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State Corporate Income Taxes No Longer Make Sense

State Corporate Income Taxes No Longer Make Sense On Saturday, August 29, 2005, Hurricane Katrina made landfall on the Gulf Coast, battering a swath of land said to be equivalent in size to Great Britain, and virtually wiping the City of New Orleans off the map. One week later, on September 3, 2005, as an estimated 42,000 American refugees were being evacuated from New Orleans’ Superdome and Convention Center, Chief Justice Rehnquist passed away. These two events at first appear to have nothing whatsoever to do with one another. Nature was simply at work, in ways great and small, ending lives and altering landscapes. There is, however, a very important issue that connects these two events: The proper role of federalism in the United States. Justice Rehnquist has been characterized as a great believer in federalism, in the sense of deferring to the powers of state government, and fettering the power of federal government. Katrina, on the other hand, stands as a vivid and painful example of circumstances in which state-level governance was simply incapable of addressing the issue at hand. Policy makers will debate what specifically went so wrong in the Gulf States but the details of that particular debate are just one element of the reality of a broader problem. In some areas of American life, a subnational system of governance is inferior to a national system of governance. Epic natural disasters that paralyze or obliterate “first responders” are, it would now seem obvious, one such instance. Corporate income taxation is another, albeit mercifully far less dangerous. The problem is not that state corporate income tax regimes are malevolently designed and therefore in need of a federal takeover. The problem instead is that these income tax regimes are antiquated, in some cases overly parochial, and hobbled by practicalities and constitutional constraints that render these taxes ill suited to our increasingly formless and multi-jurisdictional economy. Large chunks of state tax laws that worked, or at least made sense, fifty years ago do not work or make sense today. Rather than tinkering state-by-state with broken pieces, we should instead admit that, at the very least in the arena of corporate income taxation, subnational taxation is an outmoded and inefficient system that should be eliminated. This paper outlines and provides a few illustrations of four aspects of current state and local corporate income taxation that are particularly indicative of the problems of subnational taxation: Complexity, Compliance, Conformity and Competition. It then sets forth several alternatives for federalizing the corporate income tax, proposals that are but the merest beginning of what should be a national exploration of the options. Recognizing the unlikelihood of near-term fundamental change, the paper concludes with more modest suggestions of steps that can and should readily be taken to improve the very creaky and inefficient current situation. First, however, there are some interesting items in the recent history of "federalist" debates regarding state taxation, which frame some of the most basic questions, and merit mention. I. Federalism and State Taxes “Federalism” is generally described as a system of governance that divides sovereign authority between a central unit and somewhat autonomous subunits. Our federal/state bifurcation in governance resulted in some measure from the eighteenth century realities of the extant powers of the separate colonies; from a belief that state-level government is better suited to address “local circumstances and lesser interests;” and from the belief that a strong national government is necessary in areas such as defense and interstate commerce, and to protect the rights of minorities. The term “federalist(s)” has in recent times come to be applied generally to individuals and philosophies that resist federal government in favor of state governance; what sometimes seems forgotten in that rhetoric is the reality, both historical and present, that in some venues federal authority has always been recognized as the better means of governance. A proposal to federalize state and local corporate income taxation may seem at odds with the perceived conservative/libertarian concept of federalism as deferring to the primacy of the states in governance. The proposal does clearly contemplate the reduction in state autonomy in the interests of a more efficient national marketplace, so if one classifies “federalism” as securing the primacy of states in governing, the proposal is anti-federalist. However, if one thinks of federalism as an ongoing balancing act, one that recognizes the legitimacy of both levels of government in their proper spheres, then federalizing state corporate income taxes is simply an acknowledgement that, as a significant element of modern interstate commerce, this feature of American life is best handled at the federal level. The question is what federalism means. It is interesting to note that, in our decades-long debate regarding federal deductions for state taxes, “federalism” has appeared on both sides of the argument – invoked to justify the elimination of federal deductions for (at least individual) state taxes, and invoked as well to justify federal deductibility of those same taxes. President Reagan was an ardent proponent of federalism. Indeed, he issued an Executive Order on Federalism that was designed “to restore the division of governmental responsibilities between the national government and the States that was intended by the Framers of the Constitution” by ensuring that his administration always thought of states’ rights first. Yet, in proposing a fundamental overhaul of the federal income tax in 1984 and 1985, it was Reagan who proposed the repeal of all individual deductions for state and local taxes. Under the heading “Make the System More Neutral and Fair – Preferred Uses of Income,” the President’s 1985 proposal explained that “[t]he current deduction for state and local taxes disproportionately benefits high-income taxpayers residing in high-tax states. . . . Although the deduction for state and local taxpayers thus benefits a small minority of U.S. taxpayers, the cost of the deduction is borne by all taxpayers in the form of significantly higher marginal rates.” In the context of a push to lower rates and broaden the tax base, Reagan thus characterized itemized federal deductions for state and local taxes as an irrationally skewed and “inefficient” form of subsidy, benefiting some taxpayers at the expense of all. One theory advanced in support of federal deductibility is that state taxes pay for governmental services, and that a failure on the federal level to accord a deduction for payments that fund these services taxes income the taxpayer never really received/enjoyed, or amounts to “taxing a tax.” The Reagan proposal rejected the notion that repeal of a federal deduction for state taxes amounted to a “tax on a tax,” however, on several grounds: • Deductibility reduces federal revenues and shifts the burden of collecting federal revenue to low-tax states, with the result that “the Federal government loses the ability to control its own tax base and to insist that the burden of federal income taxes be distributed evenly among the States.” • State taxes are not involuntary; “state and local taxpayers have ultimate control over the taxes they pay through the electoral process and through their ability to locate in jurisdictions with amenable tax and fiscal policies.” • “State and local taxpayers receive important personal benefits in return for their taxes, such as public education, waste and sewer services, and municipal garbage removal.” • Admittedly, “not all benefits provided by state and local governments are directly analogous