While the Great Recession has been officially over for several years, state revenue collections haven't reflected the expected increase that they should have, according to the Nelson A. Rockefeller Institute of Government.
Total state tax collections, although growing during each quarter of the last four years, softened significantly in the third and fourth quarters of 2013. And in the first quarter of 2014, state income tax revenues have actually declined, according to the institute.
"The Rockefeller Institute's compilation of preliminary data from 46 states shows that collections from major tax sources increased by an insignificant 0.7 percent in nominal terms in the first quarter of 2014 compared to the same quarter of 2013," the institute reported in its April 2014 State Revenue Report. "This is the weakest growth since the first quarter of 2010. Among 46 early reporting states, 37 reported gains, while nine states reported declines in total tax revenue collections. Personal income tax collections declined in nominal terms by 0.4 percent. This is the first time since the first quarter of 2010 that states reported declines in income tax collections," it stated.
Among the issues in state taxation over the past year or more have been combined reporting, market-based sourcing, apportionment changes, unclaimed property and the mobile workforce, according to state tax authority Diane Yetter, CPA, founder of the Sales Tax Institute and president of Yetter Consulting. "Apportionment changes are aimed to get potentially more or higher apportionment percentages from out-of-state businesses. Now with market-based sourcing, and going to single-factor formulas, they're trying to benefit in-state companies and shift higher burdens to out-of-state companies."
A number of states are pursuing combined reporting, according to Tara Curran, managing director of Top 100 Firm CBIZ Tofias. "If there are means to shift some of the burden away from in-state entities to out-of state entities, that's one of the considerations."
Market-based sourcing is another "hot issue," according to Curran. "Perhaps we're no longer so much of an economy where the place where the service is provided matters, but rather the place where the benefit is received matters more, and that, in essence, is what the movement to market-based sourcing does."
Another area getting attention from the states is unclaimed property, observed Frank Czekay, a principal at Top 100 Firm ParenteBeard. "It's a hot area with the states because the legislation is already on the books -- it's a way to gain revenue without saying, 'We're increasing taxes.' They're going after items such as uncashed dividend checks, gift cards, etc. -- when they're unclaimed, the state takes possession and holds in perpetuity. It's a growing area of concern, in terms of companies getting audited, and also in the area of mergers and acquisitions since liability can transfer over to the acquirer."
"These are all revenue-increasing measures," said Peter Stathopoulos, lead partner in the state and local tax practice at Atlanta-based accounting firm Bennett Thrasher.
"Market-based sourcing is a developing issue," he said. "Back in the 1990s, most states had a majority cost of performance approach, which is the opposite of market-based sourcing. In an effort to keep Congress from getting involved, a number of states had adopted a model compact -- UDIPTA [Uniform Division of Income for Tax Purposes Act] -- designed to have uniformity in state apportionment schemes. Under UDIPTA, if you have anything other than tangible personal property, the way you source it is only apportioned to your state if the majority of the cost associated with the income-production activity occurs in your state. That's called the majority cost of performance test, and it's the opposite of market sourcing."
Under the majority cost of performance test, you ask what is the income-producing activity and where are most of the costs incurred in producing it, Stathopoulos explained. "The majority of states now have this cost of performance test. The net result is that it's not very good at capturing revenues, because for out-of-state taxpayers, their revenue is sourced back to their headquarters, instead of that particular state."
"Georgia has market sourcing," he said. "If anyone has gross receipts for intangibles, they'll source to where the customer is located. Very few adopted market sourcing, while most did performance sourcing. What ended up happening is it created a benefit for the market-sourcing states at the expense of the majority cost of performance states."
"For example, Bell South is headquartered in Georgia. They sell Yellow Page ads in Tennessee. It's not a product but is a service, so Tennessee, a UDIPTA state, sources gross receipts based on the majority cost of performance test. Therefore, Bell South files its Tennessee returns, and says we're selling ads in Tennessee but most of the costs are back in Atlanta, so Tennessee gets zero and Georgia gets everything. Then on its Georgia returns, it sources its receipts back to Tennessee, so the income went untaxed by either state. Tennessee got upset, and forced Bell South to use market sourcing. Bell South challenged, and the court upheld Tennessee's Department of Revenue's forced switch."
"Increasingly, the majority cost of performance states are dissatisfied," he explained, "so they're switching over to market sourcing more, either legislatively or by stealth as in Tennessee under the alternative apportionment provisions."
There's a trend among the states to adopt combined reporting, Stathopoulos suggested, because it nullifies state tax planning aimed at shifting income from a high-tax jurisdiction to a low-tax jurisdiction. "For years, taxpayers lowered their effective tax rates by having each of the subsidiaries in a group file a separate return, and with smart planning they would find a way to suck the income out of Subsidiary A with nexus in Tennessee and put it into Subsidiary B, which is located in a low-tax state. If a state adopts combined reporting, it requires the group to file one combined return that captures all the income of A and B, so intercompany planning goes away."
Meanwhile, the Supreme Court in May agreed to consider the Wynne case, which could have nationwide consequences for state governments. Maryland imposes a tax consisting of both a state portion and a county portion on the worldwide income of its residents. If the Maryland resident owes tax to other jurisdictions on the income, the Maryland tax code allows a credit for income tax paid with respect to the state income tax, but not the county tax. According to the Court of Appeals of Maryland, the failure to allow a credit with respect to the county income tax for taxes paid to other states on pass-through income earned in those states discriminates against interstate commerce and violates the Commerce Clause of the Constitution. Maryland appealed the case, and it will be argued at the fall term of the Supreme Court.
"For purposes of individual income taxes, most states allow a credit for income earned and taxed in other states," explained Steven Roll, managing editor of state tax at Bloomberg BNA. "At issue in Maryland is how this credit must be applied to its income tax, which is comprised of a portion representing state tax and a portion representing county tax. Maryland limits the application of the credit to the state tax portion of its individual income tax. As a result, the credit may not be claimed against the county tax portion its income tax."
"From a state tax standpoint, the case highlights an important difference between the corporate income tax and individual income tax systems," Roll said. "To avoid double taxation in corporate income tax systems, business entities allocate income to the state in which they are based and apportion income to the other jurisdictions in which they operate according to their level of business activity within the state. But there is no similar mechanism in place for pass-through entities such as S corporations, whose shareholders are subject to the individual income tax. The question of whether a state has the power to limit the application of the credit for taxes paid to other states could have important implications for small businesses, which are often organized as an S corporation, LLC or some other type of pass-through entity."
"It's long been established that corporations get to apportion their income among various states," noted Stathopulos. "This is the first time the issue involves an individual, and also that a local [county] rather than a state tax is involved. This is going to be a test of whether the Commerce Clause applies to local-level income tax, or only at the state level."
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