States Reaching for Corporate Profits

Reeling from gaping budget gaps, states are starting to explore ways to crack down on the complex accounting schemes businesses use to avoid paying state taxes.

New Jersey, in a move closely watched by other states, changed its tax laws in 2002 to keep businesses from shifting profits to affiliates in low tax states. The change has proven lucrative, bringing in $1.88 billion through April of this year, which is roughly 50 percent more than the state collected through the same period last year.

Other states considering ways to cut down on corporate tax avoidance include Alabama, Iowa, Louisiana, Massachusetts, Missouri, New York, Ohio and Pennsylvania.

“In the past couple years, there has been more state corporate tax reform activity in state legislatures than I’ve seen in 15 years,” said Michael Mazerov, a policy analyst at the Center on Budget and Policy Priorities, a left-leaning think tank in Washington, D.C.

Despite the increased activity, University of Connecticut law professor Richard Pomp said most states lack the resources to effectively police corporate tax structures.

“They don’t really have the manpower or the expertise to be able to go up against the biggest corporations in the country. It’s a David and Goliath battle, and the states are losing,” he said. Pomp is co-author of the leading legal casebook on state taxation.

Inability to police corporate tax avoidance has contributed to a severe erosion of state corporate income taxes, which supplied 10.2 percent of state tax revenue in 1979, but just 6.3 percent in 2000, according to the U.S. Census Bureau.

“As far as the states go, it’s become less and less important. It didn’t show any of the growth that we saw in the personal income tax and sales tax in the 1990’s,” said Nick Jenny, an analyst at the Nelson A. Rockefeller Institute of Government in Albany, N.Y.

Forty-five states levy corporate incomes taxes, according to the Multistate Tax Commission. Michigan, Nevada, South Dakota, Texas and Washington do not.

New Jersey changed its corporate tax code last year by starting to tax royalties from out-of-state subsidiaries of New Jersey companies and out-of-state sales not already taxed by other states. It also imposed an alternative minimum tax on a graduated basis, which is calculated according to a company’s revenues or profits. These changes are geared toward making sure New Jersey companies pay taxes for all of their economic activity.

“It’s been a tremendous success. Without it we would have been in dire straits, considering we still face a $5 billion deficit. The revamping has been critical to getting by,” said Matt Golden, a spokesperson for the New Jersey Dept. of Revenue.

Businesses complained that the changes would hurt New Jersey’s economy, but Golden says this hasn’t happened.

“One of the important things we want to make sure gets across is that new business filings are up,” he said.

Golden has been contacted by many other states looking to reform their corporate income tax structures.

U. Conn.’s Pomp said New Jersey’s fix was only a partial solution. He said the state will not be able to fully track corporate tax avoidance until it mandates combined reporting. Under combined reporting, businesses file tax reports that include all the business activity of all their affiliates no matter where they are located.

Sixteen states mandate some form of combined reporting, according to the Multistate Tax Commission.

“[Combined reporting] is like putting Humpty Dumpty back together again. It undoes what all the smart tax planning does. This says, if you’re a taxpayer, and you’ve moved money from your left pocket to your right pocket, we’re not going to respect that,” said Pomp.

One of the main ways businesses avoid state income taxes is by establishing affiliates in Delaware called passive holding companies, which are untaxed by the state. A passive holding company limits its activities to the management of intangible assets, such as dividend income, interest on notes, capital gains, trademark payments, rents and royalties.

Businesses shift money to Delaware holding companies through complex transactions that other states have trouble tracking without combined reporting, thereby avoiding state income taxes. Delaware is home to 500,000 businesses. The state is home to only 800,000 residents.

State tax officials said in off-the-record comments that combined reporting would go a long way toward solving their corporate income tax problems.

“The states know what to do. It’s a question of the legislative will to do it. Backbone is in very short supply,” said Pomp.

Analysts say businesses’ tax-avoidance strategies may be costing states billions of dollars annually but that no solid estimates exist because most tax records are not made public.

Ohio’s legislature is currently weighing a proposal from Gov. Bob Taft (R) that would crack down on corporate income tax avoidance.

“It’s just not a very effective tax. The governor’s proposal was to tighten up a lot of the loopholes, which would really increase the fairness of this tax,” Gary Gudmundson, communications director for the Ohio Dept. of Taxation, said

Taft’s proposal would raise minimum corporate tax payments, increase the cap on the business net worth tax from $150,000 to $500,000, and make it harder for businesses to shift profits to affiliates in other states.

“In today’s economy, a web of affiliated corporations, partnerships, and other business entities make it easy for businesses to enter into sophisticated transactions in such a way as to dramatically minimize their tax liability,” Taft spokesperson Orest Holubec said.

Partly as a result of tax-avoidance strategies, corporate income tax collections have declined from 17 percent of Ohio’s total tax revenue in 1977 to less than 5 percent in 2002. Spurring on the corporate tax issue in Ohio is the state’s budget deficit, which now stands at $1.7 billion for fiscal year 2004.

Analysts say some of the downward trend in corporate income tax collections stems in part from tax credits states offer businesses to lure them from other states. But a larger reason, they say, is the increasing sophistication of businesses’ tax-avoidance schemes. States are just now in the beginning stages of trying to figure out the extent of those schemes and how much revenue they are losing through them.

“The true accounting of a major corporation is so complex it would be very difficult for a state to audit them in a systematic way. If there was a glaring problem, they might try, but it would take too much of the resources of a state to go after a corporation, to really say: Are you paying enough? Are you paying what you should be paying?” said Rockefeller’s Jenny.

It is also the case that many corporate tax schemes are legal or at least arguably so. “In most cases this is all in a very gray area there is what I call the good, the bad, and the ugly,” said U. Conn.’s Pomp.

Cracking down on corporate tax avoidance is difficult for state lawmakers, many of whom depend heavily on campaign contributions from business interests. Recent attempts to address the issue in Arkansas and New York were watered-down by the business lobby, analysts say.

Business interests say that what lawmakers call tax reform is for them a tax increase. But Pomp says the issue is one of fairness.

“There are always some corporations that will benefit from change and others that will pay more. But if you’ve been underpaying your taxes for years and now all of a sudden you’re being asked to pay your fair share, I guess you could call that a tax increase, but I would say we’re finally catching up to you and getting you to pay today what you should have been paying yesterday,” he said.