How Corporate Income Taxes Work?
Corporate Income Taxes
In its simplest form, the corporate income tax is a tax on corporate profits—that is, receipts minus expenses. Like the personal income tax, the corporate tax is based on the “ability to pay” principle: just as someone who does not have any income in a given year usually does not owe any personal income tax, a corporation that does not realize a profit in any one year generally does not owe any corporate income tax that year.(How Corporate Income Taxes Work)
■ Determining who can be taxed :
A given company must determine whether it has nexus in a given state—that is, the company must determine whether it engages in a sufficient level of activity in the state to be subject to tax. The amount of in-state activity in which a company must engage before achieving nexus with a state for corporate income tax purposes is defined by a little-known federal law known as Public Law 86-272, which says that a state cannot apply its corporate income tax to companies whose only connection to the state is the solicitation of orders from, or the shipment of goods to, the residents of the state. In recent years, an increasing number of states have determined that physical presence is not necessary to establish substantial nexus. They have successfully argued in court that out of state businesses selling services to state residents (such as banking or accounting) should be subject to the corporate income tax because they have an “economic presence” in the state and are benefitting from state provided public services to conduct their business activities. As will be discussed later in this chapter, companies are well aware of nexus requirements and may structure their operations so that they avoid “crossing the nexus threshold” —and, by extension, the corporate income tax—in some of the states in which they do business.
■ Measuring profits.
Potentially taxable companies must calculate the net income, or profit, that it earned over the course of the year. To do this, most states “piggyback” on the federal corporate income tax, using the federal definition of taxable income as a starting point. While this dependence on federal tax law leaves states vulnerable to potential revenue losses in the event the law changes—as has been the case with accelerated depreciation rules or the deduction for “qualified production activities income” (QPAI) enacted in recent years—it makes tax administration easier both for states and for taxpayers.
■ Splitting income into “business” and “non-business” components.
The next step is to divide a company’s taxable income into a “business income” component and a “non-business income” component. Business income is typically considered to be the profits a company earns from its day-to-day business operations (and therefore must be distributed among the states in which it operates). Non-business income arises from certain irregular(How Corporate Income Taxes Work)
transactions such as the sale of an asset no longer used in day to day operations and is allocated in full to the state in which such a sale occurs or to the state in which the part of the company generating such income is situated (usually the state in which a company is headquartered).
■ Apportionment, or determining each state’s share of corporate “business” income.
For obvious reasons, a given state is not allowed to simply tax all of the profits of any company that has nexus in the state. If states could do this, the profits of companies that operate in multiple states might be taxed many times over.
Instead, states are required to levy their corporate income taxes in such a way that the whole of a company’s profits are subject to tax just once.1
States conform with this requirement by dividing their business income into an “in-state” portion (which is taxable in a given state) and an “out-of-state” portion (which is not). Each state uses what is known as an apportionment formula to accomplish this step.(How Corporate Income Taxes Work)
In the 1950s, legal reformers worked to set up a fair, uniform way of distributing profits among states, so that the profits of companies operating in multiple states were taxed exactly once. The result was a model piece of legislation—the Uniform Division of Income for Tax Purposes Act or UDITPA—that is today part of about twenty states’ tax codes. UDITPA recommends relying on three factors to determine the share of a company’s profits that can be taxed by a state. These factors are(How Corporate Income Taxes Work)
- The percentage of a corporation’s nationwide property that is located in a state.
- The percentage of a corporation’s nationwide sales made to residents of a state.
- The percentage of a corporation’s nationwide payroll paid to residents of a state.
The main rationale for using these three factors is that it is impossible to determine with any accuracy the specific parts of a company that generate a given dollar of profit, let alone the states in which those parts may be located. These three factors are viewed as reasonable approximations of the
share of a company’s profit that arises from doing business in a state, based on both the demand for company output in the state (the sales factor) and the production activity in which it engages in that state (the property and payroll factors), since profits are a function of both demand and supply.
UDITPA’s recommendation was to assign each of these three factors an equal weight in distributing a company’s business income among the states in which it operates. In other words, the percentage of a company’s business income that can be considered “in-state” is the average of these three percentages. If one supposes that the Acme Corporation operates in three states—each of which uses an equallyweighted three factor apportionment formula, as UDITPA recommends—40 percent of its business income will be apportioned to State A, 25 percent to State B, and 35 percent to State C. In each case, these percentages are the averages of Acme’s sales, property, and payroll factors in each state. For instance, Acme has 50 percent of its total sales, 20 percent of its property, and 50 percent of its payroll in State A. The average of these factors is 40 percent; accordingly, 40 percent of Acme’s business income will be apportioned to State A.
■ Calculating tax:
Having determined the share of its total taxable income that is attributable to a given state (including the amount of business income that can be
apportioned to the state and the amount of non-business income that is allocated to the state), the resulting sum is multiplied by the state’s corporate tax rates to yield a tax amount.
■ Subtracting credits.
Many states now allow targeted tax credits (for example, credits for research or investment activities) that companies can subtract directly from their
■ Pay the Minimum.
Most states now require that even technically unprofitable corporations must pay some minimal amount of income tax. As is discussed at greater
length later in this chapter, states’ minimum taxes vary from very modest flat dollar amounts to more substantial sums based on a company’s net worth.