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PROBLEM MATERIALS
DISCUSSION QUESTIONS
1. What states do not impose a sales tax?
2. What is a use tax? Who is responsible for collecting and remitting use taxes to the applicable
tax authority?
3. Tiger Corporation, a manufacturer based in State P, purchases office furniture from a retailer
located in P. Tiger uses the furniture in its administrative offices located in P.
a. What are the sales and use tax consequences of this purchase?
b. Now assume that instead of buying the office furniture from a local retailer, Tiger
purchases the furniture from a mail-order vendor located in another state. How does this
change the sales and use tax consequences of the purchase?
4. All states impose property taxes. What types of business assets are typically subject to property
tax?
5. What methods does a property tax assessor typically use to estimate the market value of taxable
property?
6. Which states do not levy a corporate income tax? Which states do not levy an individual
income tax?
7. An important state tax concept is “nexus.” What does “nexus” mean?
8. The physical presence test for nexus is based on what legal authority?
9. An out-of-state company must meet four requirements to qualify for protection under Public
Law 86-272. List these requirements.
10. Larger business enterprises often have legal structures that include a parent corporation with
one or more chains of subsidiary corporations. Explain the corporate group filing options for
financial reporting, federal income tax and state income tax purposes. Assume the states in
which the company has nexus all require combined unitary reporting.
11. How would your answer to Question 10 change if the states in which the company has nexus all
require separate company reporting?
12. Virtually all of the states that tax corporate income piggyback on the federal system by adopting
federal taxable income as the starting place for computing state taxable income. Some states
conform to a static federal tax base, while other states conform to a moving federal tax base.
Explain this distinction.
13. Despite the broad conformity to the federal tax base, each state requires a corporation to make
numerous addition and subtraction modifications to arrive at state taxable income. Identify the
common adjustments to the federal tax base in computing a corporation’s state taxable income.
14. Most states use apportionment formulae that place more weight on the sales factor than on the
property or payroll factors. Why are state lawmakers attracted to apportionment formulae that
emphasize the sales factor?
15. Explain the rules for assigning sales of inventory as well as business receipts other than
inventory sales to the numerator of each nexus state’s sales factor.
16. How is payroll defined for purposes of computing a state’s payroll factor?
17. A corporation apportions business income among the various states in which it has nexus. In
contrast, the entire amount of a corporation’s nonbusiness income is specifically allocated to a
single state. How does UDITPA define business versus nonbusiness income?
18. Explain the difference between how states tax the income of resident individuals as compared to
nonresident individuals.
19. Explain the difference between how states tax the income of resident versus nonresident
shareholders of an S corporation that is doing business in two or more states.
ISSUE IDENTIFICATION QUESTIONS
20. Hefti Corporation is a retailer of heavy metal music. Hefti sells exclusively over the Internet,
and makes sales in all 50 states. Customers go to Hefti’s web site and download the songs they
wish to purchase. Hefti’s offices are located in State X, and the activities of Hefti’s employees
are generally limited to State X. However, Hefti representatives do travel to States Y and Z on
a regular basis to meet with heavy metal bands and close deals to sell their songs at Hefti’s web
site. What state income tax issues should the controller of Hefti consider with respect to states
other than State X?
21. Walnut Corporation is a large corporation headquartered in State N, which does not have a
corporate income tax. Walnut also has income tax nexus in about 20 other states. During the
current year, Walnut sells its interests in a number of subsidiaries resulting in a total of $100
million in capital gains from the sale of stock. What state income tax issues should the tax
director of Walnut consider with respect to these capital gains?
22. Blue Corporation operates a retail furniture business located in a state that imposes a sales and
use tax. During the current year, Blue made $10 million of sales, which included sales to some
local churches as well as sales to the local state-owned community college. Blue’s purchases
included $6 million of inventory purchased from out-of-state furniture manufacturers and
$15,000 of office supplies purchased from an out-of-state mail-order vendor. What sales and
use tax issues should the controller of Blue Corporation consider with respect to these
transactions?
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PROBLEMS
23. Physical presence test. Green Corporation is a mail order vendor of consumer goods.
Green’s main office and distribution facility are located in State X. Green has no property or
employees located in any other state. All orders for Green’s products are filled out of its State
X warehouse with deliveries made by common carriers. During the current year, Green’s sales
to customers located in the neighboring state of Y totaled $15 million. Does Green have nexus
in Y for income tax purposes? Does Green have nexus in Y for sales tax purposes? Explain.
24. Public Law 86-272. Sparrow Corporation produces organic food products at its facilities
located in State Q for sale nationwide. Sparrow has no property or employees based in any
other state. Sparrow markets its products in State R through employee-salespersons who travel
to State R on a regular basis to call on organic grocery stores in order to solicit sales, distribute
free samples and arrange product displays without charge. The salespeople use company-
provided cars to travel in State R and carry company-owned free samples and display materials
in the trunks of their cars. Does Sparrow have income tax nexus in State R? Explain.
25. Public Law 86-272. Red Corporation manufactures industrial equipment. Red’s main office
and production facility are located in State L. Red has no property or employees based in any
other state. Because Red has numerous customers located in State M, Red employees regularly
travel to State M to solicit sales, install Red’s products, conduct customer training sessions and
provide repair services. Does Red have income tax nexus in State M? Explain.
26. Public Law 86-272. Thrush Corporation is a market research firm with offices located in State
G. Thrush has no property or employees based in any other state. However, Thrush employees
regularly travel to State H to solicit sales from potential customers. Thrush provided $10
million of services to its State H clients during the current year. Thrush was able to do all of the
market research work from its State G offices using e-mail, fax and telephone. Does Thrush
have income tax nexus in State H? Explain.
27. Corporate reporting options. Giant, Inc. is a State X corporation that has nexus only in X.
Giant has the following affiliates:
Sub 1: A 100%-owned State X corporation that is not unitary with Giant or any other
affiliate. Sub 1 has nexus in States X and Y.
Sub 2: A 60%-owned State Y corporation that is unitary with Giant and Sub 3. Sub 2 has
nexus only in State Y.
Sub 3: A 100%-owned Mexican corporation that is unitary with Giant and Sub 2. Sub 3
has nexus only in Mexico.
What are the Giant group’s filing requirements for financial reporting, federal income tax and
state income tax purposes? Assume State X requires separate company reporting, whereas
State Y requires combined unitary reporting on a water’s-edge basis.
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28. Corporate reporting options. BikeCo, Inc. is a Wisconsin corporation that manufactures
bicycles. BikeCo’s facilities are located in Wisconsin. BikeCo markets its bicycles through
independently owned distributors. BikeCo owns 100% of each of the following corporations:
▪ FloCo, Inc. A Florida corporation that manufactures component parts for BikeCo’s
bicycles. FloCo’s facilities are located in Florida.
▪ ArizCo, Inc. An Arizona corporation that functions as BikeCo’s research and
development arm. ArizCo’s facilities are located in Arizona.
▪ IowaCo, Inc. An Iowa corporation that manufactures frames for BikeCo’s bicycles.
IowaCo’s facilities are located in Iowa.
▪ CanCo, Inc. A Canadian corporation that markets BikeCo bicycles at the wholesale level
in Canada. CanCo operates out of offices located in Toronto.
Each of the above corporations has nexus only in the state in which it is organized, except for
BikeCo (parent corporation), which has nexus in Wisconsin, Florida, and Iowa.
