Solution manual SW federal taxation corporations partnerships estates and trusts 35e by hoffman chapter 16

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CHAPTER 16
MULTISTATE CORPORATE TAXATION
SOLUTIONS TO PROBLEM MATERIALS

Question/
Problem
1
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Learning
Objective
LO 1
LO 1
LO 1
LO 1
LO 2
LO 2
LO 2
LO 3
LO 3
LO 3
LO 3
LO 5
LO 5
LO 5
LO 5
LO 6
LO 6
LO 6
LO 6

LO 7
LO 7
LO 7
LO 8
LO 8
LO 8
LO 8
LO 2, 9
LO 9
LO 9
LO 9
LO 9

Topic
State tax policy
State/Federal tax law overlap
UDITPA and MTC as tax law writers
Multistate Tax Commission
States’ jurisdiction to tax; nexus
Immune sales under P.L. 86-272
P.L. 86-272 solicitation standards
Apportionment and allocation of income
Allocation and apportionment
Allocation and apportionment
Apportionment formula weights
Sales factor
Throwback rule for sales factor
Payroll factor
Property factor
Unitary theory

Unitary taxation
Unitary taxation
Unitary taxation
Out-of-state S shareholders
Composite S corporation filing
Partnerships and LLCs
Sales/use tax incidence
Sales/use tax exemptions
Streamlined Sales Tax Project
Other taxes
Planning with nexus rules
Passive investment subsidiary
Shifting taxable income from intangibles
Multistate tax planning
Capital stock tax planning

Status:
Present
Edition

Q/P
in Prior
Edition

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Modified
New
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1
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8
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17
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24
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30
31

Instructor: For difficulty, timing, and assessment information about each item, see p. 16-3.

16-1
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16-2

2012 Corporations Volume/Solutions Manual

Question/
Problem

Learning
Objective

*32
33
*34
*35
*36
37
38
*39
*40
41
42
*43
44
45
46
47
48
49
50
51
*52
53

LO 1
LO 1
LO 1
LO 1
LO 1
LO 4, 5
LO 4, 5
LO 5
LO 5
LO 5
LO 5
LO 5
LO 5, 9
LO 5, 9
LO 5
LO 5
LO 5
LO 5
LO 5, 9
LO 6, 9
LO 6
LO 7

54
*55
56
*57
58
59

LO 8
LO 8
LO 8
LO 8
LO 5, 9
LO 9

Topic
State income tax formula
State income tax formula
Addition and subtraction modifications
Addition and subtraction modifications
Addition and subtraction modifications
Apportionment formulas
Apportionment and allocation
Apportionment formulas
Apportionment formulas
Apportionment formulas
Apportionment formulas
Sales factor
Throwback rule
Payroll factor
Payroll factor
Payroll factor
Property factor
Property factor
Property factor
Unitary business, apportionment factors
Water’s edge election

Multistate S corporations, apportionment
formula
Sales tax base
Sales and use taxes
Sales tax exemptions
Franchise tax
Apportionment planning
Apportionment planning

Status:
Present
Edition

Q/P
in Prior
Edition

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54
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59

*The solution to this problem is available on a transparency master.
Instructor: For difficulty, timing, and assessment information about each item, see p. 16-3.

Research
Problem
1
2
3
4
5
6

Topic

Internet activity
Internet activity
Internet activity
Internet activity
Internet activity
Internet activity

Status
Present
Edition
Modified
Unchanged
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Modified
Modified

Q/P
in Prior
Edition
1
2
3
4
5
6

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Multistate Corporate Taxation

Question/
Problem

Difficulty

Est’d
completion
time
10

Assessment Information
AICPA*
AACSB*
Core Comp
Core Comp

1

Medium

2
3

Easy
Easy

5
5

4

Easy

5

5
6
7
8

Medium
Easy
Easy
Easy

9

Easy

5

10
11

Easy
Easy

5
10

12
13

Easy
Medium

5
10

14
15

Easy
Easy

16

Medium

17

Easy

5

FN-Measurement | FNReporting

FN-Reporting

18
19
20
21
22
23

Easy
Easy
Easy
Easy
Easy
Easy

5
5
5
5
5
5

FN-Reporting
FN-Reporting
FN-Reporting
FN-Reporting
FN-Reporting
FN-Reporting

24
25
26
27
28
29
30

Medium
Easy
Easy
Medium
Medium
Easy
Medium

10
5
5
15
20
5
10

31

Medium

10

32
33

Easy
Easy

10
5

10
5
10
5

5
5
10

16-3

FN-Measurement | FNReporting
FN-Reporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Reporting
FN-Reporting
FN-Reporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Reporting

FN-Reporting
FN-Reporting
FN-Measurement | FNReporting
FN-Reporting
FN-Reporting

FN-Reporting
FN-Reporting
FN-Reporting
FN-Reporting
FN-Reporting
FN-Reporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement
FN-Measurement | FNReporting

Communication | Analytic |
Reflective Thinking
Analytic
Analytic
Analytic
Communication | Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic | Reflective
Thinking

Analytic
Analytic | Reflective
Thinking
Analytic
Analytic | Reflective
Thinking
Analytic | Reflective
Thinking
Analytic | Reflective
Thinking
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic | Reflective
Thinking
Communication | Analytic
Analytic
Analytic
Communication | Analytic
Communication | Analytic
Analytic
Analytic
Analytic
Analytic
Analytic

*Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB
core competencies in assessment.

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16-4

2012 Corporations Volume/Solutions Manual

Question/
Problem

Est’d
completion
time

Difficulty

34

Easy

10

35
36

Easy
Medium

5
10

37

Medium

10

38

Medium

10

39
40
41
42
43

Medium
Medium
Medium
Medium
Medium

10
10
10

15
10

44

Medium

10

45

Medium

10

46

Easy

47

Medium

10

48

Easy

10

49

Easy

10

50

Medium

10

51

Medium

20

52

Easy

10

53

Medium

20

54

Easy

55

Medium

10

56
57
58

Easy
Medium
Medium

5
10
10

59

Medium

15

5

5

Assessment Information
AICPA*
AACSB*
Core Comp
Core Comp
FN-Measurement | FNReporting
FN-Measurement
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement
FN-Measurement
FN-Measurement
FN-Measurement
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting

FN-Reporting
FN-Measurement
FN-Reporting
FN-Measurement | FNReporting

Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic | Reflective
Thinking
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic | Reflective
Thinking
Communication | Analytic
Analytic
Communication | Analytic
Analytic
Analytic
Analytic

Analytic
Analytic | Reflective
Thinking
Communication | Analytic

*Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB
core competencies in assessment.

