State Taxes When Making Business Decisions
Haroldene F. Wunder
MARCH 2008 -
State business tax systems are in constant flux, as states compete
with one another in attracting businesses to stimulate economic
development and employment. Their fluid nature, however, complicates
long-range business tax planning and decisions. To make informed
decisions, businesses need to know the current condition of state
business tax systems—that is, which features are relatively
static and which are the subject of recent, current, or future legislation.
strongly indicates that state tax systems are relevant to businesses
decisions, including location. Examples of companies selecting
states due to favorable tax systems are plentiful. In 2005, Intel
built a multi-billion-dollar chip-making facility in Arizona due
to its favorable corporate income tax system. In contrast, high-tax-rate
California struggles to retain businesses attracted to neighboring
Nevada, a low-tax-rate alternative.
contributing to the constant state of flux is that states try
to enact legislation that will improve their competitive positions.
For example, Michigan repealed its Single Business Tax (SBT),
effective January 1, 2008, because of its punitive effect on corporations.
In her announcement of the new Michigan Business Tax (MBT) to
replace the SBT, Michigan Governor Jennifer Granholm acknowledged
that making Michigan’s business climate more competitive
was central to her economic plan. Granholm was careful to stress
that each component of the new MBT’s tax base is used by
a number of other states.
changing climate, trends in state business tax systems are emerging.
For example, the state corporate income tax continues to decline
as a component of state tax systems, as states increasingly enact
gross receipts taxes to replace or complement corporate income
taxes as a revenue source. Another clear and rapidly developing
trend is away from three-factor apportionment formulas and toward
sales as the single apportionment factor.
should keep informed about current trends in state business tax
systems. The authors compiled information about the following
aspects of the business tax systems of the 50 states and Washington,
income tax rates;
and use tax;
alternative minimum tax (AMT);
of S corporations and limited liability companies;
- Tax credits
(investment credit, R&D credit, jobs credit); and
of the Multistate Tax Compact Uniform Division of Income for
Tax Purposes Act (UDITPA).
of Taxes and Tax Rates
The Tax Foundation
(a nonpartisan tax research group based in Washington, D.C.; www.taxfoundation.org)
has concluded that states which raise sufficient revenue without
one of the major taxes (i.e., corporate, individual, or sales
tax) will, ceteris paribus, “out-compete those
states that levy every tax in the state tax collector’s
arsenal” (Background Paper No. 52, 2006). States
appear to be marching in the opposite direction, however, as they
no longer restrict their business tax provisions to corporate
income, franchise, and sales taxes.
1 and Exhibit
2 provide comparative information about state corporate income
tax rates and the existence of a gross receipts tax, sales and
use tax, and corporate AMT, respectively. The data in Exhibit
1 show that, of the 46 jurisdictions that levy a corporate income
tax, 31 levy a flat rate. The 30 states with flat corporate income
tax rates are in the mainstream not only in terms of numbers,
but also when compared to international trends.
replacement of Michigan’s SBT with the MBT, which taxes
business income at 1.875%, rates on income now range from this
low to Pennsylvania’s 9.99% high. The 1.875% Michigan rate
does not take into account the tax imposed on the other two components
of the MBT (0.125% for gross receipts, and 0.125% for business
A KPMG report
(KPMG’s Corporate Tax Rate Survey: An International
Analysis of Corporate Tax Rates from 1993 to 2006; www.kpmg.com)
describes the incentive effect that relatively low corporate income
tax rates have on business decisions. It concluded that as transport,
communication, and trading links improve across jurisdictions,
corporations are finding it progressively easier to site their
operations wherever they can find the best combination of resources,
skills, finance, security, and the effective rule of law. Under
those circumstances: 1) taxes effectively become a price that
corporations must pay to make use of the goods and services that
a jurisdiction can provide, and 2) like any astute consumer, corporations
are shopping around “for the best combination of price and
value.” This phenomenon is particularly applicable to interstate
analyses, because the Department of Labor has concluded that the
majority of mass business relocations are from one U. S. state
to another, rather than to a foreign location (www.bls.gov/news.release/mslo.nr0.htm).
compares jurisdictions with regard to gross receipts tax, sales
and use tax, and corporate AMT. Only three states levy neither
gross receipts, sales and use, nor corporate AMT: Montana, New
Hampshire, and Oregon.
A gross receipts
tax is becoming increasingly common. Its proponents praise the
steadier flow of tax receipts into government coffers, compared
with the fluctuating revenues generated by corporate income taxes.
The gross receipts tax appears to be roughly as stable as a retail
sales tax (see John L. Mikesell, Gross Receipts Taxes in State
Government Finances: A Review of Their History and Performance,
Washington, D.C., Council on State Taxation, 2007).