Analyze the BikeCo group’s filing options for each of the following purposes:
(i) Wisconsin corporate income tax (Wisconsin requires separate company reporting)
(ii) Florida corporate income tax (an affiliated group filing a federal consolidated return may
elect to file a Florida consolidated return, but only if the parent corporation has nexus in
Florida)
(iii) Arizona corporate income tax (Arizona is a mandatory combined unitary reporting state,
with a water’s-edge combination)
(iv) Iowa corporate income tax (Iowa permits affiliates that are included in a federal
consolidated return and have nexus in Iowa to elect to file an Iowa consolidated return)
29. Apportionment formula. Acme Corporation, which has nexus in a number of states, derived
a total of $100 million of apportionable income during the current year. Acme has 10% of its
property, 10% of its payroll and 40% of its sales located in State Z. Z uses a double-weighted
sales apportionment formula. How much of Acme’s income is apportioned to State Z?
30. Apportionment formula. Hawk Corporation conducts business in States X and Y. During
the current year, Hawk derives a total of $10 million of apportionable income, and its property,
payroll and sales are distributed as follows:
State X State Y
Property 100% 0%
Payroll 100% 0%
Sales 70% 30%
Compute Hawk’s State X and State Y taxable income under each of the following independent
assumptions:
a. Both X and Y employ an equally-weighted three-factor apportionment formulae.
b. X employs an equally-weighted three-factor formula. Y employs a double-weighted sales
formula.
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c. X employs a single-factor sales-only formula. Y employs an equally-weighted three-factor
formula.
d. Both X and Y employ a single-factor sales-only formula.
31. Sales factor. Rose Corporation has nexus in States L and M. All goods are shipped from State
L. Current year revenues include $60 million of sales to L customers and $30 million of sales
to M customers. Other business receipts include $10 million of fees derived from services
performed for customers located in State M. The underlying income-producing activity for
these services took place in State L. Compute Rose’s sales factor for State L.
32. Sales factor throwback rule. Tulip Corporation has nexus in States B and C. All goods are
shipped from State B, which uses a single-factor sales-only formula. Current year revenues
include $12 million of sales to customers located in State B, $20 million of sales to customers
located in State C and $18 million of sales to customers in states that Tulip does not have
nexus. How much higher will Tulip’s State B apportionment percentage be if B has a
throwback rule than if B does not have a throwback rule?
33. Sales factor throwback rule. Acme is a State L corporation that manufactures and sells
consumer products. Although Acme makes sales to customers nationwide, it has nexus only in
States L and M. All shipments are made from Acme’s factory located in State L. Both L and
M employ double-weighted sales apportionment formulae. During the current year, Acme’s
property, payroll and sales are distributed as follows (all numbers in millions):
State L State M Other Total
Property $90 $10 $0 $100
Payroll $18 $2 $0 $20
Sales $72 $12 $36 $120
Compute Acme’s State L and State M apportionment percentages under each of the following
independent assumptions:
a. State L does not have a sales throwback rule.
b. State L has a sales throwback rule.
34. Sales factor. Birch Corporation markets its products nationwide but has nexus only in States
Q and R. All goods are shipped from Birch’s production facility located in State Q, which has a
sales throwback rule. States Q and R include business interest, dividends and royalties in the
sales factor, and assign such income to the state of commercial domicile. Birch is commercially
domiciled in State Q. States Q and R source sales other than sales of inventory using the
income producing activity rule. Acme’s current year business receipts are as follows (all
numbers in millions):
Sales shipped to State Q customers ......................................................... $60
Sales shipped to State R customers ......................................................... $90
Sales shipped to customers in other states ............................................... $120
Interest income on short-term investments of working capital................ $2
Income from renting excess space in warehouse located in Q ................ $8
Fees for services performed for R clients (work performed in Q) ........... $11
Royalty from licensing an industrial patent ............................................ $9
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$300
Compute Birch’s sales factors for States Q and R.
35. Sales factor. Eagle, Inc., a State L corporation, is a website development firm that provides
services to customers located in States L, M, N and O. Eagle’s sales are distributed equally
among these four states. Because Eagle employees regularly travel to States L, M, N and O to
solicit sales for its services, Eagle has nexus in all four states. However, the underlying income-
producing activity (i.e., website development services) is performed at Eagle’s home office in
State L. Assuming States L, M, N and O all use a single-factor sales-only apportionment
formula, compute Eagle’s apportionment percentages for States L, M, N and O in each of the
following independent scenarios.
a. For purposes of computing the numerator of the sales factor, all four states use an income-
producing activity rule for sales of services.
b. L uses an income-producing activity rule, while M, N and O use a location-of-recipient
rule.
c. L uses a location-of-recipient rule, while M, N and O use an income-producing activity
rule.
36. Sales factor. PureCo, Inc., a State B corporation, is a consulting firm. PureCo’s customers are
located in States B, C, D and E, with sales spread equally among the four states. Because
PureCo employees regularly travel to States B, C, D and E to solicit sales, PureCo has nexus in
all four states. All income-producing activities are performed by PureCo’s employees at the
home office in State B, however. For purposes of computing the numerator of the sales factor,
States B and C use an income-producing activity rule to source sales of services, whereas States
D and E use a location-of-recipient rule. All four states use an equally-weighted three-factor
apportionment formula.
a. Assuming 100% of PureCo’s property and payroll is located in State B, compute the
percentage of PureCo’s income subject to taxation in each of the four states.
b. How would PureCo’s state apportionment percentages change if PureCo were to relocate
its offices to State D, in which case PureCo’s income-producing activities as well as 100%
of its property and payroll would now be located in State D?
37. Property factor. Pine Corporation has nexus in several states. During the current year, the
average balances in Pine’s asset accounts is as follows (all numbers in millions):
Cash ................................................................... $10
Accounts receivable ........................................... $30
Inventory ............................................................ $40
Machinery and equipment (original cost) ......... $200
Accumulated depreciation ................................. $60
Patents (net of amortization).............................. $20
Construction-in-progress.................................... $50
Compute the denominator of Pine’s property factor.
38. Property factor. ABC, Inc. is a calendar year corporation that manufactures exercise
equipment. ABC’s main office and production facilities are located in State Y. ABC markets
it products mainly through independent distributors. However, ABC does have a warehouse in
State Z, which it leases at a cost of $5 million per year. ABC has income tax nexus only in
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States Y and Z. ABC’s balance sheet at the beginning and end of the current year is as follows
(all numbers in millions):
January 1 account balances:
State Y State Z Total
Cash ....................................................................... $20 $10 $30
Accounts receivable .............................................. $40 $20 $60
Inventory ............................................................... $150 $80 $230
Property, plant and equipment .............................. $800 $180 $980
Accumulated depreciation..................................... ($300) ($20) ($320)
Land....................................................................... $200 $0 $200
Rental property (see Note 1) ................................. $400 $0 $400
Accumulated depreciation: Rental property ......... ($80) $0 ($80)
Patents, net of amortization (see Note 2) .............. $50 $0 $50
Construction-in-progress (see Note 3) .................. $100 $0 $100
December 31 account balances:
State Y State Z Total
Cash ....................................................................... $30 $20 $50
Accounts receivable .............................................. $50 $30 $80
Inventory ............................................................... $250 $80 $330
Property, plant and equipment .............................. $1,000 $180 $1,180
Accumulated depreciation..................................... ($400) ($30) ($430)
Land....................................................................... $200 $0 $200
Rental property (see Note 1) ................................. $0 $0 $0
Accumulated depreciation: Rental property ......... n.a. $0 n.a.
Patents, net of amortization (see Note 2) .............. $40 $0 $40
Construction-in-progress (see Note 3) .................. $250 $0 $250
Note 1: Last year, ABC moved into new office facilities. ABC rented its old office
building while it was for sale. The building was sold in June of the current year.
Note 2: Several years ago, ABC purchased some patents on exercise equipment.
Note 3: Last year, ABC began construction of an addition to its production facilities. The
addition was neither completed nor placed into service during the current year.