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Multistate Corporate Taxation

16-5

CHECK FIGURES
32.

Apportionable income $79,000; tax
after credits $1,650.
33.a. $5,400,000.
34.a. S; $5,000.
34.d. S; $3,000.
34.e. N.
34.f. S; $20,000.
35.
$387,000.
36.a. $650,000.

36.b. $900,000.
36.c. $920,000.
37.
D $657,200; E $1,900,640.
38.
E $2,142,800.
39.
62.34%; 37.5%.
40.
A 62.5%; B 30.56%.
41.
A 67.71%; B 35.42%.
42.a. $189,990.
42.b. $187,500.
43.
B $595,000.

44.

E 84%. Sales factor numerators total to
100%.
45.
G 16.67%; H 57.14%; I 50.0%.
46.
$725,000 to U.
47.
G 73.77%; H 26.24%.
48.
A 56.79%; B 43.21%.
49.

B 40.07%.
50.
Annual method, 40.0% property factor.
51.a. $60,478.
51.b. $110,000.
52.
B 25.0%; Q 80.0%.
53.
$0 Y; $140,067 Z.
55.a. $5,400.
55.b. $990,000.
56.a. S.
56.d. N.
57.
$3,285.
58.
Factor drops to 76.5%.

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16-6

2012 Corporations Volume/Solutions Manual

DISCUSSION QUESTIONS
1.

Nontax factors dominate most business relocation decisions. However, a combination of some
of the following incentives might also force the consideration of a tax-motivated expansion or
relocation.
•

Economic development incentives.

•

Sales and use tax exemptions reducing a customer’s acquisition price.

•

Favorable interest rates on loans to business.

•

Property tax deferrals or forgiveness for a period of time.

•

Offsets against tax liabilities or debt obligations for employee withholding amounts.

•

Income tax credits for new jobs created and retained.

•

Income tax credits for new investment in business equipment or realty.

•

Use of technology to transfer sales and purchase orders, pricing information, and other
data.

•

Ease in complying with multiple jurisdictions’ tax rules.

•

‘‘Exporting’’ of local taxes to visitors and outsiders.

•

Sophistication and effort of jurisdictional enforcement measures.

pp. 16-2 and 16-3
2.

Item

True or False

a.

All of the states and the District of Columbia assess an False, a few
income tax on entities doing business within the borders.
states have not

adopted an
income-like tax

b.

Federal tax accounting methods, such as LIFO inventory and True
specific write-off of bad debts, are followed for state income
tax purposes.

c.

State rules as to which entities can join in a consolidated False, different
return match those of Federal law.
rules are used

d.

Some of the states use Federal taxable income as their True
income tax base, while others modify this amount or create
their own state taxable income.

e.

A typical state income tax credit would equal 10% of the True
costs incurred to purchase and install solar energy panels for
an existing factory.

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Multistate Corporate Taxation
Item

16-7
True or False

f.

The corporate income tax systems of most states can be False, the
described as progressive in its rate structure.
systems are for
the most part
flat-rate.

g.

A state that “piggybacks” onto the Federal income tax likely False, none of
allows the U.S. Treasury to collect the state corporate the states do
income tax on the Federal Form 1120.
this yet.

p. 16-4
3.

The Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law relating to
the assignment of income among the states for corporations that maintain operations in more
than one state. Many states have adopted the provisions of UDITPA, either by joining the
Multistate Tax Commission (MTC), or by modeling their laws after UDITPA provisions.

The MTC issues rulings and regulations, and states can automatically (or as-needed) adopt
those regulations into their law. The MTC also offers to coordinate audits of business
taxpayers, thereby reducing the administrative costs to the state and broadening the reach of
the jurisdiction’s enforcement resources. pp. 16-7 and 16-8

4.

The Multistate Tax Commission (MTC) writes regulations and other rules to interpret
UDITPA. When a new MTC rule or regulation is created, member states propose its adoption
to their respective legislatures. The majority of (full or associate) MTC member states adopt
the regulations with no exceptions or only minor changes.
In addition, many of the states that are not MTC members model their laws after UDITPA and
MTC regulations. Thus, MTC pronouncements carry great weight in the multistate tax
system, and many see the functions of the MTC as allowing a state legislature to outsource its
tax-writing responsibilities.
pp. 16-7 and 16-8

5.

•

The state in which a business is incorporated has the jurisdiction to tax the income of the
corporation, regardless of the volume of its business activities within the state.

•

If a corporation is to be subject to tax in a state other than that of its incorporation, the
former jurisdiction must show that sufficient contact with that state (nexus) has been
established. Typically, sufficient nexus exists when a corporation derives income from
sources within the state, owns or leases property in the state, employs personnel in the

state, or has physical or financial capital there.

•

A state cannot tax the out-of-state activities of an out-of-state corporation.

p. 16-8
6.

No Oklahoma tax applies. Public Law 86-272 limits the states’ right to impose an income tax
on interstate activities. This Federal law prohibits a state from taxing a business whose only
connection with the state is to solicit orders for sales of tangible personal property, when the
orders then are approved or rejected, filled, and shipped from outside the state.

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16-8

2012 Corporations Volume/Solutions Manual
Only the sale of tangible personal property is immune from taxation under P.L. 86-272,
however. Leases, rentals, and other dispositions of tangible personal property are not immune
activities. Moreover, dispositions of real estate and intangible assets, as well as sales of
services, are not protected activities.
p. 16-8

7.

