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State Corporate Tax Issues Practice Guide

This practice guide was developed by the AICPA State and Local Taxation Committee to inform practitioners about state corporate tax issues, such as nexus, multistate tax issues, and state net operating loss (NOL) issues. This guide should be considered in connection with the checklist questions (particularly those in 600) and 700)) contained in the State Corporation Income Tax Return Checklist also included in this AICPA Tax Practice Guides and Checklists publication package. In addition, practitioners should refer to the State Tax Return Preparation Guide For All States' CORPORATION State Tax Returns (also included in this AICPA Tax Practice Guides and Checklists publication package) for common problems and unique tax issues concerning each of the states' corporate state tax returns.

Below in this practice guide is a state tax nexus checklist that contains a list of the most frequently asked questions appearing in states' nexus questionnaires. Practitioners should be aware that the weight of interpretation given to specific questions may vary from state to state. However, the list can serve as a practice tool for practitioners in soliciting information from clients and analyzing such information. This guide is intended to be a broad reference tool and an aid in addressing nexus (pages 1-7), multistate (pages 7-13), and state NOL tax issues (pages 13-14), and is not intended to answer the question of whether a specific company has nexus or certain tax obligations in a particular state. It should be noted that there are different nexus standards for the different types of taxes. The laws and policies of each state should be verified for application to specific cases.

  1. STATE TAX NEXUS ISSUES — EXPLANATION AND CHECKLIST

    In April 1997, the AICPA State and Local Taxation Committee published a detailed nexus guide with a compilation of nexus checklist questionnaires utilized by each of the fifty states and a summary of specific nexus attributes unique to each of the states. If you would like a free copy of this package, please call the AICPA Order Department at 1-800-862-4272, Dept. #1 and identify yourself as a Tax Division member and request product #061057.]

    Nexus describes the amount and degree of business activity that must be present before a state can tax an entity's income. If a taxpayer has nexus in a particular state, the taxpayer must pay and collect/remit taxes in that state. In general, nexus is created for income tax purposes if an entity derives income from sources within the state, owns or leases property in the state, employs personnel in the state in activities that exceed "mere solicitation," or has capital or property in the state. The amount of activity or connection that is necessary to create nexus is defined by state statute or case law and/or regulation and, consequently, tends to vary from state to state. However, all states are limited by Constitutional principles, judicial doctrine and federal law.

    Briefly summarized below are: the federal statute governing "protected" activities within a state, relevant issues from two key U.S. Supreme Court cases concerning nexus, and recent activities of the Multistate Tax Commission (MTC) in this area.

    1. Public Law 86-272 (15 U.S.C. §381)

      Nexus for net income tax purposes is not established merely because sales of tangible personal property are solicited within the states. The states are prohibited under Public Law 86-272 from imposing a tax on or measured by net income when an entity's only connection with the state is the solicitation of orders or sales of tangible personal property, and such orders are accepted and shipped or delivered from outside the state. The Virginia Supreme Court recently ruled (January 1997) in the National Truck Council case that delivery in company-owned trucks, standing alone, does not establish nexus for income tax purposes because of the protection afforded by Public Law 86-272. The immunity afforded by this statute does not apply, however, to any corporation incorporated within the taxing state. This immunity only applies for state income tax purposes and, consequently, does not apply to such taxes as sales/use, gross receipts, etc.

      Under Public Law 86-272, the only immunity accorded is for the solicitation of orders for the sale of tangible personal property. Thus, the solicitation for the sale of real property, intangible property, or services is not provided immunity under Public Law 86-272 and may cause a taxpayer to have nexus in a state where such solicitation occurs. The issue of "economic nexus" in the case of service providers with no physical presence in the state remains unresolved.

      For more information on the jurisdiction to tax, refer to State Taxation, by Jerome R. and Walter Hellerstein.

