Annette Nellen
Annette Nellen

Looking for a Better State Business Tax

A new approach for taxing business income emerged recently from a California commission — is it a better approach?

October 29, 2009
by Annette Nellen, CPA/Esq.

For the past few decades, there has been no shortage of proposals from tax study commissions. Some states, such as California, have even had more than one study commission in a decade's time. Commissions that have examined the state's corporate tax structure have usually focused on who should pay, how the tax should be computed and how to have a system that collects from businesses but does not deter businesses from the state. (For more on state tax studies, see Moving State Tax Systems Into the 21st Century.)

This article explains a proposal recently offered by a California commission that would apply a net receipts tax to all forms of businesses. Given the interest states have in reforming their corporate taxes, the proposal is likely to catch the attention of other states as well, even if only for the purpose of identifying strengths and weaknesses of any new approach to business taxation. All businesses should know the basics of the proposed new tax since they could easily be subject to it (if enacted) if they have sales, property or an employee in California.

BNRT Basics

The California Commission on the 21st Century Economy (Commission) was formed in October 2008 by Governor Arnold Schwarzenegger (R-CA) to recommend law changes that would reflect the 21st century economy, produce stable revenues, improve business competitiveness, promote economic prosperity and be efficient, simple and fair (Executive
Order S-03-09

After eight months of hearings, the bi-partisan Commission issued a report endorsed by nine of the 14 commissioners. A proposal for a business net receipts tax (BNRT) was one of six proposals. The proposed BNRT would replace the corporate income tax, the state level sales tax and some of the revenues lost from a proposed reduction in the top personal income tax rates.

The BNRT is a form of subtraction method value-added tax (VAT) that would apply to all business forms including sole proprietorships, partnerships and corporations. The Commission's rationale for this tax is that its broad base allows for a low, more competitive tax rate. They also note that the BNRT allows for taxation of some business activity that currently is not taxed by the state's sales tax such as services and sales to California customers by businesses with no physical presence in the state. The Commission also describes the BNRT as capable of producing a more stable revenue base. (Report (PDF), p. A-4.)

The base of the BNRT is gross receipts less purchases from other firms (that is, "net receipts"). Gross receipts would exclude most financial transactions such as interest and dividends. Purchases include raw material, inventory purchased for resale, rent, royalties and services purchased from nonemployees. Depreciable assets would be expensed in the year placed in service so depreciation would not be required. Gross receipts would include the proceeds from the sale of depreciable assets and the gain from the sale of non-depreciable assets. If purchases exceed gross receipts, the "net excess purchase" can be carried forward five years.

Gross receipts are not reduced for employee wages, benefits and payroll taxes. The rationale is that under a VAT, employee labor is the "value" a firm adds to the goods and services it acquired from other businesses.

The Commission recommended a maximum BNRT rate of four percent, an R&D credit, an exemption for businesses with less than $500,000 of gross receipts and a credit exemption system for businesses with net receipts of $250,000 or less.

An economic presence approach would be used to determine if an entity is doing business in the state (and therefore potentially subject to the BNRT). Such presence would exist if any of the following conditions are met:

  1. Organized or commercially domiciled in the state.
  2. Sales in the state exceed the lesser of $500,000 or 25 percent of total sales.
  3. Real and tangible personal property in the state exceed the lesser of $50,000 or 25 percent of the total of such property.
  4. Compensation paid in the state exceeds the lesser of $50,000 or 25 percent of total compensation.

Multistate businesses would file based on the unitary method with net receipts apportioned to the state using only a sales factor. Sales would generally be sourced to the market state.


Taxes with a broad base and low rate tend to be viewed as more fair and efficient. This fact though, is likely to be lost in promoting the BNRT due to its weaknesses relative to the corporate income tax and sales tax that it is designed to replace and confusion between a value-added tax (VAT) and other tax forms.

A VAT, such as the BNRT, is a consumption tax rather than an income tax. The subtraction method VAT is similar in concept to the more widely used credit-invoice VAT and the sales tax. Without special rates or exemptions, all three forms of consumption tax should raise the same amount of revenue. (For more on the VAT, see Nellen, Consumption Tax Information and AICPA, Tax Reform Alternatives for the 21st Century (PDF), October 2009.)

The subtraction method VAT formula looks a lot like that of an income tax except that assets are expensed rather than depreciated and there is no deduction for wages and related costs. The missing wage deduction will lead to complaints that the BNRT is a tax on wages. While an economic analysis can show that this is similar to a sales tax that only applies to the final consumer, it will be a tough sell. Any effort to address this concern, such as by allowing an R&D credit (which is primarily based on wages) or a deduction for employer-provided health care, will partly defeat the effort to have a consumption tax.

Also, while a subtraction method VAT and sales tax can raise the same amount of revenue, the incidence of this type of VAT (who pays) is hidden while it is clear who pays a sales tax separately listed on a customer's invoice. While the BNRT is intended to reach sellers, as well as services and intangibles not currently reached by California's sales tax today, it will not have the same effect. One reason is that the BNRT might not get passed along to the customer as easily as a sales tax. Also, for multistate businesses, an apportionment process is needed (because it is a net receipts tax rather than a gross receipts tax). Thus, an apportioned amount of net receipts is taxed in the state rather than the actual sales that occurred there as would be the case with a sales tax. In addition, the small business exemption means that no BNRT is owed by some businesses that today collect sales tax from customers.

The BNRT is better than a gross receipts tax because allowing purchases from other firms to be subtracted from gross receipts in computing the tax base eliminates the tax pyramiding of a gross receipts tax.

Nexus challenges would likely arise for the BNRT. A sales tax requires a physical presence in order for a vendor to have nexus. The Commission proposed an economic nexus standard for the BNRT, similar to what Ohio uses for its Commercial Activity Tax (CAT), which is a gross receipts tax.

Issues that exist with the corporate income tax, such as determining which entities are unitary, will continue with the BNRT. New planning techniques would arise. The small business exemption may encourage some businesses to avoid being unitary. The BNRT tax base will encourage businesses to use contractors rather than employees where possible.

It is uncertain whether a combination of economic presence nexus standard and sales factor apportionment for the BNRT along with a local-level sales tax which businesses can avoid by not having a physical presence in the state will provide any benefits to a state in terms of businesses wanting to locate there.

Looking Forward

The above narrative is a brief summary of the BNRT. The Commission provided over 100 pages of legislative language for the BNRT in addition to a brief summary (Report (PDF), Appendix I). While most of the reaction to the Commission's report from business, labor and others has been unfavorable, the proposal might shed light on other possible reforms. As states continue to study possible improvements to their tax systems, we'll see if any state pursues a new form, such as the BNRT.

Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Annette Nellen, CPA/Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.