Oklahoma tax now applies to all of Josie’s sales. Public Law 86-272 does not define the term
solicitation, but the Supreme Court in Wrigley held that order solicitation includes any
explicit verbal request for orders and any speech or conduct that implicitly invites an order. A
de minimis rule also may allow a transaction to stay immune under the statute.
Carrying out any of the following (common but substantively) minimal acts within a state,
though, in addition to the traditional sales-solicitation tasks of a sales force, could establish
nexus through nonimmune sales.
•

Collecting delinquent accounts; investigating creditworthiness.

•

Repairing or maintaining company products (even if performed at no charge to the
customer).

•

Approving or accepting orders.

•

Picking up or replacing damaged or returned property.

•

For other than sales personnel, conducting training or personnel-related activities.

Exhibit 16.2
8.

A business that carries out transactions in more than one state must divide such resulting
income among the states for tax purposes. Generally, this includes both an apportionment and
an allocation of such income.
Apportionment is a means by which business income is assigned to specific states by a
formula method. The formula usually takes into account the gross receipts, property, and
compensation levels generated within each state, although the states vary in the weighting of
the factors for this purpose. Allocation is a procedure by which nonbusiness income is
assigned directly to the state(s) in which it is generated. For instance, a manufacturing firm
with some rental income would allocate the net rental profit or loss to the state in which the
rental property is located.
A few states, including Connecticut and Rhode Island, fail to distinguish between business
and nonbusiness income, apportioning all of the taxpayer’s income among the states.
p. 16-10 and Figure 16.1

9.

a.

Profits from sales activities.

Apportion; business income

b.

Gain on the sale of a plot of land held by
a real estate developer.

Apportion; business income

c.

Gain on the sale of a plot of land held by
a manufacturer.

Allocate; nonbusiness income

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Multistate Corporate Taxation
d.

Rent income received by a manufacturer
from the leasing of space to a supplier.

Apportion; business income

e.

Profits from consulting and other service
activities.

Apportion; business income

a.

The sales factor is positively correlated

with the payroll, but not the property,
factor.

Probably out-of-state

b.

The sales factor is much higher than the
property and payroll factors.

Probably out-of-state

c.

The property and payroll factors are
much higher than those for other nexus
states.

Probably in-state

d.

The sales and payroll factors are low, but
the property factor is very high.

Probably in-state.

16-9

p. 16-11

10.

p. 16-13
11.

A single-factor apportionment formula consisting solely of a sales factor tends to create greater
levels of apportionable income for the state from nonresident (meaning also nonvoting) entities
than an apportionment formula that double weights the sales factor. Most states now over-weight
the sales factor for this reason. It is becoming popular to use a sales-factor-only apportionment
formula. p. 16-14 and Example 11

12.

In determining the numerator of the sales factor, most states follow UDITPA’s “ultimate
destination concept,’’ whereunder sales of tangible personal property are assumed to take
place at the point of delivery, as opposed to the location at which the shipment originates.
This sale should be sourced to Kentucky. Example 12

13.

The solution depends upon whether Iowa applies a throwback rule in its sales factor.
The throwback rule is an exception to the ultimate destination concept. It provides that, when
a corporation is not subject to tax in the destination state or the purchaser is the U.S.
government, the sales are treated as in-state sales of the origination state, and the actual
destination of the product is disregarded.
Consequently, when the seller is immune from tax in the destination state, the sales are
considered to be in-state sales of the origination state if that state has a throwback provision.
The throwback rule was established as an attempt to ensure that none of a corporation’s sales
escaped taxation. (Iowa has not adopted such a throwback rule.)
Example 13

14.

a.

Items included in the payroll factor are not split among the states in which an
employee works, unless the employee is permanently relocated during the year.
Rather, compensation is assigned in full under the UDITPA to the state in which the
services primarily are performed. Megan’s compensation should be assigned only to
Tennessee.

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16-10

2012 Corporations Volume/Solutions Manual
b.

The payroll factor includes only the compensation paid to employees. The
compensation that is paid to an independent contractor is not part of the numerator or
denominator of the payroll factor of any state. Thus, Megan’s compensation is
excluded from the Tennessee (and Georgia) payroll factor.

pp. 16-17 and 16-18
15.

An analysis of this situation should include the following tax-related inquiries.

•

Is the property tangible or intangible?

•

Where is the property located?

•

For what portion of the tax year was the property used in this state?

•

Was the property used in the taxpayer’s productive or other active business?

•

What is the tax basis of the property?

•

What was the original purchase price of the property?

•

What is the balance of accumulated depreciation for the property as of the end of the tax
year?

•

Was the property in-transit on the last day of the tax year?

•

Was the property idle or obsolete on the last day of the tax year?

•

What averaging conventions does the state allow in computing the property factor?

pp. 16-19 to 16-21
16.

The unitary theory can increase the taxpayer’s income taxes as the apportionment formula
includes operations in locations where payrolls, property values, and selling prices are higher
than normally experienced (e.g., California and the U.K.).
a.

The unitary approach to state taxation attempts to neutralize taxpayer attempts to place
profitable operations in low- or no-tax jurisdictions. States have adopted combined
reporting as a means to discourage the use of passive investment companies and to
allow the taxation of income from intangible assets (e.g., trademarks and licenses).
Whether the unitary rules apply often turns on subjective assessments as to the
structure and operations of the business. This is unlike the application of the controlled
and affiliated group rules, discussed in text Chapters 2 and 8.

b.

When the business is found to be unitary, apportionment factors are computed on the

basis of the entire unitary entity, not just the subsidiary that is based in the taxing state.
This computational convention can work to the taxpayer’s benefit when high-taxed
income now is subjected to apportionment in a low-tax state.

pp. 16-21 to 16-24 and 16-34
17.

Unitary rules tend to assign larger portions of a corporation’s taxable income to states with
higher compensation levels, property values, and consumer pricing. For each of the

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Multistate Corporate Taxation

16-11

apportionment factors, these conditions increase the in-state numerators of the payroll,
property, and sales factors, respectively. p. 16-22
18.

