Opportunities with Nonbusiness Income and State Apportionment

Editor: Alan Wong, CPA

State & Local Taxes

In the absence of a standardized system for state apportionment formulas, tax savings opportunities may arise from excluding nonbusiness income from state apportionment. By performing a careful analysis of business and nonbusiness income, it may be possible to achieve a sales apportionment factor that is less than 100%. In essence, advisers could remove the portion related to nonbusiness income from taxation, thus creating so-called nowhere income. However, the throwback rule, if applicable, may negate this opportunity. Tax practitioners could potentially take advantage of this situation by performing a more in-depth analysis of sales by state.

The body of work that dictates state apportionment formulas for many states is known as the Uniform Division of Income for Tax Purposes Act (UDITPA). It was created in 1957 as an effort to produce congruence among states when dealing with state apportionment. One of its highlights was creating a framework for defining business and nonbusiness income. In general, business income means “income arising from transactions and activity in the regular course of the taxpayer’s trade or business” (UDITPA §1(a)); it is subject to apportionment and divided among all filing states. Nonbusiness income is categorized as “all income other than business income” (UDITPA §1(e)); it is allocated to the taxpayer’s state of domicile or where the property resides (UDITPA §§4–8). Many nonconforming states have developed parallel definitions regarding business activities for their apportionment systems.

The principal purpose of the apportionment formula is to approximate the corporation’s taxable income attributable to that state. The most frequently used apportionment formula is a three-factor formula that encompasses sales, property, and payroll and weights each of these factors equally. Some states have developed apportionment formulas that weight the factors differently—for example, using a double-weighted sales factor or a single sales factor. At the core of a practitioner’s analysis of a taxpayer’s allocation of income is the comparison among states that conform to UDITPA and thus define receipts as either business or nonbusiness versus states that have their own definition of receipts.

First, taxpayers in UDITPA-conforming states will need to carefully examine their receipts and determine the portions that relate to business and nonbusiness income. Second, nonbusiness income (that is, receipts other than rents and royalties from real or tangible personal property, capital gains, interest, dividends, or patent or copyright royalties) should be analyzed to determine if they can be excluded from the receipts apportionment factor in UDITPA states, so the sales factor could be less than 100%. The nonbusiness income that is excluded is then allocated to the entity’s state of domicile.

Furthermore, if the state of domicile is a non-UDITPA-conforming state, it is possible that those receipts could be excluded from the sales factor and may be classified as receipts not attributable to any state. Some states of domicile do not have a clear definition of what constitutes business income, and businesses are required only to allocate certain types of income such as “[r]ents and royalties from real or tangible personal property, capital gains, interest, dividends, or patent or copyright royalties” (UDITPA §4). Consequently, if nonbusiness income does not fall within any of these categories, it may reduce the sales factor and thus lower the apportionment percentage to that state.

Further complicating matters, some states have implemented throwback, double throwback, and throwout rules. A discussion of specific issues goes beyond the scope of this item. Nonetheless, tax practitioners should be aware that there is a voluminous body of work that deals with other state-specific issues. Opportunities exist for lowering state taxes, but they can be identified only through a thorough analysis of the nexus rules for each state and the components of the respective states’ apportionment factors.

As states are faced with more budgetary challenges, they will likely reassess their tax structures. For now, businesses operating in a multistate environment should expect changes in the coming years. Practitioners should always consider the constant evolution of state taxation as they consult with clients.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.