Tax in the Bluegrass
Managing state tax challenges facing businesses
Issue 1
February 5, 2021
By Mark A. Loyd, JD, CPA
Most states experienced sharp revenue drops in 2020, according to the Center on Budget and Policy Priorities, States Grappling With Hit to Tax Collections (November 6, 2020), although there are exceptions like Kentucky. Logically, this means that states will be looking for revenue. The bulk of state revenues from businesses, according to Total State and Local Business Taxes (October 2020), which is published by EY, STRI and COST comes from:
- property taxes on business property (37.9 percent),
- general sales taxes on business inputs (21.3 percent),
- corporate income tax (9.3 percent) and
- individual income taxes on business income (6.5 percent).
While the sources of revenue from businesses may not surprise you (property tax, sales tax and income tax), the ranking may come as a surprise, especially since most people and businesses seem to tend to focus on how much they are paying in state income taxes.
Property taxes
When was the last time you took a hard look at the real property tax bill for each of your business properties? What about your tangible personal property tax bills?
State and local real property ad valorem taxes are assessed on non-exempt real property and tangible personal property at a percentage tax rate on each property’s fair market value. Tax rates can vary as to the type of property. So, managing property taxes entails taking advantage of available exemptions, ensuring that the rate is correct, and ensuring that property is taxed at no more than its fair market value.
Property tax exemptions are often for charitable, religious organizations, and educational organizations. Businesses may take advantage of full or partial exemptions or lower tax rates for manufacturing machinery and equipment, pollution control equipment, property in Foreign Trade Zones and inventory; this is not an exhaustive list. The tax base is fair market value. To evaluate the tax assessment property value, a property owner may ask themselves, would I sell my property for that amount?
The opportunities for a business to manage its property taxes are often constrained by annual statutory deadlines for filing tangible personal property tax returns and disputing real property taxes. Importantly, in many states, if a taxpayer does not dispute the assessment value before the statutory deadline, the assessment value is set. By the time a taxpayer gets their property tax bill, it may be too late. Businesses have to be proactive in managing their property tax bills.
Sales and use taxes
Managing a business’s sales and use taxes is more challenging than ever. The United States Supreme Court’s decision in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080; 201 L. Ed. 2d 403 (2018) eliminated the physical presence safe harbor for sales taxes. Post-Wayfair, most states have adopted a sales tax economic nexus standard similar to that of South Dakota, i.e., $100,000 in sales or 200 transactions in a year. As a result, the default for sales tax nexus has shifted. On the sales tax side, a business often has nexus in the states in which its customers are located so that businesses often have to collect sales tax in most states. Conversely, on the use tax side, a business’s out-of-state suppliers often now have nexus in the state in which that business is receiving goods from its suppliers so that they are charging sales tax on the business’s purchases.
What do the states’ responses to Wayfair mean in terms of managing a business’s sales and use tax? It means much more complexity for most businesses in terms of sales taxes that they must collect and in terms of use taxes that they may have to pay. Why? The biggest drivers of complexity here are additional state sales tax return filing obligations and compliance with documentation requirements for additional states for exempt sales and purchases. Instead of being required to file in a handful of states, a business may be required to file in almost every state with a sales tax. Also, instead of collecting and maintaining resale and other exemption certificates from customers and providing the same to suppliers in a handful of states, even relatively small businesses may have to manage resale and exemption certificates in almost every state with a sales tax.
A business also needs to manage its own sales and use tax liability on its purchases. This is done by ensuring that the appropriate tax is paid on taxable purchases and that tax is not paid on exempt purchases.
There are myriad sales tax exemptions. For businesses, some apply based on the type of transaction, e.g., for purchase for resale, the occasional sale, etc. Others apply based on the type of property, e.g., manufacturing materials, supplies, and industrial tools, manufacturing machinery, certain farming equipment and supplies, etc. There are also sales tax exemptions that are specific to particular types of businesses, such as railroad supplies.
Managing a business’s sales and use tax requires ensuring that sales taxes are collected and paid contemporaneously with each sale. A business does not want to be in the position of having under-collected sales tax so that it is left bearing the burden of under-collected sales tax on an audit. Conversely, a business does not want to overpay sales and use tax on its purchases so that is it paying more than what is owed. A business should ensure that tax is not paid on exempt purchases, either to the vendor or to the state.