to privately purchased goods and services. Examples include police and fire protection, judicial and administrative services, and public welfare. These services nevertheless provide substantial personal benefits to state and local taxpayers, whether directly or by enhancing the general quality of life in states and local communities.” • Most states deny deductions for federal taxes. The proposal also noted that a federal subsidy to states and localities might be justified, but “only if the services which state and local governments provide have important spillover benefits to individuals in other communities. The existence of such benefits has not been documented.” This deconstruction of state and local taxes featured several concepts. One was distributional unevenness – the deduction favors high income taxpayers in high tax states. Dan Shaviro argues however, that, while deductibility of state taxes may indeed favor high income /tax “Blue” states, federal spending is historically weighted in favor of lower income/tax “Red” states. Even-handed distribution of federal subsidies is a good concept, federalism-wise, but since the federal deduction is but one piece of a complex national sharing of the wealth, singling it out as the source of unevenness in federal subsidies is an oversimplification. Reagan also argued that payers of state taxes can vote, and vote with their feet. Thus, state taxes are paid by choice, and that choice reflects a desire to buy more personal services through higher state taxes. This is also a good federalist argument – do whatever you like, we’ll not get involved. Yet as a means for analyzing state-to-state differences in levels of taxation it may not lead where intended. What exactly do residents of New York buy with their higher taxes that residents of Florida do not buy? Pretty much every state or municipality provides the basics – police, fire, the oft-mentioned garbage removal. Pretty much every state maintains a prison system – which does indeed provide “important spillover benefits to individuals in other communities.” Metro-area New Yorkers use subsidized public transportation, and clearly pay state taxes, for example through “MTA-surcharges” to buy that transportation; but upstaters, like most of the country, travel interstates funded by federal excise taxes, and are not imputed income in doing so. An unscientific comparison of high-to-low-tax states suggests that a good chunk of the disparity in taxes reflects differences in spending on education, particularly higher education, on aid to the poor, and on support for cultural institutions. Those can fairly be said to reflect local “choices.” But could we not reconfigure much of that spending as (still sacrosanct) charitable contributions, and deduct it? What are left then, and common to all states, are mostly base-line payments for traditional government services that do have an element of personal benefit (the benefit of not being mugged, for instance) yet represent the type of benefit one expects from living in a civilized, governed society. The federalist issue therefore is not really about subsidized purchases of personal services -- it is whether the national government’s tax regime should subsidize the subnational provision of basic governmental services. We come then to Reagan’s last point, which is another superficially federalist response to the issue: You don’t subsidize us, we won’t subsidize you. This observation holds that the state are partners in government, not dependents, and that government at the national level needs to subsidize the states no more than state governments need to subsidize the federal. This simple statement does not, however, reach the harder question of whether the states are in fact subsidizing the national government. Specifically, it assumes that subsidies are found only in tax deductions, and flow only from the federal government to the states. But subsidies also exist where the states permit federal encroachment on traditional areas of state taxation, which encroachment appropriates to federal coffers revenues that, on some normative basis, "belong" to the states. The ability of the federal government to impose a national income tax on the citizens of the states, indeed on citizens that exist purely as a function of state law (i.e., corporations), could be seen as a state subsidy for federal government. If it is, then limiting the discussion to subsidies achieved through federal tax deductions promotes false analysis. In sum, while much of the lingo used in Treasury II to argue for repeal of the deduction sounds like standard federalism, its logic is subject to question. Interestingly, in the debate that ensued following Reagan’s proposals many who rose to challenge the proposed repeal of state and local tax deductions cited federalism as supporting their cause. Referring to “New Federalism” and the increasing devolution of responsibilities on the states, Senator Durenberger opined that “[d]eductibility allows states to raise and keep their own revenues. And it rewards them for handling their own responsibilities . . . [Deductibility] is one of the cornerstones of a healthy intergovernmental system.” Senator Javits acknowledged that “[i]t may seem a little unusual for me to be appearing on an issue of States rights . . . [b]ut the key to the issue before you on the deductibility of state and local taxes is whether or not the federalism upon which our government is organized requires that we assist rather than impede our States when they try to discharge their responsibilities.” The Governor of Wyoming, “a state with relatively low overall taxes,” expressed his concern that “[t]he proposed elimination of deductibility threatens to weaken our federation of states, which is the foundation of our nation.” Concerns were expressed for elderly homeowners and higher education. The New York City Partnership even tartly observed that, given that “American patriots fought . . . at the Battle of Saratoga . . . for a government of balance, [it is] ironic that a proposal from a President who has spoken so eloquently about restoring proper balance in the federal system now threatens that balance.” In the end, only the sales tax bit the dust – depending on one's perspective, either a victim of, or a victory for, federalism. The 1980’s debate thus reflected two divergent views of federal-state relations – Don’t Tread on me vs. E Pluribus Unum. Two decades later, after 2004 legislation that has restored a federal itemized deduction for sales taxes, while the federal AMT increasingly swallows up the entire issue, we are at it again. Active discussion started early last year, with the Joint Committee on Taxation issued a report estimating federal tax expenditures for 2005-09. In this report the JCT provided specific analyses of "Selected Individual Tax Expenditure Items," which priced the federal deduction for real estate taxes as a federal tax expenditure of $19 billion in 2004, and the federal deduction for state and local income taxes at $45 billion for 2004. The JCT report thus characterized federal tax deductions for state and local taxes first as federal tax expenditures, and then as costing around $65 billion annually – rather obviously flagging juicy cherries ripe for the picking. Corporate deductions for state and local taxes were however not addressed in the JCT report. Shortly after the JCT issued its report, responding to the perception of a renewed assault on individual deductions for state and local taxes, Congressman Rangel issued a report on the "Negative Effects" of a proposed repeal of the federal deductions for state and local taxes. The effects cited in the report are important, although not surprising. Also included in this report was an interesting historical analysis of the federal deductions for state income taxes. Once again, federalism is argued to support