The reality of the recession has affected the tax policies of nearly every state, as dwindling receipts coupled with constant or increased expenses have left most states in a budgetary crisis mode.
"It's the perfect storm of budgetary problems," said Frank Gallo, a tax partner at the law firm of Reed Smith. "Companies are making less money, so they're paying less tax. Federal stimulus dollars were a big one-time hit, but they're coming to an end and they just won't be there in the future. Costs to the states are going up or at least staying the same."
"Most states are facing budget constraints," agreed Michael Moore, managing director at the Kansas City, Mo., office of cbiz MHM. "Federal funding and reimbursement for the states has been bottlenecked in Congress, and states are struggling to fill budget gaps. Some are using debt, others are slashing additional expenses, and others are raising taxes."
"Many states are raising taxes across the board - property, sales, income and excise," he said, adding that he expects that more tax increases are on the way. "Tax increases will continue, because I don't think we will pull out of the recession rapidly. Technology has enabled states to be better and more efficient at auditing. For example, they can compare registrations for different taxes, and make sure that companies that are registered for one tax, such as payroll, are registered for all taxes as well. Historically states have not been able to compare information, but they're getting better at doing it."
"We're seeing more enforcement becoming more aggressive and more issue-focused," added Gallo. "Authorities are looking at transfer pricing, or pass-through entities, and picking out issues where they can make up revenue and issue assessments. This is a trend now among states as they try to accelerate revenue."
A record number of states have reacted to budget shortfalls by instituting amnesty programs, said Gallo. "These programs have been successful in bringing in a lot of revenue, but it's a one-time hit; you can't rely on it year after year."
"Moreover, a lot of amnesty programs have a penalty written in that if you do not participate and you were eligible, the state might impose two times the interest and two times the penalty for your non-participation," he explained. "If you do not know about your liability and three years from now you get audited, is it fair to impose the penalty for not being omniscient?"
"[The states] enjoy a big revenue boost each time they offer an amnesty program," said Mike Solomon, partner-in-charge of the Tax Department at the Philadelphia office of EisnerAmper LLP.
Solomon said that thus far, Philadelphia, which had an overlapping amnesty program with Pennsylvania, collected approximately $40 million as a result of their recent offering. "But possibly a more important benefit is getting people who previously were not reporting at all to start filing and paying tax and continuing into the future. In effect it creates an annuity for the taxing authorities, since once a business or individual starts filing, the likelihood is high that they will continue."
Philadelphia last offered an amnesty program in 1986. "At the outset, they made it clear that if you participated in 1986 you were disqualified from participating in this year's amnesty," said Solomon. "Even though there was little likelihood that they could match the records going back that far, they wanted to make it clear that they are not offering this every three or four years, and that it's a one-time forgiveness."
Tax amnesty programs should not be confused with voluntary disclosure programs, Solomon cautioned. "States and cities maintain voluntary disclosure programs all the time," he said. "Philadelphia kept its voluntary disclosure program alive during its amnesty program, but Pennsylvania suspended its program."
"In exchange for coming forward under the voluntary disclosure program, you're only assessed for the prior six years," he explained. "Under a typical amnesty program, there is no limitation on the number of years you would have to pay. But you're charged 100 percent of the interest under a voluntary disclosure program, whereas under amnesty you're only charged half of the interest. If you owe a lot of years in taxes, the 50 percent discount is insignificant to being excused for all prior years, so it's important to consider each taxpayer's particular situation."
BRINGING IN THE MOST REVENUE
Businesses with a number of subsidiaries are required by some states to file either a combined return for all the entities, or a separate return for each entity, explained Dan Shibley, a senior analyst at CCH: "This has resulted in litigation and legislation in a number of states."
The difference in filing methods can amount to several million dollars, said Geoff Christian, managing partner at Dow Lohnes Price Tax Consulting Group LLC, who said that states will likely assert the method that will bring in the most revenue.
In South Carolina, a company would file on a separate reporting basis. In a South Carolina Supreme Court case, a company wanted to file on a combined basis and the court allowed it.
In North Carolina, the legislature passed a law that allows the Secretary of Revenue to compel a company to file on a combined basis, even though the usual way to file in the state would normally be a separate filing for each entity.
In the South Carolina case, the ruling overturned the long-standing policy of the South Carolina Department of Revenue to not allow the combination of separate entities in computing tax liabilities. "In this case, the operations of the taxpayers' various subsidiaries were integrated to such an extent that the state's normal method of separate entity taxation significantly distorted the determination of tax liability," Christian explained.
The sourcing of income services is a continuing issue for states, Shibley noted. "The traditional rule is that the state where the service provider is located gets to tax the entity, but states are increasingly dissatisfied with that result," he said. "California has passed a law so that, beginning in 2011, if the benefit of a service is received in California, then the income is sourced to California."
A MORE AGGRESSIVE NEXUS
The economic substance doctrine, codified on the federal level in the recent Health Care Act, may become an issue for states, Shibley opined. "The states have had many different standards in this area, so practitioners are watching to see if the states all follow the federal standard." The economic substance doctrine is commonly used to deny tax benefits from a transaction that does not change a taxpayer's economic position, other than a reduction in tax.
States are looking for new revenue without having to raise taxes, explained George Farrah, executive editor at BNA. "One way to do this is by asserting nexus in a more aggressive manner," he said.
Nexus is the minimum amount of contact between a taxpayer and a state that permits taxation by the state. Each year, BNA surveys state tax departments to spot changes and trends in their individual policy stances. This year's survey found that after a company has income tax nexus, 30 states said that they impose tax for the entire year. All but five states said that an employee who telecommutes from a home located within their borders would create income tax nexus for the out-of-state employer.
Despite tight budgets, most state tax incentive programs for promoting energy efficiency have survived, according to Steve Heusinger, chief executive and managing principal of Ryan Tax Credit Services. "Some of these are tradable credits, so if you have a state tax credit but no state tax liability, you can sell the credit to someone who can use it," he noted.
There are over 1,200 separate state and local initiatives, including corporate, sales and property tax savings, as well as rebates and loans, Heusinger pointed out. "We're seeing an explosive growth in participation," he said. "In addition to the federal government's $2.3 billion of new incentives, many states are using federal stimulus money to fund their own programs."
One state with a rare balanced budget is Ohio, which has implemented a sweeping package of business tax reforms over the last few years.
"We repealed our two largest business taxes," said Ohio Tax Commissioner Richard Levin. "The state tax on corporate profits is gone, and we also repealed the personal property tax on machinery and inventories. At the same time, we reduced the state personal income tax."
In its place, Ohio phased in a commercial activities tax over a five-year period. "The CAT is just what you want in a tax," said Levin. "It's at a very low rate but broadly based, with no loopholes or exemptions. People are amazed that the tax is just one quarter of 1 percent on gross receipts from business activities in the state."
The state's low corporate tax structure was a bipartisan reform, and was designed to stimulate entrepreneurial activity, according to Levin. As a result, small businesses pay no corporate income tax, a flat $150 fee on the first $1 million in gross receipts, and no tax on out-of-state transactions.
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