Recent Massachusetts legislative changes have dramatically altered the landscape for businesses operating in Massachusetts. The principal legislation is an Act called "An Act Relative to Tax Fairness and Business Competitiveness." Whether it in fact promotes tax fairness and business competitiveness remains to be seen, but virtually every business operating in Massachusetts will have to take these changes into account and consider how it wishes to deal with the new landscape. The changes are conceptually simple but far reaching in their ramifications. The new rules will require planning before the January 1, 2009 effective date for many businesses. There are five principal changes: combined reporting, reporting conformity based on federal status, future corporate tax reductions, nonincome excise tax on corporations with limited Massachusetts contacts and withholding on non-residents. Collectively, the changes are revolutionary, and the importance of these changes should not be underestimated.
Combined reporting for multistate corporate filers
Under the current separate company reporting structure each corporation is required to pay tax on its Massachusetts income and file a tax return that includes only the separately-determined income and apportionment factors of that corporation. In combined reporting, each taxpayer member is responsible for tax based on its apportioned share of the business income of the combined group, together with that member's own allocated (non-business) income and its apportioned share of other business income, including business income from any other combined group of which the taxpayer is a member. This change will in many instances increase the amount of income which is subject to Massachusetts tax. Many corporate groups structure intragroup transactions so as to leave income in low or no-tax jurisdictions. Some of this income may be taxed in Massachusetts, and if there is no credit for the tax paid to the other jurisdiction, this would result in income which is taxed twice at the state level.
This general description does not begin to show the complexities of the new rules. For example, visualize an out of state holding company parent with separate subsidiaries for each state in which it operates, including some subsidiaries which sell goods or provide services to other subsidiaries or hold money or property for the subsidiaries, or a similar group without a common parent but with substantially identical ownership.
Under the new rules the taxable Massachusetts income of a member operating in Massachusetts will be an apportioned share of the income of the group rather than an apportioned share of the member's income. Income not taxed by Massachusetts as a result of intragroup pricing of goods and services may now be taxed. The group is defined as a "unitary business" under common control. If the common parent has two or more subsidiary chains which are engaged in totally separate businesses, each chain would be separate for this purpose. The group can include S corporations, C corporations and partnerships. Ownership of 50% of the vote is common control for this purpose except that a partner is treated as engaged in the partnership business however small the interest. There is a "water's edge" limitation which will generally exclude foreign operations conducted by foreign corporations from the group unless a worldwide election is made. Similarly an affiliated group for federal income tax operating two or more separate businesses can elect to be treated as one business for Massachusetts tax purposes. This may be advantageous if losses in one group can be used to offset profits in the other.
The implications of this provision are likely to affect many corporate groups and businesses should work with their attorneys, accountants and other business advisors to assess its likely impact before it comes into effect on January 1, 2009 since it may be necessary to reorganize entities. This provision does not just affect large businesses operating in many states, but may also affect smaller businesses which separate activities between corporate and noncorporate entities. Two examples illustrate the problem:
(1) A real estate partnership leases a building to an S corporation owned by the partners. The corporation pays a very generous rent which reduces its S corporation sting tax. The Internal Revenue Service (IRS) is unlikely to challenge the rent since there is no federal tax effect, but Massachusetts now has an incentive to challenge the rent.
(2) A Massachusetts S corporation conducts a business using goods imported from a foreign federally disregarded entity owned by a brother/sister S corporation incorporated in another state. In this case the IRS may have little incentive (other than foreign tax credit issues) to challenge the pricing since foreign profits will be taxed to the shareholders whether earned by the foreign entity or the Massachusetts entity. Massachusetts may embrace the opportunity to impose a sting tax on a portion of the foreign profit and the water's edge limitation will not provide a shield.
Very large businesses with activities in many states may have service entities in low tax states which previously reduced profits taxed in Massachusetts. Many business activities have little physical presence except at the point of sale where there may be a more substantial physical presence. Combined reporting may have a substantial effect on these businesses.
Combined reporting is the norm in about 20 states and will not shock multistate companies. In fact, this provision may promote business activity in Massachusetts if the rate reductions discussed below come into effect. The rate reductions will make Massachusetts a lower tax state; combined reporting will bring profits previously parked in low tax states into the Massachusetts net; and this may encourage businesses to bring the service entities and facilities into Massachusetts. The planning for these actions should start now.
Conformity with federal business entity classification (check-thebox) rules
Currently, Massachusetts business trusts and LLPs which elect corporate status for federal income tax purposes file tax returns as corporate trusts, sole proprietorships or partnerships. This was advantageous for these entities if they were federal S corporations because it avoided the so-called sting tax imposed on regular S corporations and QSUBs with gross receipts in excess of $6,000,000. In the case of Massachusetts business trusts this enabled their shareholders to reduce or eliminate their exposure to alternative minimum tax liability and get the benefit of replacing a deduction for state tax, (which provided little federal tax benefit) with an exclusion of the state tax with a full federal tax benefit. Under the new rules all federal corporate entities will be taxed in Massachusetts under the S corporation "sting tax" regime if classified as S corporations federally, C corporations if classified as C corporations federally, or as disregarded entities (QSUBS and single member corporate owned LLCs). This relatively simple provision is likely to change the preferred organizational structures for many businesses.