Ohio enacted the Commercial Activities Tax (CAT), which applies
a 0.26% rate (when fully phased in) to gross receipts in excess
of $1 million. Washington State’s Business and Occupation
(B&O) Tax applies a multi-rate schedule to gross receipts
of Washington businesses. Kentucky, New Jersey, and Texas have
also enacted gross receipts taxes, although New Jersey’s
Alternative Minimum Assessment was phased out July 1, 2006. Kentucky’s
gross receipts tax is an alternative tax; businesses pay either
the corporate income tax or the gross receipts tax, but not both.
As noted previously, Michigan replaced its SBT with the MBT, the
base for which consists of three components: gross receipts, assets,
and income (profits).
of differential sales tax rates is often apparent when crossing
the border from a high-tax state to a low-tax state; a “vast
expanse of shopping malls has sprung up along the border in the
low-tax jurisdiction” (Tax Foundation, Background Paper
No. 52, 2006). Such a phenomenon occurs on both coasts. For example,
Oregon, Arizona, and Nevada—whose sales tax rates are zero,
5.6%, and 6.5%, respectively—poach commercial activity from
California, whose base 7.25% sales tax rate can reach a maximum
rate of 8.75% in certain counties (e.g., Alameda County). On the
East Coast, Delaware—with no sales tax—attracts businesses
and shoppers from across the mid-Atlantic region, and its relative
advantage increases whenever a neighboring state raises its sales
tax rate (Tax Foundation, Background Paper No. 52, 2006).
jurisdictions impose sales and use taxes (Exhibit 2), taxes that
raise so much revenue that states cannot afford to repeal them
without enacting new or expanding existing taxes. Even Wyoming,
which the Tax Foundation concluded had the best business climate
in 2007, levies a 4% sales tax.
shows that AMTs have no redeeming features. An AMT does not improve
fairness in any significant way; it nets insignificant amounts
of revenue for state governments; its compliance costs in some
years are larger than collections; and it encourages businesses
to reduce or shift their investments.
currently levy some form of AMT (Alaska, California, Connecticut,
Florida, Iowa, Maine, Minnesota, and New York). Kentucky recently
replaced its AMT with a limited liability entity (LLE) tax levied
on corporations for taxable years beginning on or after January
1, 2007; the LLE tax incorporates the former $175 AMT. Connecticut
levies a flat $250 AMT. The remaining seven states with AMTs apply
rates ranging from 2.5% (New York) to 18% (Alaska) on some measure
of AMT income. Although Virginia does not impose a broad-based
AMT, its telecommunications companies pay a minimum tax at the
rate of 0.5% of gross receipts if the 6% income tax is less than
of S Corporations and LLCs
of pass-through business entities enables multistate business
entities to legally shift income from the state in which it was
earned to one with a lower rate, or to a state that does not impose
tax on income derived from intangible assets (ownership of an
LLC qualifies as an intangible asset).
majority of states treat S corporations as exempt, although three
states (Arkansas, New Jersey, and New York) also require a separate
S-corporation election in addition to the federal election. Only
nine jurisdictions (California, Kentucky, Louisiana, Michigan,
New Hampshire, New Jersey, Tennessee, Vermont, and the District
of Columbia) treat S corporations as taxable entities. California
S corporations pay a franchise tax of 1.5% of net income (minimum
$800). Effective January 1, 2007, Kentucky S and C corporations
are subject to the Limited Liability Entity (LLE) tax. Louisiana,
Michigan, Texas, and the District of Columbia tax S corporations
in the same manner as other corporations. New Hampshire S corporations
are required to pay a business profits tax. Vermont S corporations
are liable for income taxes imposed on nonresident shareholders.
All of the statutes that recognize S corporations contain restrictions
or conditions so that an exempt S corporation may be subject to
tax under specific circumstances (e.g., certain capital gains).
data show that the advent and growth of LLCs have been one important
cause of the decline of state corporate tax revenues (William
F. Fox and Leann Luna, “Do Limited Liability Companies Explain
Declining State Corporate Tax Revenues?,” Public Finance
Review, 33(6), 690–720, 2005). In some respects, the
treatment of LLCs is identical across jurisdictions. All have
enacted LLC-enabling legislation; permit both domestic (formed
in-state) and foreign (formed out-of-state) LLCs; and either follow
the federal income tax treatment of LLCs or have enacted state
statutes explicitly describing when LLCs are treated as partnerships.
(A minor exception is Tennessee, which subjects LLCs to a Tennessee
franchise/excise tax unless specific exemption exists.)
across jurisdictions with respect to LLCs is largely illusory,
as state-specific features matter significantly. The following
are the top 10 states, ranked by the number of LLCs created, in
- New York:
- New Jersey:
In just those
10 states, 678,376 new LLCs were created in 2006 (International
Association of Commercial Administrators; www.iaca.org).
experience is instructive in demonstrating the significance of
state-specific conditions. Three factors contributed to the large
number of LLCs created in Florida. First, during its 2006 boom
in real estate, investors created separate LLCs for each of their
properties. Second, Florida permits foreign individuals to own
an LLC interest; they cannot be S corporation owners. Third, LLCs
have been used as a vehicle to avoid certain Florida taxes, such
as the documentary stamp tax, which is imposed at the rate of
$0.70 per $100 of selling price when transferring real property.