Tax results attributable to the application of the unitary theory are neither “good” nor “bad” in
the abstract, although they may affect a particular taxpayer in a positive or negative fashion.
The use of a unitary business arrangement would improve the taxpayer’s situation when the
affiliates bring operating losses or other favorable apportionment attributes into the
combination. The unitary formulas may work to shift net income into lower tax brackets, or
apply net losses to reduce higher tax brackets. p. 16-23

19.

When a water’s-edge election is in place, the apportionment formulas for a unitary business
cannot include data derived from outside of the United States (i.e., the unitary theory does not
reach beyond the water’s edge). The tax planner should determine whether this election will
improve the taxpayer’s situation. In this regard, consider both the short- and the long-term
effects. Given that the client is operating in non-U.S. jurisdictions with relatively high prices,
a waters’-edge election likely is appropriate here.
Once a water’s-edge election is made, it generally cannot be revoked for a number of years.
Global Tax Issues, p. 16-24

20.

Some states apply a corporate-level tax on the income items attributable to out-of-state S
shareholders. Others require that the S corporation withhold state income tax on taxable
income attributable to out-of-state shareholders. It appears that Chip is not a resident of State
Q. p. 16-26

21.

Many states accept block filing or composite returns from multiple-shareholder S
corporations. Such a return essentially is a spreadsheet that discloses and computes the
allocation of ordinary income and separately stated items, on a per-state and per-shareholder
basis. p. 16-26

22.

Most states use the Federal pass-through system of taxing partners and partnerships. The
entity does not pay income tax, but it files an information return (like Form 1065), allocating
income, deduction, and credit items to the partners.

Other state taxes (such as payroll and unemployment taxes), however, are payable by these
entities. Some states apply a corporate-level tax on the income items attributable to out-ofstate partners and LLC members. Other states require that the passthrough entity withhold
state income tax on taxable income attributable to out-of-state partners/members. p. 16-27

23.

The sales representatives appear to misunderstand who pays a sales tax. A retail sales tax falls
on the customer, so HenandezCo incurs no new tax liabilities if nexus is created with State G.
But State G will require the seller to collect the customers’ sales tax liabilities, and this
compliance burden might be costly for HernandezCo. Sales tax returns are filed by the seller
when the funds are remitted. No sales/use tax return is required of the customer. p. 16-27

24.

Outline Points
Sales/use tax exemptions by:
•

Nature of the taxed product
•
•
•
•

Services
Occasional sale
Sale for resale
Groceries, medicines

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16-12

2012 Corporations Volume/Solutions Manual
•

Nature of the purchaser
•
•

•

Nature of the sale
•
•

•

Exempt organization
Government or agency

Casual/occasional sale
Amnesty or holiday

Nature of the political process
•
•

Manufacturer, farmer
Manufacturing process, packaging, shipping
• Ingredient part, consumed in process
• Not fuel or electricity

p. 16-28
25.

The Streamlined Sales Tax Project (SSTP) is an effort by state/local tax administrators to unify
the definition of items that are subject to the sales/use tax. The Multistate Tax Commission
helped to develop a common set of definitions for state legislatures to adopt, so that
enforcement of the sales/use taxes would be improved, especially with respect to cross-border
sales.
The SSTP does not force the states to adopt common tax rates or enforcement procedures, but
it includes checklists as to which types of food, clothing, and computing items might be
identified as taxable.
p. 16-28 and Tax in the News on p. 16-29

26.

A state or local government might levy one or more of the following taxes.
•

Incorporation tax, on the privilege of using the corporate form.

•

License tax, to allow a professional to conduct trade or business activities.

•

Stock transfer tax, on the transfer of shares for consideration.

•

Realty transfer tax, on the transfer of real estate for consideration.

•

Mortgage recording tax, when a large debt is incurred relative to realty.

•

Capital stock tax, on the “net worth” of a corporation.

pp. 16-30 and 16-31
27.

TAX FILE MEMORANDUM
November 3, 2011
From:

Daniel S. Lange

Subject:

Multistate tax planning

Re:

Client Ecru’s relocation decision

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Multistate Corporate Taxation

16-13

Because the states employ different definitions of the amount and type of activity necessary to
place a tax situs within the state, a company is allowed, to an extent, to select the states with
which it desires to establish nexus. When a corporation has only a limited connection with an
undesired (high-tax) state, it may abandon that activity by electing an alternative means of
accomplishing the same result. For example, when providing a sales representative with a
company-owned broadband modem in a sales office constitutes nexus in a high-tax state, the
company could eliminate its connection with that state by reimbursing sales personnel for
communication expenses, instead of providing company-owned equipment. These distinctions
are more important after Wrigley, in which the Supreme Court outlined the terms of nexus
under P.L. 86-272.
Similarly, when nexus is caused by conducting customer training sessions or seminars in the
state, the corporation could bypass this connection by sending the customers’ personnel to a
nearby state in which nexus clearly has been established, or in which the activity would not
constitute nexus.
In addition, when sufficient activity originates from the repair and maintenance of the
corporation’s products or the activities performed by the sales representatives within the state,
the organization could incorporate the service or sales divisions. This would invalidate the
state’s right to tax the parent corporation’s income; only the income of the service or sales

divisions would be subject to tax. However, this technique is successful only if the
incorporated division is a bona fide business operation and the state in which it operates is not
a unitary state. Therefore, the pricing of any sales or services between the new subsidiary and
the parent corporation must be at arm’s length, and the operations of the new corporation
preferably should result in a profit.
Although most planning techniques are employed to disconnect a corporation’s activities from
an undesirable state, they also can be utilized to create nexus in a desirable state. For example,
when the presence of a company-owned copy machine in a sales office creates nexus in a
desirable state, the corporation could provide its salespersons in that state with company-owned
equipment, rather than reimbursing or providing increased compensation for office expenses.
Establishing nexus in the state is advantageous, for instance, when that state has a lower tax rate
than the state in which the income presently is taxed.
pp. 16-32 to 16-34 and Example 31
28.