    2. Physical Presence

      Historically, cases brought before the U.S. Supreme Court relating to nexus involved factual situations in which the taxpayer had a degree of physical presence in the state seeking to impose its tax. In Quill Corp. v. North Dakota, 112 S.Ct. 1904 (1992), the U.S. Supreme Court ruled that the Commerce Clause mandated that, absent action by the U.S. Congress to the contrary, a taxpayer must have some physical presence in a state to be subject to collection responsibility for the state's use tax (Quill at 1914). Although Quill deals with use tax, the Court's discussion of the general Due Process and Commerce Clause Constitutional principles of nexus opinion sheds some light on their application to franchise and income taxes.

      The South Carolina Supreme Court, in Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993) held that a Delaware holding company that owned only intangible property used in South Carolina was subject to income tax. The court rejected Geoffrey's claim that it had not purposefully directed its activities toward South Carolina's economic forum and held that by licensing intangibles for use in the state and receiving income in exchange for their use, Geoffrey had the minimum connection and substantial nexus with South Carolina required by the Due Process Clause and the Commerce Clause of the U.S. Constitution. In addition, Geoffrey's receivables were found to have a business situs in South Carolina. The U.S. Supreme Court subsequently denied certiorari in Geoffrey (114 S.Ct. 50 - 1993), making the case applicable only in the state of South Carolina. Many states, however, have incorporated through statute or regulation the principles of economic nexus outlined in Geoffrey regarding intangibles in the nature of trademarks and trade names. Practitioners with clients having intangibles should review any recent changes in the applicable state laws and regulations in this area.

    3. Solicitation

      Under Public Law 86-272 (15 U.S.C. §381), an activity is immune from net income taxation if it consists merely of solicitation of sales of tangible personal property. The term "solicitation" is not defined by Public Law 86-272, however, the U.S. Supreme Court in Wisconsin Dept. of Rev. v. William Wrigley, Jr. Co., 112 S. Ct. 2447 (1992) (Wrigley) interpreted this term. In finding that Wrigley's activities in Wisconsin exceeded the protection of Public Law 86-272, the Court held that the solicitation of orders includes "any explicit verbal request for orders and any speech or conduct that implicitly invites an order." The clear line is the one between those activities that serve no independent business function apart from their connection to the soliciting of orders and those that the company would have reason to engage in anyway but chooses to perform through its in-state sales force. The Court affirmed the de minimis principle of Public Law 86-272 in holding that to lose the immunity afforded by Public Law 86-272, the activity must establish a nontrivial additional connection with the taxing state. In the aggregate, though minimal in comparison to Wrigley's total solicitation activities in the state, the non-immune activities exceeded the de minimis standard in the aggregate. Practitioners should consider whether activities other than solicitation are more than de minimis in a particular state.

    4. Multistate Tax Commission (MTC) Guidance to the States

      The MTC has issued lengthy guidance under P.L. 86-272: Information Concerning Practices of Multistate Tax Commission States Under Public Law 86-272 (adopted 7/11/86), Statement of Information of Multistate Tax Commission and Signatory States Under Public Law 86-272 as Revised January 22, 1993, and Statement of Information of Multistate Tax Commission and Signatory States Under Public Law 86-272 as Adopted July 29, 1994.

      Working together through the MTC, twenty-six states issued Nexus Program Bulletin 95-1 (12/20/95) targeting the computer direct marketing industry. The bulletin takes the position that because in-state repair services are not immune from taxation by reason of P.L. 86-272, the use of independent contractors or other representatives of a computer company to provide such repair services creates nexus for the computer company. Although the nature of the bulletin is informative and educational rather than regulatory, it has been met much opposition from industry and mixed reaction from the states. In fact, California has rejected the bulletin as a policy statement. The California State Board of Equalization (BOE) voted on March 14, 1996 to rescind California's inclusion on the list of 26 states that have adopted MTC Bulletin 95-1.

      In addition, the MTC is working on a draft Nexus Guideline for Application of a Taxing State's Sales and Use Tax to a Remote Seller. The AICPA State and Local Tax Committee commented on the 10/25/94 draft of these regulations on April 12, 1995. The committee objected to the concept of "deemed physical presence" and the notion that an interest in intangible property could create physical or deemed physical presence. Since then, the MTC has issued a new working draft that seeks to establish the constitutional nexus guidelines for application of a state sales and use tax to an out of state business (3/97). The MTC has asked for comments regarding the draft guidelines. The guidelines are still in the process of development (with a public participation working group, including an AICPA representative working on the guidelines) and are not expected to become final until at least April 1988.