Instead of selling real property, businesses put the property
into an LLC and then sell their interest in the LLC. Since no
deed is transferred, the documentary stamp tax is not assessed
(Michael Sasso, “Florida Leads the Way in Limited Liability
Companies,” Tampa Tribune, May 8, 2007).
3 compares the 51 jurisdictions with regard to jobs credit,
R&D tax credit, and investment tax credit. The data show that
the three business tax credits are widely represented in state
A jobs credit,
R&D tax credit, and investment credit are offered by 41, 39,
and 41 states, respectively. Twenty-eight states offer all three
tax credits; California and Oregon offer only the R&D credit;
and Washington, D. C., offers only a jobs credit. (For more detail
on state R&D credits, see B. Anthony Billings, “States’
Tax Credits for Company-Financed Research: A Current Comparison,”
The CPA Journal, February 2007). Interestingly, 41 states
offer an investment tax credit, even though the federal government
does not currently offer an investment tax credit for capital
expenditures. The increasing popularity and generosity of state
investment tax credits has been attributed to competitive pressures;
states enact the credits at approximately the same time as their
neighboring states (Robert S. Chirinko and Daniel J. Wilson, “State
Investment Tax Incentives: What Are the Facts?,” Federal
Reserve Bank of San Francisco Working Paper No. 2006-49,
available at ssrn.com/abstract=1007816).
the three tax credits are well represented in state tax systems,
by no means are their provisions identical. California’s
experience provides a relevant example. Although the California
statute contains only one of the three credits (R&D), California
has been aggressive in its attempt to use tax credits to support
particular industries. Recently a separate tax credit package
bill to benefit motion picture studios, biotech companies, and
other high-tech firms was approved by a vote of 51–19; however,
it was not joined to the recent budget provisions.
State-specific nomenclature often masks the nature of tax provisions.
One feature of the Michigan Business Tax (MBT) is the new Michigan
Economic Growth Authority (MEGA) credit. The new tax credit will
be available to an established Michigan business to help fund
R&D innovation and development at a partnering Michigan small
business. The credit is capped at $500,000. The MBT continues
the existing MEGA compensation (i.e., jobs) credit.
of the Uniform Division of Income for Tax Purposes Act (UDITPA)
is touted as facilitating multistate enterprises’ doing
business in and relocating to adopting states. Exhibit
4 compares the 51 jurisdictions with regard to their adoption
of UDITPA, which brings some degree of apportionment and allocation
Only 20 states
have adopted UDITPA, either formally or informally. The relatively
small number of adoptions is not particularly significant, however,
because states are free to model their apportionment formulas
after UDITPA without adopting the act itself. For example, although
Illinois has not formally adopted UDITPA, it considers itself
a “UDITPA state” because its provisions are consistent
with the act (Illinois Department of Revenue spokesperson). Businesses
must obtain information from the states themselves in order to
understand the nuances of specific state statutes as compared
to UDITPA. The online information of the Federation of Tax Administrators
(www.taxadmin.org) is a good starting point; however, it does
not distinguish the states from one another except at a rather
majority of apportionment formulas described in Exhibit 4 are
either the traditional three-factor formula (sales, property,
and payroll, equally weighted), double-weighted sales, or sales
only. The states that deviate from this generally employ some
other paradigm to weight sales disproportionately; for example,
Pennsylvania triple-weights sales.
significant finding to take away from the apportionment data is
the trend toward sales-only apportionment. In 2005, only three
states (Illinois, Iowa, and Nebraska) apportioned using only sales.
By 2007, six states use only sales (Illinois, Iowa, Kentucky,
Nebraska, Oregon, and Texas), and Michigan’s new MBT changes
the apportionment formula to the single sales factor. Michigan’s
rationale for the change in apportionment is to prevent business’
tax base from increasing when jobs or investment are added in
Michigan; that is, to make the state a more attractive location
for out-of-state businesses.
pursues a similar course of action. California Governor Arnold
Schwarzenegger’s campaign pledge to bring more businesses
into the state was followed by two unsuccessful efforts to change
California’s apportionment formula from three-factor (with
sales double-weighted) to sales-only. A similar bill is again
pending in the state legislature.
five more states are phasing in sales-only apportionment (Georgia,
Indiana, Minnesota, New York, and Wisconsin). Arizona and Ohio
use three factors, but weight sales 60%; Arizona will increase
the sales weight to 70% in 2008. Pennsylvania uses three factors
but uniquely triple-weights the sales factor. A total of 35 states
weight sales disproportionately.
tax systems are in a state of flux as states scurry to enact provisions
to compete with other states to attract business. Business should
be aware of which elements of state business tax systems are relatively
static and which are the subject of recent, current, or expected
legislative activity. Minding the tax effects of business location
decisions is an integral part of a business strategy.
F. Wunder, MAcc, PhD, CPA (inactive), is a professor of
taxation at California State University Sacramento.