|Almost every state and some large cities impose taxes on income earned
within their borders. These taxes are potentially imposed on every type of
business entity, including types of entities generally not subject to federal
income taxation such as S corporations, partnerships, disregarded single
member limited liability companies and foreign trusts. In addition, business
activities can cause an entity to be subject to state and local income
taxation even if the activities do not cause the business to be subject to
federal income taxation. Potentially affected businesses include those that
do not have a “permanent establishment” in the United States and those
that are otherwise protected from federal income taxation by a tax treaty.
In addition, the states have been aggressive in asserting tax jurisdiction over
companies whose trademark, copyright, patent or other intellectual property
appeared in or was used in the state. As a result, state tax planning with
intellectual property companies has become increasingly difficult.
Structuring successful arrangements requires increased attention to the
drafting of licensing agreements and to the inclusion of economic substance
and business purpose in the company holding the intellectual property, and,
as always, attention to implementation.
Computation Begins With Federal Taxable Income
In general, a business’s federal taxable income is the starting point in
determining its state and local taxable income. However, state tax policy
priorities sometimes result in adjustments to the federal figure. For
example, there is a trend among the states to deny deductions for royalties
and interest paid to affiliates that are not subject to the state’s income tax.