      The MTC also assists businesses involved in multistate commerce in voluntarily resolving potential state sales/use and income/franchise tax liabilities where nexus is the central issue. The program acts as a coordinator through which companies may approach 32 member states (AL, AZ, AR, CA, CO, CT, DC, FL, HI, ID, IA, KS, KY, ME, MD, MA, MI, MN, MO, MT, NE, NH, NJ, NM, ND, OH, SC, SD, TX, UT, WA, WI) anonymously and seek resolution of potential liabilities arising from past activities. It is the strict policy of the National Nexus Program member states and the MTC that they will not reveal the identity of a taxpayer to any state that does not accept the voluntary disclosure agreement. For further information on this program, refer to the AICPA State Tax Nexus Checklist/Practice Guide, or contact the MTC at 202-508-3800. We note that experience has shown that taxpayers may be able to negotiate a better arrangement directly with individual states.

    Conclusion

    The issue of nexus for sales/use and for income tax purposes is a complex one. As evidenced by the nexus questionnaires included in this checklist package, there is a tremendous degree of inconsistency among the states. The large number of court cases in this area highlight the fact that the Due Process and Commerce Clause analysis is largely dependent on the specific facts and circumstances of each case. Among the state court systems, emerging issues, such as agency nexus, affiliate nexus, electronic nexus, and economic nexus, evolve in the ever changing market place. This guide is meant as a broad reference tool in highlighting those areas that the individual states have deemed to create nexus within the state for purposes of subjecting the entity to taxation in the state.