TAX FILE MEMORANDUM
November 3, 2011
From:

Mark A. Barnes

Subject:

Multistate tax planning

Re:

Client Royal’s interest income

The creation of a passive investment company is a technique utilized to minimize a

corporation’s state tax burden. Nonbusiness or passive income generally is allocated to the
state in which the income-producing asset is located, rather than apportioned among the states
in which the corporation does business. Therefore, significant tax savings may be realized
when nonbusiness assets have a tax situs in a state that either does not levy an income tax or
provides favorable tax treatment for passive income.
To benefit from the provisions of those states, it is not necessary that the corporation be
domiciled in such a state. Instead, the tax savings can be realized by forming a passive

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16-14

2012 Corporations Volume/Solutions Manual
investment company to hold the intangible assets and to handle the corporation’s investment
activities. Although the passive investment company technique usually produces the desired
result in any no-tax state, Delaware and Nevada often are selected for this purpose, because of
those states’ additional corporate statutory provisions and favorable political, business, and
legal atmosphere.
For instance, Delaware does not impose an income tax upon a corporation whose only activity
within the state is the maintenance and management of intangible investments, and the
collection and distribution of income from such investments or from tangible property
physically located in another state. Consequently, patents, trademarks, stock, and other
intangible property can be transferred to a Delaware corporation whose activity is limited to
collecting passive income. Transfers of the assets to the subsidiary can be effected without a
resulting Federal income tax, under § 351.
However, to receive the desired preferential state tax treatment, the passive investment
company’s activities within the no-tax state must be sufficient to establish nexus, and the

holding company should avoid performing any activity outside the state that may result in
establishing nexus with another state. In addition, the formation of the subsidiary must be
properly implemented, to assure the legal substance of the operation. The passive investment
company must have a physical office, and it must function as an independent operation.
Nevertheless, ensuring nexus and proper formation is not difficult, since numerous consulting
organizations have been established to furnish new passive investment companies with all of
the elements necessary to fulfill these requirements.
Because the subsidiary’s activities are confined to Delaware (or some other no- or low-tax
state), and its operations generate only passive income, its income is not taxed in any
nonunitary state. Moreover, most states exclude dividends from taxation or otherwise
favorably treat them; therefore, the earnings of a passive investment company can be
distributed as a dividend to the parent at a minimal tax cost. If the state in which the parent is
located does not levy income tax on dividends received, the entire measure of passive income
may escape taxation. Formation of a passive investment company also may favorably affect
the parent corporation’s apportionment formula in nonunitary states, because the passive
income earned by the subsidiary is excluded from the numerator of its sales factor.
These desired results, however, are not fully available in states that view the entire corporate
operation as being unitary. Since those states require combined or consolidated reporting, the
income earned by the passive investment company is included in the corporation’s
apportionable or allocable income.
HIGH-TAX STATE

LOW-TAX STATE
Investment Assets
SUBCO

ROYAL CORPORATION
Earnings: dividends paid,
qualify for the dividends
received deduction

Nexus only here

p. 16-35 and Example 35

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Multistate Corporate Taxation
29.

16-15

The Geoffrey rule has been adopted by a number of states, following the South Carolina court
case of that name. As the U.S. economy has shifted to one of returns on service activities and
intangible assets, the tax base of some states has been eroded. Specifically, taxable income
that would be assigned to State A might be shifted to State B through a passive investment
subsidiary, or by other means of assigning such portable income across the border.
Geoffrey legislation allows State A to capture that income, using a rationale that the state has
provided economic and legal benefits for the taxpayer. Accordingly, the business is subject to
income taxation in that state. The rules in effect nullify income shifting techniques, especially
when the income relates to the use of a trademark or license (the fact pattern involved in the
South Carolina case and in Sherri’s situation).
Other means by which states attempt to capture shifted taxable income from intangible assets
is the use of combined reporting under the unitary theory, and the adoption of a gross receipts
tax.
Tax in the News item on p. 16-37

30.

•

Create nexus in a low- or no-tax state, so that, through the apportionment process, a lower
effective tax rate can be used.

•

Physically move operations to a low- or no-tax state, perhaps on a divisional or other
functional basis.

•

Move the investment assets into a passive investment subsidiary.

•

Reduce the payroll expense through the use of independent contractors.

•

Acquire a subsidiary that offers a presence in a no- or low-tax state, or a research division
whose losses will offset taxable income. Then optimize tax liabilities through transfer
pricing and management fee structures.

•

If the home state has not adopted a throwback rule, make new sales in low- or no-tax
states, or into states with which there is no nexus.

pp. 16-32 to 16-39
31.

A corporation might be able to reduce its capital stock liability by:
•

Funding expansion with debt, rather than retained earnings.

•

Funding subsidiary operations with debt, rather than with direct capital contributions.

•

Regularly paying dividends to parent corporations located in states that offer friendly tax
treatment of investment income (e.g., Delaware or Nevada).

p. 16-39

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16-16

2012 Corporations Volume/Solutions Manual

PROBLEMS

32.

State F taxable income is computed as follows.
Federal taxable income
Addition modifications
Subtraction modifications
State tax base
Allocated income—total
Apportionable income
Apportionment percentage
Apportioned income
Allocated income—State F
State taxable income
Tax rate
Gross income tax
Credits
Tax liability

$90,000
+19,000
–15,000
$94,000
–15,000
$79,000
× 40%
$31,600
+ 3,000
$34,600
× 5%
$ 1,730

– 80
$ 1,650

Figure 16.1
33.

a.

$5,400,000 ($9 million × 60%).

b.

$600,000 ($3 million × 20%).

c.

Business income is apportioned to the state, using a state’s apportionment formula.
Nonbusiness income is allocated to the state using a dollar-for-dollar assignment.
In most states, business and nonbusiness income are not combined in applying the
state income tax formula.

Figure 16.1
34.

a.

S. $5,000.

b.

A. $5,000.

c.

In most states, N.

d.

S. $3,000.

e.

N.

f.

S. $20,000.

g.

A. $3,000.

h.

S. $3,000.

i.

In most states, N.

Exhibit 16.1
35.

