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Who can file combined state income tax returns?

State filing requirements for a multicorporate group vary, depending on circumstances and law. Some states require taxable income to be computed on a separate-return basis, while others permit or require the filing of a combined report or consolidated return.

In order for a group of corporations to be included in a combined report, the corporations must be unitary. Unfortunately, there is no realistic definition of a unitary business. In Butler Bros. v. McColgan, 17 Cal. 2d 664 (1942), the California Supreme Court set forth the three unities test: (1) unity of ownership; (2) unity of operation, as evidenced by central purchasing, advertising, accounting and management divisions; and (3) unity of use in its centralized executive force and general system of operation. Later, in Edison California Stores, Inc. v. McColgan, 30 Cal. 2d 472 (1947), the same court added the contribution-dependency test, which is based on the extent one segment of a business contributes to or depends on another segment.

In ASARCO, Inc. v. Idaho State Tax Commission, 458 US 307 (1982), and F.W. Woolworth v. Taxation [4] Revenue Dept., 458 US 354 (1982), the Supreme Court emphasized three criteria: functional integration, centralization of management and economies of scale. An additional "flow of value" test was added by the Court in Container Corp. of America v. Franchise Tax Board, 463 US 159 (1983), which held that a unitary relationship exists if there is some sharing or exchange of value not capable of precise identification or measurement.

If a taxpayer wants to be unitary with its affiliates, it should try to establish or demonstrate as many of these ties as possible. The most straightforward unitary requirement to meet is the ownership requirement. This is usually dictated by statute and generally is a percentage of the corporation's voting stock (a 50% ownership of the voting stock of another corporation is a common ownership requirement). The lower percentage of ownership may allow a combined return to be filed when a Federal consolidated return is not. The other unitary ties are more subjective. All ties should be documented contemporaneously with the events and reasons that resulted in the decision to file a combined return. This is important because of the delay between the time a return is prepared and when it may be audited.

It is important to note that a mere change in ownership is generally insufficient to demonstrate that an acquired corporation is unitary with another corporation. States have argued that unity is a gradual process taking place over a number of months or even years. To show instant unity, the acquired corporation would have to show immediate and meaningful changes in areas such as operations, management and flow of product. If unitary ties already existed in several areas, such as management or operations, the change in ownership would be the final link allowing a combined return to be filed, instantly.

Benefits of filing combined returns

One of the benefits of filing a combined report is the ability to offset taxable income from one member of the unitary group with the losses of other group members, reducing total unitary income subject to apportionment. Another is the ability to use the combined apportionment factors of all of the members to apportion income to a state, which may result in lower taxable income in that state. A third benefit is the ability to reduce the apportionment factors of members in hightax jurisdictions with those in low-tax jurisdictions.

There are numerous factors to consider in deciding whether to establish a unitary relationship and each one should be analyzed before making the final decision. From Lee Farris, CPA, Pasadena, Cal.
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Author:Farris, Lee
Publication:The Tax Adviser
Date:Sep 1, 1995
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