State Tax Nexus Checklist — Frequently Asked Questions on State Nexus Questionnaires
  YES NO COMMENTS OR
EXPLANATION
1) Is the business qualified to do business in the state? ________ ________ ___________
2) Is the business currently filing with the state (specify type of tax)? ________ ________ ___________
3) Does the business have an office, agency, warehouse, or other business location owned or leased in the state? ________ ________ ___________
4) Does the business maintain a telephone answering service in the state? ________ ________ ___________
5) Does the business own or lease real property in the state? ________ ________ ___________
6) Does the business own or lease tangible personal property located in the state? ________ ________ ___________
7) Does the business rent or lease tangible personal property to others who then use the property in the state? ________ ________ ___________
8) Does the business license intangible property for use in the state? ________ ________ ___________
9) Does the business license software for use in the state? ________ ________ ___________
10 Has the business ever executed contracts in the state? ________ ________ ___________
11) Does the business have employees or representatives who perform any of the following activities in the state: ________ ________ ___________
  a) Solicit orders with or without authority to approve? ________ ________ ___________
  b) Engage in managerial or research activities? ________ ________ ___________
  c) Secure deposits on sales? ________ ________ ___________
  d) Make collections on regular or delinquent accounts? ________ ________ ___________
  e) Repossess items or property of the business? ________ ________ ___________
  f) Offer technical assistance and training to purchasers of its products before or after the sale? ________ ________ ___________
  g) Repair, service, or replace faulty or damaged goods? ________ ________ ___________
  h) Install or assemble its products? ________ ________ ___________
  i) Does the business license software for use in the state? ________ ________ ___________
  j) Inspect the installations of the business' products by its customers or users of its products? ________ ________ ___________
  k) Pick up or verify destruction or damaged or returned merchandise from customers or users of the business' products? ________ ________ ___________
  l) Coordinate delivery of merchandise, whether or not special promotions are involved? ________ ________ ___________
  m) Distribute replacement parts? ________ ________ ___________
  n) Conduct credit investigations or arrange for credit and financing for purchasers of its products? ________ ________ ___________
  o) Rectify or assist in rectifying any product, credit, shipping or similar complaint arising from the purchase or use of its products? ________ ________ ___________
  p) Service or maintain displays of its products? ________ ________ ___________
  q) Accept returned merchandise for customers? ________ ________ ___________
  r) Selling of tangible personal property? ________ ________ ___________
  s) Make "on the spot" sales of company products? ________ ________ ___________
  t) Carry out engineering or design functions? ________ ________ ___________
  u) Advise customers or distributors as to minimum inventory levels, remove obsolete, damaged or outdated goods? ________ ________ ___________
  v) Process complaints? ________ ________ ___________
12) Does the business have a standard form of written agreement with sales representatives? If so, please enclose a copy. ________ ________ ___________
13) Is the business a member of an affiliated group of corporations? If so, does the business file a consolidated or combined return in the state? ________ ________ ___________
14) Does the business have display merchandise in leased space in the state? ________ ________ ___________
15) Do employees have samples in the state? If yes, then state the average value thereof. ________ ________ ___________
16) Does the business reserve the right of inspection of the customer's facilities or products after delivery? ________ ________ ___________
17) Does the business provide sales or service manuals to customers, distributors, or agents? ________ ________ ___________
18) Does the business advertise in the state? If so, list the different advertising media use. ________ ________ ___________
19) Does the business do any localized advertising (cooperative or otherwise) in the state? ________ ________ ___________
20) Does the business have any employees or representatives who use their home in state: ________ ________ ___________
  a) As a business address? ________ ________ ___________
  b) To receive business callers? ________ ________ ___________
  c) To store inventory? ________ ________ ___________
  d) To maintain books/records? ________ ________ ___________
  e) To maintain company property? ________ ________ ___________
21) Are employees reimbursed for telephone, fax or utilities expenses? ________ ________ ___________
22) Are home numbers listed in local advertisements of the business? ________ ________ ___________
23) Do employees of the company solicit orders for the sale of: ________ ________ ___________
  a) Real estate? ________ ________ ___________
  b) Services? ________ ________ ___________
  c) Intangible property? ________ ________ ___________
24) Does the business perform construction contracts in the state? ________ ________ ___________
25) Is the business listed in any telephone directories in the state? ________ ________ ___________
26) Does the business have any consigned stock of goods in the state? ________ ________ ___________
27) Does the business operate a mobile store in the state? ________ ________ ___________
28) Has the business previously filed income tax returns in the state? ________ ________ ___________
29) Does the business maintain a security interest/mortgage in property until the contract price or amount borrowed has been paid? ________ ________ ___________
30) Do employees either investigate, recommend, or appoint potential dealers, agents, or distributors of the company in the state? ________ ________ ___________
31) Do employees ever check the inventories of customers or distributors in the state? ________ ________ ___________
32) Do employees authorize credits, warrant adjustments or repairs in the state? ________ ________ ___________
33) Does the business have agents or independent contractors selling products in the state? If so, are they forbidden from selling or promoting competitors' services? ________ ________ ___________
34) Does the business give approval to servicing distributors and dealers within the state where customers can have products serviced or repaired? ________ ________ ___________
35) Does the business participate in a partnership, as general or limited partner, which has operations, conducts business, or owns real property in the state? ________ ________ ___________

  1. MULTISTATE TAX ISSUES — EXPLANATION

    There are three methods of dividing the income tax base of a multistate corporation among the states in which it is taxable: (1) separate accounting, (2) specific allocation, and (3) formulary apportionment.

    1. SEPARATE ACCOUNTING

      Under the separate accounting method, the activities of a corporation within a state are considered separate and distinct from those outside the state. The corporation attempts to source each item of revenue and expense to the state where it was generated.

      Because it has several major weaknesses, separate geographical accounting in the state tax area (once the preferable method for determining the income of a corporation) is now used only in limited instances. Its primary weaknesses are the lack of accuracy and ease of manipulation.

    2. SPECIFIC ALLOCATION

      Under the specific allocation method, while certain types of income are traced to their source or other connection with a state and attributed solely to that state, other types of income are apportioned among the states where the corporation is doing business. In most states, income that is classified as nonbusiness may be specifically allocated and income that is classified as business may be subject to apportionment.