Compute ABC’s property factors for States Y and Z.
39. Nonbusiness income. For each of the following independent scenarios, apply the UDITPA
definitions of business versus nonbusiness income to determine whether the item in question is
properly classified as business or nonbusiness income.
a. Rental income. A construction company regularly makes short-term leases of temporarily
idle cranes, earth-moving vehicles, and other construction equipment.
b. Rental income. A retailer purchases a four-story building for use in connection with its
trade or business. It uses the street floor as one of its retail stores and the second and third
floors for its corporate headquarters. The fourth floor is leased to unrelated parties.
c. Gain on sale. A retailer owned an office building that it occupied as its corporate
headquarters. Because of inadequate space, the taxpayer acquired a larger building for use
7
as its corporate headquarters. The old building was rented to an unrelated corporation
under a five-year lease. At the end of the lease, the taxpayer sells the building at a gain.
d. Interest income. The taxpayer is engaged in a manufacturing business. The taxpayer has
working capital that it regularly invests in short-term interest bearing securities.
e. Dividend income. The taxpayer and several unrelated corporations own all of the stock of
a dividend-paying corporation whose business operations consist solely of acquiring and
processing raw materials for delivery to the corporate owners. The taxpayer acquired the
stock in order to obtain a source of supply of raw materials used in its manufacturing
business.
f. Royalty income. The taxpayer is engaged in the music publishing business and holds
copyrights on numerous songs. The taxpayer acquires the assets of another publishing
company, including music copyrights that are then used by the taxpayer in its business.
g. Royalty income. Same as f., except that the acquired company also held the patent on a
method of producing digital audio recordings. The taxpayer does not manufacture or sell
digital audio recordings. The taxpayer plans to sell the digital recording patent.
40. Multistate partnerships. Victor is a State J resident and Vickie is a State K resident. They
are 50-50 members in Quick-Stop, an LLC that operates a chain of convenience stores located
in States J and K. Quick-Stop is classified as a partnership for federal and state tax purposes.
Victor has sole responsibility for managing the State J operation, and Vickie has sole
responsibility for managing the State K operation. During the current year, Quick-Stop had $1
million of apportionable income, its State J apportionment percentage was 30% and its State K
apportionment percentage was 70%. How does State J tax Victor and Vickie with respect to
their interests in Quick-Stop?
41. Multistate partnerships. Debra is a resident of State X, Ed is a resident of State Y and Ted is
a resident of State Z. Debra is a 60% partner in the DET Partnership, Ed is a 10% partner and
Ted is a 30% partner. DET derives a total of $100,000 of apportionable income during the
current year. DET has nexus in States X, Y and Z, and its apportionment percentages are as
follows: 20% for X, 40% for Y and 40% for Z. Compute the amount of each partner’s share of
partnership income that is subject to tax in each state.
42. Multistate S corporations. River, Inc., a State Q corporation, manufactures kayaks at its
plant in Q. Most of River’s sales are to customers located outside of State Q, with significant
sales to customers located in State R, a state in which River maintains a retail outlet. River
does not have nexus in any other states. All sales to customers located in states other than Q
and R are shipped from its manufacturing facility in Q. River is an S corporation owned 50%
by Jack, who is a resident of State Q, and 50% by Jill, who is a resident of State R. During the
current year, River has $200,000 of apportionable income, and its property, payroll and sales
are distributed as follows:
State Q State R Other
Property 90% 10% 0%
Payroll 90% 10% 0%
Sales 30% 40% 30%
Both Q and R use an equally-weighted three-factor apportionment formula, and Q has a sales
throwback rule. Compute the following:
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a. River’s State Q apportionment percentage.
b. River’s State R apportionment percentage.
c. Jill’s taxable income for State Q and State R individual income tax purposes. (Note: State
R taxes Jill’s worldwide income, whereas State Q taxes only that portion of her income
from sources within State Q.)
d. Jack’s taxable income for State Q and State R individual income tax purposes. (Note: State
Q taxes Jack’s worldwide income, whereas State R taxes only that portion of his income
from sources within State R.)
43. Taxation of individuals. John, a resident of State Q, has a number of business interests and
investment properties in States Q and R, both of which tax the income of individuals. For each
of the following transactions that John engaged in during the current year, determine whether
the related income is likely to be subject to State R’s individual income tax?
a. Sold at a gain land located in R.
b. Prior to its sale, rented the land described in part a.
c. Sold at a gain shares of a regular corporation organized under the laws of R and operates
exclusively in R.
d. Prior to its sale, received dividends from the corporation described in part c.
e. Holds a 50% shareholder interest in an S corporation that is organized under the laws of R
and operates exclusively in R.
f. Received interest on a certificate of deposit issued by a bank located in R.
44. Taxation of individuals. Chris is a surgeon who lives and works in State X. Chris owns a
house, a lake cottage, and some rental properties in State X. Chris is single and has no
dependents. She will be retiring next year, and is contemplating buying a condominium in State
Y, and perhaps living in Y, at least during the winter months. At a minimum, however, Chris
would continue to spend summers at her lake cottage in State X. Chris knows that State Y does
not have an individual income tax, and that if she could change her residence from State X to
State Y, she may realize significant income tax savings. Chris has asked you to advise her as to
what she would need to do to change her state of residence from State X to State Y.
CASE STUDY PROBLEMS
45. Comprehensive state corporate income tax computation. Acme, Inc., a regular
corporation for income tax purposes, is a manufacturer of industrial equipment. Acme is
incorporated in State X, and has its headquarters offices and production facilities located in X.
Acme also has a distribution facility located in State Y. Acme does not have nexus in any other
states. X and Y are both mandatory separate company return states. State X taxes corporate
income at a 7% rate, and State Y taxes corporate income at a 9% rate. During the current year,
Acme reported $19,600,000 of federal taxable income, computed as follows:
Sales ..................................................................................................... $110,000,000
Cost of goods sold ................................................................................ (74,000,000)
Gross profit .......................................................................................... $36,000,000
Interest income derived from federal obligations ................................ 1,500,000
Dividend income from a 50%-owned U.S. corporation ...................... 500,000
Capital gain on the sale of raw land .................................................... 2,000,000
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Interest income derived from municipal bonds ($1,000,000)............. 0
Total gross income............................................................................... $40,000,000
State income taxes ............................................................................... (1,000,000)
Other general and administrative expenses ......................................... (19,000,000)
Federal taxable income before net operating loss and
dividends received deductions (Form 1120, line 28) ....................... $20,000,000
Federal dividends received deduction (Form 1120, line 29) .............. (400,000)
Federal taxable income (Form 1120, line 30) ..................................... $19,600,000
Additional information from Acme’s financial records:
(i) All interest and dividend income was derived from Acme’s working capital, and therefore
is properly classified as apportionable income.
(ii) The raw land that was sold during the year is located in State Y and is wholly unrelated to
Acme’s regular business operations. Acme had owned the land for ten years and it was
never rented. Therefore, for both State X and Y tax purposes, the gain is classified as
nonbusiness income allocable to the state in which the real property was located.
(iii) For federal tax purposes, Acme claimed a $400,000 credit for research and
experimentation expenses. The $400,000 of related expenses were not deducted in
computing Acme’s federal taxable income.
(iv) For State X tax purposes, Acme claimed a $500,000 enterprise zone credit. The $500,000
of related expenses were deducted in computing Acme’s federal taxable income. Acme is
not entitled to claim any credits for State Y tax purposes.
(v) Acme has no net operating loss carryforwards for federal or state tax purposes.
In both State X and Y, the computation of corporate taxable income begins with federal taxable
income before the net operating loss and dividends received deductions (i.e., Form 1120, line
28). Addition modifications are required for the following items:
(i) municipal interest that was excluded from federal taxable income (only State X requires
this adjustment),
(ii) state income taxes that were deducted in computing federal taxable income, and
(iii) expenses related to state tax credits that were deducted for federal purposes.
