Alternative Apportionment

One size does not fit all. State and local statutory standard apportionment formulas determine the “slice” of the income tax base “pie” on which a particular state or locality may impose its income tax. Traditionally, states and localities use an apportionment formula based on the average percentage of sales, property and payroll in the taxing jurisdiction versus everywhere, known as the three-factor formula. The property and payroll factors reflect the production of income, and the sales factor reflects the market. Many taxing jurisdictions, including Kentucky, have moved to a single sales factor apportionment formula, which is now the predominant standard apportionment formula, or to an apportionment formula that more heavily weights the sales factor. The standard apportionment formula generally reflects a taxpayer’s business activities in the state, but when the standard formula does not, alternative apportionment can provide relief to both taxpayers and taxing jurisdictions. Alternative apportionment may take the form of separate accounting, the exclusion or inclusion of one or more factors, or any other method to effectuate the equitable allocation and apportionment of a taxpayer’s income. 

The Michigan Supreme Court’s recent decision in Vectren Infrastructure Servs. Corp. v. Dep’t of Treasury, No. 163742, 2023 WL 4874684 (Mich. July 31, 2023) provides an interesting example of a taxpayer seeking alternative apportionment. In that case, for the three-month period ending March 31, 2011, Minnesota Limited had income of $55 million, comprised of a gain of $51 million on the sale of its business assets and $4 million in income from ongoing operations. Michigan applied its statutory single sales factor apportionment formula, which excluded the proceeds of the gain, resulting in an apportionment factor of 70%. Had the proceeds been included, the sales factor would have been just 15% (with 70% exceeding 15% by 4.7 times). For context, during the preceding decade, the taxpayer’s average Michigan sales factor was 7%, and its sales factor in 2010 was 40%. The Michigan Court of Appeals held that alternative apportionment should apply but a 4-3 majority of the Michigan Supreme Court reversed. The taxpayer asked the U.S. Supreme Court to review its case in MMN Infrastructure Services LLC v. Michigan Department of Treasury, which was supported by amicus briefs filed by the Institute of Professionals in Taxation (represented by the author as lead counsel), the American College of Tax Counsel and the Council on State Taxation, but unfortunately, the Supreme Court denied cert. What do you think? Was this a case where alternative apportionment should have applied?

Though this example is from Michigan, this issue comes up in states and localities across the nation, including in both Kentucky state income tax (which is generally apportioned using a single sales factor apportionment formula) and local occupational taxes (which are apportioned using a an equally weighted sales and payroll factor apportionment formula). Notably, the sales and payroll two-factor formula used by Kentucky localities is unique and not used by any other taxing jurisdiction. Alternative apportionment can also come up in the context of Kentucky’s limited liability entity tax, the LLET.

PTET Entities

We all know about the federal limit of $10,000 on state and local tax itemized deductions. This $10k federal SALT deduction cap has motivated the vast majority of states across the United States to enact pass-through entity tax (PTET) elections for entities to pay state and local income taxes for their owners, the IRS to issue IRS Notice 2020-75, which provided some certainty for taxing jurisdictions enacting PTET election statutes, and taxpayers, especially business owners to make PTET elections.

By making a PTET election, a pass-through entity (e.g., a partnership or S corporation) may elect to pay the state or local income tax and then deduct that tax as a business expense, notwithstanding the $10k SALT cap.

Most states including Kentucky have enacted PTET elections, although there are a handful of exceptions. The AICPA has an updated map that indicates which states have enacted PTET election statutes as well as a detailed checklist of considerations for whether or not to make a PTET election.

The $10k federal SALT deduction limit expires on December 31, 2025. But, does that mean that it will go away? Or, will it be more likely to continue with a higher limit, like $50,000 or $80,000?

Remote Workers

Especially beginning in 2020, there has been a trend toward remote work, whether totally remote or a hybrid of in-office and remote work. This trend has resulted in a shift in the workforce from one taxing jurisdiction to another to another, sometimes from one state to another state and sometimes within a state but from one locality to another.

As to income taxes on workers, states generally impose their income tax on all of the income of state residents but provide their residents with a credit for taxes paid to other states and impose their income tax on nonresidents only on income earned while working in the state; Kentucky does this. Another approach is to tax workers only on income earned while working in the taxing jurisdiction; Kentucky localities imposing occupational license taxes take this approach.

