Tax Analysts Blog

How to Save the Corporate Tax

Posted on Mar 23, 2016

Since 2002, I have been saying that states should repeal their corporate income taxes. The tax has not raised much money, and it never will. We spend an inordinate amount of time litigating, planning, auditing, and agonizing over it. We should stop pretending the tax matters, because it doesn't.

Besides not raising much money, the corporate tax is a no benefits tax. How could it be if everyone is using single sales factor? It may not do much to alleviate the decidedly regressive nature of the state tax system, as more and more research indicates that the tax falls on labor in the form of lower wages. The real beneficiaries are lawyers and accountants. A big reason for keeping the tax has been to give it away as an incentive.

A student told me recently that she didn't think the state corporate tax would go away, primarily for political reasons. After all, how do you argue for lower corporate burdens when the responsibility for providing replacement revenue would have to fall on people? Senate presidents and House speakers have asked the same question. I would raise any broad-based tax to replace the corporate tax, but then I'm no politician. My student asked how, if it isn't going away, it can be strengthened. She suggested saving it, rather than calling for its end.

So for you corporate taxophiles, here is how you can save the tax. First, get all the states in a big room and have them agree to end all targeted tax incentives. States would be able to compete, but they could not offer deals or provide breaks that are not available to every taxpayer. Not only would that be the right thing to do, but it should appeal to liberals, conservatives, and libertarians. Of course, barring a compact of some sort, Congress can jump in under the commerce clause and prohibit the use of targeted tax incentives. Smart people have argued for this approach before. Ending targeted tax incentives will raise a lot of money, reduce the cynicism that accompanies the cronyism, and help the economy. Some lawyers -- a few of whom are good friends of mine -- make their living doing targeted incentive deals. I am willing to sacrifice their livelihood for the cause.

Second, every state should adopt combined reporting. I think 24 of the 45 states with a corporate income tax require combined reporting. I have heard the counterarguments for decades, but a strong state corporate income tax requires combined reporting. Without it, the planning opportunities are legion. States using separate accounting lose revenue because their corporations set up holding companies in Delaware or Nevada. The billions of corporations headquartered in the desk drawers of a couple law firms in Wilmington were created to minimize taxes. Don't ever let anyone tell you otherwise. Sure, you can try addbacks and anti-passive-investment-company laws, but nothing is as effective at combating aggressive transfer pricing as combined reporting. My friends at the Council On State Taxation (whom I usually agree with) dislike combined reporting. But we need to sacrifice COST members for the good of the corporate income tax.

Third, and a little more technical, states need to find a way to combat business and nonbusiness income planning. I first heard Walter Hellerstein talk about it 25 years ago: Corporations routinely allocate income from the sale of assets or other "highly unusual" transactions to low- and no-tax states. Nothing ever occurs in the ordinary course of business. I understand the due process clause origins of business and nonbusiness income distinctions, but maybe, like with remote sales, it's time to revisit some of those rules in light of the modern economy. There are good arguments for ending the distinction and treating all income as unitary. I don't know how much money will be raised, but it will be substantial.

Fourth, states need to make it harder to create and use passthrough entities. Everyone knows that the limited liability company revolution has not been good to the corporate income tax. The trend for 20 years has been to create LLCs rather than traditional C corporations (when there are no particular reasons for a C corp entity, such as raising capital through the markets). Avoiding double taxation is a powerful draw. But it has wreaked havoc on the corporate income tax. It's difficult to determine how much corporate tax revenue has been or will be lost because of passthrough entities. But again, it is substantial. Harder still is trying to figure out how to slow or stop the trend toward LLCs, limited liability partnerships, etc. One idea would be to impose an entity-level income tax on all business entities. Basically, the states could treat all the LLCs as C corps for tax purposes. Is this a crazy idea? Not as crazy as you might think

Fifth, saving the corporate income tax requires uniform apportionment formulas. The way we're headed, every state will be using single-sales-factor formulas. Twenty-one use them now. Fifteen use a heavily weighted sales formula. Only nine states still use the traditional three-factor formula. The problem is that differing apportionment formulas give really smart lawyers and accountants all they need to engage in lucrative planning. And if you don't think the apportionment formulas matter, just read some of the Gillette cases. By the way, the combination of a heavily weighted sales formula, lack of uniformity, inconsistent combined reporting, and P.L. 86-272 is equivalent to drawing the inside straight flush for tax planners. Is it possible that all of these planning opportunities align in the same era? Corporate tax planners must pinch themselves in wonder.

Finally, states need to get behind uniformity in general, and the best way to do that is through the Multistate Tax Commission. Indeed, whether we are trying to save the tax or not, every state should be a full-fledged member of the MTC. Why? Because uniformity is good. It's good for the states, and it's good for the corporations. And there is no organization better suited to further the cause of uniformity. The lack of uniformity is right up there with LLCs and incentives in terms of killing the tax. So states should join the nexus program, the audit program, and the uniformity efforts of the MTC.

Some of my fixes would be difficult -- ending the use of targeted incentives would take the kind of courage rarely seen in the halls of state capitols. Some would be easy. There really is no reason why every state is not on board with the MTC. These ideas are not new. They aren't even mine. The problem with my wish list is that states won't want to pursue any of these measures. That is unfortunate because accomplishing one or two would go a long way toward saving the corporate tax.

This viewpoint first appeared in State Tax Today.


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