Subtraction modifications are required for the following items:
(i) U.S. interest that was included in the computation of federal taxable income,
(ii) expenses related to federal tax credits that were not deducted for federal purposes,
(iii) 100% of any dividends received from a 50% or more owned corporation, and
(iv) net operating loss carryforwards from a year in which the taxpayer had nexus in state.
For apportionment purposes, States X and Y both use a double-weighted sales formula. Each
state also has a sales throwback rule. Information regarding Acme’s current year property,
payroll and sales factors is summarized below.
Tangible property (amounts at cost)
State X: January 1 December 31
Land ........................................... $5,000,000 $5,000,000
Building...................................... $21,000,000 $23,000,000
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Furniture and fixtures ................ $8,000,000 $10,000,000
Machinery and equipment ......... $45,000,000 $51,000,000
Inventories .................................. $7,000,000 $9,000,000
State Y: January 1 December 31
Furniture and fixtures ................ $2,000,000 $2,000,000
Inventories .................................. $1,000,000 $3,000,000
Total company: January 1 December 31
Land ........................................... $5,000,000 $5,000,000
Building...................................... $21,000,000 $23,000,000
Furniture and fixtures ................ $10,000,000 $12,000,000
Machinery and equipment ......... $45,000,000 $51,000,000
Inventories .................................. $8,000,000 $12,000,000
The $5,000,000 figure for land does not include the raw land (nonbusiness property) that was
sold during the year. Acme’s only rental expense is the distribution facility it leases in State Y
at an annual rental cost of $500,000.
Payroll
Taxable compensation paid to employees based in State X.................... $26,400,000
Taxable compensation paid to employees based in State Y ..................... $3,600,000
Sales
Sales delivered to customers located in State X ................................... $10,0000,000
Sales delivered to customers located in State Y ................................... $20,0000,000
Sales delivered to customers located in states other than X and Y ...... $70,0000,000
All shipments to customers located in states other than X and Y were made from Acme’s
factory in State X.
Compute Acme’s apportionable income, apportionment percentages, and state income tax
liabilities for State X and State Y.
TAX RESEARCH PROBLEM
46. State corporate income tax laws. Go to the Internet site of a state revenue department of your
choice or the state assigned to you by the instructor. Links to all state revenue departments can
be found at http://www.taxsites.com/state.html. Download and printout the instructions for
filing an income tax return for a C corporation, including the instructions for apportioning
income. Note that some states refer to their corporate income tax as a "corporate franchise tax."
Using the tax return instructions, answer the following questions regarding that state’s corporate
income tax laws.
a. What is the corporate tax rate (or tax rate schedule)?
b. Under what circumstances must a corporation file an income tax return?
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c. What are the filing options for a group of commonly controlled corporations?
d. Does the computation of state taxable income start with federal taxable income? If so, does
the computation begin with line 28 or line 30 of federal Form 1120?
e. Briefly describe any addition or subtraction modifications that are required for the
following items:
(i) dividends received deduction,
(ii) state and local income taxes,
(iii) interest earned on obligations of the federal government,
(iv) interest earned on obligations of state and local governments,
(v) expenses related to federal tax credits,
(vi) expenses related to state tax credits,
(vii) royalties and interest paid to related parties,
(viii) federal Section 199 domestic production activities deduction,
(ix) income related to foreign (non-U.S.) subsidiaries, or
(x) net operating loss deductions?
f. What is the apportionment formula?
g. Are specialized apportionment formulae required for financial institutions or transportation
companies? If so, what are they?
h. Are any of the following types of gross receipts included in the sales factor?
(i) Interest on trade receivables
(ii) Interest on short-term investments of working capital
(iii) Dividends to the extent included in taxable income
(iv) Royalties on business property
(v) Capital gains from sales of intangible business property
(vi) Gains from the sale of fixed assets such as machinery and equipment
i. Is there a sales factor throwback rule?
47. Apportionment factors. You have been asked to prepare Redwood Corporation’s income tax
return for State P. State P statutes conform to UDITPA, and the state’s regulations are identical
to the Multistate Tax Commission’s model regulations for interpreting UDITPA. These
regulations and UDITPA can be found at http://www.mtc.gov. Use these regulations to address
the following issues regarding the computation of the State P property and sales factors.
a. Is construction-in-progress included in the property factor?
b. Is property that is temporarily idle included in the property factor?
c. Is inventory in transit at the end of the year included in the numerator of the property factor
of the origination state or the destination state?
d. What is the basis for determining how much of the value of mobile property (e.g.,
construction equipment) is included in the numerator of the property factor?
e. Can monthly averaging be used to value property for purposes of the property factor?
f. Are federal and state excise taxes (e.g., sales taxes) ever included in the sales factor?
g. Are sales of inventory to the federal government assigned to the numerator of the sales
factor of the origination state or the destination state?
h. Are fees for the performance of professional services assigned to the numerator of the sales
factor of the state in which the services were performed or the state in which the customer is
located?
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SOLUTIONS:
1. There are only five states that do not impose sales taxes. They include Alaska, Delaware,
Montana, New Hampshire and Oregon.
2. A use tax is imposed on tangible personal property purchased from an out-of-state vendor and
brought into a state by the buyer for "possession or use" within the state’s borders. Use taxes
are imposed on the buyer, and therefore it is up to the buyer to self-assess the use tax and remit
it to the state. Use tax compliance is often poor. As a consequence, states prefer to have the
out-of-state vendor collect the use tax in the same manner that in-state vendors collect sales tax.
A state can require an out-of-state vendor, such as a mail-order company or Internet retailer, to
collect use tax only if that vendor has a physical presence in the state (e.g., an outlet store).
3. a. A sale of office furniture to the end-user is usually subject to sales tax. The retailer is
responsible for collecting and remitting the tax to the State P tax authorities.
b. If Tiger purchases the office furniture from a mail-order vendor located in another state, no
State P sales tax is due on the sale because it did not occur within State P’s borders.
However, State P use tax is due on the purchase because Tiger uses the furniture within
State P’s borders. Assuming the mail-order vendor did not collect State P use tax, it is up
to Tiger to self-assess and voluntarily remit the tax to State P tax authorities.
4. All types of real property, including raw land, office facilities, factories, warehouses and other
types of business facilities, are generally taxable. Some jurisdictions also tax selected types of
tangible personal property used in a trade or business, such as machinery and equipment,
furniture and fixtures, and inventory.
5. There are three basic methods that an assessor can use to estimate the market value of property.
These include the market method (actual sales prices from recent sales of similar properties),
cost method (cost to reproduce or replace the property) and income method (capitalization of
the expected future net cash flows from the property).
6. There are seven states that do not impose individual income taxes, including Alaska, Florida,
Nevada, South Dakota, Texas, Washington and Wyoming. New Hampshire and Tennessee tax
individuals on only selected types of income, not including wages. The states that do not
impose a corporate net income tax include Nevada, South Dakota, Texas, Washington and
Wyoming. Although it does not impose an income tax, Michigan subjects corporations to its
single business tax (a value-added tax). Likewise, the State of Washington subjects
corporations to its business and occupation tax (a gross receipts tax). Starting in 2005, Ohio
began phasing out its corporate franchise tax, and began imposing its commercial activity tax (a
gross receipts tax). Starting in 2007, Texas began imposing its margin tax (a tax on gross
margin).
7. Nexus is the degree of contact between a company and a state necessary to establish the state’s
right to impose a tax obligation, such as a requirement to pay tax on income earned in the state
or an obligation to collect sales taxes on sales made to in-state customers.
