In a downward economy, controlling state tax costs is an essential strategic move.
For multistate corporations, state income and franchise taxes are consuming an increasing percentage of net profits. The following areas should be explored to minimize state income tax expenses.
- Apportionment factor issues. Filing income tax returns in several states involves the apportioning of income based on a variety of concepts. All of these concepts contain subjective factors, which should be closely examined.
- Nonbusiness income can be removed from the sales apportionment factors of some states. This means property and payroll related to generating this nonbusiness income can also be excluded from the apportionment factors.
- Service businesses approach apportioning revenue based on either: 1) where the cost of performing the service is located; or 2) where the customer is located. States vary on the acceptance of these concepts and the tax results can vary widely. It is even possible for income to be sourced to two states!
- Avoid over-reporting receipts that are not required to be included. Many states allow the exclusion of receipts generated by the treasury function, unrelated to general business activities.
- Minimize penalties. Underpayment of estimated taxes can result in large penalties. Minimize or eliminate unnecessary penalties by fine-tuning projected income by state and timely payments of estimates. Many states, like Delaware, impose hefty penalties on noncompliance with unclaimed property laws. Be familiar with the state laws of the locations of business activities.
- Examine franchise states. Taxes based on capital stock can be greatly impacted by restructuring. Many franchise taxes are imposed on a separate company basis. Merging a loss company with a profitable company can reduce or eliminate franchise taxes currently generated by separate related companies.
- Nexus study. A detailed review of business activities may reveal unnecessary income-tax filings. Don't assume that nexus occurs everywhere you have employees located. Employees solely soliciting sales of tangible products might not establish nexus in many states. Relocating employees or a warehouse to a lower or no tax state might result in significant tax savings.
- Explore state tax incentives. You could be eligible for lucrative state tax incentives for employee training programs that you have already established. Many states, like Rhode Island and Vermont, focus on employment based incentives, including credits and grants. Review hiring policies to focus on employees, such as displaced workers, who may qualify for state credits.
- Take advantage of combined reporting. Whether required or optional, combined reporting offers advantages in related groups where one entity has losses available to offset other entities' profits. Combined apportionment ratios may result in lowered apportionment to apply to lowered combined net income.
- Consider state tax amnesty programs. A good time to limit your past exposure when you are not in full compliance with state filing requirements, is during a state tax amnesty program. If an amnesty program is not available, a voluntary disclosure agreement with a state can reduce your past tax liability by reducing the open years you are required to file to be in compliance. Many states will waive penalties for voluntary disclosure of past tax liability.
- Review sales tax policies. State income taxes often follow the trail of sales taxes collected. Review policies for collecting sales tax and document reasons for decisions. Don't assume that income tax nexus automatically follows sales tax collections. Be aware of sales activities that are protected from income tax in each state. You could be filing tax returns and paying unnecessary income taxes in some states.
- Prepare for state tax audits. As states search more aggressively for revenue, audit activity will continue to increase. The best defense in any audit is to be prepared with adequate documentation to support positions. With the enactment of FIN 48 requiring disclosure of uncertain tax positions, procedures for proper documentation may satisfy both objectives.
- Beware of the nuances of non-income based taxes. Many states have taxes based on gross receipts, payroll or modified gross receipts such as the Michigan Business Tax, the Texas Margin Tax, the Ohio Commercial Activity Tax and the Washington Business and Occupations Tax. These taxes don't follow the normal calculations of three-factor apportionment or allow for normal business deductions and exemptions. Every state has a different definition of "gross receipts" and can result in over-reporting income. For example, some states allow for deduction of income received as an agent in a capacity such as a general contractor. It might be necessary to read all regulations issued by the state in order to determine the correct methodology for your type of business. The concept of gross receipts tax should also be closely examined on the level of city and local taxes.
- (Bonus Tip) Don't automatically "throwback" foreign sales. In a throwback state, all sales of tangible property shipped from the state to locations in which the corporation is not subject to tax are generally required to be "thrown back" to the state of origin. Not all states treat foreign sales the same. Massachusetts, for example, is a throwback state with a specific exemption for foreign sales. There is a statutory provision exempting all foreign sales from inclusion in the throwback calculation. Sometimes it pays to read the fine print.
These are just a few areas that should be carefully reviewed in order to ensure compliance in all states with business activities, at a minimal cost. Tax savings can be realized by the informed taxpayer taking advantage of every deduction and incentive available.
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Mary F. Bernard
, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.