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Income Taxation by American States and Cities  
     
  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.

     
   
     
 

This trend affects many taxpayers that for business or tax planning reasons established affiliates to hold trademarks or to make loans to other members of the affiliated group. Other adjustments may reflect the states’ refusal to participate in federal tax policy initiatives, such as the recent refusal by most states to accept the bonus depreciation provided by federal tax law. Obviously, denial of these deductions reduces the profitability of an Israeli business’s American operations. However, in appropriate circumstances state tax planning can protect some of the deductions.

Taxable Income Must Be Divided Among the States
Each state is permitted to tax only that portion of a business’s income that is earned within the state. There are, however, many different approaches used by the states to apportion income. Some formulae look at the business’s property, payroll and receipts within the state as compared to its property, payroll and receipts everywhere, while other look only to a ratio of the business’s receipts in the state as compared to everywhere. Whatever the formula used, each of the apportionment factors present interpretive issues and opportunities for tax planning.

 
     
   
     

The differences in the states’ apportionment formulae can mean that more than 100% of a business’s income is taxed (that is, some income is “double taxed”) or that less than 100% of the income is taxed, with all such results being legitimate under United States Constitutional law. There are many opportunities here for tax planning.

Conclusion
This Alert provides an introduction to American state and local income taxes. For further information and assistance with state and local tax issues anywhere in the United States, please contact David A. Fruchtman at 04-629-0520 or 312-281-1111.

 

 
 

Previous issues of the State Tax Alert Newsletter are available at:
www.statetaxalert.us/archive

 
  *David A. Fruchtman is an attorney in the United States. He is not admitted to the Israeli Bar. He is Of Counsel to Horwood Marcus & Berk Chartered, located at 180 N. LaSalle Street, Suite 3700, Chicago, Illinois 60601. He is a Harvard Law School graduate and is chairman of the American Bar Association’s Income and Franchise Taxes subcommittee. He has been named by his peers as one of Chicago’s Leading Tax Lawyers. Horwood Marcus & Berk Chartered has one of the largest state and local tax law practices in the United States. The firm provides tax planning advice to clients of all sizes and has successfully represented clients before courts and administrative tribunals throughout the country, including at the United States Supreme Court.