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8. Article 1 of the U.S. Constitution (the Commerce Clause) states that Congress shall have the
sole authority to regulate commerce among the states. The Supreme Court has interpreted the
Commerce Clause as prohibiting states from enacting laws that unduly burden or otherwise
inhibit the free flow of trade among the states. Specifically, the Commerce Clause prohibits a
state from taxing a business unless that business has a "substantial nexus" in the state. In Quill
Corporation v. North Dakota (504 US 298, 1992), the Supreme Court ruled that, at least for
sales and use tax purposes, a business does not have substantial nexus in a state unless that
business has a nontrivial physical presence within the state’s borders. Thus, a physical presence
established through real or tangible personal property, employees, or other agents, is a
prerequisite for establishing nexus in a state.
9. Public Law 86-272 prohibits a state from imposing a net income tax on an out-of-state
company if that company’s only in-state activity consists of the following:
(i) the presence of representatives who limit their activity to the solicitation of orders,
(ii) the orders are for tangible personal property,
(iii) the orders are sent outside the state for approval, and
(iv) if approved, the orders are shipped or delivered from a point outside the state.
10. Generally accepted accounting principles require that all majority-owned subsidiaries be
consolidated with the parent corporation. For federal income tax purposes, every regular
corporation must compute and report its tax separately, with the exception of members of an
“affiliated group” of corporations, which can elect to file a consolidated federal income tax
return (IRC Sec. 1501). The basic theme underlying the preparation of a consolidated federal
income tax return is computing the income of the related corporations as if they were a single
economic entity. Unlike GAAP, which requires a worldwide consolidation that includes foreign
country subsidiaries, only a corporation organized in the United States is includible in a federal
consolidated return. For state income tax purposes, combined unitary reporting is similar in
nature to federal consolidated reporting, but there are some important differences. For example,
the minimum stock ownership requirement for a combined unitary return is usually more than
50 percent, as opposed to 80 percent or more ownership in the case of a federal consolidated
return. A combined unitary report is also limited to those group members engaged in the same
trade or business, that is, a “unitary business,” as indicated by such factors as operational
integration and centralized management.
11. The answers regarding financial reporting and federal income tax reporting would not change.
However, for state income tax purposes, each affiliate with nexus in the state would now file its
own return and compute its income as if it were a separate and distinct economic entity.
12. Under a static federal tax base, state taxable income is defined in terms of the Internal Revenue
Code in effect as of a specific date (e.g., December 31 of the prior year). Amendments to the
Code have no effect on the state tax base until the state legislature affirmatively votes to adopt
these changes. Under a moving federal tax base, any amendments to the Code are
automatically adopted for state purposes. Even with a moving federal tax base, however, a state
legislature has the authority to amend state law to exclude specific federal changes that, in
retrospect, the legislature chooses not to adopt.
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13. Common adjustments to the federal tax base in computing a corporation’s state taxable income
include:
(i) dividends received deductions,
(ii) deductions for state and local income taxes,
(iii) interest earned on obligations of the federal government,
(iv) interest earned on obligations of state and local governments,
(v) expenses related to federal and/or state tax credits,
(vi) net operating loss deductions,
(vii) federal first-year bonus depreciation (claimed on assets placed into service from
September 11, 2001 to December 31, 2004),
(viii) federal Section 199 domestic production activities deduction,
(ix) royalties and interest paid to related parties, and
(x) income related to foreign (non-U.S.) subsidiaries.
14. State lawmakers are attracted to apportionment formulae that place more weight on the sales
factor than on the property or payroll factors for two reasons. First, such formulae reduce the
corporate income tax burden of in-state corporations that have large amounts of property and
payroll in the state but sales nationwide, while potentially increasing the tax burden of out-of-
state corporations that have relatively low proportions of property and payroll but with
substantial sales in the state. Second, if a state uses a formula that emphasizes the sales factor,
locating additional property or payroll in the state has less effect on that state’s apportionment
percentage. This creates a tax incentive for businesses to locate, expand or retain their
operations in the state.
15. For purposes of computing the numerator of the sales factor, a destination test is employed for
receipts from the sale of inventory, whereby such receipts are assigned to the state to which the
goods are shipped or delivered. An important exception to the destination test is the sales
throwback rule, under which a sale delivered to a state in which the taxpayer does not have
nexus is assigned to the state from which the good was shipped. Only about half the states
require throwback. In contrast to the destination test for sales of inventory, an income-
producing activity test is generally used to determine the source of business receipts other than
sales of tangible personal property. Under this approach, a business receipt is assigned to a state
if the income producing activity that gives rise to the receipt occurred in the state. For example,
fees from the performance of personal services are assigned to the state in which the services
were performed.
16. For purposes of computing a state’s payroll factor, payroll is generally defined as all
compensation paid to employees that is taxable for federal income tax purposes, including
salaries, wages and commissions. Payments to independent contractors are excluded, as are
nontaxable fringe benefits, such as employer-provided medical insurance.
17. UDITPA defines business income as any item of income that meets one of the following two
tests: (i) the income arises from transactions and activity in the regular course of the taxpayer’s
trade or business (transactional test); or (ii) the income is derived from property, the acquisition,
management and disposition of which constitute integral parts of the taxpayer’s regular trade or
business (functional test). UDITPA defines nonbusiness income as all income other than
business income.
15
18. For administrative ease, the computation of an individual’s state taxable income usually begins
with the amount of federal adjusted gross income or federal taxable income reported on the
individual’s federal Form 1040. Gross income for federal tax purposes includes income from
whatever source derived. Therefore, by virtue of piggybacking on the federal tax base, states
generally end up taxing the worldwide income of individuals residing within their borders. In
contrast to residents, a state taxes nonresidents only on selected types of income derived from
sources within the state’s borders. Examples include compensation for personal services
performed in the state, profits from business activities conducted in the state, and income from
real and tangible personal property located in the state. Income from intangibles, such as
dividend, interest and royalty income, is generally taxable only in the state of residence.
19. The state of residence generally taxes the entire amount of a resident shareholder’s pro-rata
share of S corporation income, regardless of where the income was earned. On the other hand,
states generally tax nonresident shareholders on only that portion of the nonresident
shareholder’s pro-rata share of S corporation income that is attributable to the S corporation’s
in-state activities, and then only if the S corporation has established income tax nexus in the
state.
20. A threshold issue for any corporation that sells its products nationwide is determining the states
in which it has income tax nexus. As a general rule, income tax nexus is a concern only in those
states in which Hefti has some sort of physical presence, which includes the regular and
systematic presence of Hefti’s employees. Hefti obviously has nexus in State X where its main
offices are located. Hefti may also have nexus in States Y and Z because Hefti employees
travel to those states on a regular basis to conclude contracts with suppliers. Therefore, Hefti
may have an income tax filing obligation in States Y and Z.
21. The entire amount of a nonbusiness gain from the sale of intangible property is allocated to the
state of commercial domicile. Thus, if every state in which Walnut has nexus were to agree that
the $100 million of capital gains was properly classified as nonbusiness income, the gains
would be taxable only in State N (the commercial domicile state), which does not have a
corporate income tax. As a practical matter, the 20 or so states in which Walnut has nexus may
argue that the capital gains are business income, in which case each nexus state would be
entitled to tax an apportioned percentage of the gains. The Supreme Court has ruled that a gain
on the sale of stock is business income if there was a unitary relationship between the taxpayer
(in this case, Walnut) and the corporation whose stock was sold, or if ownership of the stock
served an operational function in the taxpayer’s business.
