Boutwell on Prop 39…what the heck is apportionment anyways?

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First and foremost, taxation is complicated.  Multistate corporate taxation is even more complicated.  We are being asked to consider a very complicated proposition in a few weeks and hopefully those who decide to vote on it, understand the tax implications.  Despite the title of the Proposition including clean energy, I am looking at it more from the strict tax perspective and not looking too much at the clean energy job perspective.

In essence, apportionment is the method that a state utilizes to determine what share of a business’s income should be taxed by their state.  Most states that have an income tax use some sort of formula for determining their share of a company’s tax burden assuming that a company has enough nexus, or touches in their state to warrant paying income tax.  In most cases, if a company is transacting business in the state through its people or have property in the state, they will have nexus.  These companies that act in more than one state are considered “multistate businesses” in Prop 39 language.  These multistate businesses can be based in California and have enough connection to another state to pay tax there or it could be an business that is mainly outside of California and has enough connection to pay tax here.  It could also be a large entity that has no one really could discern where they are really located because they have a large presence in California. So, each state has to determine its own method for determining their share of taxes.  The states generally do not act as a group and have the same rules, although the results often will be coordinated.  Just because income is taxed in one state will not prohibit another state from taxing it also because they may not have the same apportionment rationale.  The two most common approaches are 3 Factor Apportionment (3FA) and Single Sales Factor Apportionment (SSFA).

As a reminder, a “YES” vote will eliminate the 3FA while a “NO” vote will keep the status quo of having an option to choose between 3FA and SSFA.

Three Factor Apportionment

Generally, the 3FA approach is to calculate a company’s connection to the taxing state by averaging the total of payroll, assets (usually inventory, fixed assets, rent paid times a factor of 8), and sales in the state compared to the total everywhere.  A lot of states including California double their weight sales.  The rationale is that the more property, payroll, and sales you have in a state the more public services you are utilizing and should share in the burden for financing government.  The downside of the 3FA is that it could encourage a company to try to reduce as much as possible the amount of property and people they have in the state.  Ordinarily, a company does not try to limit sales- at least those that want to be successful.

Single Sales Factor

Other states are utilizing a SSFA where a company calculates its “in state” sales compared to sales everywhere to determine its apportionment factor.  The factor is generally then multiplied by the tax calculated as if 100% of its activities were in the state.  A SSFA system seems to be much easier to calculate as you are only concerned with sales and not property and people in the calculation.  However, from reading the actual bill language, I am not positive that the same definition of in state sales will be in play under Prop 39 compared to the current sales factor.

Where is CA Now?

Well, we are allowed to pick which one is most advantageous.  We are able to choose between a 3FA and a SSFA factor.  Obviously those that sell a lot to out of state locations yet have a lot of property and people in the state, are likely to choose the SSF.  On the other side, those that have a lot of sales to CA yet little property and few people, would likely choose the 3FA.

For years and year, there was mainly one way to calculate apportionment in California.  It was based upon the three factors: payroll, property, and sales.  Again, I presume that the originators of 3FA likely looked at these areas and determined that the more people, property, and sales a company has in the state, the more public services that they should help pay for with their tax dollars.

Then in order to break some Sacramento Gridlock, in the Capitol not the roads, in September 2008, the legislators decided to allow companies to choose between the traditional 3FA and the new SSFA.  The first year of this change was 2011…yes, the tax returns that just got filed over past months.  This has presumably reduced the corporate tax revenue from the state general fund by around a billion dollars or so.

The revenue generated by a “yes” vote, presumably the same money that was lost due to the change in the first place, seems to be split between clean energy jobs and the general fund.  The clean energy earmark is for a five year period.  So even though the lost revenue reduced the general fund and all things that come along with the general fund, the replacement places a higher value on the clean energy sector than the general fund.

The Impact

The goal of the writers of the Proposition seems to be to remove the incentive to locate employees and property in other states thereby reducing the tax a company pays in California.  If a company has an incentive to move people and payroll, they may very well do it.  A SSFA will remove the people and the property from the apportionment calculation.

They are implying that a back room deal needs to be corrected.  Remember, the back room deal that they are referring to is inclusion of the SSFA back a few years ago.  Before that, it was solely the 3FA.  The back room deal included what they now want as the sole option.  The deal included other tax changes was part of a large package.

It would seem to be a good thing to encourage businesses to locate people and property in California.  Obviously by having people here, there is increased economic activity.  With more property here in California, there is more property taxes and likely sales taxes also.  Both would appear to be economic generators and we should encourage that.  The SSFA would seemingly encourage companies to locate people and property in California.  This may even make their sales activity increase in California also.

Right now, businesses are able to choose between SSFA and 3FA.  They are not punished for having people and property here…if they have a lot of people and property, then they will utilize the SSFA for California tax purposes.  If they have few people and property here, then they will utilize 3FA methodology.  Businesses are able to do what is best for them.  Obviously, what is best for them often means what is not so great for California tax rolls.  Companies should pay their fair share, but like always, what is “fair”.  Should the job creators who have a high number of employees in the state (and utilize state resources) pay higher tax than someone who does not have people here in California but sells to Californians?  Should someone who sells primarily to California pay more than a company who is primarily located in California yet sells most products to out of state customers?

As a tax professional, I would also state that I believe that tax law changes should be rare and foreseeable.  2011 was the first year for having a choice between SSFA and 3FA.  If we were going to be moving to a SSFA, the model of having a few years migration may actually seem like a good thing.  However, that is not the case.  I believe that these rules would be in place starting next year in 2013.  It is better than the retroactive tax increases that we see in other Propositions we are asked to vote on, but regardless this is a hard right hand turn in a tax world that likes to have smooth curves or plenty of notification of a upcoming change.  The scary thing is that if we the people vote on this and then a few years down the line, another proposition can come along to reverse it.  This can be concerning for businesses.  With our situation up in Sacramento, it is also unrealistic to think that they will actually be able to decide tax policy in a bipartisan manner.  There is too much gridlock and not enough compromise.  When that is the case, the people must speak.

By the way, this is mainly a C Corporation issue as the entity pays its own tax prior to determining how much in dividends, if any, to distribute out to its shareholders.  C Corporations can be small mom and pop stores (likely not a multistate business), to a successful small business with location inside and outside of California, all the way up to large multi-national companies.  Pass-through entities such as Partnerships, LLC’s, and S Corporations that have out of state owners are also impacted though as the owners will pay personal income tax based on the apportioned income passed through to them.  Remember, if you are a resident of California and you receive pass through income, all of your worldwide income is taxed here and then you receive a credit for the taxes you pay to other states, for the most part at least.

Where do I stand?

I like jobs.  I like jobs no matter where they are located.  I like jobs the most in my family, then my friends, then my local community, then my state, then the US, and then the world.  Some may consider that to be selfish or greedy, but I am fine with my thinking.  I do believe that the business environment can help to encourage job creation if done appropriately.  I do not feel that California has the most business friendly environment.  We should encourage a business friendly environment.  We also have to be responsible with the tax revenue that is collected and the use of it.

A client asked me the other day, “But what do you think? Where do you stand?” after I was doing my absolute best to explain in a neutral manner the positions of the POTUS versus Romney, future impacts of the Propositions on their personal situation, and other tax changes coming down the road.  My response to the client was in the realm of “If I have done my job well, then you won’t be able to tell what I think, but you will be able to be better informed and able to make a decision that you feel is best for you based on your beliefs- not based on mine.”  You may be able to decipher my inclination for a vote, which is fine, but please be informed on the topic prior to voting for yourself.

As always, open for civilized discussion…