      1. Business v. Nonbusiness Income

        The distinction between business and nonbusiness income is significant because while nonbusiness income is allocable to a specific state (either the taxpayer's state of commercial domicile or the situs of the property), business income will be subject to apportionment and will be divided among the states in which the multistate taxpayer does business based on a mathematical apportionment formula.

        The three main methods used to determine whether income is business or nonbusiness are:
        1) UDITPA Definitions of Business and Nonbusiness Income;
        2) MTC Regulations (when adopted by a state); and
        3) United States Supreme Court cases.

        1) UDITPA Definitions of Business and Nonbusiness Income

        Under UDITPA, business income is defined as income that arises from transactions and activities in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations. UDITPA §1(a). UDITPA defines nonbusiness income as all income other than business income. UDITPA §1(e).

        Most states interpret the UDITPA (Uniform Division of Income for Tax Purposes Act) definition of business income as incorporating two tests for determining whether income is business income. The tests are referred to as the "transactional test" and the "functional test." Most states take the position that if income is classified as business income under either test, the income will be classified as business income. However, the courts of several states have interpreted the UDITPA language as requiring both tests be satisfied in order to classify income as business income.

        1. Transactional Test

          Under the transactional test, income is considered business income if it arises from "transactions and activities in the regular course of the taxpayer's trade or business." The focus is on the type of transaction giving rise to the income, and how the transaction relates to the taxpayer's regular trade or business.

          Example: The sale of a factory by a manufacturer normally would be considered unusual, extraordinary, and occurring outside the normal course of business. As such, the gain would be considered nonbusiness income under the transactional test.

        2. Functional Test

          Under the functional test, income is considered business income if the acquisition, management, and disposition of the asset that generates the income constitute integral parts of the taxpayer's regular trade or business operations. The functional test focuses on the relationship between the asset giving rise to the taxable income, and the business itself.

          Example: Gain or loss on the sale of a factory by a manufacturer likely would be considered business income under the functional test because the factory was acquired and used in the taxpayer's regular trade or business.

        2) MTC Regulations

        Under the Multistate Tax Commission (MTC) regulations, which interpret UDITPA, there is a presumption in favor of classifying income as business income. According to the MTC regulations, "the income of a taxpayer is business income unless clearly classifiable as nonbusiness income." MTC Reg. §IV.1.(a). The following are examples of business income under the MTC Regulations:

        • Rents received from property "used" in or "incidental [to]" the taxpayer's trade or business.
        • Gains and losses from dispositions of real or personal property if the property was used in the taxpayer's trade or business.
        • Interest, if the intangible generating the interest is used or arose from the trade or business or where the purpose for acquiring and holding the intangible is related to or incidental to such trade or business operations.
        • Dividends, if the stock arose out of or was acquired in the regular course of the taxpayer's trade or business operations or where the purpose for acquiring and holding the stock is related to or incidental to the taxpayer's trade or business.
        • Patent and copyright royalties are business income if the patent or copyright arose out of or was created in the regular course of the taxpayer's trade or business operations or where the purpose for acquiring and holding the patent or copyright is related to or incidental to such trade or business operations.

        3) The United States Supreme Court

        In addition to the rules under UDITPA and the MTC regulations, the U.S. Supreme Court has adopted another test to determine whether income is subject to apportionment.

        In Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992), the Court held that only income from the taxpayer's unitary business is apportionable income. If the taxpayer's activities and properties are part of a unitary business, income from such activity or property is considered to be derived from the regular course of the taxpayer's trade or business and is deemed to be apportionable income. Income that is unrelated to the taxpayer's unitary business is considered to be income subject to allocation.

        However, while affirming the unitary test for determining whether income is apportionable, the Court held that it is not the exclusive means of meeting the constitutional requirements for apportioning income.

        The Court introduced the operational versus investment function test. Under this test, a transaction or activity may create apportionable income if it serves an operational, rather than an investment, function. By way of example, the Court pointed out that interest earned by a corporation on short-term bank deposits used as working capital may be apportionable even though the bank and corporation are not engaged in a unitary business. Likewise, income received from stock of a company held by a corporation to ensure a steady supply of raw materials for the corporation's production process would presumably constitute apportionable income even if the supplier was not part of the taxpayer's unitary business. Similarly, income from stock investments that constitute interim uses of idle funds accumulated for future business operations would apparently constitute apportionable income.