22. Blue must have procedures in place to ensure that it collects sales tax on all taxable sales of
furniture. States generally provide special exemptions for sales to tax-exempt organizations and
government agencies, such as a church or a state-owned community college. Blue will need to
obtain the requisite documentation from the exempt buyers. Use tax is not due on the $6
million of inventory purchased from furniture manufacturers because these purchases qualify
for the sale for resale exemption. However, Blue is obligated to self-assess and voluntarily
remit use tax on the $15,000 of office supplies purchased from the out-of-state mail-order
vendor, assuming Blue is the end-consumer of the supplies.
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23. Green has an economic presence in State Y in the sense that it has a significant customer base in
that state. However, Green does not have a physical presence in State Y. Therefore, under the
physical presence test, Green does not have nexus in State Y for either income tax or sales tax
purposes. Note that State Y is constitutionally prohibited from taxing Green, despite the fact
that State Y government expenditures help maintain a commercial environment and customer
base that Green exploits for its own profit.
24. Public Law 86-272 prohibits a state from taxing the income of an out-of-state company if that
company’s only in-state activity is the presence of employees who limit their activity to the
solicitation of orders for tangible personal property, where such orders are sent outside the state
for approval, and, if approved, are shipped or delivered from a point outside the state. The issue
here is whether Sparrow’s State R activities are limited to the “solicitation of orders,” as the
term is defined for purposes of Public Law 86-272. The Supreme Court has defined solicitation
as requests for purchases as well as any other activities that are entirely ancillary to requests for
purchases, that is, the activities serve no independent business function apart from solicitation.
The use of company-owned cars by sales persons, distributing free samples and setting up
display racks without charge all fall within the definitional bounds of solicitation. Thus,
Sparrow probably does not have income tax nexus in State R.
25. Public Law 86-272 prohibits a state from taxing the income of an out-of-state company if that
company’s only in-state activity is the presence of employees who limit their activity to the
solicitation of orders for tangible personal property where such orders are sent outside the state
for approval, and if approved, are shipped or delivered from a point outside the state.
Performing installation, customer training and repair services on a regular basis exceeds the
definitional bounds of mere solicitation, and therefore Red probably has income tax nexus in
State M.
26. Public Law 86-272 applies only to sales of tangible personal property, and therefore does not
protect in-state activities related to sales of professional services. Because Thrush employees
were physically present within State H on a regular basis, Thrush probably has nexus in State H
for income tax purposes.
27. For financial reporting purposes, Giant must prepare consolidated financial statements that
includes all three subsidiaries. For federal income tax purposes, Sub 3 need not file a U.S.
return and Sub 2 must file a federal return on a separate company basis. Giant and Sub 1 can
either file separate federal returns or elect to file a federal consolidated return. For State X
purposes, Giant and Sub 1 must file on a separate entity basis. For State Y purposes, Giant and
Sub 2 must file a combined unitary return (Sub 3 is excluded because it is a Mexican
corporation and State Y requires a water’s-edge combination). Sub 1 must file a State Y return
on a separate company basis because it is not unitary with Giant or Sub 2.
28. (i) Wisconsin – BikeCo is the only affiliate with nexus in Wisconsin so it files on a separate
company basis.
(ii) Florida – Assuming they elect to file a federal consolidated return, members of the BikeCo
federal affiliated group may elect to file a Florida consolidated return. These include BikeCo,
FloCo, ArizCo, and IowaCo. CanCo is excluded because it is a foreign corporation. If the
17
election is not made, BikeCo and FloCo would each file a Florida return on a separate company
basis.
(iii) Arizona – All U.S. members of the BikeCo unitary group, including BikeCo, FloCo,
ArizCo and IowaCo, would file an Arizona combined unitary report. CanCo is excluded
because it has no U.S. operations.
(iv) Iowa – BikeCo and IowaCo are the only affiliates with nexus in Iowa, so they may elect to
file an Iowa consolidated return. If the election is not made, BikeCo and IowaCo would each
file an Iowa return on a separate company basis.
29. Acme’s State Z taxable income is $25 million ($100 million of apportionable income Z
apportionment percentage of 25% [{10% of property in Z + 10% of payroll in Z + 2(40% of
sales in Z)} 4]).
30. a. State X income is $9 million ($10 million [{100% + 100% + 70%} 3]) and State Y
income is $1 million ($10 million [{0% + 0% + 30%} 3]).
b. State X income is $9 million (see part a.) and State Y income is $1.5 million ($10 million
[{0% + 0% + (2 30%)} 4]). Due to the inconsistent apportionment formulae,
$500,000 of Hawk’s income ([$9 million + $1.5 million] $10 million) is subject to
double taxation.
c. State X income is $7 million ($10 million 70%) and State Y income is $1 million (see
part a.). Due to the inconsistent apportionment schemes, $2 million of Hawk’s taxable
income ($10 million [$7 million + $1 million]) escapes state taxation.
d. State X income is $7 million (see part c.) and State Y income is $3 million ($10 million
30%). Note that as long as the taxing states’ apportionment schemes are consistent (as in
parts a. and d.), Hawk’s income is not subject to either under or over taxation.
31. Rose Corporation’s total sales are $100 million ($60 million + $30 million + $10 million).
Under the destination test for inventory sales, $60 million of sales is assigned to State L. In
addition, under the income-producing activity rule, the $10 million of fees for services rendered
is also assigned to L. Therefore, the State L sales factor is 70% ([$60 million + $10 million]
$100 million).
32. Tulip Corporation had total sales of $50 million ($12 million + $20 million + $18 million). If
State B does not have a sales throwback rule, Tulip’s sales factor equals 24% ($12 million
destination sales $50 million total sales). If B does have a sales throwback rule, Tulip’s sales
factor equals 60% ([$12 million destination sales + $18 million throwback sales] $50 million
total sales). Therefore, the State B apportionment percentage will be 36 percentage points
higher if B has a throwback rule.
33. a. If State L does not have a throwback rule, Acme’s State L property, payroll and sales
factors are 90% ($90 million $100 million), 90% ($18 million $20 million), and
60% ($72 million $120 million), respectively. Therefore, the L apportionment
percentage is 75% ([90% + 90% + {2 60%}] 4). Acme’s State M property, payroll
and sales factors are 10% ($10 million $100 million), 10% ($2 million $20 million),
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and 10% ($12 million $120 million), respectively. Therefore, the M apportionment
percentage is 10% ([10% + 10% + {2 10%}] 4). In sum, because L does not have a
throwback rule, 15% of Acme’s income (100% [75% + 10%]) is not taxable in any state.
b. If State L has a throwback rule, Acme’s State L sales factor is now 90% ([$72 million
destination sales + $36 million throwback sales] $120 million). This increases the L
apportionment percentage from 75% (in part a.) to 90% ([90% + 90% + {2 90%}] 4).
The State M apportionment percentage is still 10%. Therefore, as a result of throwback,
the L and M apportionment percentages sum to 100%, and no income escapes state
taxation.
34. Birch’s sales factors for States Q and R are computed as follows (all numbers in millions):
State Q State R Total
Sales (destination test) ..................................... $60 $90 $150
Sales (throwback) ............................................ $120 $0 $120
Interest income (commercial domicile)........... $2 $0 $2
Rental income (where used) ............................ $8 $0 $8
Fees for services (where performed) ............... $11 $0 $11
Royalties (commercial domicile) .................... $ 9 $0 $9
$210 $ 90 $300
The State Q sales factor is 70% ($210 $300), and the State R sales factor is 30% ($90
$300).
35. a. Because the income-producing activity takes place at Eagle’s home offices in State L, the
state apportionment percentages are as follows: L100%, M0%, N0%, and O0%.