Perk’s state taxable income is determined as follows.
Federal taxable income
A income tax expense
A income tax refund

$200,000
+10,000
– 3,000

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Multistate Corporate Taxation

16-17

Depreciation modification ($300,000 – $120,000)
A taxable income

+180,000
$387,000

Exhibit 16.1 and Example 1
36.

a.

Sales
Cost of sales
Cost recovery (Federal)
Interest income (Federal)
X income tax expense
Federal taxable income

$4,000,000
–2,800,000
–400,000
+50,000
–200,000
$ 650,000

b.

If interest generated from X obligations is exempt from state tax, state taxable
income is computed as follows.
Federal taxable income
State income tax expense
Depreciation modification ($400,000 – $300,000)
Interest on Federal obligations
X taxable income

c.

$650,000
+200,000

+100,000
– 50,000
$900,000

If interest generated from X obligations is subject to state income tax, state taxable
income is computed as follows.
Federal taxable income
State income tax expense
Depreciation modification ($400,000 – $300,000)
Interest on Federal obligations
Interest on X obligations
Expenses related to X obligations
X taxable income

$650,000
+200,000
+100,000
–50,000
+30,000
–10,000
$920,000

Exhibit 16.1 and Examples 1 and 2
37.

STATE D TAXABLE INCOME
Income subject to apportionment (business income)

$2,000,000

Apportionment formula
Sales
$3,000,000/$10,000,000
Property $600,000/$2,100,000
Payroll $1,200,000/$3,000,000
Total
State D apportionment factor (98.57%/3)
Taxable income apportioned to D
Plus: Income allocated to D
D taxable income

=
=
=

30.00%
28.57%
40.00%
98.57%

× 32.86%
$ 657,200
–0–*
$ 657,200

*Since the property for which the $800,000 gain was derived was located in E, such income is
not allocated to D.
STATE E TAXABLE INCOME
Income subject to apportionment (business and
nonbusiness income)

$2,800,000

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16-18

2012 Corporations Volume/Solutions Manual
Apportionment formula
Sales
$7,800,000*/$10,800,000* =
72.22%
Property $1,500,000/$2,100,000
=
71.43%
Payroll $1,800,000/$3,000,000
=
60.00%
Total
203.65%
State E Apportionment Factor (203.65%/3)
E taxable income

× 67.88%
$1,900,640

*Includes $800,000 gain on sale of nonbusiness property.

Examples 5, 6, and 8 to 10
38.

Jest’s income is subject to tax in States D and E, respectively, is computed as follows.
D taxable income, as in problem 37

$ 657,200

STATE E TAXABLE INCOME
Income subject to apportionment (business income only)

$2,000,000

Apportionment formula
Sales
$7,000,000/$10,000,000 =
70.00%
Property $1,500,000/$2,100,000
=
71.43%
Payroll $1,800,000/$3,000,000
=
60.00%
Total
201.43%
State E Apportionment Factor (201.43%/3)
Taxable income apportioned to E
Plus: Income allocated to E
E taxable income

× 67.14%
$1,342,800
800,000
$2,148,800

Examples 5, 6, 8, and 10
39.

Because of the components of the apportionment factors in the two states, less than 100% of
taxable income is subject to state income taxation.
State A Income Apportionment
Sales
$1,000,000/$1,600,000 =
Property $280,000/$680,000
=
Payroll
$2,500,000/$3,000,000 =
Total
A Apportionment Factor (187.01%/3)

62.50%
41.18%*
83.33%
187.01%

62.34%

*Owned property is included in the factor at net depreciated basis, and rent payments are
included in the factor at 8 times the annual rental expense. Therefore, the numerator of the
factor is computed as $280,000 [$500,000 (average cost) less $300,000 (average

accumulated depreciation)] plus [8 × $10,000 (annual rental payments)]. The denominator of
the factor is computed as $680,000 {[$800,000 (total average cost) less $400,000 (total
average accumulated depreciation)] plus [8 × $35,000 (total annual rental payments)]}.
State B Income Apportionment
Sales $600,000/$1,600,000
B Apportionment Factor (37.5%/1)

=

37.5%
37.5%

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Multistate Corporate Taxation

16-19

Examples 11, 19, and 20
40.

Because of the components of the apportionment factors in the two states, less than 100% of
taxable income is subject to state income taxation.
State A Income Apportionment
Sales $1,000,000/$1,600,000

=

62.5%

A Apportionment Factor (62.5%/1)

62.5%

State B Income Apportionment
Sales
$600,000/$1,600,000
Property $300,000/$800,000
Payroll
$500,000/$3,000,000
Total
B Apportionment Factor (91.67%/3)

=
=
=

37.5%
37.5%*
16.67%
91.67%

30.56%

*Property is included in the factor at historical, undepreciated cost, and rent payments are not
included in the factor.
p. 16-14 and Examples 11 and 19

41.

Because of the components of the apportionment factors in the two states, more than 100% of
taxable income is subject to state income taxation.
State A Income Apportionment
Sales
$1,000,000/$1,600,000 = 62.5% × 2
Property $500,000/$800,000
Payroll
$2,500,000/$3,000,000
Total
A Apportionment Factor (270.83%/4)

=
=
=

125.0%
62.5%*
83.33%
270.83%

67.71%

*Property is included in the factor at historical, undepreciated cost, and rent payments are not
included in the factor.
State B Income Apportionment
Sales
$600,000/$1,600,000 = 37.5% × 2
Property $200,000/$400,000

Payroll
$500,000/$3,000,000
Total
B Apportionment Factor (141.67%/4)

=
=
=

75.0%
50.0%*
16.67%
141.67%

35.42%

*Property is included in the factor at net depreciated basis, and rent payments are not included
in the factor.
Examples 10, 11, and 19
42.

a.

Sales ($600,000/$1,000,000)
Property ($300,000/$600,000)
Payroll ($200,000/$250,000)
Sum of Apportionment Factors
Average
State A apportionment factor

=
=
=
=

. 60.00%
50.00%
80.00%
190.00%
÷3
63.33%

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16-20

2012 Corporations Volume/Solutions Manual
Apportionable income
Income apportioned to State A

× $300,000
$189,990

b.