deductibility. In this historical review, Rangel’s Report included the following quote from the legislative history of the Revenue Act of 1964, an Act which it characterized as eliminating federal deductions for "sin taxes," but otherwise continuing the 100-year tradition of allowing a federal deduction for all other forms of state and local taxes: "In the case of state and local income taxes, continued deductibility represents an important means of accommodation where both the state and local governments on one hand, and the federal government on the other hand, tap this same revenue source, in some cases to an important degree. A failure to provide deductions in this case could mean that the combined burden of state, local and federal income taxes might be extremely heavy." As characterized in the Rangel Report, this legislative history reflects the "compelling" rationale that federal deductions for (at least) individual state income taxes are mandated by "a combination of federalism and preventing double taxation." As further summarized in the Rangel Report, the 1964 Act's legislative history explained the federal deduction for property tax as an incentive for home ownership; and justified the federal deduction for sales tax as a means to avoid discrimination between states favoring income taxes and those favoring sales taxes: "It is important for the federal government to remain neutral as to the relative use made of these three forms of state or local revenue sources." The Rangel view, thus, is that federal deductions for the principal forms of state taxation are based upon a longstanding deference to states' needs to pay for their governmental services, as well as concerns about the financial burden of multi-jurisdictional taxation. A recent Congressional Research Services Report on the "Federal Deductibility of State and Local Taxes" takes a different view. This Report focused on "the interplay between the federal and state and local tax systems through the federal deductibility of state and local taxes . . . ." (Again, the report concentrated primarily on individual, rather than business, taxpayers.) Under the caption of "Other Policy Considerations," this report once again raised some of the recurring issues: • "[A]re the tax expenditures for state and local taxes paid truly federal tax 'expenditures'? • "Or do these 'expenditures' represent a return of taxpayer income that was never the federal government's to begin with? • "[W]ould the absence of a federal deduction for state and local taxes paid amount to 'taxing a tax'?" According to the analyst author, under the rubric of an "ideal" income tax, state and local taxes can either be viewed as payment for a service that could be privately provided (he cites garbage removal) or as "lost income resulting in a reduced ability to pay federal income taxes," his example being sales taxes paid to fund "general government provision of public goods such as fire and police protection." While incapable of rigid analysis given the myriad ways in which states and localities spend money, there again is merit in reexamining whether the deductibility of state and local taxes might better be analyzed in terms of whether the states/localities act as proxies for private sector services, or instead as proxies for the federal government (or more accurately as components of some all-encompassing traditional concept of "government") in providing truly governmental services. The CRS report suggested that a system in which property taxes are not deductible because they fund quasi-private services, while sales taxes are deductible because they fund governmental services, "would theoretically seem more desirable." That seems an extraordinarily oversimplified analysis of the sources and uses of governmental funds, but the underlying theory remains interesting. If states and localities use their tax revenues to provide private sector-type goods and services for free (utilities, for example), then deductibility seems the "wrong" answer. If on the other hand they use tax revenues to provide traditional governmental services in place of the federal government (health care for the poor, for example), then the "right" answer might be to allow state taxpayers to credit the state taxes they pay against their federal taxes. In such a paradigm, deductions might be viewed a practical compromise between two possible and theoretically correct treatments of different types of state and local taxes and expenditures. This kind of nuanced analysis seems to have been entirely lost on the President's Advisory Panel on Federal Tax Reform, however, which had issued its own proposal a few weeks prior. The President’s Panel was convened with the mandate to “identify the major problems in our nation’s tax code and to recommend options to make the code simpler, fairer and more conducive to economic growth,” while “[r]aising] the same amount of money” and keeping tax benefits for home ownership and charitable giving. Its 272-page report, proposing rather significant alternatives for federal tax "reform," was issued on November 1, 2005. A well-understood element of the Panel's now-stalled recommendations, under both its "Simplified Income Tax Plan" and it "Growth and Investment Tax Plan," is the proposal to eliminate individual deductions for state and local taxes. This would mean the elimination of currently allowed deductions for property taxes; for income taxes; and for sales taxes (as now allowed under the 2004 legislation in lieu of income tax deductions). In eliminating the individual deductions the Panel reprised many of the 1980’s arguments, and explained that: "This deduction provides a federal subsidy for public services provided by state and local government. Taxpayers who claim the state and local tax deductions pay for these services with tax-free dollars. These services, which are determined through the political process, represent a substantial personal benefit to the state or local residents who receive them. . . . The Panel concluded that these expenditures should be treated like any other nondeductible personal expense, such as food or clothing, and that the cost of those services should be borne by those who want them -- not by every taxpayer in the country." Once again, we see the uneven distribution argument, the vote with your feet argument, and the private benefit argument. Weirdly, however, the Panel seems to have concluded that nothing provided at the subnational level substitutes for the "normal" functions of a national government -- security, education, infrastructure -- and because of this the federal government has no need to recognize or subsidize the expenditures Americans pay for through state and local taxes. This conclusion seems both harsh and ill-founded. Even more startling, however, is the Panel's recommendations that businesses no longer be entitled to deduct state and local taxes. Neither the 1980's era push to repeal state and local tax deductions nor more recent analyses of the issue focused on the possibility that businesses be denied deductions for state and local taxes. Business deductions for state and local taxes have, instead generally been considered a normal part of allowable business expenses. Disallowance of business deductions for state and local taxes is, however, a specific recommendation of the President's Panel. The Panel recommended that "[t]o level the playing field between large businesses that pay tax at the entity level [under the Panel's plan] and small business owners who pay tax on business income on their individual returns, the deduction for state and local income taxes would be eliminated for large businesses under the Simplified Income Tax Plan." Under the Panel's flat tax-type "Growth and Investment Plan" state and local taxes likewise appear to be nondeductible; that base is described as "total sales, less their