Because all four states use the same source rule, the apportionment percentages sum to
100%.
b. Under an income-producing activity rule, the State L apportionment percentage is still
100%; whereas under a location-of-recipient rule, the apportionment percentages for States
M, N and O each increase to 25%. Due to the inconsistent source rules, 75% of Eagle’s
income is subject to double taxation.
c. Under an income-producing activity rule, the State M, N and O apportionment percentages
are all 0%; whereas under a location of recipient rule, the apportionment percentage for
State L is 25%. Due to the inconsistent source rules, 75% of Eagle’s profits is not subject
to tax in any state.
36. a. Because PureCo incurs the entire cost of providing its services at its home offices in State
B, under an income-producing activity rule the B sales factor is 100% and the State C sales
factor is 0%. On the other hand, under a location-of-recipient rule, the State D sales factor
is 25% and the State E sales factor is 25%. Therefore, the applicable apportionment
percentages are as follows:
State B: 100% ([1/3][100% property] + [1/3][100% payroll] + [1/3][100% sales])
State C: 0% ([1/3][0% property] + [1/3][0% payroll] + [1/3][0% sales])
State D: 8.33% ([1/3][0% property] + [1/3][0% payroll] + [1/3][25% sales])
19
State E: 8.33% ([1/3][0% property] + [1/3][0% payroll] + [1/3][25% sales]).
In sum, a total of 116.66% of PureCo’s income would be subject to state taxation.
b. If PureCo were to relocate its offices to State D, under an income-producing activity rule
the State B and C sales factors would now both be 0%. Under a location-of-recipient rule,
the State D and E sales factors would now both be 25%. Therefore, the applicable
apportionment percentages would now be as follows:
State B: 0% ([1/3][0% property] + [1/3][0% payroll] + [1/3][0% sales])
State C: 0% ([1/3][0% property] + [1/3][0% payroll] + [1/3][0% sales])
State D: 75% ([1/3][100% property] + [1/3][100% payroll] + [1/3][25% sales])
State E: 8.33% ([1/3][0% property] + [1/3][0% payroll] + [1/3][25% sales]).
In sum, a total of 83.33% of PureCo’s income would be subject to state taxation.
37. The property factor includes the undepreciated cost of tangible and real property owned or
rented by the taxpayer and used in the regular course of the taxpayer’s business. Intangible
property, such as cash, receivables and patents, are excluded. In addition, construction-in-
progress is excluded because it is not yet being used to generate business income. Therefore,
the denominator of Acme’s property factor equals $240 million (inventory of $40 million +
machinery and equipment of $200 million).
38. The property factor includes the undepreciated cost of tangible and real property owned or
rented by the taxpayer and used in the regular course of the taxpayer’s business. Intangible
property is excluded. Business property that is temporarily (as opposed to permanently) idle is
usually included, whereas construction-in-progress is excluded until the asset is placed into
service. Finally, rentals are included in an amount equal to eight times the net annual rental.
The average value of property in State Y is $1.5 billion, computed as follows (all numbers in
millions):
Jan. 1 Dec. 31 Average
Inventory .......................................... $150 $250 $200
Property, plant and equipment ......... $800 $1,000 $900
Land.................................................. $200 $200 $200
Rental property ................................. $400 $0 $200
$1,500
The average value of property in State Z is $300 million, computed as follows (all numbers in
millions):
Jan. 1 Dec. 31 Average
Inventory .......................................... $80 $80 $80
Property, plant and equipment ......... $180 $180 $180
Rentals (8 $5 million) ................... $40
$300
Therefore, the State Y property factor is 83.33% ($1.5 billion [$1.5 billion + $300 million]),
and the State Z property factor is 16.67% ($300 million [$1.5 billion + $300 million]).
39. a. Rental income from a construction company’s short-term leases of temporarily idle
construction equipment should be classified as business income. Both the transactional and
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the functional tests are satisfied. The transactions arise in the regular course of the
taxpayer’s construction business and the leased equipment is an integral part of that
business.
b. Rental income from a retailer’s purchase of an office building, using three of the four floors
itself and leasing the other floor to unrelated parties, should be classified as business
income. The functional test is satisfied. The lease is incidental to the taxpayer’s trade or
business and the majority of the building is an integral part of the taxpayer’s retailing
business.
c. A retailer that sells its corporate headquarters office after renting it out for five years
should classify the gain (and the rental income) as nonbusiness income. Neither the
transactional nor the functional test is satisfied. The sale of real estate is not in the ordinary
course of the taxpayer’s retail business and the old corporate headquarters office is not an
integral part of that business.
d. Interest income that a manufacturer derives from its working capital should be classified as
business income. Both the transactional and the functional tests are satisfied. The
transactions arise in the regular course of the taxpayer’s manufacturing business and the
working capital is an integral part of that business.
e. A taxpayer’s dividend income from stock owned in a corporation that supplies materials
used in the taxpayer’s manufacturing business should be classified as business income.
The functional test is satisfied because acquiring and holding the underlying intangible is
integral to the taxpayer’s manufacturing business.
f. A music publisher’s royalty income from music copyrights it has purchased from another
company should be classified as business income. The functional test is satisfied because
the purpose for acquiring and holding the underlying intangibles is an integral part of the
taxpayer’s music publishing business.
g. A music publisher’s royalty income from a patent for producing digital audio recordings,
when the taxpayer is not in the business of manufacturing or selling digital audio
recordings, should be classified as nonbusiness income. Neither the transactional nor the
functional test is satisfied. The taxpayer is not involved with manufacturing or selling
digital audio recordings in the ordinary course of its music publishing business and the
purpose for acquiring and holding the underlying intangibles is not an integral part of that
business.
40. Victor is a resident of State J. Therefore, State J taxes the full amount of his distributive share
of Quick-Stop’s profits, or $500,000 (50% partnership interest × $1 million of apportionable
income). Vickie is a resident of State K. Therefore, State J taxes only that portion of her
distributive share of Quick-Stop’s profits that is from sources within State J, or $150,000 (J
apportionment percentage of 30% × [50% partnership interest × $1 million of apportionable
income]).
41. The state of residence generally taxes the entire amount of a resident partner’s distributive share
of partnership income, regardless of which state that income was derived from. On the other
hand, states generally tax nonresident partners on only that portion of the nonresident partner’s
distributive share of partnership income that is attributable to activities of the partnership within
the state’s borders. The distribution of the DET Partnership’s profits, by partner and by state, is
as follows:
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Debra (60%) Ed (10%) Ted (30%) Totals
State X source (20%) $12,000 $2,000 $ 6,000 $20,000
State Y source (40%) $24,000 $4,000 $12,000 $40,000
State Z source (40%) $24,000 $4,000 $12,000 $40,000
$60,000 $10,000 $30,000 $100,000
Based on the residence of each partner and the source of the partnership’s income, these income
amounts are taxed as follows:
Debra Ed Ted
State X taxable income $60,000 * $2,000 $ 6,000
State Y taxable income $24,000 $10,000 * $12,000
State Z taxable income $24,000 $4,000 $30,000 *
* State of residence
Note that each partner is subject to double taxation. For example, Debra’s actual share of
partnership income is $60,000 but she is taxed on a total of $108,000 of income, including
$60,000 of income taxed by the state of residence and $48,000 of income ($24,000 + $24,000)
taxed by the source states. In such cases, the state of residence (in Debra’s case, State X)
usually allows a resident partner to claim a credit for income taxes paid to other states.
