State Tax Trends for 2010
With states struggling to balance budgets during the worst economic crisis since the Depression, tax policies are under constant revision. What can be expected this year?
March 25, 2010
In the past few years, states have seen a precipitous drop in tax revenues. With more corporations struggling to stay afloat, cut costs and reduce staffing, state income, sales and employment taxes have been reduced to a point to cause severe hardships to many, if not all, states. To compensate for the reduced revenue, states are increasing property taxes, expanding sales tax bases and revising tax policies with an eye towards replacing some of the reduced revenue caused by decreased spending by both businesses and consumers. With more disposable income directed at reducing debt, the economy suffers by contracting. Some states are burdened with deficits in the current fiscal year and little hope of compensating for the lost revenue. All tax policies are under scrutiny for changes that may increase revenue necessary to provide at least minimal services, education and municipal administration. What kinds of changes can you expect to see this year in the income and sales tax areas?Sales Tax
Digital Products. The biggest trend in changes in sales tax law involves the impact of the digital age. Historically, sales tax generally applied only to tangible property. With the ability to transmit knowledge electronically, the need for tangible products diminishes, thus decreasing sales tax revenue formerly generated by the sale of tangible products. Most electronic transmissions escaped sales tax. The activities of downloads, Web hosting, Internet sales and electronic transfers of software are under scrutiny in many states as fertile ground for expanding the sales tax base. Most sales tax statutes were written long before the digital age and do not address the Internet activities of today. The struggle for states to keep up with the constantly changing Internet environment, has led to quickly enacted statutes involving tax-rate increases as well as the addition of new taxable products. Along those same lines, an increase in sales taxes on services is occurring in some locations. Digital services are now being included along with digital products as the expansion of taxable bases continues. To add to the confusion, digital transactions are being defined differently from state to state. Some states adopt the Streamlined Sales Tax definitions, while other states do not conform, generally leaving interpretation up to the users who remain at risk of noncompliance. The fast pace of technology can easily outrun the enactment of state statutes, leaving taxpayers with little or no guidance on proper procedures.
“Amazon Tax.” In 2008, New York shook up the sales-tax environment with its controversial “Amazon Tax.” This legislation is designed to target out-of-state online retailers, such as Amazon.com, that pay commissions for sales generated by in-state businesses from ads that link to the vendor’s Website. Amazon.com challenged the law in court objecting to the imposition of tax collection obligations on out-of-state entities without substantial nexus in New York. Another online retailer, Overstock.com, also filed suit. The state prevailed and several states are now considering this type of law — California, Connecticut, Maryland, North Carolina and Tennessee. Rhode Island passed similar legislation shortly after New York’s law was implemented. There will most likely be continued interest in similar legislation, unless there are further challenges.Income Tax
Combined Reporting. Although it is usually more politically acceptable to adjust sales tax, income-tax rates and bases are currently under consideration for changes. There is an increasing trend towards considering alternative taxing methodologies. Combined reporting was formerly required in only a handful of states. After 20 years passed with no new states adopting this methodology, Vermont started the rush to combined reporting in 2006. Since then, combined reporting has gained popularity, with the anticipation of increasing state revenues. Now, more than half the states who impose income taxes require combined reporting and many more states allow optional compliance. This methodology requires a business to combine all related entities involved in a unitary business in order to more accurately reflect the business activities within a state. Although the results can be mixed, the states adopting combined reporting expect that most out-of-state businesses will pay more in taxes under this methodology.
Apportionment Formulas. Alternatively or additionally, states are revising the method they apply in apportioning income generated within their borders. The traditional three-factor apportionment formula involving sales, property and payroll has morphed into many different calculations. Less than a dozen states still use this traditional equal-weighted formula. The use of single-sales factors or at least double-weighted sales has been seen as a way to redistribute the tax burden to the out-of-state businesses. In-state businesses normally have higher payroll and property investments that would increase their apportionment factor. Using only sales as the apportionment factor heavily favors in-state businesses.
Sourcing of Service Revenue. When determining the source of revenue generated by services, states have generally considered the “cost of performance” in generating that revenue to source the income for income-tax purposes. The state in which the greater cost of performance occurs is considered the source of the revenue. Recently, the trend towards considering the “market” served by such services, rather than the cost of performance, has increased in popularity. There are currently 11 states using this methodology for sourcing service revenue and California will be added to the list effective January 1, 2011. This trend will likely continue following the increase in our service-oriented economy that in many cases does not require providers to leave their offices.
Economic Nexus. Since the MBNA (Tax Comm. v. MBNA, 640 S.E.2d 226 (WV 2006)) and Lanco (Lanco, Inc. v. Director, 908 A.2d 176 (N] 2006)) cases in 2006, the concept of economic nexus has been spreading. West Virginia and New Jersey expanded the reach of their income taxes by assessing corporations with no physical presence in the state. These states maintain that a corporation deriving benefit from customers within their state incurred a sufficient minimum connection required by the Commerce Clause to justify the imposition of income tax. In both cases, the Quill (Quill v. North Dakota, 504 US 198 (1992)) case requiring a physical presence in the state was determined to apply only to sales tax, not income tax. This concept was quickly adopted by New Hampshire, Oregon and Wisconsin and is currently being considered in several states. Connecticut is adopting economic nexus effective January 1, 2010, with California adopting next year. More activity can be expected in this area in anticipation of states trying to balance their budget by expanding the revenue base.
Gross Receipts Taxes. The failing economy is somewhat responsible for fostering the shift away from a tax based on net income. Several states have moved to a tax based on gross receipts or modified gross receipts, in an attempt to create revenue from companies that are not generating a profit. States like Michigan, Ohio and Texas impose taxes that are not based on net income. California’s Business Net Receipts Tax proposal effective in 2012 also follows a shift away from an income-based tax. These alternative-tax schemes will be watched by states hoping to follow suit.
Additional Changes to Watch. Due to the economic downturn, many states are delaying or foregoing tax incentives such as Enterprise Programs, payroll-based credits and grant programs. Some states are freezing or disallowing net operating losses (NOL). There is a lot of activity in decoupling from federal incentives and credits to conserve revenue.
Some states have a long way to go to make up for the shortfall in tax revenue. This trend will likely continue through the next few fiscal years. The states are being forced to become more creative in attempting to stimulate their local economy while preserving their revenue streams. There is a fine line to walk to offer incentives to encourage business growth while still balancing the state budget. States that are successful will most likely find their policies replicated. This will not be a stagnant year for tax policy. The biggest problem will be keeping current of the changes to stay in compliance.
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Mary F. Bernard, CPA, is a tax principal and director of state and local tax services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.