purchases of goods and services from other businesses [i.e., not from government?], less wages and other compensation paid to their workers." Plainly, the loss of businesses' deductions for state and local taxes would dramatically increase the cost of such taxes. Business-to-business sales taxes, excise taxes (telephones, utilities), property taxes (would garbage removal to be deductible if procured privately?), as well as franchise taxes and net income taxes are inescapably costs of doing business. Repealing the federal deductions for these business taxes is tantamount to a significant rate increase at the state and local level, and seems a clear instance of federal appropriation of monies previously shared with the states. (Note also that the Panel's alternative replacement of the current federal income tax regime with a consumption tax could spell the collapse of the entire state income tax system in any event, as piggy-backing on the federal system may no longer be an option. ) Taken together then, the Panel's treatments of state and local taxation reflect a federal government that is essentially blind to the means by which states fund governmental operations, as well as to the burdens on those who pay for such operations. In the context of the concerns reviewed in this article, a United States in which all state and local taxes are ignored by the federal tax regime could easily become an environment in which interstate complexity and competition grow exponentially, as do compliance issues. Rather than fostering an environment of greater coordination and transparency, the loss of federal deductibility, and even more the loss of a practical incentive to conform state taxes to the federal, could well drive states to greater localization, fragmentation and opacity in taxation. From the perspective of multi-state businesses, this may look attractive, as presenting new opportunities for reducing specific tax burdens, but those benefits will likely be targeted and uneven. More likely, for the community as a whole, life would become more complex, more unpredictable, and more expensive. For the time being, the Panel's recommendations have been shelved. The Panel Report is nonetheless notable not only for continuing the debate about the allowability of individual state and local tax deductions, but also for introducing the notion that state and local taxes should not be "subsidized" in the business context either. Whether that is the ultimate in federalism, or its ultimate defeat in the realm of state and local taxation, again depends upon one’s point of view. In sum, in the field of taxation it could be said that the purest form of federal deference to state government is a federal tax credit for state taxes paid, and great federal deference to the power of states to reach out and tax persons who are making money in their markets. This does not, however, seem to be the trend. We had a credit system under the estate tax, for example, but that federal credit was repealed, and estate tax monies previously paid to the states now flow to the federal government (less a deduction). The least deference to state taxing power is a federal tax that disregards state taxes -- particularly comparable and/or encroached-upon state taxes -- altogether. Whether that will happen remains to be seen, although interestingly the theme of ignoring state taxation is a perennial favorite of the political stripe commonly thought of as “federalist.” The discussion that follows addresses the problem of "federalism" and state taxation not in terms of the merits of federal tax deductions, which has constituted much of the modern debate. (The other hot topic currently is nexus, and particularly business activity tax nexus, where the political drumbeat in Washington is sounding rather opposed to states’ rights.) This paper posits that, given the realities of modern interstate commerce, the time has come to scrap subnational corporate income taxation in favor of a more unified national tax. States will not view it so, but this is a federalist proposal, in the sense it reflects the side of the federalism scale in which issues best handled nationally are ceded to federal governance. II. Four Problems with Subnational Corporate Income Taxation In considering the state and local taxation of multi-state business, four issues are of particular significance. In each case, they create both opportunities and burdens for taxpayers -- opportunities to save state and local taxes and thus enhance profitability, and burdens not just in the cost of the taxes themselves, but more importantly in the difficulties involved in ascertaining one's obligations, and the frictions between what "is" and what "ought to be," in a policy sense. For governments as well, each of these four issues presents both opportunities and challenges; autonomy comes at a price. A. Complexity One significant problem with multi-jurisdictional taxation is complexity. There are fifty states and thousands of municipalities that impose some form of taxation, including real, personal and intangible property taxes, business privilege taxes, sales taxes, gross receipts taxes, excise taxes on fuels and utilities, unemployment and payroll taxes, transfer taxes, capital taxes, net income taxes and inheritance taxes. These basic facts alone indicate the complex nature of state and local taxation. Yet even within the limited confines of state and local taxation of corporate income complexity is a major issue. One major area of complexity has been the apportionment of income, but it is by no means the only source of complexity. Consider the following, a relatively simple fact pattern. A partnership (P-1) conducts business in six states: Illinois, New Jersey, New York, North Carolina, Ohio and Virginia. An interest in P-1 is owned by an upper-tier partnership (P-2). The partners in P-2 include C corporations (C) and federal S corporations (S) . P-2 sells its interest in P-1. Question: What are the tax consequences, to S and C, of P-2's sale of its partnership interest in P-1? As a federal income tax matter, this is not a particularly complex question. P-2's sale of P-1 interest produces capital gain, except to the extent of P-1's "hot assets," which can generate ordinary income. P-2's gain is allocated among S, C and the other partners of P-2, as specified in the partnership agreement and the Search7RH704 regulations. P-2's sale of the P-1 interest might also generate deemed distributions, as P-2's share of the liabilities of P-1 is reduced on the sale. Those deemed distributions pass on to the partners of P-2, in the proportions those P-2 partners included the P-1 liabilities in their bases. For the partners in P-2, the allocable share of the gain from the sale of the P-1 interest, together with any gain resulting from a deemed distribution and/or the actual distribution of any sales proceeds (in excess of basis), is included in taxable income. The computation of gain might be affected by Search7RH754 elections, and/or by different outside bases in the interests in P-2. In the case of C, the gain is subject to tax at the corporate level. In the case of S, the federal gain passes through to the S shareholders, who include their proportionate shares of the S corporation's income in taxable income. What happens at the state and local level is a considerably more complex question. The first problem lies in identifying the taxpayers. This question, in turn, relates both to entity classification and to nexus. The first step is investigating whether the federal S corporation is or is not an S corporation for purposes of state and local taxation. In New York, for example, a federal S corporation that is not doing business in New York State will automatically be treated as an S corporation for state purposes. As a result, a New York resident shareholder of a federal S corporation conducting