        As in ASARCO v. Idaho State Tax Comm'n, 458 U.S. 307 (1982), the Court rejected a "business purpose" test, stating that the mere fact that an intangible asset was acquired pursuant to a long-term corporate strategy of acquisitions and dispositions does not convert an otherwise passive investment into an operational function.

      2. Allocation Of Nonbusiness Income

        Once income has been classified as nonbusiness, the next step is determining to which state it is allocated. Generally, the income is sourced to the state in which the property is located (for tangible assets) or to the taxpayer's commercial domicile (for intangible assets).

        1) Commercial Domicile

        Depending on the taxpayer, the identification of a taxpayer's state of commercial domicile can be a very simple or a more complex process. Under UDITPA §1(b), commercial domicile is defined as the "principal place from which the trade or business of the taxpayer is directed or managed." The criteria that are typically used to determine the commercial domicile of a taxpayer include:

        • Site of board of directors' meetings;
        • Location of stockholder meetings;
        • Location and residence of the officers; and
        • Location of corporate records and bank accounts, etc.

        Although many states apportion business income and allocate nonbusiness income, not all states follow this practice. Some states specifically allocate only specified types of income (e.g., interest, dividends, rents, royalties) and others apportion all types of income except that on which the state is prohibited under the U.S. Constitution from imposing tax - See Allied Signal.

    3. FORMULARY APPORTIONMENT

      As indicated above, certain states apportion income that is classified as "business" income. However, according to the U.S. Supreme Court, the Constitution requires that formulary apportionment be applied only to the income of a unitary business. As the Court states, "[t]he linchpin of apportionability in the field of state taxation is the unitary business principle." Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980).

      1. Unitary Business

        A number of requirements for determining the scope of a unitary business have developed. In addition to Supreme Court decisions addressing unitary business principles, the following tests devised at the state level have gained widespread applicability: (1) the three unities test, (2) the contribution and dependency test, (3) the Multistate Tax Commission test, and (4) the factors of profitability test. There may also be "unitary" implication for a single corporate entity in addition to "unitary" implications in relation to a unitary group of affiliated corporations.

        1)Three Unities Test

        The three unities approach was developed in Butler Brothers v. McColgan, 111 P.2d 334, 341 (Cal. 1941), and provides that analytically "the unitary nature of a business is definitely established by the presence of the following circumstances: (1) unity of ownership; (2) unity of operation as evidenced by central purchasing, advertising, accounting, and management divisions; and (3) unity of use in its central executive force and general system of operation."

        Unity of ownership refers to a common ownership structure of a business and its affiliates. Although the resolution of this test depends in large part on the particular provisions of each states' law, as a general rule, there must be greater than 50 percent stock ownership before a group of businesses satisfy the unity of ownership requirement.

        Unity of operation is evidenced by centralized support functions such as:

        • corporate accounting;
        • legal;
        • personnel;
        • purchasing;
        • advertising;
        • selling; and
        • research and development, or other like departments.

        Unity of use is apparently shown by a central executive force, and a general system of operations. Although unity of use appears to require executive direction to achieve corporate goals, it is not clear as to what extent control must be exercised by the central executive force.

        Although it is hard to differentiate between the unity of operation and unity of use tests, one California decision, Chase Brass & Copper Co. v. Franchise Tax Board, 10 Cal. App. 3d 496 (1970), attempted to reconcile the two tests. The unity of operation test refers to the personnel of an organization who furnish auxiliary and advisory services and do not directly participate in production. The unity of use test refers to the personnel who are directly responsible for manufacturing and assembling functions in the various stages of production.

        2)Contribution and Dependency Test

        The contribution and dependency approach was set forth in Edison California Stores v. McColgan, 183 P.2d 16 (Cal. 1947). The California Supreme Court stated that where "the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state, the operations are unitary," 183 P.2d at 24-25.