State income taxes
A large business is often set up for income tax purposes as a C corporation so that the business is the taxpayer for income tax purposes. Most states have a corporate income tax; although some do not, like Nevada, Ohio, Texas and Washington, which have gross receipts taxes instead of income taxes, and South Dakota and Wyoming, which do not have a corporate income tax.
Most closely-held (often, but not necessarily “small”) businesses operate as pass-through entities, oftentimes, as limited liability companies taxed as partnerships or as LLCs or corporations taxed as S corporations. So, the income tax compliance burden often falls on the individual owners. Generally, individual owners are taxed on all of their income by their state of domicile (or residence) and receive a credit for taxes paid in other states which are based on business done in such states. Not all states impose individual income taxes on an individual’s business income; Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming do not.
Notably, Tennessee imposes taxes on pass-through entities as though they were corporations. Likewise, some states like Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin, have enacted entity-level taxes with a credit for each owner’s share of the entity-level tax paid. This makes a work-around available for the state and local deduction $10,000 cap for federal income taxes, which the Internal Revenue Service endorsed in IRS Notice 2020-75. Will other states follow? Or, will Congress repeal the $10,000 cap? Kentucky imposed an entity-level income tax on pass-through entities in 2005 and then promptly repealed it; some may remember that the Kentucky entity-level income tax on pass-through entities created issues for owners in other states with the creditability of the Kentucky income tax.
As with sales tax, income tax nexus is a big issue for businesses. State income tax nexus may be limited by Public Law 86-272, codified as 15 U.S.C. § 381 to 384, which precludes the imposition of income tax by the taxing state if the only business activity within the taxing state is the solicitation of orders for the sale of tangible personal property that are sent outside of the taxing state for approval or rejection, and if approved, are filled by shipment or delivery from a point outside the taxing state. Whether Public Law 86-272 applies to a particular business in a particular state requires a fact-intensive analysis.
The state income tax base of virtually every state with an income tax starts with federal taxable income, but decouples from the Internal Revenue Code of 1986, as amended, in some way. Two of the most commonly decoupled provisions are depreciation and net operating losses, but there are others.
The state income tax base is apportioned to each taxing state using an apportionment formula. The apportionment formula is a percentage applied to the tax base; the product of which is the income apportioned to the state; a percentage income tax rate is applied to the income apportioned to the state, which results in the business’s state income tax in that state. The most common apportionment formula is now the single sales factor; other states use a three-factor formula, comprised of a sales factor (often double-weighted or more), a property factor and a payroll factor. Differences in state apportionment formulas and their application to particular business operations and tax rates often drive a business’s state income tax effective rate.
States also use different reporting methods, which impact the computation of state income tax, including separate company reporting, unitary combined reporting, and consolidated reporting (often elective). States, particularly those that use separate reporting, often disallow certain related intangible and interest expenses. The application of reporting methods to particular business operations can also drive a business’s state income tax effective rate.
With most businesses, it is the business dog that wags the tax tail and not vice versa. Effective management of state income taxes requires ensuring that business operations drive the business and there is consideration to tax efficiency. Given this, state income taxes should be modeled in conjunction with business decisions, but so should property taxes and sales and use taxes.
State tax incentives and credits
State tax incentives should also factor into a business’s management of its property, sales and income taxes. Most states and localities offer economic development incentives and credits that can reduce a business’s tax burdens. It is pertinent to know what incentives and credits are available, especially when making major business decisions and investments.
“You know what I think? I think we’re both gonna make it - big. I am very optimistic. I mean it.” Lana in “Risky Business” (1983).
Managing state taxes is something that all businesses should do. They should pay what they owe, but not more than that. Efficient tax planning enables them to pay what they owe in taxes.
About the author: Mark A. Loyd, JD, CPA, is a partner of Dentons Bingham Greenebaum LLP in Louisville and chairs its Tax and Finance group. Loyd chairs the Society’s Editorial Board. He can be reached at mark.loyd@dentons.com; 502.587.3552.