The effects of the economic downturn have been particularly hard on states, which will make life interesting in the year ahead for firms that sell services in the state and local tax area.

“Driving this is the fact that 45 states are operating under a deficit, with a combined total of $280 billion,” said Alan Osmolowski, head of the tax department at New England regional firm CCR LLP. “The states are not like the federal government, which can simply print more money. Any increase in income or sales tax has to be approved by the legislature, so states are looking for new types of taxes on commercial enterprises, particularly out-of-state businesses.

“On average, it takes a state budget four to five years to recover from a recession,” he noted. “A lot of taxes are being enacted that are not based on income because so many businesses don’t have any income. So you’ll find taxes on gross receipts, gross margin, net worth or assets, and other types of taxes not based on income. It’s creating challenges for businesses to be compliant.”

In fact, there will be further budgetary pain, even if the economy improves, according to Grant Thornton’s SALT (state and local tax) legislative outlook.

“In what is expected to be a historically critical time for states, it will be exceedingly difficult to make specific predictions as to how states will address their state budgetary issues in 2010,” said Jamie Yesnowitz, a SALT senior manager in Grant Thornton’s National Tax Office. Nevertheless, Yesnowitz and Grant Thornton tax partner and SALT technical services practice leader Giles Sutton came up with a number of predictions of the state and local tax trends for the rest of the year.

Some of the predictions include:

•    States will experience further budgetary pain, even if the economy improves;
•    Significant changes will be made to corporate tax systems, particularly in large states;
•    More states will adopt the Amazon rule;
•    Lengthened legislative sessions will be necessary to deal with revenue shortfalls; and,
•    The Supreme Court will hear a case with substantial impact on the state and local tax world.

“Many states were able to put off making wholesale changes to their tax system because they could rely on money from the federal stimulus packages,” Yesnowitz noted. “Large-scale budget gaps are likely in 2011, as money from federal stimulus funding authorized in 2009 and 2010 runs out. At some point in 2010, states will be forced to accept additional federal funding. The problem will be how many strings are attached. States are sensitive to conditions that might affect their level of sovereignty.”

The bigger the state, the more major changes will be made to the corporate tax system, Yesnowitz predicted. “New York is the most likely to put forth tax reform in April when the budget is resolved, and California is likely to see some reform,” he said.

“State legislatures will evaluate New York’s Amazon rule and offer up their own versions,” predicted Yesnowitz. The rule, which places a rebuttable presumption of taxability arising from sales generated by referral agreements with in-state residents, was enacted by North Carolina and Rhode Island during 2009.

Longer legislative sessions are necessary to deal with budgetary crises, and many will need to call for special sessions later in the summer and the fall. “These special sessions are likely to result in wholesale changes,” said Yesnowitz. “We predict that a majority of these extended sessions will result in broad-based corporate tax increases or reforms designed to increase state corporate tax revenue.”

Finally, Yesnowitz predicts the Supreme Court will hear a case relevant to state and local taxation. “They don’t hear a lot of cases – usually less than 100 a year,” he noted. “But so many state law concerns have constitutional implications, for example, the constitutionality of subjecting a corporation that does not have physical presence in a state to an income tax. We expect the court will take one case in this area this year for oral argument.”

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