        This test is the one most widely used in determining whether a unitary business exists. Although it does not suffer from the narrow scope of the three unities test, its breadth is also the test's primary weakness because of its inability to identify what elements are important in making a unitary determination.

        If any element of operational interdependence, however insubstantial, was sufficient to create a unitary business, then apparently any commonly controlled businesses would constitute a unitary business (e.g., due to common accounting and reporting systems, common officers, common insurance plans) under this test. Thus, for the unitary business concept to have any meaning, some weight apparently must be given to the substantiality of the interdependence

        3)Multistate Tax Commission Test

        The Multistate Tax Commission (MTC) has issued guidance on whether the activities of a taxpayer are to be regarded as a single trade or business or separate trades or businesses and, although the regulations speak of the operations of one taxpayer, many states have chosen to apply the rules across legal entities.

        According to MTC Reg. §IV.1.(b), any of the following factors creates a strong presumption that the activities of the taxpayer constitute a unitary business:

        • Same type of business;
        • Steps in a vertical process; and
        • Strong centralized management.

        4)Factors of Profitability Test

        In Mobil Oil Corp. v. Vermont Tax Commissioner, 445 U.S. 425 (1980), the U.S. Supreme Court held that the income of a multistate business can be apportioned if its intra-state and out-of-state activities form a part of a unitary business. In Mobil, the Court set out the following factors, which have become the basis of determining whether a business is unitary:

        • functional integration;
        • centralization of management; and
        • economies of scale.

      2. Apportionment Formulas

        Under formulary apportionment, there is no attempt to trace items of income to the state in which the income was generated. Rather, a formula is used to arrive at an accurate approximation. Formulary apportionment divides a multistate corporation's tax base among the states in which it does business by applying a fraction representing the ratio of in-state factors to total factors. Formulary apportionment merely approximates the amount of income of a business that should be attributed to a particular state. Dividing the income of a corporation by the use of a statutory formula provides a rough approximation of the corporation's income that is reasonably attributable to the corporation's operations in the state.

        The fact that a corporation has sales in other states does not automatically mean the corporation has the right to allocate and apportion its income. Most states do not permit a corporation to allocate or apportion its income to other states unless the corporation is taxable in another state. Some states require that the corporation actually file an income tax return with at least one other state before the corporation has the right to allocate and apportion its income.

        The method most frequently used to apportion business income to a particular state uses a three-factor formula that compares the ratio of in-state to overall property, payroll, and sales.

        Although most states use the standard evenly-weighted, three-factor formula, certain states incorporate formulas that deviate slightly from the standard formula. For example, a majority of states assign more weight to the sales factor than the other two factors (i.e., double weight the sales factor) or use a formula with less than three factors (two-factor or single-factor formulas). In addition, some states provide different formulas depending upon the taxpayer's industry.

        Generally, in determining the apportionment formula, the sum of the factors is divided by no more than the number of applicable factors. Therefore, if one or more of the factors is not present for the total operations of a corporation (i.e., the denominator of the factor is zero), the average apportionment typically is determined by dividing the sum of the factors by the number of the factors present. For example, for a state that has adopted an evenly-weighted three-factor formula, if either the sales, property or payroll factors are not present, the apportionment formula is determined by dividing the sum of the remaining two factors by two.

        In general, a taxpayer first ascertains the income that is to be apportioned (and then multiplies this amount by the arithmetical average of three ratios:

        • in-state property to total property;
        • in-state payroll to total payroll; and
        • in-state sales to total sales.

        1)Property Factor

        In general, the property factor consists of the taxpayer's real and tangible personal property owned or rented and used during the tax period in the regular course of the taxpayer's trade or business. Intangible property is not usually included in the property factor. Additionally, only property used to produce business income, not property that produces nonbusiness income, is included in the property factor. Property owned typically is valued at its average (beginning of year and end of year) cost. Rented property usually is valued at eight times its annual rental.

        2)Payroll Factor

        In general, the payroll factor consists of compensation paid by the taxpayer in the regular course of its trade or business during the tax period. Compensation consists of:

        • taxable wages
        • salaries;
        • commissions; and
        • any other form of remuneration paid to employees for personal services, (but does not include amounts paid to independent contractors).