Sales ($600,000/$1,000,000) × 2
Property ($300,000/$600,000)

Payroll ($200,000/$250,000)
Sum of Apportionment Factors
Average
State A apportionment factor
Apportionable income
Income apportioned to State A

=
=
=

120.00%
50.00%
80.00%
250.00%
÷4
62.50%
× $300,000
$187,500

c.

Sales ($600,000/$1,000,000)
State A apportionment factor
Apportionable income
Income apportioned to State A

=

60.00%

60.00%
× $300,000
$180,000

Examples 10 and 11
43.

Item

A Sales

B Sales

Ordinary sales
Checking account interest
Rental income, business
U.S. Treasury bill interest
Occasional sales, nonbusiness
Royalty income
Sales factor numerator

$300,000

$500,000
5,000

40,000
–0–
–0–
$340,000

–0–
–0–
90,000
$595,000

pp. 16-15, 16-16, and Example 12
44.

The E throwback rule places in the E sales factor any sales to customers in G and to the U.S.
government.
E sales factor = $210 million*/$250 million
F sales factor = $40 million/$250 million
Total of sales factors

=
=

84%
16%
100%

*$75 million (E) + $100 million (G) + $35 million (U.S. government).
This arrangement calls for better tax planning, in that shipping from E keeps the total of the
sales factors at 100%, whereas it appears that the throwback sales should be in the sales factor
numerator of no state. Shipments should be made from a non-throwback state, like F.
p. 16-16 and Example 13
45.

G payroll factor $200,000/$1,200,000

H payroll factor $400,000/$700,000
I payroll factor $600,000/$1,200,000
Total of payroll factors

=
=
=

16.67%
57.14%
50.00%
123.81%

This arrangement calls for better tax planning, in that placing the officers’ salaries in I
increases the total of the payroll factors far above 100%. The salaries for the executives
should be sourced to H.

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Multistate Corporate Taxation

16-21

p. 16-17 and Example 14
46.

The State U payroll factor includes $725,000 for Judy. An employee’s includible

compensation generally is assigned to one state, specifically, the state in which she or he
performs services for the employer. If such services are performed in several states, the
compensation is assigned to the state in which she or he has a base of operations. pp. 16-17 to
16-19

47.

Because of the differences in the G and H payroll factors, Justin’s aggregate factors do not
equal 100%.
Justine’s State G payroll factor is determined as follows.
($500,000 + $200,000 + $200,000)
($700,000 + $270,000 + $250,000)

=

$900,000
$1,220,000

= 73.77%

Justine’s State H payroll factor is determined as follows.
[$200,000 + 70%($70,000)]
$249,000
[$700,000 + 70%($70,000) + $200,000] = $949,000 = 26.24%
pp. 16-17 to 16-19 and Examples 16 to 18
48.

Under the statutes of States A and B, accumulated depreciation and nonbusiness property (i.e.,
rental property) are not taken into consideration in computing the property factor.
Average Property in A

Inventory
Plant and equipment
Land
Total

Beg. of yr.
$ 300,000
2,500,000
600,000

End of yr.
$ 400,000
2,500,000
600,000

Total
$ 700,000
5,000,000
1,200,000

Average
$ 350,000
2,500,000
600,000
$3,450,000

Beg. of yr.
$ 200,000
1,500,000
1,000,000

End of yr.
$ 150,000
1,200,000
1,200,000

Total
$ 350,000
2,700,000
2,200,000

Average
$ 175,000
1,350,000
1,100,000
$2,625,000

Average Property in B
Inventory
Plant and equipment
Land
Total
Property Factor for A
$3,450,000 (In-state property)
$6,075,000 (Total property $3,450,000 + $2,625,000)

= 56.79%

Property Factor for B
$2,625,000 (In-state property)

$6,075,000 (Total property $3,450,000 + $2,625,000)

= 43.21%

pp. 16-19 to 16-21 and Example 19

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16-22
49.

2012 Corporations Volume/Solutions Manual
Under the statutes of A and B, accumulated depreciation is not taken into consideration in
computing the property factor. Nonbusiness property (i.e., rental property) is excluded from
the property factor of A, but is included in determining the property factor for B.
HISTORICAL COST—EXCLUDING NONBUSINESS PROPERTY
Property factor for A, as in problem 48

56.79%

HISTORICAL COST—INCLUDING NONBUSINESS PROPERTY
Average Property in A
Inventory
Plant and equipment
Land
Rental property
Total

Beg. of yr.
$ 300,000
2,500,000
600,000
900,000

End of yr.
$ 400,000
2,500,000
600,000
950,000

Total
$ 700,000
5,000,000
1,200,000
1,850,000

Average
$ 350,000
2,500,000
600,000
925,000
$4,375,000

Beg. of yr.
$ 200,000
1,500,000
1,000,000

300,000

End of yr.
$ 150,000
1,200,000
1,200,000
300,000

Total
$ 350,000
2,700,000
2,200,000
600,000

Average
$ 175,000
1,350,000
1,100,000
300,000
$2,925,000

Average Property in B
Inventory
Plant and equipment
Land
Rental property
Total
Property Factor for B
$2,925,000 (In-state property)
$7,300,000 (Total property $4,375,000 + $2,925,000)

= 40.07%

Example 19
50.

Annual Method
Average X property [($1.5 million + $700,000)/2] = $1.1 million
Average total property [($3 million + $2.5 million)/2] = $2.75 million = X property factor
(1.1/2.75) = 0.40
Monthly Method
11

$1.5 million
$3.0 million

+
12

$0.7 million
$2.5 million

= 0.481 property factor

The late disposal of the X facility is reflected much more favorably in that state’s property
factor when the annual method is used.
p. 16-20

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Multistate Corporate Taxation
51.

a.