business solely in Ohio would include in New York PIT-taxable income his or her pro rata share of the Ohio corporation's income. If, however, the corporation does business in New York as well, S corporation classification requires a separate New York State S election. Here, our federal S corporation is not itself doing business anywhere, but the business of P-1 is imputed to the indirect corporate partners, meaning S is considered to be doing business in New York, and will be a New York S corporation only if its shareholders have timely made an S election -- or alternatively if New York State can be prevailed upon to forgive a late election. (Of course, it is possible S's shareholders might deliberately have chosen not to make the New York S election -- either because nonresidents preferred not to file in New York, or because New York State C corporation status was preferable as a planning matter.) At the other end of the flexibility spectrum lies New York City, in which S corporation status is never recognized. If P-1's New York business is conducted in New York City, therefore, the New York City classification of S will be as a C corporation subject to GCT. New York City's "as if there were no federal S election" treatment leads to a variety of subsidiary complications, including the treatment of qualified subchapter S subsidiaries (which are not disregarded but instead must file on a combined basis with their parent -- assuming they can), and under Search7RH338(h)(10) which the City deems inapplicable, leading (in theory if not in practice) to an entirely separate computation of corporate income for City purposes. A different approach to S corporation classification is simply to conform automatically to the federal treatment. As discussed below, this can lead to collection complications, but it makes the classification question simpler. The second step in identifying the taxpayer(s) is the question of nexus. Business interests argue that, under Quill, some "physical presence" is needed to confer upon a state the jurisdiction to impose income tax, and as evident from, for example, a House Judiciary Subcommittee’s recent approval of a bill that would limit states’ jurisdiction to impose business activity taxes by clearly imposing various standards of presence, federal legislation to restrict states from taxing multistate enterprises is under active consideration. States argue, by contrast, that Quill is confined to the sales tax, where the business/vendor is not really the taxpayer but instead is charged with a duty to assist the states by collecting and remitting on their behalf the taxes they impose on their own residents and businesses. Under the "lower" Due Process standard of nexus articulated in Quill, states assert, entities that "purposely avail themselves" of the state's marketplace in their conduct of business can be subjected to state income tax. Another model of nexus could be said to be New York's statutory "doing business" regime, under which corporations are taxable if they "do business," own or employ capital, maintain an office, etc. This is not necessarily the same threshold as either the “physical presence” standard or the “purposely availing” standard; obviously it cannot be broader than the constitution allows, but it can be narrower. In identifying "nexus" it is important also to bear in mind that regional interests sometimes create some explicit carve-outs to state jurisdiction, thus protecting, multi-jurisdictional businesses from taxation notwithstanding their incontrovertible nexus to the state. Examples include using a New York "fulfillment center," or a foreign corporation's engaging in only limited investment activities in New York. A second problem on the nexus front, often referred to as "attributional nexus," is the treatment of activities of a lower-tier entity, and whether these can be imputed to its upper-tier members. We commonly assume that the nexus-making activities of a pass-through entity can be attributed to its members for purposes of requiring those members to pay tax at the member level. Old line partnership principles (agency, tenancy-in-partnership) have supported the attribution of nexus from partnerships. However, income tax pass-through status is not the same as Due Process nexus. As a result, nonresident shareholders of an S corporation may not, absent an individual concession of nexus to tax (as in New York), be reachable under classic nexus concepts. More exotically, state LLC statutes adopt many corporate features. Under Delaware law, for instance, an LLC member explicitly has no interest in the property of the LLC. If P-1 and P-2 are LLC's, therefore, there may be legitimate constitutional reasons for questioning a state's ability to tax the P-2 members where the sole basis for asserting nexus is the attribution of the lower-tier entities' activities. The opposite problem in this area is evidenced in the Louisiana Supreme Court's recent decision in Autozone, a decision that illustrates as well the phenomenon in which principled debate as to the proper meaning of Due Process nexus becomes obscured when local interests are faced with aggressive state tax planning devices. In Autozone, a parent formed a "captive" REIT to lease real property to car dealer affiliates. This generated (at least on paper) rental deductions to the Louisiana-based lessees, income to the REIT, a dividends paid deduction to the REIT for its dividends to its parent, and no Louisiana income to the parent, which claimed to be based in Nevada. While a variety of options seemed available to deconstruct this plan, the court's decision was based on its conclusion that Louisiana had jurisdiction to tax the parent/shareholder based on the shareholder's receipt of dividends from the REIT. Interestingly, upon the taxpayer’s request for rehearing (denied as untimely) the Chief Judge of Louisiana's Supreme Court did at last acknowledge the possibility that the decision might have exceeded Louisiana's constitutional authority, but it still stands. Another issue in identifying the taxpayer(s) is determining whether state or local taxes apply to entities we perceive federally as nontaxable. In Illinois, for example, partnerships are subject to its Personal Property Replacement Tax. New York City's unincorporated business tax is another example of a state/local tax on pass-through entities. And while the UBT (i) prescribes certain carve-outs for investment partnerships and for non-dealer real estate activities, and (ii) provides a credit against City corporate tax (and upper-level UBT tax) for lower-tier UBT paid, these are not necessarily full insulation against a net tax cost at the local, lowest-tier level. S corporations also present a possibility for a state or local income tax, particularly where corporate rates exceed individual rates. Once we identify who is taxable, the next exercise entails the computation of taxable income for S and C in those states in which they have a filing obligation. A variety of complications are engendered by differences between federal and state definitions of taxable income, a problem that is addressed under "Conformity," below. This exercise is further affected by the possibility of state-specific benefits, a phenomenon discussed under "Competition," below. Conformity and Competition are subsets of Complexity, but in their own right are sufficiently important to merit separate consideration. Skipping these for now, the next problem of complexity in the measurement of taxable income relates to the allocation and apportionment of income. Turning then to "allocation" and "apportionment," income has historically been apportioned based on formulas that reflect income-producing "factors"; and factor apportionment has frequently been premised on three factors -- Payroll, Property, and Receipts (or Sales). This three-factor apportionment was devised