Issues can arise when taxing jurisdictions fail to provide to residents adequate credits for taxes paid to other taxing jurisdictions. For example, in its 2015 Comptroller of Maryland v. Wynn decision, the U.S. Supreme Court held that Maryland, which imposed a state and county income tax, violated the Commerce Clause by failing to provide a credit against the county taxes for taxes paid to other states. This may be contrasted with the Pennsylvania Supreme Court’s November 22, 2023 decision in Zilka v. Philadelphia Tax Review Board, holding that it did not offend the Commerce Clause for Philadelphia to provide a credit to a Delaware resident only for Wilmington tax. The dissent in Zilka would have held that the Pennsylvania and Philadelphia taxes and the Delaware and Wilmington taxes should have been considered together in the aggregate, which would have resulted in the Delaware resident receiving a full state and local credit. The concurring opinion suggested that the U.S. Supreme Court should review the case.

Another example from Ohio illustrates an issue involving in-state localities. In Schaad v. Alder, the Ohio Supreme Court is considering the question of whether the city in which the business for which a nonresident employee works may subject that nonresident employee’s wages to tax, when that nonresident employee worked from home and did not work in that city or whether the state legislation that authorized such tax was unconstitutional.

In Kentucky remote workers have the benefit of reciprocal agreements with states like Indiana so that only one state, i.e., the state of residence, but not the other (i.e., the state in which they are employed) may subject their wages to tax. As to occupational license taxes imposed by Kentucky localities, only the locality in which work is performed may subject wages of a worker to tax. That is not to say that issues cannot arise; indeed, it can be an administrative burden on workers and their employers to comply with the many locally administered taxes in Kentucky.

PL 86-272

Public Law 86-272 is a federal law enacted in response to the U.S. Supreme Court’s 1959 decision in Northwestern States Portland Cement Co. v. Minnesota, which upheld the imposition of tax on an out-of-state company that had a sales office in Minnesota and solicited orders there. P.L. 86-272 precludes the imposition of income tax by a state if the company’s sole activity in the state is its representatives’ solicitation of orders for the sale of tangible personal property provided that the orders are sent outside the state for approval (or rejection) and are filled by shipment from outside of the state, regardless of the method of shipment or delivery.

States must follow P.L. 86-272, as it is federal law. The Kentucky Department of Revenue has recognized the application of P.L. 82-272 to Kentucky in 103 KAR 16:240, which cites Wisconsin Department of Revenue v. William Wrigley, Jr., Co., the 1992 U.S. Supreme Court decision interpreting P.L. 86-272.

But, states, like California, are trying to push the boundaries of P.L. 86-272. In 2022, the California Franchise Tax Board issued Technical Advice Memorandum 2022-01 and updated FTB Publication 1050, taking the position that the placement of internet cookies on computers for certain purposes may exceed the scope of P.L. 86-272. American Catalog Mailers are challenging the FTB’s unpromulgated administrative pronouncements in Superior Court in San Francisco County.

Unequal and Non-Uniform Property Tax Assessments

The U.S. Constitution and state constitutions provide protections against unequal property tax assessments, and state constitutions also provide protections against non-uniform assessments. When a property subject to a market rate lease is assessed at its fair market value (called fair cash value in Kentucky) and a similar nearby property subject to an above market lease with a tenant with a better credit rating is assessed at a value two or three times the former property’s value, is that a violation of constitutional guarantees of equal protection or uniformity? Disparate assessments like this are happening across the country, including in certain counties in Kentucky. The disparities in assessment value results when the assessor uses the income capitalization method to determine the latter property’s assessment value using the above market contract rent and a capitalization rate computed by reference to that tenant, instead of using market rent and a market capitalization rate and also results when the assessor uses a recent sale price for a purchase of the latter property with the lease in place by an investor with the intent to secure the cash flow from the property, not the property itself, and thus, the investor pays a price based on the contract rent and the tenant’s creditworthiness. The solution is simple. When the assessor assesses both properties using the same market data, both properties are assessed at each property’s fair market value, and the assessments are thus equal and uniform.

“It was salt in an open wound.” Scotty Smalls in The Sandlot (1993).

What do you think about this list of the biggest state tax issues of 2023? Are there other SALT issues that made your list?

This is a modified version of Mark A. Loyd’s regular column, Tax in the Bluegrass, “2023’s Biggest State Tax Issues” which appeared in Issue 5, 2023 of the Kentucky CPA Journal.