        Some states exclude officers' compensation from the payroll factor.

        3)Sales Factor

        In general, the sales factor consists of all gross receipts from transactions and activities in the regular course of the taxpayer's trade or business. The sales factor normally includes, but is not limited to the following:

        • gross sales (less returns and allowances)
        • fees and commissions received from the performance of services;
        • rents and lease payments received from renting real or tangible property;
        • proceeds from the disposition of other tangible and intangible assets; and
        • royalties and other payments received from the sale, assignment, or licensing of intangible personal property such as patents and copyrights.

        In order to prevent certain receipts from escaping inclusion in any state's sales factor numerator, many states incorporate the "throwback" rule. Sales to a destination state where the seller is not taxable (e.g., because its activities do not exceed solicitation under P.L. 86-272) are "thrown back" to the numerator of the state from which the goods were shipped.

  2. NET OPERATING LOSSES (NOLs) STATE TAX ISSUES — EXPLANATION

    Most states permit a deduction for NOLs. While some states explicitly adopt the federal NOL deduction by using line 30 of federal Form 1120 (taxable income after the NOL deduction and special deductions) without modification as the starting point for computing state taxable income, others use line 30 as the starting point of the state tax calculation, but add back the federal NOL deduction and provide a specific computation of the state NOL deduction. Still other states begin the tax calculation with line 28 of the federal return (taxable income before NOL deduction and special deductions) and provide their own set of rules for determining the NOL deduction. These states typically permit a state-level NOL deduction that generally parallels the federal approach.

    The most common variation in determining state NOLs involves the determination of the period of carryback and carryforward. Many states do not follow the federal rules under I.R.C. §172. Approximately 15 states limit the carryforward period, while approximately 20 states do not allow NOL carrybacks at all. Note that federal and state NOL periods may not match because the taxpayer may not have been doing business in the state in the loss year, or because the NOL arose before the state began imposing the tax.

    Regardless of conformity to line 28 or 30, the state NOL and the amount of carryback or carryover allowed may differ from the federal amount as a result of state adjustments (modifications), the application of apportionment factors, whether the corporation was subject to the state's tax in the loss year, and the segregation of business and nonbusiness income (i.e., allocation of nonbusiness income and the apportionment of business income).

    Some states require that the NOL be carried over from the loss year after allocation and apportionment. These states provide that the NOL deduction should be applied in the carryover year after allocation and apportionment. This permits only the loss attributable to that state to be carried over against income from that state.

    In determining the amount of NOLs in states that compute NOLs on a post-apportionment basis, a state may use the apportionment factor in the loss year or the apportionment factor in the year the loss is utilized. Other states, however, allow the NOL computation to be made before apportionment and permit the deduction to be applied in the carryover year before apportionment.

    A few states permit an affiliated group of corporations to file a consolidated state return rather than separate returns for each affiliated corporation if the requirements of the Internal Revenue Code and state law are satisfied. Even if consolidated returns are filed at both the federal and state levels, the calculation of the NOL deduction for federal and state purposes may differ markedly.

    CONSOLIDATED RETURNS

    Some states, even in the context of a consolidated filing, may require NOLs to be tracked on a separate company basis.

    Some states add their own restrictions on the use of NOLs generated in separate return filing years. A number of states do not permit consolidated returns and hence require affiliated group members filing a consolidated federal return to compute their state NOL deductions on a separate company basis.

    COMBINED REPORTING

    Combined reporting may be elective or required by a state. States that provide for combined reporting differ as to how the NOL computation is to be made.

    If a state allows or requires a member of an affiliated group filing a consolidated federal return to file on a separate company basis, the NOL generally is computed as if the member filed on a separate company basis for federal income tax purposes. Thus, the NOLs available for state purposes may differ from those reported on the federal consolidated returns.

    Note that each state's definition of consolidated versus combined reporting should be reviewed prior to preparing any state tax returns. Also note that the states vary in their treatment of NOL carryovers after corporate reorganizations, acquisitions, or liquidations.

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