when we were largely a manufacturing country. It sought to divide income by looking to the places where workers actually labored (payroll), where investments were made in plant and equipment (property) and where sales were made to customers (receipts). Initially equally weighted, three-factor apportionment was the state corporate tax norm for decades. Obviously, times are changing in many ways. On a macro level, equal weighting of the three traditional factors has come under criticism as under-emphasizing the importance of sales -- i.e., of the marketplaces from which revenues are derived. Payroll and property factors also are now recognized as proxies for "jobs" and "property tax revenues," and discouraging the enhancement of either through the magnetic effect they have on corporate income has been recognized as potentially deleterious to economic development. As one example of the rethinking of factor apportionment, New York State is moving to a single, sales-factor apportionment regime, effective 2008, and New York City permits double-weighting of receipts for "manufacturers." Of course, as a state shifts its revenue base away from in-state companies to remote manufacturers who make sales into the state, it runs a real risk of giving up its known corporate tax base in favor of sellers who can structure themselves out of nexus. This, in turn, puts more pressure on the definition of nexus, and on the mechanisms businesses might employ to save state taxes. "Micro" factors have also affected the relevance of factor apportionment. Where the payroll factor is based solely on W-2 wages it may omit significant in-state activities conducted by independent contractors, for example, a feature of corporate life that was virtually nonexistent when payroll was first conceived as a factor. In a services-dominated economy, moreover, payroll is harder to "locate," and more frequently is disassociated from an employer's physical plant. The property factor also shows signs of age. Property is commonly defined by reference to tangible personal property and real property. Increasingly, however, intangible property can play a significant role in the production of income. The Disney case in New York serves as an excellent example of such a situation. Excluding intangibles from the property factor, while taxing the income they produce, plainly can skew factor representation by omitting valuable contributors to income. Including intangibles in the factor, by contrast, presents very difficult questions of valuation, as well as of location. Receipts present their own problems. When one ships a widget to Paducah, Kansas it is not particularly difficult to conclude that the receipt is a Kansas receipt. When, by contrast, the thing that is sold is services, and the person to whom services are sold is in an unknown location, or will consume those services across a broad range of locations in the conduct of its business, sourcing receipts becomes much more complex. Sales of investment-type assets (as compared to inventory) present another set of issues; do we include all the gross receipts, or only the gain? These are just simple examples of the current creakiness in factor apportionment. Our example involves yet a further set of problems -- what to do when a business and its factors is one or more levels down from the person to whom the income will be taxed -- a person that may, in turn, pick up other businesses with other factors as we travel up the chain. The need to address factor apportionment through tiers is receiving increasing attention. Recently, for example, the tax departments of New York State and City have been working with the private sector to address this and other questions that arise when corporations conduct business through lower-tier pass-through entities. Their basic concept is to adopt an aggregate approach in circumstances where corporations have (or are deemed to have) sufficient information to report on an aggregate basis. This is a fundamentally reasonable approach, and quite possibly necessary to avoid the use of pass-through entities to achieve state tax planning results inconsistent with the direct conduct of business -- a prospect that might further the march against pass-through treatment. While the aggregate approach can readily be recognized as reasonable, it is by no means simple. In the narrow realm of factor apportionment a number of questions arise. Consider for instance, the treatment of transactions between a partner and a partnership. If a 30% partner owns a factory and leases it to the partnership, does the partner’s property factor include 100% of the building as owned, plus 30% of the product of eight times rent? Assuming that the business of owning the building is unitary with the business of the partnership, and that the corporate partner earning rental income also concurrently accrues a deduction for 30% of the rent, it seems a form of double-counting to include both the building owned (at 100%) and the building leased (at 30%) in its property factor. Another problem in applying the aggregate method to pull partnership factors into corporate returns is the need to identify the share of partnership factors that belongs to each partner. Receipts, being a precursor to income and an annually mutating thing, may rationally follow allocations of income. Payroll, being one of many deductible items, may follow allocations of deductions (although query what to do with capitalized payroll costs). Property, it would seem, should follow partners' capital interests, as that most closely reflects the share of the property a partner might receive upon liquidation of the pass-through entity. This is not, however, a universally attractive model. Separating the allocation of each year's net profit from the allocation of the factors generating such profit is viewed by some as distortive. For those who consider it so, the better reflection of factor apportionment lies in allocating partnership factors in the same manner as profit is allocated -- again, no easy task, and not clearly "correct” either. It bears mention at this point that there really are no "pro-taxpayer" or "pro-government" answers to most of these questions. Depending upon the terms of a partnership agreement, the composition and location of the partnership's factors and of the partners' factors, and the income (or even losses) reported by corporate partners, there are circumstances in which one rule benefits one constituency, while a different rule benefits a different constituency. This is a good thing, as it means that answering these kinds of questions has no easily understood revenue implications. It can, however, be a bad thing when answers do not exist at all, or are poorly understood or implemented, as that inevitably gives rise to situations of self-help (on both sides), as well as to litigation-driven analysis, which is never adequate to the task of resolving complex questions of tax law and policy across a range of fact patterns. One final general note in regard to complexity here relates to information. The aggregate approach to the state and local taxation of corporate partners seems logical, sensible, and the right direction for future guidance. But pity the return preparer. Proper completion of corporate income tax returns on an aggregate basis requires a potentially vast amount of information from partnerships. Moreover, this information is not necessarily limited to the information necessary to comply with the taxes of the jurisdictions in which the partnership does business. Corporate partners may do business, and be required to file tax returns, in jurisdictions that have nothing to do with the partnership. Proper compliance with the laws of those jurisdictions requires information tailored to the laws of those jurisdictions. How does the corporate partner obtain that information? Consider for example a