Basics of State Corporation Taxation in the US

The US has a federal system of government. Unlike the UK’s unitary system, in the US each level of government (federal, state, and local) exercises certain powers that are either exclusive to that level or shared with other levels. One shared power is the power to tax corporations. Consequently, the federal government imposes a tax on corporations, as do 48 of the 50 US states and a small number of local governments.

Two US states (South Dakota and Wyoming) have no corporate tax whatsoever. Four states (Nevada, Ohio, Texas, and Washington) impose a “gross receipts tax,” in lieu of a corporate income tax, under which tax is imposed on all gross receipts in excess of certain thresholds. Delaware imposes both a corporate income tax (of 8.7%) and a gross receipts tax. Among those states with corporate income taxes, rates range from 2.5% (North Carolina) to 12% (Iowa).

Contrary to popular belief, the state of incorporation does not usually determine a corporation’s tax rate or burden. Instead, a corporation’s national income is apportioned among the states where it is doing business. Generally, if a corporation is subject to tax by a state, the amount of tax owed will be determined using a formula designed to approximate the degree to which the corporate profits arise out of the corporation’s connection with that state.

How do you know which states have the power to tax your corporation? Firstly, the state of incorporation always has the power to impose tax. Secondly, under US Supreme Court decisions interpreting the due process and commerce clauses of the US constitution, a state can tax out-of-state corporations only if the corporation engaged in an activity which has a “substantial nexus” with the taxing state.

Unfortunately, this is a concept with no universally accepted meaning. Generally, one looks to the extent of the corporation’s economic ties to the state to determine whether substantial nexus exists. In fact, many states have established specific thresholds for property, payroll, and sales. If the value of the corporation’s property, payroll, or sales in that state exceeds the specified threshold, then the corporation is deemed to have substantial nexus with its state. Since each state’s definition of what constitutes substantial nexus is different, the system can seem bewilderingly complex. If a corporation has substantial nexus with a state, it generally must file a corporate tax return with that state.

Once it is determined that a state has the power to tax your corporation, it must then be determined what portion of your corporation’s income is subject to tax by that state. The US Supreme Court has ruled that a state’s power to tax the corporate income of a multistate corporation is validly exercised only if the tax is “fairly apportioned.” That is, the tax imposed must fairly reflect the tax attributable to the corporation’s contacts with the taxing state.

Each state has adopted legislation to implement the constitution’s requirement for fair apportionment of multistate corporate income. A few states employ a three “factor” formula, which take into account the taxpayer’s property, payroll, and sales in each state, relative to the taxpayer’s total property, payroll, and sales. However, most states either consider only sales or double weight the sales factor. Thus, if your corporation has substantial nexus with states using different formulas, it is possible that the same business income could be subject to tax more than once.

As noted above, usually corporations must apportion their profits among the states and pay corporate income tax to the states where those profits arise. To facilitate interstate commerce, Congress has carved out a narrow exception to this rule. Under Public Law 86-272, if the corporation’s activity in a state is limited to the mere solicitation of orders for the sale of tangible personal property and those orders are to be approved and filled from outside the state, then the state has no authority to impose income tax on the profits of the transaction.

Fortunately, with proper planning, it is often possible to structure business transactions to legally reduce the burden of complying with state reporting requirements, as well as the total tax owed.