42. a. River, Inc.’s State Q apportionment percentage is 80% ([90% property + 90% payroll +
{30% destination sales + 30% throwback sales}] 3).
b. River, Inc.’s State R apportionment percentage is 20% ([10% property + 10% payroll +
40% sales] 3).
c. Because Jill is a resident of State R, R taxes the full amount of her distributive share of
River’s apportionable income, or $100,000 (50% shareholder interest × $200,000 of
apportionable income). On the other hand, State Q taxes Jill only on that portion of her
distributive share of River’s profits that is from Q sources, or $80,000 (Q apportionment
percentage of 80% × [50% shareholder interest × $200,000 of apportionable income]). To
prevent double-taxation, State R will allow Jill to claim a credit for the taxes paid to State
Q.
d. Because Jack is a resident of State Q, Q taxes the full amount of his distributive share of
River’s apportionable income, or $100,000 (50% shareholder interest × $200,000 of
apportionable income). On the other hand, State R taxes Jack only on that portion of his
distributive share of River’s profits that is from R sources, or $20,000 (R apportionment
percentage of 20% × [50% shareholder interest × $200,000 of apportionable income]). To
prevent double-taxation, State Q will allow Jack to claim a credit for the taxes paid to State
R.
43. States generally tax nonresident individuals only on selected types of income derived from
sources within the state, including income derived from personal services conducted within the
state, income from in-state business activities conducted through a flow-through entity, and
income derived from real and tangible personal property located in the state. Income from
intangible property and income derived from sources outside the state are generally not subject
to taxation.
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a. Yes, because the real property is located in R.
b. Yes, because the real property is located in R.
c. No, nonresidents are generally not subject to tax on gains from the sale of stock, even if the
underlying corporation is organized in and operates exclusively within the state.
d. No, nonresidents are generally not subject to tax on dividend income, even if the
underlying corporation is organized in and operates exclusively within that state.
e. Yes, nonresidents are generally subject to tax on the distributive share of an S corporation’s
income that is attributable to business activities within the state.
f. No, nonresidents are generally not subject to tax on interest income, even if the payer is a
bank located within the state.
44. An individual’s state of residence is the location of his or her fixed and permanent home. It is
the place where the individual intends to remain indefinitely and which, whenever absent, the
individual intends to return. Chris is currently a resident of State X. To change her residence to
State Y, she must demonstrate by her actions the intention to both abandon her State X
residence and to establish a new residence in State Y. Specific actions that would be helpful in
making the argument that her residence has changed to State Y include: (i) selling her principal
residence in State X, (ii) purchasing, furnishing and occupying a new dwelling in State Y, (iii)
spending most of her time in State Y, (iv) changing her driver’s license, automobile registration,
bank accounts, and legal residence for insurance and other purposes from State X to State Y,
(v) surrendering her State X medical license, (vi) registering to vote and actually voting in state
of State Y elections, and (vii) terminating her ties to any churches, clubs or other organizations
based in State X. It would also be helpful if she sold her vacation home in State X, but that is
not an absolute prerequisite to terminating her residence in State X.
45. Apportionable income
State X State Y
Federal form 1120, line 28 $20,000,000 $20,000,000
+ Interest income from municipal bonds + 1,000,000 n.a.
+ State income tax deduction + 1,000,000 + 1,000,000
+ Expenses related to State X tax credit + 500,000 n.a.
Interest income from U.S. obligations 1,500,000 1,500,000
Expenses related to federal tax credits 400,000 400,000
Dividend received deduction 500,000 500,000
Income subject to allocation and apportionment $20,100,000 $18,600,000
Nonbusiness income (gain on sale of land) 2,000,000 2,000,000
Apportionable income $18,100,000 $16,600,000
Apportionment percentages
Property factor
The average value of Acme’s tangible property is $92 million in State X and $8 million in
State Y, computed as follows:
State X Jan. 1 Dec. 31 Average
Land $5,000,000 $5,000,000 $5,000,000
Building $21,000,000 $23,000,000 $22,000,000
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Furniture and fixtures $8,000,000 $10,000,000 $9,000,000
Machinery and equipment $45,000,000 $51,000,000 $48,000,000
Inventories $7,000,000 $9,000,000 $8,000,000
$92,000,000
State Y Jan. 1 Dec. 31 Average
Furniture and fixtures $2,000,000 $2,000,000 $2,000,000
Inventories $1,000,000 $3,000,000 $2,000,000
Rentals (8 $500,000) $4,000,000
$8,000,000
Therefore, the State X property factor is 92% ($92 million [$92 million + $8 million]),
and the State Y property factor is 8% ($8 million [$92 million + $8 million]).
Payroll factor
Acme has $26.4 million of payroll attributed to State X and $3.6 million of payroll
attributed to State Y. Therefore, the State X payroll factor is 88% ($26.4 million [$26.4
million + $3.6 million]), and the State Y payroll factor is 12% ($3.6 million [$26.4
million + $3.6 million]).
Sales factor
Acme has $80 million of sales attributed to State X and $20 million of sales attributed to
State Y, computed as follows:
State X State Y Total
Sales (destination test) $10,000,000 $20,000,000 $30,000,000
Sales (throwback) $70,000,000 $0 $70,000,000
$80,000,000 $20,000,000 $100,000,000
Therefore, the State X sales factor is 80% ($80 million [$80 million + $20 million]), and
the State Y sales factor is 20% ($20 million [$80 million + $20 million]).
Apportionment percentages
Acme’s State X apportionment percentage is 85% ([92% of property in X + 88% of payroll
in X + 2{80% of sales in X}] 4), and the State Y apportionment percentage is 15% ([8%
of property in Y + 12% of payroll in Y + 2{20% of sales in Y}] 4).
State tax liabilities
State X State Y
Business income subject to apportionment $18,100,000 $16,600,000
Apportionment percentage 85% 15%
Business income apportioned $15,385,000 $2,490,000
Nonbusiness income allocable to State Y $0 + $2,000,000
Taxable income $15,385,000 $4,490,000
Tax rate 7% 9%
Tax before credits $1,076,950 $404,100
Credits $500,000 $0
Tax liability $576,950 $404,100
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46. Answer varies with state.
47. a. No. Property or equipment under construction during the tax period, except inventoriable
goods in process, is excluded from the property factor until such property is actually used
in the regular course of the taxpayer’s trade or business. MTC Reg. IV.10.(b).
b. Yes. Property used in the regular course of the taxpayer’s trade or business remains in the
property factor until its permanent withdrawal is established by an identifiable event, such
as the lapse of an extended period of time (normally, five years) during which the property
is held for sale. MTC Reg. IV.10.(b).
c. Destination state. Property in transit between a seller and a buyer, which is included by a
taxpayer in the denominator of its property factor in accordance with its regular accounting
practices, is included in the numerator of the destination state. MTC Reg. IV.10.(d).
d. Time within the state. The value of mobile property which is located within two or more
states during the tax year is included in the numerator of the property factor on the basis of
the time within the state during the tax year. MTC Reg. IV.10.(d).
e. Yes. As a general rule, the average value of property owned by the taxpayer is determined
by averaging the values at the beginning and ending of the tax year. However, the state tax
authority may require or allow averaging by monthly values if such method of averaging is
required to accurately reflect the average value of the taxpayer's property for the tax year.
Averaging by monthly values will generally be applied if substantial fluctuations in the
values of the property exist during the tax year or where property is acquired after the
beginning of the tax year or disposed of before the end of the tax year. MTC Reg. IV.12.
f. Yes. Federal and state excise taxes, including sales taxes, are included in the sales factor if
such taxes are passed on to the buyer or included as part of the selling price of the product.
MTC Reg. IV.15.(a).
g. Origination state. Gross receipts from sale of tangible personal property to the U.S. federal
government are assigned to the state from which the property was shipped. MTC Reg.
IV.16.(b).
h. State in which the services were performed. Gross receipts for the performance of personal
services are attributable to a state to the extent such services were performed in that state.
If services relating to a single item of income are performed in more than one state, the
receipts are attributed to the state only if a greater proportion of the services were
performed in the state based on cost of performance. MTC Reg. IV.17.
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