means companies that otherwise are exempt from paying income tax in a given state may have a franchise tax liability if they do business in the state.
* CPAs CAN BEST SERVE AN EMPLOYER OR CLIENT by reviewing the company's interstate activities to see if it has established nexus in a state for franchise tax purposes. If so, the company should proceed with voluntary disclosure in that state, which generally limits negotiated look-back periods to three years.
Includes a good summary of state apportionment factors.
An excellent portal for getting to the Web site for each state's department of revenue.
BRUCE HOWARD, CPA, PhD, is professor of business and economics and department chairman at Wheaton College in Wheaton, Illinois. His e-mail address is firstname.lastname@example.org.
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|Publication:||Journal of Accountancy|
|Date:||Nov 1, 2002|
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