corporate partner who seeks to obtain from a Massachusetts hedge fund the information needed to apply New York's investment capital rules. Can that corporation ever hope as a practical matter to get to the "right" answer? With these and other thoughts in mind we return to our simple example. Identifying the taxpayers, we find partnership-level income taxation in Illinois and New York City. Separate S elections are required in New York and New Jersey; S status is not available at all in New York City; the rest of the states automatically conform to federal S status. Several states impose withholding-type obligations on the various pass-through entities; these can be very costly, and are discussed generally under Compliance, below. Allocation and apportionment here are particularly interesting. We first consider whether P-2's gain is allocable or apportionable. This distinction is relevant when corporations file in states that apportion business income but allocate nonbusiness income. The difficulties of distinguishing business from nonbusiness income are apparent from a reading of the Supreme Court's decision in the New Jersey Allied-Signal case. Moreover, the distinctions between New Jersey's UDITPA-type system and New York's Business/Investment/Subsidiary income regime are illustrated by New York's Allied-Signal case. The differences between those two regimes can be summarized as the difference between a facts-based inquiry into the integration of a particular holding into the overall corporate business (New Jersey) versus a highly technical rule favoring certain corporate securities (New York). There is nothing “wrong” with either system. That said, the more legitimate question is whether, if one were designing a system of multistate corporate taxation for the twenty-first century, one would use this template. While it is lovely to inhabit a world in which two neighboring jurisdictions can employ such different theoretical approaches, and generate so much litigation in regards to a single stock sale, one looks at situations such as these and wonders whether the overall national good is best served by hosing so many dancing angels. The complexity issues come into sharper focus as we finish off our simple example. We have aggregate-vs-entity issues in determining whether P-2's sale of the P-1 interest is a sale of an intangible investment interest, or a sale of the line of business conducted and assets owned by P-1. We have further questions within the apportionment factors themselves -- are the payroll, property and receipts of P-1 pulled into P-2 and thence into C (and also S)? Is the gain on P-2's sale in the receipts factor? If so, in which state does the gain, and/or proceeds, belong in the numerator? In Ohio, for example, the sales factor does not include receipts from the sales of intangibles, even though gain from such sales is apportionable (if not entirely allocable) to Ohio based on a formula of 20% payroll, 20% property and 60% sales. Illinois seems to say that capital gains from sales of intangibles are always allocated to the corporation's domicile; but if P-2's gain were characterized on an aggregate basis, Illinois might (subject to a cessation of business analysis) use a sales-only factor, one which excludes receipts from the sales of intangibles unless they represent more than fifty percent of receipts for the year of sale and two previous years. Virginia, with a stern voice on what nonbusiness income does not include, likely would apportion C's share of P-2's gain under a three-factor formula with double-weighted sales; and likely would include partnership factors in calculating C's factor apportionment -- although with nothing approaching the level of detail New York is considering in accomplishing this. But while P-2's receipts from its sale likely would be receipts for C's purposes, they would not be Virginia receipts, and thus would be reflected in the denominator but not the numerator of the Virginia sales factor. North Carolina also uses three-factor, double-weighted sales apportionment, but excludes casual sales from receipts altogether - meaning they are neither in the numerator nor in the denominator. New York, as discussed, is working on aggregate attribution of factors. However its sales factor -- soon to become the sole factor in apportionment – currently excludes receipts from the sale of a "capital asset." So, New York may ignore P-2's receipts from the sale of its P-1 interest in apportioning gain on the P-1 interest. Finally, and again relevant only to business income, New Jersey currently uses a double-weighted, three-factor formula, and includes in its sales factor "all other business receipts." This would appear to include the gain (not the total receipts) from P-2's sale of the P-1 interest, although whether that gain belongs, to any degree, in the New Jersey numerator may be a question of fact. New Jersey also has a rather interesting consent-based procedure for including in corporate partners' factors the factors of limited partnerships, either to compute an overall unitary apportionment if the partnership business is unitary with the corporation's, or to compute a “separately allocated" corporate income. Here, if the corporate partners fail to consent, the partnership becomes obligated to pay tax on the corporation's share of New Jersey income, allocated based on the partnership's factors. This last feature (1) raises interesting questions for multitiered structures, (2) raises interesting business questions for partnerships, and for persons who partner with corporations; and (3) is another example of the problem of Compliance, discussed below. The rules states use to measure their shares of taxable income thus are similar in gross, but are riddled by state-specific nuance, with no particular pattern and at best fundamentally local logic. States share similar interests and concerns, but often address them differently. From the taxpayer's perspective this means that the simplest of questions may have at least as many answers as the number of jurisdictions involved. Saddling multistate businesses with this level of interstate complexity is a difficult policy to defend. B. Compliance Compliance is a problem with two sides, and a problem for taxpayers and taxing authorities alike. For taxpayers intent on fully complying with all state and local tax obligations, compliance can present a daunting task of finding the law, filling in the inevitable interpretative gaps, gathering the relevant information, and correctly completing state and local tax returns. On that last score, even the most sophisticated return preparation programs rarely get it all right, meaning that large multistate taxpayers with numerous combined or separate affiliates filing in multiple states require a highly sophisticated tax and IT capability simply to get the returns done correctly. This is even more the case when the state tax base departs from the federal. (See Conformity, below). For taxpayers who fail to comply, whether on purpose, unwittingly, or as a reasoned position, the costs of improper noncompliance can be high. Interest generally accrues at above-market rates; penalties are, in some instances, almost automatic; and audits can quickly become very costly, not just in dollars but in their absorption of corporate resources. Responding to questions can be very difficult when the facts are three, five or even more years old, particularly for businesses that have experienced changes in ownership and personnel -- i.e., most large companies and many small ones as well. Taxpayers whose initial filing (or nonfiling) positions are not sustained on audit can also face problems of mismatched taxes. For instance, as noted above New Jersey's receipts factor does not include in the denominator receipts that are sourced to jurisdictions in which the taxpayer is not subject to tax. If, upon