In most cases Massachusetts business trusts should consider converting to the regular corporate form. There will be no Massachusetts advantage to the use of a Massachusetts business trust which is a corporation federally. Those Massachusetts business trusts which are partnerships or disregarded entities federally will no longer have an alternative minimum tax advantage since they will be taxed in Massachusetts as partnerships or sole proprietorships.
There are some benefits to this change which may offset the sting tax cost. Whether the Massachusetts business trust is an S corporation or has a noncorporate federal classification, owners will be able to net Massachusetts profits and losses; non-Massachusetts resident owners will be able to use credits for Massachusetts tax more efficiently; and Massachusetts business trusts will be able to obtain the benefit of some local property tax exemptions.
There is no Massachusetts tax advantage to Massachusetts business trust/QSUB groups after December 31, 2009, and in most cases these should be simplified by merging the Massachusetts business trust into the QSUB on or after January 1, 2009. Similarly, LLPs and similar noncorporate entities which are classified federally as corporations should consider whether to reorganize on or after January 1, 2009.
It is hard to fault this provision in tax policy terms since it levels the playing field for different types of entities by reducing the Massachusetts tax regime applied to business entities to three: C corporation, S corporation and noncorporate. This promotes both fairness and competitiveness by enabling businesses to organize based on non-tax considerations taking into account factors such as governance, limitation of liability and ability to raise capital. The opportunities for tax planning will still be there, but they will be different.
Corporate excise rate reductions
The current tax rate of 9.5% is scheduled to be reduced for tax years beginning in 2010 to 8.75%, for tax years beginning in 2011 to 8.25% and for tax years beginning after 2011 to 8%.
Sting tax rates will be correspondingly reduced. Since these rate reductions are in future years budgetary considerations may delay or eliminate these reductions. The planning issue is whether to rely on these scheduled reductions. If rate reductions, combined reporting, entity simplification measures, withholding and the imposition of the non-income tax on limited contact entities result in enhanced Massachusetts revenues, the rate reductions will be self-funding and the policies of fairness and competitiveness intended by these changes will be a self-fulfilling prophecy.
Non-income measure and minimum excise imposed on corporations protected by federal law
Federal law provides that no state has the power to impose a net income tax on the income derived within the state from interstate commerce if the only business activities within the state during a tax year are limited to the solicitation of orders for sales of tangible personal property and (i) orders are sent outside the state for approval or rejection, and (ii) if approved, the orders are filled by shipment or delivery from a point outside the state. The new rules subject corporations otherwise protected by this law to the greater of the non-income (property or net worth) excise tax or the minimum excise tax of $456. This provision may give the Department of Revenue the opportunity to scrutinize the activities of companies which previously were exempt and seek to bring them under the income measure of excise. Assuming broad compliance with this provision by previously nonfiling entities, the Department of Revenue may use this as an audit device to test for liability for the excise tax on income. Businesses which fail to comply with provision may find themselves vulnerable for years of taxes since no statute of limitations will apply. The problem may be compounded for companies whose initial very limited activities do not require filing (internet sales for example), but which gradually expand to impose liability under this provision and eventually expand to impose both income and non-income liability. Businesses which have been relying on federal law to avoid Massachusetts filings should take a hard look at their Massachusetts contacts to determine whether they should have been filing and if it makes sense to maintain such minimal contacts or to reduce their Massachusetts contacts. This should be done before January 1, 2009.
Withholding on non-residents
Withholding was authorized in the most recent Massachusetts budget and regulations will impose withholding requirements on partnerships and S corporations with non-resident members and shareholders. This is scheduled to come into effect starting in 2009. The entity withholding provisions will pose difficulties for some entities which will have to pay taxes even if the income base for the withholding is noncash or phantom income. Withholding will be required even if the entity was not planning to distribute dividends or similar distributions generally and may pose problems if loan agreements and other restrictions on distributions apply. Withholding is a distribution to the nonresident owners which is likely to require matching distributions to resident owners. The new rules contain many exemptions which reduce its fiscal impact, but increase compliance costs.
Similar withholding regulations are expected to be issued in regard to sales of real estate by non-residents. Real estate withholding will add another agenda item to real estate closings; sellers will have the burden of claiming general exemptions, exempting loss transactions and obtaining a lesser withholding rate based on actual gain. Sellers will have to prove that they are exempt or subject to a reduced rate to avoid full withholding.
As burdensome as withholding may be, it is justified in tax policy terms because it is difficult for the Commonwealth to collect small tax amounts from the numerous non-residents who have Massachusetts source income. Provisions such as these are common in many states, and the enhanced revenues may make the corporate tax rate reductions possible.
One or more of the new corporate provisions will affect Massachusetts businesses except those with no non- Massachusetts activities, no affiliates and no non-resident owners. In many instances no adjustments will be required. In other cases substantial adjustments will be needed and an early consultation with lawyers, accountants and other tax and financial advisors is in order. These changes are revolutionary in scope in terms of Massachusetts business tax policy and likely to be beneficial. Perhaps, similar changes may occur in terms of individual income tax and property tax policy.