16-23

State A Income Tax
Total apportionable income ($1,000,000 – NOL $400,000)

$600,000

Apportionment formula
Sales
$2,500,000/$6,500,000 =
Property $1,000,000/$3,500,000 =
Payroll
$500,000/$2,000,000
=
Total
State A apportionment factor (92.03%/3)
Taxable income apportioned to State A
State A tax rate
State A tax liability, if unitary

38.46%
28.57%

25.00%
92.03%

× 30.68%
$184,060
× 8.00%
$ 14,725

State B Income Tax
Total apportionable income ($1,000,000 – NOL $400,000)

$600,000

Apportionment formula
Sales
$4,000,000/$6,500,000 =
Property
$2,500,000/$3,500,000 =
Payroll
$1,500,000/$2,000,000 =
Total
State B Apportionment Factor (207.97%/3)
Taxable income apportioned to State B

61.54%
71.43%
75.00%
207.97%

State B tax liability, if unitary

× 69.32%
$415,940
× 11.00%
$ 45,753

State A tax liability
State B tax liability
Overall state tax liability, if unitary

$ 14,725
45,753
$ 60,478

b.

True Corporation, State A ($0 × 8%)
Trumaine Corporation, State B ($1,000,000 × 11%)
Aggregate state income tax, if nonunitary

$
–0–
110,000
$110,000

c.

OFFICIAL CORRESPONDENCE
November 3, 2011
To:

Board of Directors
Trumaine Corporation
1234 Mulberry Lane
Chartown, AL 35298

From: Alison Brown, CPA, MST
Re:

Unitary treatment of operations of the True and Trumaine Corporations

Some states apply a so-called unitary approach in computing the income tax liabilities
of corporations doing business within its borders. When the unitary theory is in effect,
operating income and losses, and indicators of the level of in-state business activities
are computed taking into account all of the other entities related to the corporation.

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16-24

2012 Corporations Volume/Solutions Manual
Unitary computations are favorable to a taxpayer when related corporations generate
operating losses or generally are less profitable than the taxpayer. When more
profitable entities enter the mix, state tax liabilities tend to increase. Similarly, if a
unitary group can shift taxable income into low- and no-tax states, the overall tax
liability of the group declines.
Related corporations generally are found to constitute a unitary group where their

ownership, operations, and corporate decision-making are interrelated.
I have determined that, if True and Trumaine are found to be a unitary group, the
combined A and B income tax liability for the group will be cut almost $50,000 (i.e.,
from $110,000 to about $60,000). This happens essentially because of our ability to
shift more taxable income into A, a lower tax rate state, and to use the True operating
loss to shelter the net taxable income of Trumaine.
I recommend that we undertake to establish and document our position that True and
Trumaine constitute a unitary group, and to inform the A and B revenue departments
of that fact as soon as possible.
pp. 16-21 to 16-24 and Examples 24 and 25

52.

Because of the water’s edge election, the sales to the Despina customers are not included in
either state’s sales factor.
Sales
B
Q

Entity

Sales Factor

Chang
Unitary group

$20 million/$80 million = 25.00%
$80 million/$100 million = 80.00%

pp. 16-22, 16-23, Concept Summary 16.1, and Global Tax Issue on p. 16-24

53.

MEMORANDUM
November 3, 2011
To:

Shareholders of Hernandez Corporation
5678 Alabaster Circle
Koopville, KY 47697

From: Dustin Greene, CPA, MST
Re:

Tax liability of the corporation this year

We elected so-called S corporation status at the Federal level long ago. This election
eliminates the exposure of corporate income to double taxation—the corporate level tax is
zero, but all of the taxable income for the year passes through to the shareholders
proportionately and is taxed to them immediately.
Not all of the states recognize the S election in computing corporate and individual income
taxes. In our case, one of the states in which we do business (Z) taxes Hernandez as a regular
or ‘‘C’’ corporation, while our other state (Y) applies the S election for its purposes. This
makes our tax computation more complicated—corporate taxable income must be computed
in the aggregate and then apportioned among the states, based on the sales, property, and
payroll activities in each. Here is a summary of my determinations of Hernandez’s tax
liabilities for this year.
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Multistate Corporate Taxation

16-25

State Y
Since Y recognizes S corporation status, Hernandez is not subject to tax on any of its income
in that state. The income of the corporation is passed through to the shareholders; such
income then is subject to tax at the shareholder level.
State Z
Since Z does not recognize S corporation status, Hernandez is subject to tax in the same
manner as a C corporation. Hernandez’s taxable income before apportionment, determined as
though it were a regular corporation, is $518,000. By applying the Z apportionment formula
to this amount, Hernandez is subject to a corporate level tax on $140,067.
Income determined as though it were a C corporation
Ordinary business income
Taxable interest income
Capital loss
Dividend income
Income before dividends received deduction
Dividends received deduction ($40,000 × 80%)
Taxable income

$500,000
10,000
(–0–)*
40,000
$550,000
(32,000)
$518,000

*C corporations can offset capital losses only against capital gains.
Z Taxable Income
Sales
$800,000/$1,800,000
Property
$100,000/$600,000
Payroll
$200,000/$1,000,000
Total
Average (81.11%/3)
Taxable income
Z apportionment percentage
Z taxable income

=
=
=

44.44%
16.67%
20.00%
81.11%
27.04%

$518,000
× 27.04%
$140,067

pp. 16-25, 16-26, and Example 26

54.

Businesses are merely the collection agents for the states with regard to the sales tax. Thus,
Grande must collect and remit, to the state, tax on the $1,100,000 general sales transactions.
Medical devices and out-of-state sales are exempt from this collection requirement, although
use tax might be due on the mail-order sales. On the goods Grande purchased from its
supplier, neither party need collect and remit the tax. A resale exemption applies in virtually
all states, so that only the ultimate consumers of the goods—here, Grande’s customers—pay
tax on the transaction. pp. 16-27 and 16-28

55.

a.

9% sales tax rate × $60,000 office supplies = $5,400.
Granite is the final consumer of the office supplies, so it must pay the sales tax on
such materials to the vendors from whom purchases are made. Other supplies and
tools used in the assembly process to create the computer systems are exempt from
tax, in anticipation of the subsequent resale of the systems. The final consumers of
those systems are liable for the tax thereon.

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