[Editor's note: This article is Part 1 of an overview of various tax issues. The full article appears on the MBA web siteclick here. The rest of the article will appear in the April 2002 Lawyers Journal.]
As states search for new streams of revenue, collection and assessment of various tax types has increased. State collections increased by 67 percent from 1990 to 1999 and have tripled since 1980.1 While preliminary figures indicate that state tax revenues have decreased in recent years2, anecdotal evidence would suggest that this is a result of the recent economic downturn rather than a concerted effort by the states. As state tax collection efforts grow, the business lawyer must continue to be aware of the state tax consequences of a client's business.
This article attempts to make the general practitioner aware of some basic state tax theories and alert the practitioner to traps.
Multistate corporate income tax principles
In order for a state to impose a corporate income or franchise tax on a specific taxpayer, the taxpayer must have at least a minimum level of contact (nexus) with the taxing jurisdiction. A state has the jurisdiction to impose a tax on any business that is incorporated in that state. However, in order to impose a tax on a foreign (out-of-state) corporation, a state is bound by constitutional limitations and both federal and state law.
The constitutional limitations derive from both the Due Process Clause and Commerce Clause. The Due Process Clause has been interpreted to require that a taxpayer have nexus with the state before a state can impose a tax. The question is "whether the state has given anything for which it can ask return."3 The Supreme Court has held that the Due Process Clause requires that there be a minimal connection between the interstate activities and the state imposing the tax, and a rational relationship between the income attributed to the state and the interstate values of the business.4 This minimal connection typically has required some sort of physical presence, recently, however, states have been asserting nexus where there has been economic presence and intangible property within the state.5 A Massachusetts Department of Revenue Directive provides examples of situations where the state will assert economic nexus.6
The Commerce Clause may contain a more stringent standard and place a higher burden on a taxing jurisdiction than does the Due Process Clause. The Commerce Clause has been interpreted to include a requirement of substantial nexus.7 The Commerce Clause prevents a state from levying a tax that imposes an undue burden on interstate commerce.8 In a sales tax case, the constitutional principles of which might apply to any tax concerning interstate commerce, the Supreme Court held that some minimal physical presence was required in a state.9 However, there is no similar precedent at the Supreme Court level for an income tax case, so the possibility remains that the state could assert jurisdiction over a taxpayer even in the absence of physical presence.10
In addition to the limitations proscribed by constitutional principles, taxing authorities are limited by state statutes. However, most states' statutes empower the taxing authority to impose a filing obligation to the fullest extent allowed by the Constitution. State statutes typically require a corporation merely to be "doing business" or earning income from sources in the state. Accordingly, state statutes generally impose no additional restrictions beyond those of the Due Process Clause and Commerce Clause. In certain instances, a state's statute may be more restrictive than the limitations imposed by the Constitution. As such, both state statutes and the constitutional limitations should be considered when determining if a state has the authority to assert a filing obligation on a taxpayer.
In 1959, Congress enacted Public Law 86-272.11 The Public Law provides protection for companies doing business in-state, beyond the statutory and due process protection. Specifically, Public Law 86-272 provides that a state may not impose "a net income tax" on a taxpayer "if the only business activities with such State" are limited to "the solicitation of … sales of tangible personal property, which orders are sent outside of the state for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the state."12
In sum, the Public Law limits state taxation of (1) taxes based on or measured by net income by taxpayers (2) engaged in the solicitation of (3) sales of (4) tangible personal property. The key facets of the Public Law relate to:
1. determining if a tax is based on or measured by net income,
2. the definition of solicitation,
3. the distinction between a sale and a service, and
4. the distinction between tangible personal property and property other than tangible personal property.
While most states impose a corporate tax based on or measured by net income, some states impose a corporate level tax that is outside the reach of P.L. 86-272.13
The term "solicitation" is not defined in P.L. 86-272. Accordingly, historically each state applied its own interpretation of the term. The Supreme Court finally addressed the issue in Wrigley Co. v. Wisconsin Department of Revenue, 1992 U.S. Lexis 3694 (June 19, 1992). The court expanded the definition to include any activities that are ancillary to making a sale. The court distinguished such activities from those in which the corporation would engage even if it had no sales force in the taxing state.
The court defined the term "solicitation of orders" as any explicit verbal requests for orders and any speech or conduct that implicitly invites an order. However, while the court addressed the definition of solicitation, it did not give specific examples of the types of activities that would be protected.14
For purposes of Public Law 86-272, "the term net income tax means any tax imposed on, or measured by, net income."15
The Multistate Tax Commission (MTC) has published guidelines listing activities that constitute solicitation of sales - protected activities, and activities that go beyond mere solicitation - unprotected activities.
In summary, in order for a taxpayer to fall within the protection of Public Law 86-272, the tax in question must be measured by net income, and the taxpayer's activities must be limited to the solicitation of sales (not services) of tangible personal property. The protection of the Public Law extends only to taxes imposed on or measured by net income.
Allocation and apportionment
A taxpayer that has nexus with more than one state must determine the portion of net income that will get taxed by each state.16 In order to do this a taxpayer will apportion its business income17 according to formulae in each state. Most states employ a three-factor formula is trying to approximate their fair share of a taxpayer's income. The three-factor is based on some combination of: (1) a sales factor, (2) a property factor, and (3) a payroll factor. However, states have divergent treatments of these factors. More than half of the states (including Massachusetts, for non-manufacturers) now have statues that double-weight the sales factor.18 Some states (including Massachusetts, for manufacturers only) adopt a single-sales factor apportionment formula.19 As a result of this divergent treatment, a taxpayer likely will be taxed on more or less than 100 percent of its net income for state income tax purposes.
The property factor is a fraction: the numerator is the average value of the corporation's real and tangible personal property, owned or rented, and used in the state during the taxable year; the denominator is the average value of all of the corporation's real and tangible property, owned or rented, and used during the taxable year - wherever it is located.
Property owned by the corporation is typically valued at its average original or historical cost plus the cost of additions and improvements, but without adjusting for depreciation. Some states, however, allow the property to be included at its net book value for federal adjusted tax basis.
Leased property, when included in the property factor, is usually valued at eight times its annual rental less any subrentals.
See next month's issue for part 2 of this article.