Corporations that produce and sell goods in multiple states are required to pay state corporate income taxes based on the portion of their profits that can be attributed to the states in which they operate. Each state uses an apportionment formula to determine how much of a company’s profits are taxable in that state.
Traditionally, states have used a formula that weights property, payroll, and sales equally. For example, if Hammer Company has 50% of its property in a particular state, 50% of its payroll, and 25% of its sales, then 42% if its profits would be taxable in that state. The math is: (50 + 50 + 25) / 3.
The Growth of Corporate “Nowhere” Income
Federal law does not allow a state to tax a corporation that does not have physical facilities or “nexus” in the state. Simply making sales to a state’s residents, without a factory or other tangible presence, does not create nexus and therefore exempts the corporation from tax liability in that state. As a result, many multi-state corporations have “nowhere” income — profits that are not taxable in any state. For example, if Nails Inc. has all of its property and payroll in two states, but just 10% of its sales in those states, then it will pay state income taxes on only 70% of its profits: (100 + 100 + 10) / 3. The other 30% will go untaxed.
The volume of “nowhere” income has grown in recent years, because many states have altered their apportionment formulas to more heavily weight the sales component. Many states now count sales as half of the formula, with property and payroll each counting as one-quarter. For example, if the state where Hammer Company operates shifts to this kind of formula(known as a “double-weighted sales formula”), then only 37.5% if its profits would be taxable in that state: (50 + 50 + 25 + 25) / 4
Some states have even adopted a “single-sales factor” formula, in which all that counts is what percentage of the company’s sales are in that state. To see how this has increased the amount of nowhere income, consider the example of Nails Inc. If the two states where Nails Inc. has facilities switch to a single-sales factor formula, then only 10%of the company’s profits will be subject to state income taxes. The remaining 90% will be nowhere income.
The Current System is Unfair to Small Businesses
There are many reasons to be concerned about the shift to single-sales factor apportionment and the growth of nowhere income. Companies with factories in states that have adopted single-sales factor formulas may not be paying enough tax to cover their use of public services, such as state highways. The growth of nowhere income is one factor behind the overall decline in corporate taxes as a percentage of state revenue. Between 1979 and 2000, the share of total state tax revenue contributed by corporate income tax fell from 10.2 to 6.3 percent. This decline has shifted more of the tax burden to residents.
But one particularly important reason to be concerned about the current state tax system is that it is unfair to small businesses. Small firms with facilities in only one state must pay state income tax on 100% of their profits. This is true whether the business produces only for local customers or has sales nationwide. If a business has all of its property and payroll in one state, it is not allowed to attribute any of its income to other states, regardless of what kind of apportionment formula the state has or where the firms sales occur. Because their larger rivals may not have to pay state taxes on a significant portion of their income, this places small businesses at a competitive disadvantage.
The Solution: Throwback Rules
States can solve this problem by adopting a measure known as a “throwback rule.” Twenty-five states already have it on the books. A throwback rule says that if a corporation with facilities in the state has income that is not taxed by any state (because it does not have sufficient physical presence in some states where it has sales), then that income is “thrown back” and taxed in the state where the company has facilities.
The other twenty states that tax corporate income (five states do not tax corporate profits), but do not have a throwback rule in place are: Arizona, Connecticut, Delaware, Florida, Georgia, Iowa, Kentucky, Louisiana, Maryland, Massachusetts, Minnesota, Nebraska, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Tennessee, and Virginia.
As Michael Mazerov of the Center on Budget and Policy Priorities notes,”Enacting the throwback rule is a simple change in a state’s corporate income tax law that generally entails adding a single sentence to the statute imposing the tax: ‘Sales of tangible personal property are[deemed to be] in this State [for apportionment purposes] if the property is shipped from an office, store, warehouse, factory, or other place of storage in this State and the taxpayer is not taxable in the State of the purchaser.'”
- State Tax Policy and Entrepreneurial Activity
In this November 2006 study, the U.S. Small Business Administration found that states that have adopted combined reporting and throwback rules have higher entrepreneurship rates. The study hypothesizes that “the presence of these policies might represent an overall state tax climate that is less favorable toward larger businesses and perhaps more favorable toward small businesses.”
- Closing Three Common Corporate Income Tax Loopholes Could Raise Additional Revenue for Many States
by Michael Mazerov, Center on Budget and Policy Priorities, May 2003
- The ‘Single Sales Factor’ Formula for State Corporate Taxes: A Boon to Economic Development or a Costly Giveaway?
by Michael Mazerov, Center on Budget and Policy Priorities, September 2001
- Four Corporate Tax Loopholes States Should Close
from the Hometown Advantage News Archive, March 12, 2009