later examination, it turns out the taxpayer was indeed taxable in a particular jurisdiction, then those receipts should not have been thrown out. It may however be too late to amend (or other circumstances may counsel against amending) the New Jersey returns to correct the sales factor. This is just one example of the inefficiencies that can result when original filing positions are changed in later years. From the government's perspective, problems with compliance again are two-faceted, and have ramped up significantly. On the “service” side, taxing authorities carry a tremendous burden of making compliance as frictionless as possible. This translates to a need to provide guidance clearly, comprehensively and quickly, and to design tax forms that efficiently yet clearly reflect the multiple glories of the jurisdiction's peculiar rules. That requires significant and intelligent staffing. On the enforcement side, states and localities need to identify, audit and collect the proper tax due from all taxpayers. At the state and local level this burden is much higher than the federal. Substantive state and local tax rules can be complex, under-interpreted and in many cases out-of-date, meaning that the simple act of applying known state tax laws to a known set of facts often produces a great deal more uncertainty than exists at the federal level. States deal as well with a range of constitutional and federal law issues for which there is no central interpretative administration, and the law must be divined by analyzing cases -- not always the best path to clear guidance. States and localities also face a far greater incidence of taxpayers who do not file at all, or whose filings omit significant amounts of income. This is by no means unjustified in every case, but again it is a very big problem at the state level. Take the Geoffrey phenomenon, for instance. As the names of some of the decided cases make clear, this method of state tax planning -- entirely legitimate when done correctly -- has been both a very popular tax planning strategy in corporate America, and a very contentious and expensive area for the states. The sheer volume of cases, and of state statutory responses, makes clear that the corporate use of tax-free zones within the United States constitutes a tremendous compliance issue. Before the next bright idea hits the corporate streets, we should examine whether this is the best way to run a railroad. Amnesties provide another example of the degree to which compliance, or the lack thereof, impacts state and local tax systems. Amnesties, and their close cousins Voluntary Disclosure Initiatives (and Agreements), are governmental admissions that there is significant money to be had in simply getting noncompliant taxpayers on the books, usually at the cost of forgiving penalties. A recent survey concluded that at least forty states had offered an amnesty program in the past two decades, and "most of the states have enacted amnesty programs multiple times." New York alone has had three "once-in-a-lifetime" amnesties, in addition to its current program for the voluntary disclosure of tax shelter-related deficiencies. The prevalence, and seemingly increasing frequency, and lucrative results of state amnesties demonstrate that states are not able to enforce the laws they have with the resources available to them. Pass-through entities raise particularly troubling issues with regard to compliance. Taxpayers conducting business through pass-through entities tend to be invisible in the taxing jurisdiction. Some use that invisibility as a cloak in choosing not to file; other non-filers may have legitimate statutory or constitutional arguments in support of nonfiling. Either way, however, income earned in a jurisdiction is not always taxed in full by that jurisdiction. This, understandably, has led many jurisdictions to adopt provisions that impose financial responsibility for member's taxes on the pass-through entity. These may entail obligations to file composite returns ; obligations to withhold on distributions ; obligations to pay state taxes for members who fail to certify that they are in compliance with state tax laws ; or even provisions that deny pass-through treatment to entities whose members fail to acknowledge their obligations to pay state taxes. Understandable as these compliance-enhancers are, they create new levels of complexity, and have the potential to create significant economic dislocations. A partner with overall losses may find tax has been withheld by a partnership, meaning it must seek a refund -- by no means a speedy solution in many jurisdictions. Recalcitrant partners with non-cash or "phantom" income may refuse to certify their compliance, so as to push the cash-flow problem of paying state taxes (or suffering liens) onto the entity. Federal pass-through entities may become fully taxed at the state (or local) level, changing the economics of the business, and potentially creating complex issues for corporate members conducting unitary businesses. Again, the number of states which have adopted some means to make pass-through entities financially responsible for their owners' taxes demonstrates that this is a very serious compliance problem; unfortunately, the solution to the problem has been found in different means of denying state pass-though status to federal pass-through entities. In this, Compliance issues lead to more Complexity, and may end up impacting a wide range of business economics in unexpected and negative ways. C. Conformity This is a question of the degree to which state and local tax bases conform to the comparable federal income tax base. In the context of C corporations, it is an inquiry into the similarity, or not, of the ingredients used in calculating federal taxable income and the ingredients used in calculating state taxable income. Obviously, the more closely state tax bases conform to the federal, the simpler a state tax is to apply, and the greater the likelihood a state taxpayer will be in compliance with its state tax obligations. As state tax bases drift away from the federal they engender complexity. With complexity come costs, and a fall-off in compliance. There are forty-six states, plus D.C. and New York City, which impose a corporate income tax. Most of these states premise their taxes on the federal base, with relatively minor adjustments (for example, adding back interest on other states' bonds). In recent years, however, there have been a variety of notable breaks with federal conformity. These instances of nonconformity often stem, again understandably, from states' fiscal inability to match federal tax breaks. Unfortunately, the very fact so many states are finding occasions to decouple speaks to a fundamental breakdown in (or absence of) dialogue between federal law- and policy-makers and their counterparts in state government. Whatever the cause, it is a worrisome trend. Federal bonus depreciation serves as perhaps the best example of the mess that can ensue when states decouple, however rationally, from the federal calculation of taxable income. In March, 2002, federal legislation was enacted to provide various forms of accelerated depreciation for property placed in service after September 10, 2001. The concept was to jump start a traumatized economy by providing a quick federal subsidy for capital investment. For states, the problems were that (1) the subsidy was retroactive, affecting budgets already set or closed; and (2) the subsidy was very expensive. Over the ensuing months and years states "decoupled" from federal bonus depreciation, generally adopting instead the cost recovery rules as in effect September 10, 2001. What decoupling means is that, for every asset affected by federal bonus depreciation, taxpayers must calculate depreciation, basis, and gain or loss at the federal level, and then make differen